Arthur Andersen and Enron: Positive Influence on the Accounting Industry

 Todd Stinson


 

            Arthur Andersen and Enron - two names that will forever live in infamy because of the events leading up to and including the debacle of December 2001, when Enron filled for bankruptcy.  These two giants in the utility and accounting industries, and known throughout the world, took advantage of not only investors, but also the government and public as a whole, just so that those individuals involved could illegally increase their personal wealth.  How could the backlash from the actions of the management of these two organizations have a positive influence in the accounting industry as a whole?  The fallout from Enron’s bankruptcy and the SEC investigation that followed resulted in many changes to the industry to make standards tougher, penalties harder, and the accounting industry more reliable.  At first glance, these “improvements” just seem like they are making more work for the many honest accountants in the industry, who are already doing the right things.  However, this thesis will show how these changes actually are positive for the industry.  In order to do this safety measures that were in place at the time of the debacle will be shown, the actual events leading up to the downfall of Enron and Arthur Andersen will be discussed, the changes that have occurred since the fall through the present day will be given, the changes that appear to be on the horizon for the accounting industry will be shown, and finally how all of this will impact the accounting industry as a whole in a positive fashion will be made clear.

Safety Measures in place Prior to the events.

            Prior to the fall of Enron and their accountants, Arthur Andersen, there were many different types of safety measures in place to help protect the investors and the public as a whole.  These safety measures included Generally Accepted Accounting Principles (GAAP), Generally Accepted Auditing Standards (GAAS), Statements on Auditing Standards (SAS), and all professional ethics.  The use of GAAP by accountants is standard protocol.  An accountant follows these principles as a matter of daily routine.  According to Several accounting texts, GAAP is identified as a “dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements.”

During yearly audits performed by external, independent auditors, checks are performed to make sure that a business is following GAAP consistently.  If they are not, then the business must show why they are not, and present rationale to demonstrate that what they are doing is both ethical and appropriate in their specific situation.  This leaves the field open to interpretations of what is appropriate for different situations.  Since interpretations are quite subjective, the American Institute of Certified Public Accountants (AICPA), added the stipulation that the treatment must also be applied consistently over time.  These rules are in place to make financial statements as accurate and reliable as possible.  Enron took these rules and circumvented them to allow certain individuals within the company to make money from the increased investments from stockholders.  They did this by bolstering their balance sheet with inflated asset values, and dispersing their liabilities to subsidiaries that they just didn’t consolidate.  Meaning that Enron didn’t include these companies in their financial statement accounts at the end of their fiscal years, causing massive misstatements.  Since these partnerships were, in most cases, wholly owned subsidiaries or partnerships, they should have been shown on the consolidated financial statements with Enron.  When Enron declared bankruptcy they had $13.1 billion in debt on Enron’s books, $18.1 billion on their subsidiaries’ books, and an estimated $20 billion more off the balance sheets (Zellner). 

While GAAP guidelines relate to how financial statements are presented, GAAS, on the other hand, are standards set down specifically for the audit cycle of a company.  It tells auditors what tests they should do, and to what extent this testing is to be done, and what level is acceptable in the audit (Imhoff)  Arthur Andersen had a responsibility to the investors and to the public interest under GAAS.  Auditors, according to GAAS, are to remain independent in both fact and appearance. Meaning that even if an auditor appears to have a connection with their client, even though they may not have, they should drop the audit immediately.  Anderson took a very active role in Enron’s business through both auditing and consulting.  This should have been enough to make anyone question Anderson’s independence.  They did not execute their duties independently because of the amount of revenue that Enron was providing them, not only in audit fees, but also in consulting fees.  “In 2000, Enron paid Andersen $52 million, including $27 million for consulting services” (Weil).  This amount was enough to make Enron Andersen’s second largest account in 2000. 

