Comprehensive Case A.1 – Enron
- Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read in conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing Standards that are referenced in this book are available for free at:
In addition, the AU Sections that are referenced in this book are available for free at: Finally, a summary of the provisions of the Sarbanes-Oxley Act of 2002 is available for free at:
- Case Questions – Answer Key
1.What is auditor independence, and what is its significance to the audit profession? What is the difference between independence in appearance and independence in fact?
The second general standard of generally accepted auditing standards (GAAS) is, “In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors.” If the auditor is not independent, the financial statements are considered unaudited for all practical purposes. In case where the SEC has found that a CPA firm was not independent, it has required that the financial statements be re-audited by another firm. A lack of independence can result in disciplinary action by regulators and/or professional organizations and litigation by those who relied on the financial statements (e.g., clients and investors). The profession, as a whole, depends on the value of independence in that the auditor’s opinion on the financial statements loses its value if the auditor is not considered to be substantially independent from the management of the firm.
Article IV of the AICPA’s Professional Code of Conduct requires that “a member in public practice should be independent in fact and appearance when providing auditing and other attestation services.” To be independent in fact, an auditor must have integrity, a character of intellectual honesty and candor; and objectivity, a state of mind of judicial impartiality that recognizes an obligation of fairness to management and owners of a client, creditors, prospective owners or creditors, and other stakeholders. To be independent in appearance, the auditor must not have any obligations or interests (in the client, its management, or its owners) that could cause others to believe the auditor is biased with respect to the client, its management, or its owners. Even if the auditor does not have any direct or indirect financial interest or obligation with the client in fact, they must assure that no part of their behavior or actions appear to affect their independence in the opinion of the public. When behavior seems to affect independence it has a similar effect on public opinion as a breach of independence in fact.
The facts of the case reveal numerous issues that suggest that Andersen's independence may have been compromised. For example, Enron was one of Andersen’s biggest audit clients. It paid Arthur Andersen $46.8 million in fees for auditing, business consulting, and tax work for the fiscal year ended August 31, 1999; $58 million in 2000; and more than $50 million in 2001. At Andersen, the compensation of partners depended on their ability to cross-sell other services to its audit clients. More than half of the fees for Enron were charged for non-audit services. By 2001, Duncan was earning more than $1 million a year. The size of the fees would likely have made it hard for Duncan and his fellow auditors to challenge Enron's management team on difficult accounting issues.
In addition, the substantial amount of non-audit work completed by Andersen provided incentives to work as an advocate on behalf of Enron. For example, Arthur Andersen boasted about the closeness of their relationship in a promotional video. “We basically do the same types of things…We’re trying to kinda cross lines and trying to, you know, become more of just a business person here at Enron,” said one accountant.
In addition, Since 1993 Andersen had performed Enron’s internal audit function in addition to performing the audit on its financial statements. Performing both the internal and external auditing functions meant that Andersen was auditing its own work and thus would not be unbiased. In addition, more than eighty former Arthur Andersen accountants were working at Enron. Several were in senior executive positions, including Jeffrey McMahon, who served in the positions of treasurer and president; and vice president Sherron Watkins; and chief accounting officer Richard Causey.
Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: “A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.” Close relationships might affect independence in appearance, even if independence in fact is maintained. Clearly there was cause for concern at Enron. Causey was good friends with Andersen’s global engagement partner, David Duncan. In fact, their families had even gone on vacations together. Andersen employees often attended Enron-sponsored events and office parties. The nature of Causey and Duncan’s close relationship violated the AICPA Code of Conduct’s requirements for independence in appearance.
2.Refer to Section 201 of SARBOX. Identify the services provided by Arthur Andersen that are no longer allowed to be performed. Do you believe that Section 201 is needed? Why or why not?
Section 201 says that it shall be unlawful for a registered public accounting firm to provide any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible.
Arthur Andersen provided services to Enron that would be prohibited today by SOX Section 201. “More than half of that amount (more than $50 million) was for fees that were charged for nonaudit services… $27 million for consulting and other services, such as internal audit services.” Andersen had been providing internal audit services to Enron for eight years. The nonaudit services that Andersen provided were encouraged by the structure of partner compensation.
