Case 4.1: Enron
Corporation and Andersen, LLP: Analyzing the Fall of Two Giants*
*The case
was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of
North Carolina State University and Steven M. Glover, Ph.D. and Douglas
F. Prawitt, Ph.D. of Brigham Young University, as a basis for class
discussion. It is not intended to illustrate either effective or
ineffective handling of an administrative
situation.
Mark
S. Beasley, Frank A. Buckless, Steven M. Glover, Douglas F. Prawitt
Learning Objectives
After completing and discussing this case, you should be able to
- Understand the events leading to Enron’s bankruptcy and Andersen’s
downfall
- Appreciate the importance of understanding an audit client’s core
business strategies
- Recognize potential conflicts arising from auditor relationships
with their clients
- Understand how accounting standards may have contributed to the
Enron debacle and describe how the accounting profession is seeking to
change the fundamental nature of those standards
- Consider challenges facing the accounting profession and evaluate
alternative courses of action for overcoming these obstacles
Introduction
Enron
Corporation entered 2001 as the seventh largest public company in the
United States only to later exit the year as the largest company to ever
declare bankruptcy in U.S history. Although investigations into the
company’s demise will likely continue for years, reasons for Enron’s
collapse are already becoming clear. Investors who lost millions and
lawmakers seeking to prevent similar reoccurrences are stunned by these
unbelievable events. The following testimony of Rep. Richard H. Baker,
chair of the House Capital Markets Subcommittee, exemplifies these
feelings:
We are here today to examine and begin the process of
understanding the most stunning business reversal in recent history. One
moment an international corporation with a diversified portfolio
enjoying incredible run-up of stock prices, the darling of financial
press and analysts, which, by the way, contributed to the view that
Enron had indeed become the new model for business of the future,
indeed, a new paradigm. One edition of Fortune magazine called it the
best place in America for an employee to work. Analysts gave
increasingly creative praise, while stock prices soared.... Now in
retrospect, it is clear, at least to me, that while Enron executives
were having fun, it actually became a very large hedge fund, which just
happened to own a power company. While that in itself does not warrant
criticism, it was the extraordinary risk taking by powerful executives
which rarely added value but simply accelerated the cash burn-off rate.
Executives having Enron fun are apparently very costly and, all the
while, they were aggressive in the exercise of their own [Enron] stock
options, flipping acquisitions for quick sale. One executive sold a
total of $353 million in the 3-year period preceding the failure. What
did he know? When did he know it? And why didn’t we? 1
Although company
executives may have been involved in questionable business practices even
bordering on fraud, Enron’s failure was ultimately due to a collapse of
investor, customer, and trading partner confidence. In the boom years of
the late 1990’s, Enron entered into a number of aggressive transactions
involving “special purpose entities” (SPE’s) for which the underlying
accounting was questionable. Some of these transactions essentially
involved Enron receiving borrowed funds that were made to look like
revenues, without recording liabilities on the company’s balance sheet.
The “loans” were guaranteed with Enron stock, trading at over $100 per
share at the time. The company found itself in real trouble when,
simultaneously, these transaction deals went sour and Enron’s stock price
plummeted. Debtholders began to recall the loans due to Enron’s diminished
stock price, and the company found its accounting positions increasingly
problematic to maintain. Then, the August 2001 resignation of Enron’s
chief executive officer (CEO), Jeffrey Skilling, only six months after
beginning his “dream job” further fueled Wall Street skepticism and
scrutiny over company operations. Shortly thereafter, The Wall Street
Journal’s “Heard on the Street” column of August 28, 2001 drew further
attention to the company, igniting a public firestorm of controversy that
quickly led to the company’s loss of reputation and trust. The subsequent
loss of confidence by trading partners and customers quickly dried up
Enron’s trading volume, and the company found itself facing a liquidity
crisis by late 2001.
Jeffrey Skilling,
former CEO, summed it up this way when he testified before the House
Energy Commerce Committee on February 7, 2002:
It is my belief that Enron’s failure was due to a classic ‘run on
the bank:’ a liquidity crisis spurred by a lack of confidence in the
company. At the time of Enron’s collapse, the company was solvent and
highly profitable - but, apparently, not liquid enough. That is my view
of the principal cause of its failure.2
Public disclosure of
diminishing liquidity and questionable management decisions and practices
destroyed the trust Enron had established within the business community.
This caused hundreds of trading partners, clients, and suppliers to halt
doing business with the company—ultimately leading to its downfall.
Enron’s collapse,
along with events related to the audits of Enron’s financial statements,
caused a similar loss of reputation, trust, and confidence in Big-5
accounting firm, Andersen, LLP. Enron’s collapse and the associated
revelations of alleged aggressive and inappropriate accounting practices
caused major damage for this international firm. But, news about charges
of inappropriate destruction of documents at the Andersen office in
Houston, which was in charge of the Enron audit, and the subsequent
unprecedented federal indictment was the kiss of death for this former
Big-5 accounting firm. As with Enron, Andersen’s clients quickly lost
confidence, and by June 2002, more than 400 of its largest clients had
fired the firm as their auditor, leading to the sale or desertion of
various pieces of Andersen’s U.S. and international practices. On June
15th, a federal Houston jury convicted Andersen on one felony
count of obstructing the SEC’s investigation into Enron’s collapse.
Although the Supreme Court overturned the decision in May of 2005, it was
too late for Andersen. Soon after the June 15th verdict,
Andersen announced it would cease auditing publicly owned clients by
August 31, 2002. Thus like Enron, in an astonishingly short period of
time, Andersen went from being one of the world’s largest and most
respected professional services firms, to an embattled, shriveled shadow
of its former self.