SAS constitute the third important safety measure.  These statements on auditing standards are produced to address current issues in the business of auditing.  The American Institute of Certified Public Accountants (AICPA) sets down these rules.  The one that played a predominant role in this incident is SAS 82.  SAS 82 was issued in 1997, and it “requires auditors to ascertain management’s understanding of the risk of fraud” (Jakubowski).  This statement also included the duty to find out if any of the management knew of any fraud being committed against the company, and added new fraud terminology to the representation letter produced by management.  This SAS was the first to clearly state that auditors had any responsibility to look for fraud.  Up until 1997 it was expected that an auditor would report fraud if they happened upon it, but they had no responsibility to actively look for it.  This one SAS along with all the others were supposed to protect the public interest.  However, in lieu of the lucrative fees being collected by Andersen from Enron these were also overlooked.  In spite of all of these safety measures the wrongdoings at Enron went undetected for a long period of time.  The major problem was that of collusion.  GAAP and GAAS can not prevent fraud when people work in collusion to perpetrate that fraud.  Therefore, when events like these transpire, changes are required in an attempt to prevent similar occurrences.

History (Chronology of Events)

The events that led up to the bankruptcy filing in December of 2001, started long before anyone began to suspect fraud at Enron.  Andersen’s role in the Enron debacle should have been anticipated.  Andersen had two major audit failures just a few years apart and just a short time before Enron filed bankruptcy.  In 1996, Waste Management’s audit reports from Andersen were materially false and misleading resulting in an inflation of income by over $1 billion dollars between 1992 and 1996.  This information came out in an SEC investigation, and led to Waste Management selling out to another company.  In 1997 Sunbeam was found by the SEC to be using accounting tricks to create false sales and profits, Andersen signed off on these financial statements even after a partner flagged them.  Sunbeam would later file for bankruptcy (Weber). 

These two major audit failures should have put Andersen on their guard against another client failure, however the worst was yet to come.  Internal memos at Andersen showed that there were conflicts between the auditors and the audit committee of Enron.  Also included in these memos are several e-mails expressing concerns: about accounting practices used by Enron.  However, the leading partner on the audit, David B. Duncan, overturned these concerns.  Also, there is proof that Duncan’s team wrote memos fraudulently stating that the professional standards group approved of the accounting practices of Enron that hid debts and pumped up earnings (McNamee).  However, because of the relationship between audit and non-audit fees, Andersen’s independence was probably flawed (Frankel).  During the fallout of Enron’s bankruptcy and Andersen’s role in it, Andersen began to run an ad that Andersen would do what was right.  In doing this they were trying to rebuild the consumer confidence in their accounting firm.  While Andersen was attempting to pick up the pieces of their business, Paul Volcker, former Federal Reserve Chairman, presented a plan for a restructuring of Andersen so that they would have a chance of surviving this incident.  Andersen did eventually agree to the restructuring, but it was too late to save the firm as a whole (Alexander).  Anderson still exists as a company, although their only reason for doing so is to complete all the litigation against the firm.  They are no longer auditing or consulting.  Anderson was the major accounting influence in this incident, however they were not the main player.

Enron’s role started when they emerged as a competing force within their industry.  Enron became more and more arrogant as time passed.  They had a banner in the lobby of their headquarters, which read, “the world’s leading company.”  Many believe that it was this arrogance on the part of the management that led to the escalation of the fraud that followed (McLean). 

  

Exhibit 1

Text Box: Timeline of Events
1996 -              Arthur Andersen has an audit failure in Waste Management; Andersen paid a censure of $7 million.
1997 -              Arthur Anderson has an audit failure in Sunbeam; Andersen paid $110 million to settle shareholder litigations.
January 1997-  Jeffery Skilling is named president and COO of Enron.  Skilling implements his assets are bad intellectual assets are good campaign to “clean up” Enron’s financial statements.  Begins using the LJM partnerships run by Andrew Fastow, Enron’s CFO.
Early 2001-      Jim Chanos takes note of Enron’s lack of money-making activities and begins to wonder about the LJM partnerships.
February 2001-Skilling’s promotion to CEO takes effect, he replaced Charles Lay.
June 2001-       Enron executives sell shares as stocks slid 39% in the first quarter.
August 2001-   Skilling quits for personal reasons, and Charles Lay is named CEO again.
Oct. 16 2001-  Enron reports a third quarter loss of $618 million.  They cite the loss as being partially due to the LJM partnerships.
Oct. 22 2001-  SEC starts an investigation into the LJM partnerships, and CFO Fastow leaves Enron.
Nov. 8 2001-   Enron’s Net income back through 1997 is revalued by $586 million.
Nov. 9 2001-   Dynergy offers to buy Enron for $10 billion.
Nov. 28 2001- Dynergy refuses to buy Enron.
Dec. 2 2001-   Enron Files for Bankruptcy.
June 2002-       Arthur Anderson is convicted of obstruction of justice and loses its auditing rights.
 

