Case 1.

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Enron Corporation

Prepared by:
Alexa Rodriguez

for
Professor C.E. Reese
in partial fulfillment of the requirements for
ACC502-- Advanced Auditing
College of Business/Graduate Studies
St. Thomas University
Miami Gardens, Fla

Term SP2/Spring, 2020

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 Table of Content
Issues 3
Facts 4
Analysis/Authority 7
Conclusions/Recommendations 12
References 12

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Issues:
1. SEC does not require quarterly financial statements to be audited, but should they?
Should audit firms have any responsibility with regard to the quarterly financial
statements?
2. What are three consulting services that audit firms cannot provide to public companies?
What are the specific threats that these services pose for the audit firms’ independence?
3. If Anderson’s involvement in Enron’s accounting and financial reporting decisions from
the Powers Report is true did Anderson violate any professional auditing standards? If
so, which ones and how were they violated?
4. What are the key elements in professional auditing standards for preparing and retaining
audit workpapers? Who owns the audit workpapers?
5. What are five recommendations to help strengthen the audit firm’s independence after the
Enron scandal? Do you support these recommendations? Why or why not? Which of
them were actually implemented?

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Facts:

Anderson grew up with parents who instilled three key characteristics: discipline, honesty

and a strong work ethic. He became the youngest CPA in Illinois when he was 23 years old. At

this time there were no rules that required companies to report material events that occurred after

the financial statement’s end date; however, Anderson insisted that his client report it so that

third parties would be informed of the loss. Anderson became known for his motto “think

straight, talk straight” and was described as opinionated, stubborn and honest. During the Great

Depression, Anderson helped his clients obtain necessary loans, and because he gained trust with

the banks for providing honest financial statements, they referred many clients to him. Before it

was required, Anderson made his employees take continuing education classes. After Anderson

died in 1947, Leonard Spacek took over and continued to uphold Anderson’s belief that the

clients should honestly report their financial affairs to the investors and lenders.

Northern Natural Gas Company was created with the goal of being the largest natural gas

supplier in the US. Later it became InterNorth Inc and expanded its services by including oil

exploration, chemicals, coal mining, and fuel related operations. In 1986 it changed names to

Enron and it became known as one of the most innovative companies in America; however, in

2001 it quickly fell apart. Its stock price began to drop and Enron suffered a major loss where

there was an unexplained $1.2 billion reduction in owner’s equity and assets. Enron had to

restate its financials for the last five years resulting in a wipe out of $600 million in profits and

eventually led to the bankruptcy of the company.

Enron was engaged in aggressive accounting methods, which consisted of complex

transactions that included multiple limited partnerships of Enron. At this time the SEC and

FASB provided little guidance for companies in accounting and auditing standards. Enron used

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these special purpose entities (SPEs) to download underperforming assets since they were not

audited and there were no consolidated financial statements. While the SPEs would be sold

assets that were significantly overpriced and suffered many losses, Enron’s financials looked

great and its executives were making millions in profits. When Enron’s management discovered

this, it required that they enter the data into a consolidated financial statement. Enron also abused

of the mark to market accounting principle for its long-term contracts and would inflate profits in

the accounting books. The Enron culture was known to encourage rule breaking and

discouraged employees from reporting ethical issues or questionable business deals. There was

also a serious lack of internal controls.

Anderson maintained that Enron’s dishonesty exempted the audit firm from

responsibility; however, there were three key issues related to the audit that would prove

otherwise including the scope of services issue, which meant that Anderson was providing

consulting services as well as performing the audit. Because the audit firm made the majority of

its money from Enron by these consulting services and not the audit itself, it was considered to

be a conflict of interest. The second issue was that Anderson was involved and aware of Enron’s

treatment of the SPE transactions. Finally, the fact that Anderson was caught shredding audit

documents was seen as a method of preventing law enforcement from being able to have

evidence to incriminate the firm.

Unfortunately, with the lawsuit claims filed, Anderson lost many clients and the firm had

to lay off 25% of the employees. Once a federal jury found the firm guilty of obstruction of

justice by shredding the files, they were forced to end any ongoing relationships with clients.