Despite inclusion in
the Fortune 500, few people outside of Texas had heard of Enron prior to
its fall and the subsequent Congressional investigation. However, because
of the Congressional hearings and intense media coverage, along with the
tremendous impact the company’s collapse has had on the corporate
community and accounting profession, the name “Enron” will reverberate for
many years to come. Here is a brief analysis of the complex fall of these
two giants.
Enron in the
Beginning
Enron
Corporation, based in Houston, Texas, was formed as the result of the July
1985 merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In
its early years, Enron was a natural gas pipeline company whose primary
business strategy involved entering into contracts to deliver specified
amounts of natural gas to businesses or utilities over a given period of
time. In 1989, Enron began trading natural gas commodities. After the
deregulation of the electrical power markets in the early 1990s—a change
for which senior Enron officials lobbied heavily—Enron swiftly evolved
from a conventional business that simply delivered energy into a “new
economy” business heavily involved in the brokerage of speculative energy
futures. Enron acted as an intermediary by entering into contracts with
buyers and sellers of energy, profiting on the price difference. Enron
began marketing electricity in the U.S. in 1994, and entered the European
energy market in 1995.
In
1999, at the height of the Internet boom, Enron furthered its
transformation into a “new economy” company by launching EnronOnline, a
Web-based commodity trading site. Enron also broadened its technological
reach by entering the business of buying and selling access to high-speed
Internet bandwidth. At its peak, Enron owned a stake in nearly 30,000
miles of gas pipelines, owned or had access to a 15,000-mile fiber optic
network, and had a stake in several electricity-generating operations
around the world. In 2000, the company reported gross revenues of $101
billion.
Enron continued to
expand its business into extremely complex ventures by offering a wide
variety of financial hedges and contracts to customers. These financial
instruments were designed to protect customers against a variety of risks,
including events such as changes in interest rates and changes in weather.
The volume of transactions involving these “new economy” type instruments
grew rapidly and actually surpassed the volume of traditional contracts
involving delivery of physical commodities (such as natural gas) to
customers. To ensure that Enron managed the risks related to these “new
economy” instruments, the company hired a large number of employees who
were experts in the fields of mathematics, physics, meteorology, and
economics.3
Within a year of its
launch, EnronOnline was handling more than $1 billion in transactions
daily. The web site was much more than a place for buyers and sellers of
various commodities to meet. Internetweek reported that, “It was
the market, a place where everyone in the gas and power industries
gathered pricing data for virtually every deal they made, regardless of
whether they executed them on the site.”4 The site’s success
depended on cutting-edge technology and more importantly on the trust the
company developed with its customers and partners who expected Enron to
follow through on its price and delivery promises.
When
the company’s accounting shenanigans were brought to light, customers,
investors, and other partners ceased trading through the energy giant when
they lost confidence in Enron’s ability to fulfill its obligations and act
with integrity in the marketplace.5
Enron’s
Collapse
On
August 14, 2001, Kenneth Lay was reinstated as Enron’s CEO after Jeffrey
Skilling resigned for “purely personal” reasons after having only served
for a six-month period as CEO. Skilling joined Enron in 1990 after leading
McKinsey & Company’s energy and chemical consulting practice and
became Enron’s president and chief operating officer in 1996. Skilling was
appointed CEO in early 2001 to replace Lay, who had served as chairman and
CEO since 1986.6
Skilling’s
resignation would prove to be the beginning of Enron’s collapse. The day
after Skilling resigned, Enron vice president of corporate development,
Sherron Watkins, sent an anonymous letter to Kenneth Lay (see Exhibit 1). In the letter,
she detailed her fears that Enron “might implode in a wave of accounting
scandals.” The letter later branded her as a loyal employee trying to save
the company through her whistle-blowing efforts.
Exhibit 1 Sherron Watkins Letter to Enron CEO,
Kenneth Lay
(1st
page only)
Dear
Mr. Lay,
Has
Enron become a risky place to work? For those of us who didn’t get rich
over the last few years, can we afford to stay?
Skilling’s abrupt
departure will raise suspicions of accounting improprieties and valuation
issues. Enron has been very aggressive in its accounting - most notably
the Raptor transactions and the Condor vehicle. We do have valuation
issues with our international assets and possibly some of our EES MTM
positions.
The
spotlight will be on us, the market just can’t accept that Skilling is
leaving his dream job. I think that the valuation issues can be fixed and
reported with other goodwill write-downs to occur in 2002. How do we fix
the Raptor and Condor deals? They unwind in 2002 and 2003, we will have to
pony up Enron stock and that won’t go unnoticed.
To
the layman on the street, it will look like we recognized funds flow of
$800 mm from merchant asset sales in 1999 by selling to a vehicle (Condor)
that we capitalized with a promise of Enron stock in later years. Is that
really funds flow or is it cash from equity issuance?
We
have recognized over $550 million of fair value gains on stocks via our
swaps with Raptor, much of that stock has declined significantly - Avici
by 98%, from $178 mm to $5 mm, The New Power Co by 70%, from $20/share to
$6/share. The value in the swaps won’t be there for Raptor, so once again
Enron will issue stock to offset these losses. Raptor is an LJM entity. It
sure looks to the layman on the street that we are hiding losses in a
related company and will compensate that company with Enron stock in the
future.
I am
incredibly nervous that we will implode in a wave of accounting scandals.
My 8 years of Enron work history will be worth nothing on my resume, the
business world will consider the past successes as nothing but an
elaborate accounting hoax. Skilling is resigning now for ‘personal
reasons’ but I think he wasn’t having fun, looked down the road and knew
this stuff was unfixable and would rather abandon ship now than resign in
shame in 2 years.