 

 

 


 

Enron’s strategy was to have a balance sheet with many intellectual assets, like patents and trademarks, and that actual assets were bad and should be immaterial when compared to the intangibles.  Most of the debts and tangible assets of the company were on the balance sheets of partnerships that were run by high-ranking officials within the corporation (Zellner).  With this kind of strategy for business the company quickly began to falter.  Knowing that Enron needed help, a competitor, Dynergy, offered to buy them out for $10 billion.  Then, on October 16, 2001 Kenneth Lay, ex-CEO of Enron, told the public that Enron would have to decrease shareholders equity by $1.2 billion.  This announcement, along with the November 19, 2001 announcement of a $700 million charge to buy out a note payable, caused Dynergy to bail out of the deal to buy Enron on November 28, 2001.  This proved to be the defining moment for Enron -- that would cause Enron’s management to realize that Enron had no hope of survival.  Finally on December 2, 2001 Enron filed for bankruptcy (Zellner).  In the end Enron fared no better than other companies that perpetrate this kind of activity.  This description is what really happened, but how these events were displayed to the public is a different story.

In early 2001 Jim Chanos, the person who runs Kynikos Associates, was the first to say what everyone can now see -- Enron had absolutely no way to earn money.  The parent company had become nothing but a hedging entity for all of its subsidiaries and affiliates.  The operating margin for Enron was way down in 2001, at 2%, from its level in 2000, of 5% (McLean).  This kind of a decrease in one year is unheard of in the utilities industry.  Chanos went on to point out how Enron was still aggressively selling stock, even though management understood that there was very little to back up the shares that they were selling.  Chanos was also the first person to take notice of and publicly identify the partnerships where Enron was hiding some of its debt (McLean).  Enron’s CFO Andrew Fastow ran these partnerships, which would later become known as the LJM partnerships.  These partnerships were recorded as related parties, but were never consolidated so that the debt never showed up on Enron’s financial statements, as it would have if statements were prepared according to GAAP (McLean).  Thanks to Jim Chanos the public was made aware of what was going on, and actions have been taken to implement changes to prevent a similar instance in the future.

Changes

Since these events have taken place, see exhibit 1, many changes have come about within the accounting industry.  Some of these changes originated with the AICPA and other accounting groups.  Still other changes have come from the government and government agencies or have just naturally evolved with time. 

The AICPA made several new Statements on Auditing Standards in response to the Enron events.  The three that appear to be most closely linked to the Enron and Andersen debacle are SAS 96, SAS 98, and SAS 99.  SAS 96 became effective January of 2002 and dealt with the record retention policies of accounting firms.  In SAS 96 the requirements of SAS 41, which was the first SAS to address record retention, were reaffirmed.  Also several new regulations were added.  SAS 96 contains a list of factors that auditors should consider when attempting to determine the nature and extent of documentation for a particular audit area and procedure.  It also requires auditors to document all decisions or judgments that are of a significant degree (SAS 96).  For example, a decision of a significant degree would be an auditor approving a client not using GAAP for a portion of their financial statements.  These changes appear to be a direct result of the paper shredding that went on at Arthur Andersen immediately after the Enron bankruptcy.  SAS 98 makes a lot of revisions and amendments to previous statements.  These changes include changes to GAAS, changes to the relationship between GAAS and quality control standards, and audit risk and materiality concepts in audits (SAS 98).  All of these changes would appear to be related to problems that were discovered in the Andersen audit of Enron. SAS 99 outlines what fraud is, reaffirms the auditor’s responsibility to look for fraud, and reaffirms the necessity to gather all information for an audit (SAS 99).  These changes appear to be in connection to the fact that Anderson did not find any fraud in Enron’s books, where fraud existed.  These changes all came from within the AICPA.

