The Enron Fraud Enron Corporation began as a small natural gas distributor and o

Question

The Enron Fraud Enron Corporation began as a small natural gas distributor and over the course of 15 years grew to become the seventh largest company in the United States. Soon after the federal deregulation of natural gas pipelines in 1985, Enron was born by the merging of Houston Natural Gas and Inter North, a Nebraska pipeline company. Initially, Enron was merely involved in the distribution of gas, but it later became a market maker in facilitating the buying and selling of futures of natural gas, electricity, broadband, and other products. However, Enron’s continuous growth eventually came to an end as a complicated financial statement fraud and multiple scandals sent Enron on a downward spiral to bankruptcy.

1. What important internal controls were ignored when LJM1 was created?
2. How might Enron’s harsh Performance Review Committee have aided company executives in committing the fraud?
3. The fraud at Enron is one of many major financial statement frauds that have occurred in recent years (Qwest, Global Crossing, WorldCom, etc.). What are some factors that could explain why the falsifying of financial statements is occurring so frequently?
List four factors.
4. Suppose you are a certified fraud examiner but enjoy investing in the stock market as an additional source of income. Upon research of Enron’s stock, you notice that although its stock has a history of strong growth and a seemingly promising future, Enron’s financial reports are unclear and, frankly, confusing. In fact, you can’t even explain how Enron is making money. Could this lack of clarity in its financial reporting serve as a red flag in alerting you to the possibility of fraud at Enron? Why or why not?
5. How could the auditor, Arthur Andersen in this case, have performed Enron’s audits and not caught the fraud? Is it possible for a financial statement auditor to perform an audit in compliance with generally accepted auditing standards (GAAS) and not catch major financial statement fraud? How would GAAS auditing need to change to guarantee that all frauds are caught?

Explanation / Answer

The internal controls that were ignored when LJM1 was created were first, any SPE that was created must have a certain percentage of equity owned by outside investors. The LJM1 failed to do that. Second, LJM's books were kept separate from Enron's. The accounting firm, Arthur Andersen should not have allowed LJM's financial statements to go unconsolidated. Third, Enron allowed Fastow to sit on the Board of Directors of LJM1, which was a violation of their Code of Conduct. Fourth, Fastow used Enron stock as its capital to sell the Rhythms stock. This is a clear violation as it created a scenario where Enron was basically insuring itself, and therefore, without insurance.

2. How might Enron's harsh Performance Review Committee (PRC) have aided company executives in committing the fraud?

Enron's harsh performance review could have significantly aided their company. The performance review was so strict that if someone was not performing in a given period of time, they would indicate a poor rating to that employee and fire them. This caused employees to be at the top of their game if they expected to remain an employee. Such strict guidelines could have ensured that Enron employees followed all government guidelines and any Code of Ethics that Enron had in place.

3. The fraud at Enron is one of many major financial statement frauds that occurred in recent years (Qwest, Global Crossing, WorldCom, etc.). What are some factors that could explain why the falsifying of financial statements is occurring so frequently?

The falsifying of financial statements occurs so frequently because it is easy to do. Companies find ways around inputting the correct financial information. Furthermore, auditors and other governmental agencies have so many companies that they must examine, that it is hard for them to pay attention to the details of each company.

"Financial statement frauds are caused by a number of factors occurring at the same time, the most significant of which is the pressure on upper management to show earnings. Preparing false financial statements is made easier by the subjective nature of the way books and records are kept. The accounting profession has long recognized that, to a large extent, accounting is a somewhat arbitrary process, subject to judgment. The profession also indirectly recognizes that numbers are subject to manipulation. After all, a debit on a company's books can be recorded as either an expense or an asset. A credit can be a liability or equity. Therefore, there can be tremendous temptation-when a strong earnings showing is needed-to classify those expenses as assets, and those liabilities as equity".

4. Suppose you are a certified fraud examiner but enjoy investing in the stock market as an additional source of income. Upon research of Enron's stock, you notice that although its stock has a history of strong growth and a seemingly promising future, Enron's financial reports are unclear and, frankly, confusing. In fact, you can't even explain how Enron is making money. Could this lack of clarity in its financial reporting serve as a red flag in alerting you to the possibility of fraud at Enron? Why or why not?

The fact that Enron's financial reports should definitely serve as a red flag". In 2000, Enron produced $1.22 billion of owner earnings-the first positive year in four. Using pure speculation, let's assume that Enron would have grown 15% a year for the next ten years, and then slowed to 5%. Sure, there's no basis for our reasoning, but let's forge ahead. Using the above assumptions, Enron would have been worth $60 a share using a 9% discount rate. With a 50% margin of safety, we couldn't buy Enron for more than $30 a share, and certainly not at $90. By the time Enron dropped below $30, the reports of scandal were coming in. If you can't trust the financial statements, you can't own the business-and you would have gotten out as fast as you had jumped in".

1. How could the auditors, Arthur Andersen in this case, have performed their audits and not caught the Enron fraud? Is it possible for a financial statement auditor to form a GAAS-compliant audit and not catch major financial statement fraud? Has GAAS auditing changed enough since Enron to guarantee that all frauds are caught?

In an audit, it is possible that not all documents were provided to Arthur Anderson. It is possible that Anderson only reviewed the documents that they were given, and no fraud was found in those documents. "Fraud schemes are crafted to purposely exploit the accounting system and controls, and therefore it is more difficult for an auditor to find them. Since auditors are not all-knowing beings, the assurance that the financial statements are correct can only be "reasonable" assurance and not total assurance"

It is not the fault of Anderson to find fraud when they are not provided all pertinent information and documents.

I think it is possible for an auditor, from what I have read, to make a complaint but not catch fraud. An auditor can only attempt to mitigate any risk. They cannot fully prevent all fraudulent acts. "The client sometimes fails to acknowledge that the auditors clearly outline their audit and review responsibilities with engagement letters. Those letters usually state that the auditors provide reasonable assurance that they will detect material misstatements, but not absolute assurance".

I think that GAAS auditing has changed sufficient to ensure that many frauds are detected. I think that it is probably impossible to prevent all fraud, even with the standards in place. The government has created SOX to ensure that auditing firms are doing everything that they should to detect fraud.

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