Is
there a way our accounting guru’s can unwind these deals now? I have
thought and thought about how to do this, but I keep bumping into one big
problem - we booked the Condor and Raptor deals in 1999 and 2000, we
enjoyed a wonderfully high stock price, many executives sold stock, we
then try and reverse or fix the deals in 2001 and it’s a bit like robbing
the bank in one year and trying to pay it back 2 years later. Nice try,
but investors were hurt, they bought at $70 and $80/share looking for
$120/share and now they’re at $38 or worse. We are under too much scrutiny
and there are probably one or two disgruntled ‘redeployed’ employees who
know enough about the ‘funny’ accounting to get us in trouble.
What
do we do? I know this question cannot be addressed in the all employee
meeting, but can you give some assurances that you and Causey will sit
down and take a good hard objective look at what is going to happen to
Condor and Raptor in 2002 and 2003?
Watkins, Sherron.
Letter to Kenneth Lay, CEO. 15 Aug. 2001
Two
months later, Enron reported a 2001 third quarter loss of $618 million and
a reduction of $1.2 billion in shareholder’s equity related to
partnerships run by chief financial officer (CFO), Andrew Fastow. Fastow
had created and managed numerous off-balance-sheet partnerships for Enron,
which also benefited him personally. In fact, during his tenure at Enron,
Fastow collected approximately $30 million in management fees from various
partnerships.
News
of the company’s third quarter losses resulted in a sharp decline in
Enron’s stock value. Lay even called U.S. Treasury Secretary, Paul
O’Neill, on October 28 to inform him of the company’s financial
difficulties. Those events were then followed by a November 8th
company announcement of even worse news—Enron had overstated earnings over
the previous four years by $586 million and owed up to $3 billion for
previously unreported obligations to various partnerships. That sent the
stock price further on its downward slide.
Despite these
developments, Lay continued to tell employees that Enron’s stock was
undervalued. Ironically, he was also allegedly selling portions of his own
stake in the company for millions of dollars. Lay was one of the few Enron
employees who managed to sell a significant portion of his stock before
the stock price collapsed completely. In August 2001, he sold 93,000
shares for a profit of over $2 million.
Sadly, most Enron
employees did not have the same chance to liquidate their Enron
investments. Most of the company employees’ personal 401(k) accounts
contained large amounts of Enron stock. When Enron changed 401(k)
administrators at the end of October 2001, employee retirement plans were
temporarily frozen. Unfortunately, the November 8th
announcement of prior period financial statement misstatements occurred
during the freeze, paralyzing company employee 401(k) options. When
employees were finally allowed access to their plans, the stock had fallen
below $10 per share from earlier highs exceeding $100 per share.
Corporate “white
knights” appeared shortly thereafter spurring hopes of a rescue. Dynegy
Inc. and ChevronTexaco Corp. (a major Dynegy shareholder) almost spared
Enron from bankruptcy when they announced a tentative agreement to buy the
company for $8 billion in cash and stock. Unfortunately, Dynegy and
ChevronTexaco later withdrew their offer after Enron’s credit rating was
downgraded to “junk” status in late November. Enron tried unsuccessfully
to prevent the downgrade, and allegedly asked the Bush administration for
help in the process.
After Dynegy
formally rescinded its purchase offer, Enron filed for Chapter 11
bankruptcy on December 2, 2001. This announcement eventually forced the
company’s stock price to a low of $0.40 per share. On January 15, 2002,
the New York Stock Exchange suspended trading in Enron’s stock and began
the process to formally de-list it.
It
is important to understand that most of the earnings restatements may not
technically have been attributable to improper accounting treatment
in the periods since 1997. So, what made these enormous restatements
necessary? In the end, the decline in Enron’s stock price triggered
contractual obligations that were never reported on the balance sheet due
to “loopholes” in accounting standards that Enron exploited. An analysis
of the nuances of Enron’s partnership accounting provides some insight
into the unraveling of this corporate giant.
Unraveling the
“Special Purpose Entity” Web
The
term “special purpose entity” (SPE) has become synonymous with the Enron
collapse because these entities were at the center of Enron’s aggressive
business and accounting practices. SPE’s are separate legal entities set
up to accomplish specific company objectives. For example, SPE’s are often
created to help a company sell off assets. After identifying which assets
to sell to the SPE, the selling company secures an outside investment of
at least three percent of the value of the assets to be sold to the
SPE.7 The
company then transfers the identified assets to the SPE. The SPE pays for
the contributed assets through a new debt or equity issuance. The selling
company can then recognize the sale of the assets to the SPE and thereby
remove the assets and any related debts from its balance sheet. This is
all contingent on the outside investors bearing the risk of their
investment. In other words, the investors cannot finance their interest
through a note payable or other type of guarantee that may absolve them
from accepting responsibility if the SPE suffers losses or fails.8
While SPE’s are
commonplace in corporate America, they are controversial. Some argue that
SPE’s represent a “gaping loophole in accounting practice.”9 Tradition dictates
that once a company owns 50% or more of another, the company must
consolidate. However, as the following quote from Business Week
demonstrates, such is not the case with SPE’s:
The controversial exception that outsiders need invest only three
percent of an SPE’s capital for it to be independent and off the balance
sheet came about through fumbles by the Securities & Exchange
Commission and the Financial Accounting Standards Board. In 1990,
accounting firms asked the SEC to endorse the three percent rule that
had become a common, though unofficial, practice in the ’80s. The SEC
didn’t like the idea, but it didn’t stomp on it, either. It asked the
FASB to set tighter rules to force consolidation of entities that were
effectively controlled by companies. FASB drafted two overhauls of the
rules but never finished the job, and the SEC is still waiting.