Many accounting firms and independent CPAs reacted to these events and implemented changes in procedure voluntarily.  The biggest change that accounting firms made was a move made by the four remaining members of the big five, KPMG, Ernst and Young, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers.  These four companies decided to break all ties with Andersen in an attempt to avoid being dragged down with the selling controversy surrounding the Enron scandal.  This distancing was also due to the major changes mandated to Andersen as a way to get back on their feet after the scandal broke, and the other firms were afraid that these changes would be forced on them as well (Schroeder). 

This scandal also caused many major companies who had used Andersen as their auditor in past years to hire auditors to go over past years audits double checking all of the audit work that could be double checked.  This cloud of doubt also extended to companies that Andersen gave qualified audit reports or consulting advice to.  PSC Inc. is a software manufacturer with increasing financial problems.  When Andersen performed their last audit on the company they raised many questions about the company’s ability to continue to exist as a viable entity (Elstein).  Leaders of many blue-chip firms were very concerned by this scandal, and they met to discuss plans for future changes.  At the end of these meetings, it was decided that a new oversight committee should be proposed and that these companies were the people to propose such an idea.  This idea would set up a committee sponsored completely by the SEC.  The members of this committee were to be completely independent of the public accounting firms (Bryan-Low).  The oversight committee mentioned was never instated because the current public oversight committee dissolved itself only a short time after this proposal was made, as they felt they had let down the community and the industry.  All other changes that would be to come into the accounting industry would have to be brought in by the government or other outside sources, because the accounting industry felt that they had changed more than enough to forestall a reoccurrence of the Enron/Arthur Anderson debacle.

The government reacted aggressively when they became aware of the Enron scandal, and a flurry of legislation and proposals emanated from Congress and the SEC about how best to deal with this situation.  President Bush even announced one post-Enron plan.  This plan was to make disclosures in financial statements more informative and in the management’s letter of representation.  This plan would also include higher levels of financial responsibility for CEOs and accountants.  Bush’s goal was to be tough, but not to put an undue burden upon the honest accountants in the industry (Schlesinger). 

By far the biggest change brought about is the Sarbanes-Oxley Act (Ditman).  The Sarbanes-Oxley Act requires companies to reevaluate it’s internal audit procedures and make sure that everything is running up to or exceeding the expectations of the auditors.  It also requires higher level employees, like the CEO and CFO to have an understanding of the workings of the companies that they head and to affirm the fact that they don’t know of any fraud being committed by the company.  Sarbanes-Oxley also brought with it new requirements for disclosures.  These requirements included reporting of transactions called reportable transactions.  These transactions are broken down into several categories, which impact every aspect of a business.  One of these categories is listed transactions-which are by far the worst. They are transactions that are actually written out in a list, each one pertaining to one specific situation. Another is transactions with a book-to-tax difference of more than ten million dollars.  There are several others, however these two will have the greatest effect.  Accompanying these requirements are strict penalties if these transactions are not reported and discovered later.  This act will mean significant additional work for accountants over the next several years. 

The GAO (Government Accounting Office), held several meetings revolving around this scandal and the resulting fallout.  One such meeting had David Walker, Comptroller of the United States, discussing his beliefs as to where serious problems existed.  The four major areas outlined in his discussion were corporate governance, independent audit of financial statements, oversight of the accounting profession, and accounting and financial reporting issues (GAO-02-483T).  This discussion sparked the bringing several GAO accountants and heads of business into Congress committees for advice and to get feedback for proposed ideas.  The other large meeting was held to discuss the Sarbanes-Oxley act that was put before Congress.  Paul Sarbanes, Chairman of the Committee on Banking, Housing, and Urban Affairs presented the new act to the GAO, in an attempt to allow the members to see the necessity of the Sarbanes-Oxley act, as well as support it at the congressional level (GAO-02-742R).  These were the two main changes emanating from the Government Accounting Office.

Another big change that came from the Enron bankruptcy filing was a new push to separate auditing services from consulting services.  Immediately after it became clear that Andersen had no chance for survival Andersen’s management decided to try one last thing to raise some money to settle the lawsuits filed against them.  This last effort was to sell off their consulting service.  Several years before the Enron/Andersen debacle, Anderson’s consulting arm had forcefully split from the company because of a lack of distribution of income to partners from the consulting arm of the business (Toffler).  Concordantly, the consulting arm was relatively new to the company.  The buyer of the consulting service would be KPMG, one of the now big four accounting firms, and they would pay more than $250 million for this consulting arm (Frank).

