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United International University

Auditing (ACN 4340)


Assignment-2 (Case Study: - The Enron Collapse)
Section- A

Submitted to,
Mohammad Tariq Hasan (MTH)
Assistant Professor

Submitted by,
Name ID Serial No.
Sadman Ahmed 111 151 292 4

Sania Anjuman Nuri 111 161 141 28

Submission Date: - 20 August 2019


Summary of The Enron Collapse (USA 2001)

Enron scandal, series of events that resulted in the bankruptcy of the U.S. energy, commodities,
and services company Enron Corporation and the dissolution of Arthur Andersen LLP, which
had been one of the largest auditing and accounting companies in the world. The collapse of
Enron, which held more than $60 billion in assets, involved one of the biggest bankruptcy filings
in the history of the United States, and it generated much debate as well as legislation designed
to improve accounting standards and practices, with long-lasting repercussions in the financial
world. Enron was founded in 1985 by Kenneth Lay in the merger of two natural-gas-
transmission companies, Houston Natural Gas Corporation and InterNorth, Inc.; the merged
company, HNG InterNorth, was renamed Enron in 1986. Under Skilling’s leadership, Enron
soon dominated the market for natural-gas contracts, and the company started to generate huge
profits on its trades. Skilling also gradually changed the culture of the company to emphasize
aggressive trading. The bull market of the 1990s helped to fuel Enron’s ambitions and
contributed to its rapid growth. There were deals to be made everywhere, and the company was
ready to create a market for anything that anyone was willing to trade. Under pressure from
shareholders, company executives began to rely on dubious accounting practices, including a
technique known as “mark-to-market accounting,” to hide the troubles. Mark-to-market
accounting allowed the company to write unrealized future gains from some trading contracts
into current income statements, thus giving the illusion of higher current profits. Furthermore,
the troubled operations of the company were transferred to so-called special purpose
entities(SPEs), which are essentially limited partnerships created with outside parties. Although
many companies distributed assets to SPEs, Enron abused the practice by using SPEs as dump
sites for its troubled assets. Transferring those assets to SPEs meant that they were kept off
Enron’s books, making its losses look less severe than they really were. Ironically, some of those
SPEs were run by Fastow himself. Throughout these years, Arthur Andersen served not only as
Enron’s auditor but also as a consultant for the company. The severity of the situation began to
become apparent in mid-2001 as a number of analysts began to dig into the details of Enron’s
publicly released financial statements. An internal investigation was initiated following a
memorandum from a company vice president, and soon the Securities and Exchange
Commission (SEC) was investigating the transactions between Enron and Fastow’s SPEs.
As the details of the accounting frauds emerged, the stock price of the company plummeted from
a high of $90 per share in mid-2000 to less than $1 by the end of November 2001, taking with it
the value of Enron employees’ 401(k) pensions, which were mainly tied to the company stock.
Many Enron executives were indicted on a variety of charges and were later sentenced to prison.
Arthur Andersen came under intense scrutiny and eventually lost a majority of its clients. The
damage to its reputation was so severe that it was forced to dissolve itself. In addition to federal
lawsuits, hundreds of civil suits were filed by shareholders against both Enron and Andersen.
Critical Evaluation (Enron)
Client perspective: -
The conventional wisdom is that it was "innovative" accounting practices and their
consequences that started the tide of losses that brought the energy giant down. Enron
collapsed not so much because it had gotten too big, but because it was perceived to be much
bigger than it really was in the first place. By decentralizing its operations into numerous
subsidiaries and shell corporations, Enron was able to hide huge derivative losses that would
have halted its growth much sooner if widely understood. Publicly traded corporations are
required to make their financial statements public, but Enron's finances were an impenetrable
maze of carefully crafted imaginary transactions between itself and its subsidiaries that
masked its true financial state. In other words, losses were held off the book by subsidiary
companies, while assets were stated. Here we tried to evaluates the weaknesses of Enron’s
corporate governance structures, weaknesses that lead to the collapse of the company. Overall,
poor corporate governance and a dishonest culture that nurtured serious conflicts of interests and
unethical behavior in Enron are identified as significant findings.
Findings:
 Firstly, Enron’s Board of Directors failed to fulfil its fiduciary duties towards the
corporation’s shareholders.
 Secondly, the top executives of Enron were greedy and acted in their own self-interest.
 Thirdly, many of Enron’s employees witnessed the wrongdoings of Enron’s top
executives, and quite a few whistleblowers came forward.
 Lastly, Enron outsourced external auditing for its internal audit function instead of
establishing a functionally internal audit mechanism and its external auditor acquiesced
in the application of questionable accounting and fraudulent financial reporting.
Auditors Perspective: - (Arthur Anderson)
Auditors Mistakes: -
Enron's auditor firm, Arthur Andersen, was accused of applying reckless standards in its audits
because of a conflict of interest over the significant consulting fees generated by Enron. During
2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this
amount accounted for roughly 27% of the audit fees of public clients for Arthur
Andersen's Houston office). The auditor's methods were questioned as either being completed
solely to receive its annual fees or for its lack of expertise in properly reviewing Enron's revenue
recognition, special entities, derivatives, and other accounting practices.
Enron hired numerous Certified Public Accountants (CPAs) as well as accountants who had
worked on developing accounting rules with the Financial Accounting Standards Board (FASB).
The accountants searched for new ways to save the company money, including capitalizing on
loopholes found in Generally Accepted Accounting Principles (GAAP), the accounting industry's
standards. One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to
our advantage. All the rules create all these opportunities. We got to where we did because we
exploited that weakness.
Andersen's auditors were pressured by Enron's management to defer recognizing the charges
from the special purpose entities as its credit risks became known. Since the entities would never
return a profit, accounting guidelines required that Enron should take a write-off, where the value
of the entity was removed from the balance sheet at a loss. To pressure Andersen into meeting
Enron's earnings expectations, Enron would occasionally allow accounting companies Ernst &
Young or PricewaterhouseCoopers to complete accounting tasks to create the illusion of hiring a
new company to replace Andersen.[11]:148Although Andersen was equipped with internal controls
to protect against conflicted incentives of local partners, it failed to prevent conflict of interest. In
one case, Andersen's Houston office, which performed the Enron audit, was able to overrule any
critical reviews of Enron's accounting decisions by Andersen's Chicago partner. In addition, after
news of U.S. Securities and Exchange Commission (SEC) investigations of Enron were made
public, Andersen would later shred several tons of relevant documents and delete nearly 30,000
e-mails and computer files, causing accusations of a cover-up.
Revelations concerning Andersen's overall performance led to the break-up of the firm, and to
the following assessment by the Powers Committee (appointed by Enron's board to look into the
firm's accounting in October 2001): "The evidence available to us suggests that Andersen did not
fulfill its professional responsibilities in connection with its audits of Enron's financial
statements, or its obligation to bring to the attention of Enron's Board (or the Audit and
Compliance Committee) concerns about Enron's internal contracts over the related-party
transactions".
Auditors Responsibilities: -
The problem is not compliance with the rules. No, the problem is the rules themselves, which
permit conflicts of interest and ultimately undermine auditor independence. Auditor
independence is a cornerstone of our capital markets. It means that auditors should be able to
objectively assess whether publicly traded companies are telling the truth about their finances.
And this independence is threatened by cozy, long-term partnerships that develop between firms
and their auditors.