10
While SPE’s can
serve legitimate business purposes, it is now apparent that Enron used an
intricate network of SPE’s, along with complicated speculations and
hedges—all couched in dense legal language—to keep an enormous amount of
debt off the company’s balance sheet. Enron had literally hundreds of
SPE’s. Through careful structuring of these SPE’s that took into account
the complex accounting rules governing the required financial statement
treatment of SPE’s (e.g., FAS 140), Enron was able to avoid consolidating
the SPE’s on its balance sheet. Three of the Enron SPE’s have been made
prominent throughout the congressional hearings and litigation
proceedings. These are widely known as “Chewco,” “LJM2,” and
“Whitewing.”
Chewco was
established in 1997 by Enron executives in connection with a complex
investment in another Enron partnership with interests in natural gas
pipelines. Enron’s CFO, Andrew Fastow, was charged with managing the
partnership. However, to prevent required disclosure of a potential
conflict of interest between Fastow’s roles at Enron and Chewco, Fastow
employed Michael Kopper, managing director of Enron Global Finance, to
“officially” manage Chewco. In connection with the Chewco partnership,
Fastow and Kopper appointed Fastow relatives to the board of directors of
the partnership. Then, in a set of complicated transactions, another layer
of partnerships was established to disguise Kopper’s invested interest in
Chewco. Kopper originally invested $125,000 in Chewco and was later paid
$10.5 million when Enron bought Chewco in March 2001.11 Surprisingly, Kopper
remained relatively unknown throughout the subsequent investigations. In
fact, Ken Lay told investigators that he did not know Kopper. Kopper was
able to continue in his management roles up until January 2002.12
The
LJM2 partnership was formed in October 1999 with the goal of acquiring
assets chiefly owned by Enron. Like Chewco, LJM2 was managed by Fastow and
Kopper. To assist with the technicalities of this partnership, LJM2
engaged the accounting firm, PricewaterhouseCoopers, LLP and the
Chicago-based law firm, Kirkland & Ellis, where Whitewater prosecutor
Kenneth Star serves as partner. Enron used the LJM2 partnership to
deconsolidate its less productive assets. Eventually, these actions
generated a 30 percent average annual return for the LJM2 limited-partner
investors.
The
Whitewing partnership, another significant SPE established by Enron,
engaged in purchasing an assortment of power plants, pipelines, and water
projects originally purchased by Enron in the mid-1990s that were located
in India, Turkey, Spain, and Latin America. The Whitewing partnership was
crucial to Enron’s move from being an energy provider to becoming a trader
of energy contracts. Whitewing was the vehicle through which Enron sold
its energy production assets.
In
creating this partnership, Enron quietly guaranteed investors in Whitewing
that if Whitewing’s assets (transferred from Enron) were sold at a loss,
Enron would compensate the investors with shares of Enron common stock.
This obligation—unknown to Enron’s shareholders—totaled $2 billion as of
November 2001. Part of the secret guarantee to Whitewing investors
surfaced in October 2001, when Enron’s credit rating was downgraded by
credit agencies. The credit downgrade triggered a requirement that Enron
immediately pay $690 million to Whitewing investors. When this obligation
surfaced, Enron’s talks with Dynegy to sell the company failed. Enron was
unable to delay the payment and was forced to disclose the problem,
stunning investors and fueling the fire that led to the company’s
bankruptcy filing on December 2, 2001.
In
addition to these partnerships, Enron created financial instruments called
“Raptors,” which were designed to reduce the risks associated with Enron’s
own investment portfolio and backed by Enron stock. In essence, the
Raptors covered potential losses on Enron investments as long as Enron’s
stock market price continued to do well. Enron also masked debt using
complex financial derivative transactions. Taking advantage of accounting
rules to account for large loans from Wall Street firms as financial
hedges, Enron hid $3.9 billion in debt from 1992 through 2001. At least
$2.5 billion of those transactions arose in the three years prior to the
Chapter 11 bankruptcy filing. These loans were in addition to the $8 to
$10 billion in long and short-term debt that Enron disclosed in its
financial reports in the three years leading up to its bankruptcy. Because
the loans were accounted for as a hedging activity, Enron was able to
explain away what looked like an increase in borrowings, (which would
raise red flags for creditors), as hedges for commodity trades, rather
than as new debt financing.13
The Complicity of
Accounting Standards
Limitations in
generally accepted accounting principles (GAAP) are at least partly to
blame for Enron executives’ ability to hide debt from the company’s
financial statements. These technical accounting standards lay out
specific “bright-line” rules that read much like the tax or criminal law
codes. Some observers of the profession argue that by attempting to
outline every accounting situation in detail, standard-setters are trying
to create a specific decision model for every imaginable situation.
However, very specific rules create an opportunity for clever lawyers,
investment bankers, and accountants to create entities and transactions
that circumvent the intent of the rules while still conforming to the
“letter of the law.”
In
his congressional testimony, Robert K. Herdman, SEC Chief Accountant,
discussed the difference between rule and principle-based accounting
standards:
Rule-based accounting standards provide extremely detailed rules
that attempt to contemplate virtually every application of the standard.
This encourages a check-the-box mentality to financial reporting that
eliminates judgments from the application of the reporting. Examples of
rule-based accounting guidance include the accounting for derivatives,
employee stock options, and leasing. And, of course, questions keep
coming. Rule-based standards make it more difficult for preparers and
auditors to step back and evaluate whether the overall impact is
consistent with the objectives of the standard.14
While the specifics
are still under investigation, in some cases it appears that Enron neither
abode by the spirit nor the letter of these accounting rules (for example,
by securing outside SPE investors against possible losses). It also
appears that the company’s lack of disclosure regarding Fastow’s
involvement in the SPE’s fell short of accounting rule compliance.
These “loopholes”
allowed Enron executives to hide many of the company’s liabilities from
the financial statements being audited by Andersen, LLP, as highlighted by
the Business Week article summarized in Exhibit 2. Given the alleged
abuse of the accounting rules, many are asking, “Where was Andersen, the
accounting firm that was to serve as Enron’s public ‘watchdog,’ while
Enron allegedly betrayed and misled its shareholders?”