Three years later the ruling was overturned by the Supreme Court as there was no proof the

documents were shredded with the intention of obstructing justice. Despite that Anderson was

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unable to open and its failure tainted the whole accounting industry. There was clearly a need

for strict rules and standards, especially related to independent audit functions. This led the

FASB to create guidelines for SPEs and Congress to pass the Sarbanes Oxley Act. SOX limited

the consulting services that audit firms could provide to clients, required public companies to

have internal controls evaluated, and created the PCAOB to oversee that audit firms remained

independent.

Analysis:
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1.

SEC does require that publicly traded companies submit quarterly financial reports, but

they do not have to be audited (AU Section 722 Interim Financial Information). While audit

firms do not have to audit the quarterly reports, they do have a responsibility to perform

procedures on those reports to determine if any material misstatements occurred or if there is

anything of significant value that needs to be disclosed (AU Section 722 Interim Financial

Information). Although auditing is important, it would be extremely costly and time consuming

for a company to have their quarterly reports audited as well as their annual report. If audit firms

follow the procedures listed by the PCAOB and test elements of the company’s quarterly reports,

then there is no need to actually have to audit all of them; performing sufficient tests on the

quarterly financials and auditing the annual financials should be enough to assure third parties

that the company’s statements are an accurate representation of their financial position.

2.

There are a few non audit services that are prohibited to audit firms providing companies

with audit reports because they threaten the firm’s independence (Audit Committees and Auditor

Independence). One of those prohibited services is bookkeeping, which is the recording of a

company’s financial transactions (Audit Committees and Auditor Independence). If auditors are

providing this service and performing an audit it calls into question their independence because

they could easily help the client hide suspicious or fraudulent activity, since they know how their

audit teams works and what they look for in the audit. A second prohibited service is designing

and implementing the financial information systems for the company the audit firm is auditing.

Similar to the bookkeeping scenario, if auditors design the system that their client uses, they

once again have insider knowledge on how to cover their tracks better and help their clients get

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away with devious behavior. Finally, providing management functions or human resources to

the audit client’s company can be viewed as threatening the independence because they have

participated closely with the client, meaning they might be unable to give an unbiased opinion.

Without independence, the quality of the audit reports is questionable, so it is vital that audit

firms maintain their independence by avoiding the prohibited services listed.

3.

Anderson was overly involved in helping Enron record the transactions related to the

SPEs which violates the auditor independence as they are not supposed to provide bookkeeping

services if they are also doing the audits. According to the Powers Report, Anderson billed

$335,000 for the consultation regarding the related party transactions and $1.3 million for the

Raptor-related work, which means they may have been more likely to dismiss concerns for fear

of angering Enron and losing them as a client, when they were making so much money from

them. This is a clear violation of the independence standard for auditing professionals (Auditing

Standards).

They also failed to notify the audit committee regarding these unique transactions or their

concerns regarding Enron’s lack of internal controls. Part of the auditing standards requires that

the audit firm communicate with the audit committee regarding matters that are difficult or

contentious; the transactions related to the SPEs should have been mentioned to the audit

committee (Auditing Standards ). Furthermore, they failed to disclose these related party

transactions on the financial statements and continued to issue an unqualified opinion; related

party transactions should always be disclosed of in the footnotes of the financial statements to

give a fair presentation of the company’s financial framework (Auditing Standards).

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 Finally, the manner in which these transactions were recorded was incorrect and violated

the accounting rules. The 3 percent rule was manipulated to not have to report the SPEs on a

consolidated financial statement and therefore they did not give an accurate picture of Enron’s

financial position. Not being forthright with all the information and hiding the losses in the SPEs

showed great lack of integrity, so not only did Anderson break the rules, but they also violated

the professional code stating that auditors should act with integrity (Auditing Standards).

4.

An auditor’s work papers are made up of records of the work performed by the auditor

and the conclusions that they came to during the process (AU Section 339A - Working Papers).

They function to provide support to the report and help the auditors in their conduct and

supervision of the audit (AU Section 339A - Working Papers). Theses records range from audit

programs, analyses, memoranda, letters of confirmation, abstracts and schedules (AU Section

339A - Working Papers). Working papers should include enough documentation to show that

the audit was planned and supervised, there was sufficient understanding of the company’s

internal controls, and the audit evidence obtained, audit procedures applied, and tests performed

provide sufficient backup for the opinion (AU Section 339A - Working Papers). The audit work

papers are the property of the auditor but they are confidential and therefore should be kept

safely and kept only for the legally required amount of time (AU Section 339A - Working

Papers).

