The Lessons from Enron: The Importance of Proper Internal Controls

The events were finally resulting the filing for bankruptcy in December 2001, started way much before fraud at Enron could be even suspected.  Andersen played a major role in the collapse of Enron.  Andersen failed two times regarding audit issues just a few years short time before the collapse of Enron, at Waste Management in 1996 and at Sunbeam in 1997. The two audit failures mentioned above should have been huge warning signs for Andersen to protect itself against another client failure but what they had to face regarding Enron was worse than they ever had.  Some internal memos at Andersen made it clear that several conflicts existed between the auditors and the audit committee of Enron.   These memos contained several e-mails as well which expressed concerns about accounting practices used by Enron.  David B. Duncan as the leading partner on the audit tipped over these concern. 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. Andersen’s independence is also highly questionable due to the relationship between audit and non-audit fees. The person who first spotted in 2001 that there wasn’t even any chance for Enron to make profit was Jim Chanos, the head of Kynikos Associates. He said that that parent company had technically become nothing more than a hedging entity for all of its subsidiaries and affiliates.  In 2001 the operating margin of Enron went down significantly to 2% from the previous year’s figure of 5% which is more than interesting because this kind of a decrease in one year is unheard of in the utilities industry. Chanos also pointed out that Enron was still aggressively selling stocks, despite there was hardly any capital to back up the shares they were selling.

To be professional and effective, auditors must be independent of management and evaluate the financial representations of management for all users of financial statements. Less than 30% of the fees that Andersen received from Enron came from auditing, with the balance of fees coming from consulting. Andersen acted as Enron’s external auditor and as its internal auditor. Andersen’s work as a consultant raises several questions. It appears that Andersen’s audit team, when faced with accounting issues, chose to ignore them, acquiesced in silence to unsound accounting, or embraced accounting schemes as an advocate for its client.

Auditors assess the internal controls of a client to determine the extent to which they can rely on a client’s accounting system. Enron had too many internal control weaknesses to be given here. Two serious weaknesses were that the CFO was exempted from a conflicts of interest policy, and internal controls over SPEs were a sham, existing in form but not in substance. Many financial officials lacked the background for their jobs, and assets, notably foreign assets, were not physically secured. The tracking of daily cash was lax, debt maturities were not scheduled, off balance sheet debt was ignored although the obligation remained, and company-wide risk was disregarded. Internal controls were inadequate; contingent liabilities were not disclosed; and, Andersen ignored all of these weaknesses.

Auditors focus on material misrepresentations. A misrepresentation is material if knowledge of the misrepresentation would change the decisions of the user of financial statements. When Enron began to restate its financial statements and investors began to grasp its misrepresentations, the response of the market is indisputable as to materiality. Many errors were known, but were dismissed by Andersen as immaterial. Other errors may not have been known, but should have been known if reasonable inquiry would have revealed them.

At Enron and at Andersen, the business model and the organizational culture were changing. Enron was moving to a new business model dominated by intangible assets, the rights to buy and sell commodities. This change in assets was driven by a new organizational culture which then aggressively cultivated its own growth. As auditors moved to become part of a consulting industry, their business model and organizational culture were changing too. It is likely that both the changes at Enron and at Andersen were increasing risks for investors. Enron’s movement away from the dominance of fixed assets to the dominance of intangible assets was likely to increase volatility, and this prospect was compounded by the use of mark-to-market accounting. Also, Andersen’s movement away from the professionalization of auditing to the commercialization of consulting was likely to weaken auditors as monitors of management. Into the mix of changing business models and cultures, add people who were not equipped for the changes. The young trading executives at Enron chased the deal for earnings, while failing to grasp the risks attached to the intangibles that were driving growth in earnings. Likewise, young auditors at Andersen embraced consulting, while failing to understand the risk of audit failure.

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.

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.

By far the biggest change brought about is the Sarbanes-Oxley Act. The Sarbanes-Oxley Act requires companies to revaluate their 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.

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 centres 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. 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. 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.

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