Exhibit 2 The Enron/Andersen Tug-of-War
In
the memos that have poured out of federal investigations, the tug-of-war
between Arthur Andersen LLP and Enron Corp. is clear. Time after time,
Enron would seek creative accounting for some joint venture or
special-purpose entity. Some Andersen accountants would resist, arguing in
many cases that the deal didn’t serve any legitimate business purpose: “In
effect, nothing was accomplished in this transaction but a sale of future
revenues,” Andersen partner Carl E. Bass wrote in a Mar. 4, 2001,
e-mail.
But
the bottom line was always clear: If Andersen couldn’t show Enron a
specific rule prohibiting what it wanted to do, Enron would do it.
Now
the mandarins who write accounting rules want to change that dynamic. The
idea: slash the 100,000-plus pages of rules that define “generally
accepted accounting principles” in favor of broader, simpler statements of
what accountants are supposed to look for when they review, say, a lease
or a hedging transaction.
Advocates—led by
Securities & Exchange Commission Chairman Harvey L. Pitt—say a return
to simpler standards will paint a clearer picture for investors. The move
will allow auditors to focus on whether the bookkeeping for a deal makes
good business sense. It also will put the burden on corporate clients to
prove that their aggressive accounting meets the standards. “What we’ve
got now,” says Robert K. Herdman, the SEC’s chief accountant, “invites
Wall Street and others to create transactions that dot every ‘i’ and cross
every ’t,’ but violate the intent of the rules and fuzz up what’s really
going on.”
Source:
BusinessWeek, May 20, 2002, p. 123. Used with
permission.
The Role of
Andersen
It is
clear that investors and the public believe that Enron executives are not
the only parties responsible for the company’s collapse. Many fingers are
also pointing to Enron’s auditor, Andersen, LLP, which issued “clean”
audit opinions on Enron’s financial statements from 1997 to 2000 but later
agreed that a massive earnings restatement was warranted. Andersen’s
involvement with Enron destroyed the accounting firm—something the global
business community would have thought impossible in the fall of 2001.
Ironically, Andersen ceased to exist for the same reasons Enron failed–the
company lost the trust of its clients and other business partners.
Andersen in the
Beginning
Andersen was
originally founded as Andersen, Delaney & Co. in 1913 by Arthur
Andersen, an accounting professor at Northwestern University in Chicago.
By taking tough stands against clients, Andersen quickly gained a national
reputation as a reliable keeper of the public’s trust:
In 1915, Andersen took the position that the balance sheet of a
steamship-company client had to reflect the costs associated with the
sinking of a freighter, even though the sinking occurred after the
company’s fiscal year had ended but before Andersen had signed off on
its financial statements. This marked the first time an auditor had
demanded such a degree of disclosure to ensure accurate
reporting.15
Although Andersen’s
storied reputation began with its founder, the accounting firm continued
the tradition for years. A phrase often said around Andersen was,
“There’s the Andersen way and the wrong way.” Andersen was the only
one of the major accounting firms to back reforms in the accounting for
pensions in the 1980s, a move opposed by many corporations.16 Ironically, prior to
the Enron debacle, Andersen had also previously taken an unpopular public
stand to toughen the very accounting standards that Enron exploited in
using SPE’s to keep debt off its balance sheets.
Andersen’s Loss of
Reputation
Prior
to the Enron disaster, Andersen’s reputation suffered largely because of
the number of high profile SEC investigations launched against the firm.
The firm was investigated for its role in the financial statement audits
of Waste Management, Global Crossing, Sunbeam, Qwest Communications,
Baptist Foundation of Arizona, and WorldCom. In May 2001, Andersen paid
$110 million to settle securities fraud charges stemming from its work at
Sunbeam. In June 2001, Andersen entered a no-fault, no-admission-of-guilt
plea bargain with the SEC to settle charges of Andersen’s audit work on
Waste Management, Inc. for $7 million. Andersen later settled with
investors of the Baptist Foundation of Arizona for $217 million without
admitting fault or guilt (the firm subsequently reneged on the agreement).
Due to this string of negative events and associated publicity, Andersen
found its once-applauded reputation for impeccable integrity questioned by
a market where integrity, independence, and reputation are the primary
attributes affecting demand for a firm’s services.
Andersen at
Enron
By
2001, Enron had become one of Andersen’s largest clients. Despite the
recognition that Enron was a high-risk client, Andersen apparently had
difficulty sticking to its guns at Enron:
[Andersen had] found $51 million of problems in the company’s
books – and decided to let them go uncorrected. While auditing Enron’s
1997 financial results, Andersen proposed that the energy company make
‘adjustments’ that would have cut its annual income by almost 50
percent, to $54 million from $105 million.....Enron chose not to make
those adjustments and Andersen put its stamp of approval on the
company’s financial report anyway.17
Andersen chief
executive, Joseph F. Berardino, testified before the U.S. Congress that,
after proposing the $51 million of adjustments to Enron’s 1997 results,
the accounting firm decided that those adjustments were not
material.18
Congressional hearings and the business press allege that Andersen was
unable to stand up to Enron because of the conflicts of interest that
existed due to large fees and the mix of services Andersen provided to
Enron.
In
2000, Enron reported that it paid Andersen $52 million—$25 million for the
financial statement audit work and $27 million for consulting services.
Andersen not only performed the external financial statement audit, but
also carried out Enron’s internal audit functions, a relatively common
practice in the accounting profession before the Sarbanes-Oxley Act of
2002. Ironically, Enron’s 2000 annual report disclosed that one of the
major projects Andersen performed in 2000 was to examine and report on
management’s assertion about the effectiveness of Enron’s system of
internal controls.