5.

After the fall of Enron, there was a lot of focus on the need to improve accounting

standards in an attempt to avoid similar financial scandals. There were multiple

recommendations made on how to improve auditor independence but the main ideas included:

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requiring that partners on the audit engagement team to rotate after 5-7 consecutive years, setting

rules that if members of the company’s management team became members of the auditing team

that the firm would not be independent, stating that any auditor found providing additional

services loses their independence, requiring that the audit firm maintain communication with the

audit committee regarding the non-audit services, and enforcing the disclosure of those non-audit

services provided on the financial statements (Commission Adopts Rules Strengthening Auditor

Independence). All of these recommendations have valid points in maintaining the auditor

independence.

If an audit partner is on the same case for many years, he may develop a relationship with

the client in which he is more prone to trust the client’s word instead of gathering sufficient

evidence, or will allow certain things to slide instead of requiring that they are done right.

Making audit engagement partners rotate is a good idea to prevent relationships from interfering

with independence and it always helps to have a new set of eyes reviewing the information.

Also, if a member of the audit firm quits and begins working for the client, it poses a huge threat

to independence as the individual knows how the audit team works so he can hide information

better and can potentially influence the auditors because of the previous close relationship.

When auditors provide services in addition to auditing, it can impair independence because

sometimes the auditors get paid more for those fees than they do for the actual audit; this means

they may be prone to approve of an audit report so as not to anger the client and risk losing their

business for the other services (Lessons from Enron: The Importance of Proper Accounting

Oversight). Similarly, if the auditors do provide other services or even if they are unsure as to

whether the relationship inhibits independence, they should communicate those concerns with

the audit committee and disclose them on the financial statements so everyone can make

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educated and informed decisions regarding the matter.

Conclusions:
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 Although the fall of Enron and Anderson had devastating effects, it taught the accounting

community a lot and made them create better standards and procedures to help ensure that these

huge financial scandals would be avoided in the future. Enron violated several aspects of the

auditing codes like not maintaining their independence in regards to the related party

transactions, and not disclosing them on the financial statements or reporting them to the audit

committee. There actions also lacked integrity as they purposefully manipulated the 3 percent

rule in order to hide losses and not have to report the SPEs on a consolidated financial report.

One of the major lessons learnt from Enron was the importance of auditor independence.

There now exists a list of consulting services that are auditors are prohibited from performing if

they are doing the client’s audit as well in order to maintain the independence function. There

were also several recommendations made after Enron collapsed to strengthen independence like

rotating audit partners, communicating with the audit committee, disclosing potential

independence threats and not allowing former audit team members to be engaged in the audit

procedures if they work for the client.

While audit firms are not required to perform audits on quarterly financials for public

traded companies, they should perform tests to make sure that there were no material

misstatements before continuing to do their annual audit work. The audit firms also should

maintain records of their auditing workpapers, which they own, and keep them in a safe place;

Anderson shredded their workpapers related to the Enron case, which caused people to believe

that they were involved and trying to hide it. Work papers should never be deleted or shredded

until after they have passed the legal threshold for the amount of time a firm is required to keep

the files.

References:

AU Section 339A - Working Papers. (n.d.). Retrieved April 14, 2020, from

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 https://pcaobus.org/Standards/Archived/Pages/AU339A.aspx

AU Section 722 Interim Financial Information. (n.d.). Retrieved April 14, 2020, from

https://pcaobus.org/Standards/Archived/PreReorgStandards/Pages/AU722.aspx

Audit Committees and Auditor Independence (May 7, 2007). Retrieved April 14, 2020 from

https://www.sec.gov/info/accountants/audit042707.htm

Auditing Standards. (n.d.). Retrieved April 14, 2020, from

https://pcaobus.org/Standards/Auditing/Pages/default.aspx

Commission Adopts Rules Strengthening Auditor Independence. (n.d.). Retrieved April 14, 2020, from

https://www.sec.gov/news/press/2003-9.htm

Lessons from Enron: The Importance of Proper Accounting Oversight. (n.d.). Retrieved April 14, 2020,

from https://pcaobus.org/News/Speech/Pages/07262006_GoelzerTokyoAmericanCenter.aspx

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