Recommendation: -
From our point of view, we recommend that: -
 They should enable safeguard to protect ethical climate
 Comprehensive understanding of assets, tools and resources can prepare leadership and
managers to find new solutions for new problems encountered
 Proper focus to the core values that guide the most useful principles
 Implement systems that guide and measure the effectiveness of ethics initiatives
 Visible code of ethics to encourage ethical business decisions as a priority
 Refuse to tolerate misconduct from the top down
 Supported and clear flow of company work should be followed
 Independency of auditors’ work must be ensured
 Effectiveness and efficiency of company internal control must be ensured
 Before selecting governing body must evaluate everyone’s previous status and personal
and professional ethics and integrity.
Conclusions: -
Enron was highly growth and innovative company. Through its rapid growth and high revenues,
it was one of the top leading company in the USA. But they could not hold that positions much
longer. At Enron's peak, its shares were worth $90.75; when the firm declared bankruptcy on
December 2, 2001, they were trading at $0.26. To this day, many wonder how such a powerful
business, at the time one of the largest companies in the United States, disintegrated almost
overnight. Also difficult to fathom is how its leadership managed to fool regulators for so long
with fake holdings and off-the-books accounting. In addition to Andrew Fastow, a major player
in the Enron scandal was Enron's accounting firm Arthur Andersen LLP and partner David B.
Duncan, who oversaw Enron's accounts. As one of the five largest accounting firms in the United
States at the time, Andersen had a reputation for high standards and quality risk management.
This case was a major scandal in auditing history. So it actually knocks us to maintain and
monitoring proper books of accounts and ensured of auditors’ independence in act and
performance. Giving a true and fair picture to external parties and maintain proper ethicalism and
corporate guidelines must be ensured to make a healthy and going concern concept of a
company.