Comments by
investment billionaire, Warren E. Buffett, summarize the perceived
conflict that often arises when auditors receive significant fees from
audit clients: “Though auditors should regard the investing public as
their client, they tend to kowtow instead to the managers who choose them
and dole out their pay.” Buffett continued by quoting an old proverb:
“Whose bread I eat, his song I sing.”19
It
also appears that Andersen knew about Enron’s problems nearly a year
before the downfall. According to a February 6, 2001 internal firm e-mail,
Andersen considered dropping Enron as a client. The e-mail, which was
written by an Andersen partner to David Duncan, partner in charge of the
Enron audit, detailed the discussion at an Andersen meeting about the
future of the Enron engagement. The essential text of that email is
reproduced in Exhibit
3.
Exhibit 3 Internal Andersen Email on Enron
To:
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David B. Duncan@ANDERSEN WO, Thomas H. Bauer@ANDERSEN
WO
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cc:
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Date:
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02/06/2001 08:24 AM
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From:
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Michael D. Jones, Houston, 2541
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Subject:
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Enron retention
meeting
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Dave, I was not sure
whether you were planning on documenting the meeting yesterday. My
significant notes were as follows (these were not very detailed, but I was
not sure how detailed you wanted to get, assuming that you were going to
document the meeting). Let me know if you want me to take a stab at it
first (if so we should probably get together for a few minutes to discuss
your documentation ideas).
Attendees:
By
Phone: Samek, Swanson, Jeneaux, Jonas, Kutsenda, Stewart
In
Houston: Bennett, Goddard, Goolsby, Odom, Lowther, Duncan, Bauer,
Jones
Significant
discussion was held regarding the related party transactions with LJM
including the materiality of such amounts to Enron’s income statement and
the amount retained “off balance sheet.” The discussion focused on
Fastow’s conflicts of interest in his capacity as CFO and the LJM fund
manager, the amount of earnings that Fastow receives for his services and
participation in LJM, the disclosures of the transactions in the financial
footnotes, Enron’s BOD’s views regarding the transactions and our and
management’s communication of such transactions to the BOD and our testing
of such transactions to ensure that we fully understand the economics and
substance of the transactions.
The
question was raised as whether the BOD gets any competing bids when the
company executes transactions with LJM. DBD replied that he did not
believe so, but explained their transaction approval process generally and
specifically related to LJM transactions.
A
significant discussion was also held regarding Enron’s MTM earnings and
the fact that it was “intelligent gambling.” We discussed Enron’s risk
management activities including authority limits, valuation and position
monitoring.
We
discussed Enron’s reliance on its current credit rating to maintain itself
as a high credit rated transaction party.
We
discussed Enron’s dependence on transaction execution to meet financial
objectives, the fact that Enron often is creating industries and markets
and transactions for which there are no specific rules which requires
significant judgement and that Enron is aggressive in its transaction
structuring. We discussed consultation among the engagement team, with
Houston management, practice management and the PSG to ensure that we are
not making decisions in isolation.
Ultimately the
conclusion was reached to retain Enron as a client citing that it appeared
that we had the appropriate people and processes in place to serve Enron
and manage our engagement risks. We discussed whether there would be a
perceived independence issue solely considering our level of fees. We
discussed that the concerns should not be on the magnitude of fees but on
the nature of fees. We arbitrarily discussed that it would not be
unforseeable that fees could reach a $100 million per year amount
considering the multi-disciplinary services being provided. Such amount
did not trouble the participants as long as the nature of the services was
not an issue.
In
addition to the above discussions were held to varying degrees on each
page of the presentation materials.
Take
away To Do’s:
Inquire as to
whether Andy Fastow and / or LJM would be viewed as an “affiliate” from an
SEC perspective which would require looking through the transactions and
treating them as within the consolidated group.
Suggest that a
special committee of the BOD be established to review the fairness of LJM
transactions (or alternative comfort that the transactions are fair to
Enron, e.g., competitive bidding).
Why
did Andy not select AA as auditors, including when PWC was replaced with
KPMG. Discussions concluded that we would likely not want to be LJM’s
financial advisors given potential conflicts of interest with Enron.
Focus on Enron
preparing their own documentation and conclusions to issues and
transactions.
AA
to focus on timely documentation of final transaction structures to ensure
consensus is reached on the final structure.
©2001 Arthur
Andersen. All Rights Reserved. David B. Duncan
The Andersen
Indictment
Although the massive
restatements of Enron’s financial statements cast serious doubt over the
professional conduct and audit opinions of Andersen, ultimately it was the
destruction of Enron-related documents in October and November 2001 and
the March 2002 Federal indictment of Andersen that led to the firm’s rapid
downward spiral. The criminal charge against Andersen related to the
obstruction of justice for destroying documents after the Federal
investigation had begun into the Enron collapse. According to the
indictment, Andersen allegedly eliminated potentially incriminating
evidence by shredding massive amounts of Enron-related audit workpapers
and documents. The government alleged that Andersen partners in Houston
were directed by the firm’s national office legal counsel in Chicago to
shred the documents. The U.S. Justice Department contended that Andersen
continued to shred Enron documents after it knew of the SEC investigation,
but before a formal subpoena was received by Andersen. The shredding
stopped on November 8th when Andersen received the SEC’s
subpoena for all Enron-related documents.
Andersen denied that
its corporate counsel recommended such a course of action and assigned the
blame for the document destruction to a group of rogue employees in its
Houston office seeking to save their own reputations. The evidence is
unclear as to exactly who ordered the shredding of the Enron documents or
even what documents were shredded.
