Global Perspectives on Accounting Education Volume 3, 2006, 27-48 ENRON AND ARTHUR ANDERSEN: THE CASE OF THE CROOKED E AND THE FALLEN A Gary M. Cunningham Visiting Professor Department of Business Administration Åbo Akademi University Turku, Finland Jean E. Harris Accounting Department Pennsylvania State University, Harrisburg Campus School of Business Administration Middletown, Pennsylvania USA ABSTRACT Outside the US, the failures of Enron and Arthur Andersen remain puzzles. How could the accounting and audit failures associated with Enron and Arthur Andersen happen in the US where auditing is sophisticated, accounting principles are strong, and disclosure is emphasized? This is a teaching case for persons outside the US to review the financial reporting and auditing issues related to Enron and to explain the regulation of accounting and auditing in the US. It has broad implications for corporate governance and accounting regulation in other countries as well. In the years after the Enron Corporation declared bankruptcy in 2001 and Arthur Andersen failed in 2002, people are still asking, especially those outside the US, how could this happen? What went wrong? The US has a well-developed set of Generally Accepted Accounting Principles (GAAP) that requires extensive disclosures in audited financial statements, and a well-established federal agency, the Securities and Exchange Commission (SEC) that monitors financial reporting. This case is written for accounting students and others, who are outside the US, to explore the financial reporting and auditing issues related to the debacles at Enron and Andersen and to explain the financial reporting environment in the US. The case is presented in four parts. Part I presents general information about Enron and Andersen. In Part II, the government and legal system 27 28 Cunningham, and Harris of the US, and the regulation of financial reporting and auditing, is described. In Part III, US accounting principles and disclosures are discussed. Finally, in Part IV, the specific financial reporting and auditing aspects of Enron are analyzed, including a review of reforms in the aftermath of Enron. Exhibit 1 provides a list of accounting terminology that may be a useful reference. Introductory observations presented in Exhibit 2 give insight to start the case. EXHIBIT 1 Terminology AICPA American Institute of Certified Public Accountants. Private voluntary professional organization of certified public accountants in the US. CPA Certified Public Accountant. The only professional person who may audit public companies and issue audit opinions in the US. FASB Financial Accounting Standards Board. A private organization designated by Securities and Exchange Commission to establish generally accepted accounting principles for publicly traded companies. GAAP Generally Accepted Accounting Principles. Guidelines for the presentation of financial statements in the US. GAAS Generally Accepted Auditing Standards. Guidelines and procedures used by certified public accountants to conduct audits. Formerly established by the American Institute of Certified Public Accountants. Responsibility now with the Public Company Accounting Oversight Board for public companies. PCAOB Public Company Accounting Oversight Board. Board established by the US Congress to oversee virtually all aspects of the auditing of publicly traded companies. Private company A company for which shares are not traded publicly, thus regulated by the states rather than the Securities and Exchange Commission. Some companies’ shares may be sold publicly solely within a single state and thus be regulated only by a state. Public company A company for which shares trade publicly in interstate commerce and (also publicly therefore must be registered with the Securities and Exchange traded company) Commission. All companies listed on any of the stock exchanges in the US are public companies. (continued) Enron and Arthur Andersen: The Case of the Crooked E and the Fallen A 29 EXHIBIT 1 (continued) SEC registrant Any company that offers its securities in interstate commerce and therefore must register with the Securities and Exchange Commission (SEC). Securities can include debt securities as well as shares of stock. A very small number of companies sell debt securities in interstate commerce but do not sell shares. Such companies are nonetheless required to register with the SEC and are subject to SEC regulation. SEC Securities and Exchange Commission. The agency of the US Government with the primary responsibility for regulation of securities markets. SPE Special Purpose Entity. An entity that is created by another company to engage in a limited specific type of business activity, such as owing or leasing real estate. State board (or An agency in each state that regulates the licensing of certified public state board of accountants and the conduct of accounting within the state, including accountancy) codes of ethics. EXHIBIT 2 Introductory Observations • When faced with massive greed, collusion, and lapse of ethics among company officials, external auditors, outside legal counsel, bankers, and