Importantly, the bill allows an accounting firm to “engage in any non-audit service, including tax services,” that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. The audit committee is required to disclose to investors in its periodic filings its decision to pre-approve non-audit services.
Most observers now agree that Section 201 was needed. The rise of non-audit services has been a common trend in the public accounting profession. In 1993, 31% of the fees in the industry came from consulting. By 1999, that number had jumped to 51%. In fact, the AICPA released a publication in 1999 titled “Make Audits Pay: Leveraging the Audit Into Consulting Services.” The book advised the auditor to think of himself as a “business advisor.” It did note that conflicts could arise from performing the role of business advisor (which was a client advocate) and the auditor (which had to be independent). It advised erring on the side of looking out for the public interest. Other striking examples include KPMG, which billed Motorola $3.9 million for auditing and $62.3 million for other services; Ernst & Young, which billed Sprint Corp. $2.5 million for auditing and $63.8 million for other services; andPricewaterhouseCoopers, which billed AT&T $7.9 million for auditing and $48.4 million for other services.
3.Refer to Sections 203 and 206 of SARBOX. How would these sections of the law have impacted the Enron audit? Do you believe that these sections rewere needed? Why or why not?
Section 203 says that the lead audit or coordinating partner and the reviewing partner must rotate off of the audit every 5 years. Section 206 says that the CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position cannot have been employed by the company’s audit firm during the 1-year period ("the cooling off period) proceeding the audit. Section 203 could have impacted the Enron audit. Lead partner for the Enron engagement, David Duncan had formed a close personal relationship with Enron’s Chief Accounting Officer, Richard Causey. “…and their families had even gone on vacations together.” The nature of this close relationship put Duncan in a position that he might not be able to challenge management. A key point to raise in this response is that David Duncan would not have been the lead audit partner after 5 years of service because of the establishment of Section 203. It is important to point out that the relationship that develops among professionals is interrupted by regulation to help insure independence.
Section 206 requires a “one year cooling off period” for former Andersen employees to accept a position as CEO, CFO, Controller, or Chief Accounting Officer. “Causey was responsible for recruiting many Andersen alumni to work at Enron. Over the years, Enron hired at least 86 Andersen accountants. Several were in senior executive positions.” Section 206 of SOX would have prevented some of these hirings before the cooling off period had expired.
Since both of these laws help to insure independence in appearance and in fact, most students are likely to agree that they were needed. Both Section 203 and Section 206 would have impacted the Enron engagement.
4.Refer to Section 301 of SARBOX. Do you believe that Section 301 is important to maintaining independence between the auditor and the client? Why or why not?
Section 301 of SARBOX requires that the “audit committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer.” As a result, the relationship between the audit firm and the CFO and/or Controller at an audit client has changed dramatically. In the past, it may have been difficult for an auditor to challenge the CFO and/or the Controller on difficult accounting issues because the auditor knew that these individuals had the authority to fire the audit firm from the job. At a minimum, this was a major threat to independence in appearance. Now, the auditor reports directly to the audit committee. As a result, the independence between the auditor and client has improved.
5.Consider the principles, assumptions, and constraints of Generally Accepted Accounting Principles (GAAP). Define the revenue recognition principle and explain why it is important to users of financial statements.
The revenue recognition principle of GAAP states that revenue must be both earned and realized before it is recognized and is supported by the FASB Statement of Financial Concepts No. 5. In addition, the amount of the sale needs to be fixed and determinable. Also, the recognition of revenue is dependent on an assumption that the cash will be collected from the customer in a timely manner. Other points that should be made to students are that the buyer needs to assume the risks and rewards of ownership of the product (i.e., the risk of damage or physical loss). In addition, for certain types of sales, the SEC has established specific and exacting criteria that must be followed in the revenue recognition process.
In the case of Enron, the manner in which MTM accounting was applied to its trading business was suspect. That is, by recognizing the present value of the stream of future inflows under the entire contract as revenues and recognizing the present value of future costs under the entire contract as expenses. Of course, this violated the revenue recognition principle because Enron hadn’t performed under the contract at the time it recognized revenues.