However, central to
the Justice Department’s indictment was an email forwarded from Nancy
Temple, Andersen’s corporate counsel in Chicago, to David Duncan, the
Houston-based Enron engagement partner. The body of the email states,
“It might be useful to consider reminding the engagement team of our
documentation and retention policy. It will be helpful to make sure that
we have complied with the policy. Let me know if you have any
questions.”20
Andersen, like all
professional service firms, has policies guiding the retention and
destruction of documents. Auditors often obtain documents and other files
throughout an audit that are ultimately not relevant to the audit.
Unfortunately, a common problem in the audit profession is that these
documents and files are often inadvertently retained by staff who fail to
appropriately dispose of the files at the end of the audit. In many
instances, this occurs due to the significant work pressure placed on the
staff who have moved onto other engagements. As a result, the staff fail
to take the time to dispose of the unused files on a timely basis. Firm
document retention policies must now conform to the rigorous requirements
of PCAOB’s Auditing Standard No. 3 dealing with audit documentation on
audits of public companies.
The
Justice Department argued that the Andersen general counsel’s email was a
thinly veiled directive from Andersen’s headquarters to ensure that all
Enron-related documents that should have previously been destroyed
according to the firm’s policy were destroyed. Andersen contended
that the infamous Nancy Temple memo simply encouraged adherence to normal
engagement documentation policy, including the explicit need to retain
documents in certain situations and was never intended to obstruct the
government’s investigation. However, it is important to understand that
once an individual or a firm has reason to believe that a federal
investigation is forthcoming, it is considered “obstruction of justice” to
destroy documents that might serve as evidence.
In
January 2002, Andersen fired the Enron engagement partner, David Duncan,
for his role in the document shredding activities. He later testified that
he did not initially think that what he did was wrong and initially
maintained his innocence in interviews with government prosecutors. He
even signed a joint defense agreement with Andersen on March 20, 2002.
Shortly thereafter, Duncan decided to plead guilty to obstruction of
justice charges after “a lot of soul searching about my intent and what
was in my head at the time.”21
In
the obstruction of justice trial against Andersen, Duncan testified for
the Federal prosecution, admitting that he ordered the destruction of
documents because of the email he received from Andersen’s counsel
reminding him of the company’s document retention policy. He also
testified that he wanted to get rid of documents that could be used by
prosecuting attorneys and SEC investigators.22
Although convicted
of obstruction of justice, Andersen continued to pursue legal recourse by
appealing the verdict to the Fifth U.S. Circuit Court of Appeals in New
Orleans. The Fifth Court failed to overturn the verdict and so Andersen
appealed to the Supreme Court. Andersen claimed that the trial judge “gave
jurors poor guidelines for determining the company’s wrongdoing in
shredding documents related to Enron Corp.”23 The Supreme Court
agreed with Andersen and on May 31, 2005, the Court overturned the lower
court’s decision.
The
Supreme Court’s decision will have little effect on the future of Arthur
Andersen. By 2005, Andersen employed only 200 people, most of whom were
involved in fighting the remaining lawsuits against the firm. The ruling
however, may help individual Arthur Andersen partners in civil suits named
against them. The ruling may also make it more difficult for the
government to pursue future cases alleging obstruction of justice against
individuals and companies.
The End of
Andersen
In
the early months of 2002, Andersen pursued the possibility of being
acquired by one of the other four Big-5 accounting firms:
PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte &
Touche. The most seriously considered possibility was an acquisition of
the entire collection of Andersen partnerships by Deloitte & Touche,
but the talks fell through only hours before an official announcement of
the acquisition was scheduled to take place. The biggest barrier to an
acquisition of Andersen apparently centered around fears that an acquirer
would assume Andersen’s liabilities and responsibility for settling future
Enron-related lawsuits.
In
the aftermath of Enron’s collapse, Andersen began to unravel quickly,
losing over 400 publicly traded clients by June 2002—including many
high-profile clients with which Andersen enjoyed long
relationships.24 The list of former
clients includes Delta Air Lines, FedEx, Merck, SunTrust Banks, Abbott
Laboratories, Freddie Mac, and Valero Energy Corp. In addition to losing
clients, Andersen lost many of its global practice units to rival
accounting and consulting firms, and agreed to sell a major portion of its
consulting business to KPMG consulting for $284 million as well as most of
its tax advisory practice to Deloitte & Touche.
On
March 26, 2002, Joseph Berardino, CEO of Andersen Worldwide, resigned as
CEO, but remained with the firm. In an attempt to salvage the firm,
Andersen hired former Federal Reserve chairman, Paul Volcker, to head an
oversight board to make recommendations to rebuild Andersen. Mr. Volcker
and the board recommended that Andersen split its consulting and auditing
businesses and that he and the seven-member board take over Andersen in
order to realign firm management and implement reforms. The success of the
oversight board depended on Andersen’s ability to stave off criminal
charges and settle lawsuits related to its work on Enron. Because Andersen
failed in this regard, Mr. Volcker suspended the board’s efforts to
rebuild Andersen in April 2002.
Andersen faced an
uphill battle in its fight against the federal prosecutors’ charges of a
felony count for the obstruction of justice, regardless of the trial’s
outcome. Never in the 212-year history of the U.S. financial system has a
major financial-services firm survived a criminal indictment, and Andersen
would not likely have been the first, even had the firm not been convicted
of a single count of obstruction of justice on June 15, 2002. Andersen,
along with many others, accused the justice department of a gross abuse of
governmental power, and announced that it would appeal the conviction.
However, the firm also announced that it would cease to audit publicly
held clients by August 31, 2002.
The
details surrounding Enron’s bankruptcy and Andersen’s fall from grace will
continue to be uncovered for years. Only time will tell the fate of those
involved. But one thing is certain—the Enron debacle will have a profound
and lasting impact on the accounting profession and on the entire business
community for years to come.
Requirements
- What were the business risks Enron faced, and how did those risks
increase the likelihood of material misstatements in Enron’s financial
statements?