investment firms, it is highly unlikely that any realistic form of regulation would have been able to prevent the financial losses to the employees, shareholders, and creditors of Enron. Enron as a corporate entity did not benefit from the greed. Rather, its shareholders and its employees who had their pension funds invested in Enron shares suffered large financial losses. The SEC and the Texas State Board of Public Accountancy, as well as the US Congress, acted quickly, and began reforms that may minimize similar losses in the future. Arthur Andersen received the ultimate “punishment,” being forced into bankruptcy by the market place, and became a negative example for other major accounting firms. The regulatory approach of the US federal government continues to be a model that other countries are considering. As one example, in January 2006, Mexico adopted reforms that are very similar to those of the Sarbanes-Oxley Act. • Enron the corporate entity likely did not commit obvious major crimes. Enron misled outsiders and misrepresented its financial situation. Under US law, misleading misrepresentation is not necessarily a crime. Fraud is a crime, however, but criminal intent to defraud is very difficult to prove. Arthur Andersen was found guilty of (continued) 30 Cunningham, and Harris EXHIBIT 2 (continued) committing one crime, obstruction of justice, for having destroyed potential evidence by shredding documents, knowing that such documents could be used in an investigation by the SEC. Specific individuals associated with Enron have been charged with serious crimes, and some Enron officials plead guilty to crimes, including conspiracy to mislead through unfair financial reports. • Enron and Andersen both acted with an obvious disregard of any notion of ethical conduct. The breaches of ethics are so obvious they need not be presented in detail. Interesting issues about ethics of the legal, banking, and financial analysis professions are also apparent, but are beyond the scope of this case. It is important to note that breach of ethics is not a crime, ethics and crime are separate issues. • Enron violated GAAP, through 1) incorrect accounting for SPEs including failure to consolidate, selective use of the equity method of accounting, and failure to eliminate the impact of transactions among entities, 2) failure to provide complete disclosure, and 3) unfair financial reporting. It is now apparent that both Enron and Arthur Andersen 1) viewed GAAP as rules rather than principles 2) sought to interpret GAAP in the most aggressive manner, 3) did not consider the fairness principle, one of the most fundamental of GAAP, and 4) ignored the legal precedent that emphasizes fairness over detailed rules, as well as the accounting concept that emphasizes economic substance over legal form. • In other countries, similar bankruptcies have occurred without such a scandal because of one or a combination of four factors: 1) non-Anglo-Saxon companies typically have few public shareholders; 2) few countries other than the US have employee pension funds invested in a company’s own stock; 3) no blatant crimes have been committed or regulations broken, and unfair financial reporting per se is not a crime; 4) a culture of business secrecy often prevails; transparency in reporting is not an objective. The recent Parmalat situation has generated a scandal because crimes, presumably theft, allegedly occurred. • The need for reform is indicated by the Enron case and reforms are occurring in the US. These reforms are designed to give the SEC and the new PCAOB a more activist regulatory role. Public regulation is replacing self-regulation for auditors of public companies. For public companies, the regulation of auditing, traditionally left to the states, is shifting to the federal level. Some aspects of the reform, though, cannot be accomplished by legislative action, regulation, or decree. For example, financial analysts and others cannot be mandated to read and to heed disclosures in financial statements. Enron and Arthur Andersen: The Case of the Crooked E and the Fallen A 31 PART I ENRON AND ANDERSEN – A UNIQUE AND INNOVATIVE COMPANY WITH A PRESTIGIOUS AUDITOR Enron was a leading energy commodities and service company with revenue of US $101 billion in 2000. It employed about 21,000 people, mostly at its headquarters in Houston, Texas. Enron began in 1985 with the merger of two companies, Houston Natural Gas and InterNorth, which sold and transported natural gas. After the merger, Enron was applauded for being innovative in opening new markets. To create new markets, Enron acted as a bank for commodities, buying a commodity from suppliers and selling it to buyers. For example, it would contract to sell natural gas for future delivery at a fixed price. Then if it wanted to hedge the transaction, it would contract again to buy natural gas at the same future date. These types of future contracts are among those called derivatives. To deal with the buyers and sellers who were central to a “trading partners” strategy, sound credit and liquidity were essential. Enron had to deliver cash when buy