  For many years the SEC Chairman, then Arthur Levitt Jr., had been calling for the separation of auditing and consulting services within one company.  However big firms like Andersen would apply their proverbial weight to attempt to show that consulting did not interfere with an auditor’s independence.  Since the major concern of Andersen’s role in the controversy centers on their independence, and because of the large monetary consulting fees being paid to them by Enron, the push has been started anew by Paul Volcker the former Federal Reserve Chairman.  Realistically, few think that the big firms will be able to dissuade the SEC from actually implementing such a rule (Brown).    Many companies who use auditors believe that this is not the answer, because of the fact that it will cause them to hire one firm to do auditing work, and another to do non-audit work like taxes and other filings (Solomon).  In an attempt to not get damaged by any imminent government action, many business-including Disney and Apple Computer Inc-have already begun splitting their audit and non-audit work between different firms.  Harvey Pitt, current SEC Chairman, does not believe that such a drastic change is called for, and instead is pushing for not allowing external auditors to perform internal audits for companies, and that all other non-audit work be approved by the SEC and board audit committees before the work is done (Byrnes).  This controversy has long outlasted both companies involved in the actual debacle, and will continue until specific actions are taken.

These events have also allowed the world of academia to make many influential changes to curriculums, without adding or dropping classes.  These changes include a new emphasis on accounting ethics and on special purpose entities.  Ethics have always played an important role in the accounting industry.  However, in recent years ethics education within accounting classes had fallen by the wayside as audit failures continue to stack up, and accountants are viewed as at least partially to blame.  Several professors of accounting at several different colleges across the United States have redoubled their efforts to include ethics in their teachings at every level, from principles to advanced.  Special purpose entities are not something that have been highly discussed in many accounting classes up to this point in time.  However, in light of the tax shelter abuse perpetrated by Enron, many professors are now finding it necessary to begin to explain these entities and their uses to their students.  The goals of all the curriculum changes are to make accounting graduates better prepared to confront ethical issues so that events such as the Enron/Anderson debacle will not be repeated in the future (Wei).

The effects of the Enron/Anderson debacle can even be felt at an international level as more precautionary measures are taken.  In Singapore, there has been a push to have banks and other lenders rotate their auditors.  The controlling government agency, Monetary Authority of Singapore (MAS), is attempting to make it necessary for all listed companies to rotate their auditors every five years.  The executive director of MAS, Ravi Menon, said “with an extended relationship, auditor firms run the risk of getting too close to the management of the banks they audit, and begin to identify too closely with the banks’ practices and culture” (Day).  It is this closeness that caused Andersen and Enron to work in collusion to escalate the fraud that Enron’s management had perpetrated.  Several other countries where the remaining big four practice are now also looking into such restrictions and changes to protect their citizens.  The effects of the debacle are not merely restricted to the United States; indeed they are felt throughout the business world.

Positive Nature of the Changes

            The changes that have been made, are being made, and will be made, all will have a positive impact on the accounting industry.  These changes, some implemented by accounting companies and agencies, some by the government and governmental agencies, and others by outside sources, will require more work from accountants, but will in the long run improve many factors within the industry. 

            The changes implemented by accounting companies and different accounting agencies will affect only the companies making the changes and the American companies, and subsidiaries.  The three new SAS presented earlier will help to expose fraud and deception where it exists in a company.  They not only make the auditor work harder to demonstrate more fully that no material misrepresentation exists, but also require the company to take a more proactive role in their audits and accounting.  These new SASs will help to restore some of the public’s confidence in auditors and businesses. 

            The move by many businesses to hire new auditors to recheck their past audits, after Andersen’s contributing role had been exposed as aiding and abetting the fraud that existed at Enron, was a wise decision.  This allows the public to see that companies do care that they do not misrepresent their position to the public.  It also creates more work for the accounting industry, which creates job security for accountants.  These changes allow companies to show that even though their auditors were corrupt; the company itself was fine, thereby restoring public confidence in publicly traded companies.