- What are the responsibilities of a company’s board of directors?
Could the board of directors at Enron—especially the audit
committee—have prevented the fall of Enron? Should they have known about
the risks and apparent lack of independence with SPE’s? What should they
have done about it?
- In your own words, summarize how Enron used SPE’s to hide large
amounts of company debt.
- What are the auditor independence issues surrounding the provision
of external auditing services, internal auditing services, and
management consulting services for the same client? Develop arguments
for why auditors should be allowed to perform these services for the
same client. Develop separate arguments for why auditors should not be
allowed to perform non-audit services for their audit clients.
- Explain how “rules-based” accounting standards differ from
“principles-based” standards. How might fundamentally changing
accounting standards from “bright-line” rules to principle-based
standards help prevent another Enron-like fiasco in the future? Are
there dangers in removing “bright-line” rules? What difficulties might
be associated with such a change?
- Enron and Andersen suffered severe consequences because of their
perceived lack of integrity and damaged reputations. In fact, some
people believe the fall of Enron occurred because of a “run on the
bank.” Some argue that Andersen experienced a similar “run on the bank”
as many top clients quickly fired the firm in the wake of Enron’s
collapse. Is the “run on the bank” analogy valid for both firms? Why or
why not?
- A perceived lack of integrity caused irreparable damage to both
Andersen and Enron. How can you apply the principles learned in this
case personally? Generate an example of how involvement in unethical or
illegal activities, or even the appearance of such involvement, might
adversely affect your career. What are the possible consequences when
others question your integrity? What can you do to preserve your
reputation throughout your career?
- Why do audit partners struggle with making tough accounting
decisions that may be contrary to their client’s position on the issue?
What changes should the profession make to eliminate these obstacles?
- What has been done, and what more can be done to restore the public
trust in the auditing profession and in the nation’s financial reporting
system?
Notes
1Rep.
Richard H. Baker (R-LA), December 12, 2001 Hearing of the Capital
Markets, Insurance, and Government sponsored enterprises subcommittee
and oversight and investigations subcommittee of the House Financial
Services Committee, “The Enron Collapse: Impact on Investors and
Financial Markets.”
2Skilling,
Jeffrey, “Prepared Witness Testimony: Skilling, Jeffrey, K.” House
Energy Subcommittee. See the following web site: http://energycommerce.house.gov/107/hearings/02072002Hearing485/Skilling797.htm
3“Understanding Enron: Rising Power.” The
Washington Post. May 11, 2002. See the following web site: http://www.washingtonpost.com/wp-srv/business/enron/front.html
4Preston,
Robert. “Enron’s Demise Doesn’t Devalue Model It Created.”
Internetweek. December 10, 2001.
5Ibid.
6“The Rise
and Fall of Enron: The Financial Players.” The Washington Post.
May 11, 2002. See the following web site: http://www.washingtonpost.com/wp-srv/business/daily/articles/keyplayers_financial.htm
7Since the
collapse of Enron, the FASB has changed the requirements of FAS 94,
Consolidation of All Majority-Owned Subsidiaries, and now
requires a ten percent minimum outside investment (See FASB
Interpretation No. 46, Consolidation of Variable Interest Entities –
an interpretation of ARB No. 51).
8The FEI
Research Foundation. 2002. Special Purpose Entities: Understanding
the Guidelines. Accessed at http://www.fei.org/download/SPEIssuesAlert.pdf
9Henry,
David, “Who Else is Hiding Debt?” Business Week. May 11, 2002.
See the following web site: http://www.businessweek.com/magazine/content/02_04/b3767704.htm
10Ibid.
11The Fall
of Enron; Enron Lawyer’s Qualms Detailed in New Memos. The Los
Angeles Times. February 7, 2002. Richard Simon, Edmund Sanders,
Walter Hamilton.
12Fry,
Jennifer. “Low-Profile Partnership Head Stayed on Job until Judge’s
Order.” The Washington Post. February 7, 2002.
13Altman
Daniel. “Enron Had More Than One Way to Disguise Rapid Rise in Debt,”
The New York Times, February 17, 2002
14Herdman,
Robert K. “Prepared Witness Testimony: Herdman, Robert K., US House of
Representatives.” See the following web site: http://energycommerce.house.gov/107/hearings/02142002Hearing490/Herdman802.htm
15Brown,
K., et al., “Andersen Indictment in Shredding Case Puts Its Future in
Doubt as Clients Bolt,” The Wall Street Journal, March 15,
2000.
16Ibid
17Hilzenrath, David S., “Early Warnings of
Trouble at Enron.” The Washington Post. December 30, 2001 See the
following web site: http://www.washingtonpost.com/wpdyn/articles/A40094-2001Dec29.html
18Ibid
19Hilzenrath, David S., “Early Warnings of
Trouble at Enron.” The Washington Post. December 30, 2001. See
the following web site: http://www.washingtonpost.com/wpdyn/articles/A40094-2001Dec29.html
20Temple,
Nancy A. Email to Michael C. Odom, “Document Retention Policy” October
12, 2001.
21Beltran,
Luisa, Jennifer Rogers, and Brett Gering. “Duncan: I Changed My Mind.”
cnnfn.com. May 15, 2002.
See the following web site: http://money.cnn.com/2002/05/15/news/companies/andersen/index.htm
22Weil,
Jonathan, Alexei Barrionuevo. “Duncan Says Fears of Lawsuits Drove
Shredding.” The Wall Street Journal. New York. May 15, 2002.
23Bravin,
Jess. “Justices Overturn Criminal Verdict in Andersen Case.” The Wall
Street Journal. New York. May 31, 2005.
24Luke,
Robert. “Andersen Explores Office Shifts in Atlanta.” The Atlanta
Journal - Constitution, May 18, 2002.
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