transactions were settled financially. Therefore, it became important for Enron to generate cash flow and report cash flow internally. Throughout its existence, Enron relied crucially on borrowed cash for its day-to-day operations. With past success, bull markets, debt, inexperienced employees, and diverse businesses, Enron raced to become anything and everything. Its businesses were foreign and domestic, low-tech and high-tech, commercial and residential, wholesale and retail, and regulated and unregulated. It is unlikely that any company could have developed the expertise required. So, it is not surprising that weaknesses emerged. As Enron grew, it began to trade commodities about which its employees knew little. Its commodity banking expanded from natural gas into electricity, Internet broadband, weather futures, and other goods and services. As Enron’s trading grew, its assets shifted from fixed assets such as pipelines, to intangibles, especially contractual rights to commodities, a form of derivatives. Often budgetary and other basic controls were abandoned. Enron did not have a unified strategy. As a result, its aggressive dealmakers transformed Enron from an operating company to an investment fund. Enron’s management and its auditors were not prepared for this transformation and unable to recognize the risks. For many top executives, business was not about selling goods and services; it was about managing earnings, managing reported cash flow, and managing the numbers. Andersen was among the most prestigious international accounting firms in the world. Accounting students in the US often viewed it as the most glamorous and desirable employer. Andersen marketed itself as having fewer offices than its competitors because it operated with larger offices to serve prominent clients. Although Andersen’s client base was diversified, it often had “high flying” companies such as Enron and WorldCom as clients. Enron was Andersen’s second largest client, and the largest client in Andersen’s Houston office. Players in Enron and in Andersen are presented in Exhibit 3 and the downfall is described in Exhibit 4. PART II GOVERNMENT, LEGAL, AND ACCOUNTING ENVIRONMENT OF THE U.S. Government and Legal System Separation of Powers The separation of powers between the federal government and the states is one of the most fundamental aspects of government in the US. The Constitution of the US grants to the federal government only those powers that the states have explicitly ceded to it; all other powers remain by 32 Cunningham, and Harris EXHIBIT 3 Key Players in the Enron-Andersen Case • Kenneth Lay was Enron's Chief Executive Officer (CEO) since 1985. Lay gave up his position in early 2001 to Jeffrey Skilling, but was re-elected in August 2001 when Skilling resigned. Under pressures from creditors, Lay resigned in January 2002. Skilling reported that he left due to personal reasons after more than ten years with Enron. Lay and Skilling allegedly played major roles in the bankruptcy, but did not have a direct impact on the financial reporting and auditing issues. • Andrew Fastow was Enron’s Chief Financial Officer (CFO) until October 2001, when Lay fired him. Fastow had the reputation of being a money wizard who constructed the complex financial vehicles that drove Enron’s growth. Since 1993, Fastow created SPEs that permitted accounting deceptions. Fastow plead guilty in a plea-bargaining arrangement with his wife, who was also implicated. • David Delainey was the CEO of the retail and wholesale energy divisions. He plead guilty to insider trading, for knowingly participating in manipulating reported financial performance. • Ben Gilsan, Jr. was treasurer of Enron until he was fired in October 2001, for benefiting personally from one of Enron’s complex SPE investments. He was a former accountant with Andersen and played a key role in accounting-related deceptions. He plead guilty to one count of conspiracy related to financial reporting deception. • Michael Kopper was Fastow’s assistant who was actively and aggressively involved in creating and managing SPEs, and in the accounting deception, along with Ben Gilsan. He plead guilty to a lesser charge and has been cooperating with the government to investigate and prosecute others. • Richard Causey was the chief accountant working under Fastow. He plead guilty to crimes related to unfair financial reporting in a plea-bargaining arrangement in exchange for his information in the prosecution of Lay and Skilling. • Sherron Watkins previously had a senior position at Enron that was eliminated in a downsizing activity. She was later re-hired and played a major role as the so-called “whistle blower” who started the downfall. She had worked several years as an accountant for Arthur Andersen and then moved to Enron where she worked for Andrew Fastow for eight years. (continued) Enron and Arthur Andersen: The Case of the Crooked E and the Fallen A 33 EXHIBIT 3 (continued) • David Duncan, a partner in the Houston office of Andersen, headed the Enron audit and allegedly orchestrated a document shredding campaign. Arthur Andersen terminated Duncan’s