6.Consider the Sithe Energies contract described in the case. Does the accounting for this contract provide an example of how Enron violated the revenue recognition principle? Why or why not? Please be specific.
According to GAAP, in order for revenue to be recognized, it must have been earned by the company. In the present context, Enron used MTM accounting to allow for the recognition of the present value of the stream of future inflows as revenues on its contract with Sithe Energies. However, the application of MTM (in this context) clearly violates the revenue recognition requirements under GAAP. Consider that Enron recognized revenue from the Sithe contract before the Sithe plant had even begun its own operations. As a result, Enron had not done its part in fulfilling its contract obligations. Thus, revenue on this contract was not yet earned and should not have been recognized.
7.Consult Paragraph 2 and Paragraph A5 (in Appendix A) of PCAOB Auditing Standard No. 5. Based on the case information, do you believe that Enron had established an effective system of internal control over financial reporting related to the contract revenue recorded in its financial statements? Why or why not?
According to paragraph #2 of Auditing Standard #5, “effective internal control over financial reporting provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statement for external purposes. If one or more material weaknesses exist, the company's internal control over financial reporting cannot be considered effective.” In the Appendix of Auditing Standard #5, paragraph #A5 provides more specifics about the definition of an internal control system.
According to that paragraph, such a system is “a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that – (1) Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.”
Enron did not have an effective system of internal control over financial reporting related to contract revenue recorded in its financial statements. Stated simply, Enron’s internal control system does not provide reasonable assurance that revenue was being recorded fairly, and in accordance with GAAP. Consider the valuation assertion. An example of a control procedure that would help to prevent a material misstatement related to the valuation assertion related to revenue would be to require an independent valuation firm to be responsible for valuing all material contracts. When considering the discretion of an independent 3rd party upon an estimate, the estimate can be considered more reliable and competent. Although this valuation procedure can be costly to the client, the reliability of the estimate is far more valuable to users that are dependent upon an unbiased and objective MTM estimate. An example of a control procedure designed to detect a material misstatement related to the valuation assertion about revenue would be to have the internal audit department perform independent recalculations of the valuation of material contracts. In such a situation, the internal audit department would be responsible for evaluating (independent of management) the subjective components of the MTM valuation to determine if the valuation is reasonable, reliable, and has competent evidence to support the valuation. For example, an interest rate used in the calculation of an MTM valuation must be supported by market information that supports the use of a particular interest rate.
8.Consult Paragraphs .21-.22 of AU Section 326. As an auditor, what type of evidence would you want to examine to determine whether Enron was inappropriately recording revenue from the Sithe Energies contract?
According to paragraph #21 of AU Section 326, “To be competent, evidence, regardless of its form, must be both valid and relevant.” Indeed, “the validity of evidential matter is so dependent on the circumstances under which it is obtained that generalizations about the reliability of various kinds of evidence are subject to important exceptions.” So, the competence of audit evidence refers to the quality of the evidence gathered for a financial statement assertion about a financial statement account balance and/or an economic transaction(s). And, as indicated in the standard, there are two aspects to evidence quality that are most important: relevance and reliability. The relevance of audit evidence specifically relates to whether the evidence gathered actually relates to the financial statement assertion being tested. That is, will the evidence allow the auditor to reach conclusions related to that financial statement assertion?
The reliability of the evidence specifically relates to whether the evidence gathered can truly be relied upon as providing a true indication about the financial statement assertion being tested. There are a number of factors that should influence an auditor’s conclusions about reliability, the most important of which is the source (e.g., is it from a third party?) of the audit evidence.
According to paragraph #22 of AU Section 326, “The amount and kinds of evidential matter required to support an informed opinion are matters for the auditor to determine in the exercise of his or her professional judgment after a careful study of the circumstances in the particular case.” So, the sufficiency of audit evidence refers directly to the quantity of the audit evidence gathered about a financial statement assertion. All things being equal, the greater the risk of material misstatement related to the financial statement assertion, the more audit evidence will be gathered by the auditor.