            The governmental changes had the farthest-reaching effect of all the changes that would result from the Enron/Anderson debacle.  The plan that President Bush announced would make the penalties stiffer and would make the culpable, high-level management employees responsible for the workings of the company, something not yet established in American law.  This gives the management of a company a new impetus to make sure that everything is absolutely correct.  Which in turn means that financial statements should be more reliable than ever before. 

            The Sarbanes-Oxley Act will drastically improve the accounting industry in two ways.  First it creates a lot more work for many of the public companies.  This additional work means more job opportunities for many accountants and job opportunity means freedom to tell a client when they are wrong, which in turn makes audits more reliable.  The second way is that it requires tougher restrictions on internal audits and in judging how well the internal audit is conducted.  If the internal audit is functioning effectively, it cuts down on the volume of work that the auditors have to do, thus making it easier for auditors to do audits.  As well as increasing reliability on the internal audit, these changes increase the reliability on the financial statements produced by the companies as well.  This increase in  reliability will in turn increase the public’s confidence in the accounting industry.

            The other changes will have varied levels of effect on the accounting industry, but will all be positive in nature.  The separation of auditing and consulting will move the accounting industry forward a great distance toward increased credibility.  It will decrease the occurrence of non-independence by auditors.  At the same time, this will allow companies to reap the benefits of having both auditors and consultants.  The accounting industry should again flourish, and businesses will see that once the consulting firm gets used to working with a company they will work just as well as the company that they use for audits.  This should provide a means of checks and balances.

The changes in academia will produce a new kind of accountant.  The new accountants will have more training in ethics.  This training in ethics will increase the public’s confidence in accountants and the accountants’ confidence in each other.  Also, accountants will be better prepared to deal with special-purpose entities which will allow more meaningful and correct accounting procedures to prevail where bad or antiquated procedures may have been used in the past.  This will improve the reliability and usefulness of financial statements as well as their reliability.

            All of the positive changes center on revitalizing the public’s ability to trust accountants as well as the companies in which they invest.  Once these bonds of trust have been repaired, after being so badly damaged as a result of the Enron/Andersen debacle, the economic world can move forward with confidence and integrity in a new a positive direction for all people involved.

Conclusion

            Executives at Arthur Andersen and Enron did not set out to have a positive impact on the accounting industry or any industry.  They set out to make as much money for themselves as quickly as possible.  They were willing to do whatever it took to make that money.  These thoughtless acts and greed led both companies to an eventual downfall in bankruptcy.  However, the accounting industry reacted by introducing changes that would, in the long run, improve itself and the economy in which it exists.  The changes that are a response to the Andersen/Enron debacle may be coming to an end.  We are probably seeing the last laws, pronouncements, and statements that are a direct result of these actions.  Still, the changes that have occurred leave the accounting industry and the economy stronger.  Will the industry ever be perfect?  Probably not, but accountants and the world must continue to strive to make it as functional as it can be.  Only by this continued striving can the industry be good enough to function effectively and even thrive.


 

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American Institute of Certified Public Accountants.  Statement on Auditing Standards.  New York, NY.  No. 96.  January 2002.

 

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American Institute of Certified Public Accountants.  Statement on Auditing Standards.  New York, NY.  No. 99.  November 2002.

 

Brown, Ken and Jonathan Weil.  Questioning the Books: How Anderson’s Embrace of Consulting Altered the Culture of the Auditing Firm.  The Wall Street Journal.  March 12, 2002.

 

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Schaffler, Rhonda (Byline).  Market Call [Television Program] January 11, 2002.  Cable News Network.

 

Schroeder, Michael.  Senate Panel Seeks Sweeping Change for Auditors.  The Wall Street Journal.  March 7, 2002.

 

Shwartz, Nelson D.  Enron Fallout: Wide But Not Deep.  Fortune December 24, 2001: 71.

 

Torriero, E. A. and Robert Manor.  Government has More at Stake in Anderson Trial.  Chicago Tribune.  March 3, 2002.

 

Turner, Lynn.  Rethinking Audit Regulation.  CPA Journal January 2002: 10