partnership shortly after events became known publicly. • Joseph Bernardino, managing partner and CEO of Andersen, tried to defend its audit of Enron rather than admitting failures and accepting the consequences. • Carl Bass, head of the Professional Standards Group at the Houston office of Andersen. Bass advised against the auditors’ accepting certain misleading accounting practices of Enron, but Joseph Bernardino overruled him because of complaints by Duncan. default with the states. Because two of the powers granted to the federal government are international relations and national defense, many persons outside the US assume the federal government is more powerful than it actually is, and assume that it can control the states. Instead, the states are essentially sovereign and control many aspects of day-to-day life and conduct of business. Property rights, enforceability of contracts, and marital status, among other things, are controlled by the states, and the US federal government must recognize the states’ authority. One of the powers granted to the US federal government is regulation of interstate and international commerce. Because Enron’s shares of stock were sold publicly in interstate commerce, its financial reporting was regulated by the SEC, a federal agency. However, the accounting profession, notably auditing, is regulated primarily by the states. Andersen was subject to regulation of Enron’s financial reporting by the SEC and the regulation of its audit of Enron by the Texas State Board of Public Accountancy (http://www.tsbpa.state.tx.us/). Legal System In the US, the federal government and all of the states except Louisiana follow English common law. The case law aspect of English common law is relevant here. Often, written statutory law is unclear or incomplete. Courts then use case law to make decisions. Using case law, decisions of cases in one court are legal precedents in law that, in addition to written law, are to be followed by other courts in the same system of courts. This case-law concept varies from Roman code law that applies in most industrialized non-Anglo-Saxon countries, in which only written statutory law is used for legal decisions. State courts are not obligated to follow legal precedents of federal case law or of case law in other states. Regulation of Financial Reporting and Auditing in the US Regulation of financial reporting and auditing in the US falls into three areas. A summary of details is presented in Exhibit 5. 34 Cunningham, and Harris EXHIBIT 4 The Downfall • Watkins informed CEO of potential crisis. Shortly after Lay resumed the CEO position, Watkins wrote an anonymous letter to him, then sent a signed letter, and visited personally. She informed Lay that Enron’s financial reporting was becoming much too aggressive and misleading, and that the company would implode soon if the misrepresentations were discovered, unless actions were taken. Lay, having been informed, could not deny knowledge of the problem and engaged Enron’s primary outside law firm, Vinson and Elkins, to investigate and to advise whether Enron needed to take specific action. • Law firm responded that no action is needed. Vinson and Elkins responded that the charges were serious, but that no action was needed because the accounting was acceptable. This raises an interesting issue about the ethics of the legal profession issuing an opinion on accounting issues. During the investigation, Vinson and Elkins consulted with Arthur Andersen. The fact that Vinson and Elkins would bring the issue to Enron’s outside auditor raises serious ethical issues. Shortly after the Vinson and Elkins report, Lay and his wife sold some personal shares of Enron, leading to charges of trading based on confidential inside information. • Enron restated its financial statements. In October 2001, shortly after the Vinson and Elkins report, Enron and Andersen announced that Enron’s financial results for previous years would be restated to reflect lower profits and a less favorable financial position. In November 2001, the restated results were released. The market price of Enron decreased steadily and the announcement triggered interest from the SEC and the Texas State Board of Public Accountancy. Subsequently, Enron declared bankruptcy. • Andersen convicted and ceased to conduct business. In June 2002, Andersen was convicted in a US federal court of the crime of obstructing justice by shredding working papers related to Enron audits because Andersen personnel knew that the papers would be evidence in a SEC investigation. A criminal conviction would mean that Andersen could not audit SEC registrants. Andersen announced its intent to go out of business before the SEC took formal action to bar it from auditing SEC clients. In a symbolic action, in August 2002, the Texas State Board of Public Accountancy revoked Arthur Andersen’s license to practice accounting in the State of Texas because of the firm’s professional and ethical misconduct. In June 2005, the US Supreme Court overturned Andersen’s conviction on a legal technicality, but did not absolve Andersen from guilt. Enron and Arthur Andersen: The Case of the Crooked E and the Fallen A 35 EXHIBIT 5 Regulations of Accounting in the US Nature of Company Public Companies Public Companies Private Traded Interstate Traded Intrastate Companies not (more than one state) (within one state) Traded Publicly Aspect of Regulation A. ACTIVITIES Right to Practice in State Boards State Boards State Boards General Right to Practice Before US / SEC N/A N/A SEC Conduct of Audits Formerly: State boards State boards based State boards based on GAAS. on GAAS based on GAAS Currently: PCAOB with SEC oversight B. FINANCIAL INFORMATION Financial Reporting SEC based on GAAP State law and None regulation The Practice of Public Accounting and Auditing Public accounting regulation includes rules of professional and ethical conduct, testing and licensing of auditors, and similar items. In Texas, as in other states, regulation of the public practice of auditing includes certifying and licensing public accountants and enforcing rules for professional conduct. An audit opinion may be signed only by a licensed Certified Public Accountant (CPA). The Texas State Board of Public Accountancy, like most of the state boards, is non-activist, meaning it does not actively monitor accounting activity, but instead punishes accountants who violate standards of professional conduct. The SEC requires that SEC registrants must be audited by a CPA licensed by a state. Also, the SEC grants permission for specific accounting firms to represent clients before the SEC. The SEC has relied largely on the states for the regulation and qualification of accountants. Private voluntary professional associations, such as the American Institute of Certified Public Accountants (AICPA), have influence, but no direct role in regulating financial reporting and 36 Cunningham, and Harris auditing. Historically, however, the AICPA had more influence on the practice of public accounting than it now has. Financial Reporting The SEC as well as state securities agencies and various private stock exchanges specify the kinds of financial reports that public companies must issue. The SEC web site http://www.sec.gov gives the SEC requirements. Among other things, the SEC requires registrants to file unaudited quarterly financial statements (10-Qs) and audited annual financial reports (10-Ks). SEC filings are available to the public via Internet or via written request, and annual reports must be sent to shareholders individually. In general, the approach of the SEC is non-activist; it does not attempt to monitor information. Instead, by assuring information is available to the public, it has relied on the market place to be self-regulating, based on the notion that financial markets are efficient and will respond immediately and in an unbiased manner to publicly available information. The expectation is that the SEC will respond quickly with enforcement action and apply sanctions when suspected irregularities are brought to its attention. In some cases, the SEC does monitor the reports of companies that it suspects of improper reporting. The SEC is now under pressure to expand its monitoring and enforcement activities. Conduct of Audits Audits in the US are performed in accordance with Generally Accepted Auditing Standards (GAAS); auditing is not addressed by GAAP. Until 2002, auditing was largely self-regulated. Auditing standards were established by the Auditing Standards Board (ASB), a senior technical committee of the AICPA. Additionally, mandatory quality reviews for auditing firms with AIPCA members were directed by the AICPA’s Division of Firms and conducted by members of the AIPCA. In 2002, in response to a wave of financial reporting scandals, the US Congress adopted the Sarbanes-Oxley Act. Part of this act provides for the creation of the Public Companies Accounting Oversight Board (PCAOB) to establish auditing standards with approval by the SEC and to oversee the quality of work performed by auditing firms. Thus, the auditing of publicly traded companies is now regulated by the US federal government rather than by the profession itself. PART III FINANCIAL REPORTING PRINCIPLES AND DISCLOSURES US federal law requires publicly traded companies to present financial reports in accordance with GAAP, and the SEC has the authority to establish GAAP. Rather than exercising this right, the SEC has relied on other organizations to set financial reporting standards under its oversight. The evolution of written GAAP is presented in Exhibit 6. Currently, the Financial Accounting Standards Board (FASB) establishes GAAP for publicly traded companies. The FASB began as a private-sector organization but has evolved into a quasi-public organization supported by the US federal government and by sales of publications. In the US, there is no expectation that a company would use the same accounting principles for external financial reporting as for income tax reporting. For income tax purposes, companies tend to minimize taxable income. Thus, it is common and ethical for companies to report less taxable income than financial statement income. This differs from a substantial number of other