Holmes Institute HI6026: Enron Scandal and Auditor's Legal Liability

This report provides an in-depth analysis of the Enron scandal, examining the timeline of events, the factual issues that led to the scandal, and the penalties imposed on involved parties. It delves into the relevant issues in auditing and accounting raised by the case, including the failure of Arthur Andersen to detect and prevent fraudulent activities. The report identifies the root causes of these issues, such as organizational culture and the use of mark-to-market accounting. It also discusses the judgments for the defendants and offers recommendations for improving audit strategies, programs, and other effective measures to prevent similar scandals in the future. The analysis highlights the importance of auditor independence, ethical conduct, and adherence to accounting standards, as well as the impact of the Sarbanes-Oxley Act. The report provides valuable insights into the complexities of financial fraud and the critical role of auditors in maintaining transparency and accountability.

Auditing Theory and Practice
Module Number

Executive summary
As the field of finance become more popular in last two decades, so the fraudulent
and scandalous activity amongst it. To check this frauds and scandals from happening, all the
financial companies employees the team of auditors from within and outside the company.
But even then, some companies still are not able to eradicate the scandals from happening
(Li, 2010). Most of the time these scandals happen due to the negligence of the auditors and
the firms doing the accounting for the company. This assignment uncovers one such scandal
known as Enron scandal. Enron scandal happened because the accounting practices adopted
by the company were false, incorrect and improper. It is found that in the given case,
auditors were not concerned with prepared falsified misstatement of the recorded items the
financial statements which are not correct, Enron continued its fraud activities and provided
shareholders with the statements that were misrepresented. This reveals that however,
auditors could have assisted company to comply with the accounting standards and maintain
the transparency in the books of account.

Table of Contents
Executive summary.........................................................................................................1
Introduction....................................................................................................................2
Main body......................................................................................................................2
Time line of events and factual issues that caused Enron Scandal....................................2
Penalties imposed on involved parties...........................................................................3
Relevant issues in Auditing and Accounting raised by the case........................................5
Root cause of the issues................................................................................................6
Judgement for the defendants........................................................................................7
Recommendations and possible improvements to:..........................................................7
 The audit strategy..............................................................................................7
 The audit programme.........................................................................................7
 Other effective measures....................................................................................8
Conclusion......................................................................................................................8
References....................................................................................................................10

Introduction
With the changes in the economic, all the companies needs to get their financial
reports audited with the auditors. All the auditors works in the best interest of the
stakeholders and stands in the fiduciary position to the stakeholders. They help companies to
set up true and fair view of the recorded items in the books of account of company. The
auditors are the highly responsible for the auditing work and helps Company to strengthen
transparency in their recorded books of accounts. In this paper study has done to understand
how a renowned company can be scandalised because of negligence on some auditor’s part.
This case helps to understand some theories and show their practical implication in real life
conditions. Arthur Andersen, the party found to be negligent professionally is undertaken in
this case, the penalties levied on it and the reasons of negligence and penalties are also
discussed in depth (Cunningham & Harris, 2006). This case threw light on the issues in
accounting and auditing, factors that contributed to the negligence on the part of auditors and
put forward some recommendations for how to improve auditor’s behaviour. Thus providing
a layout to improve the strategy, measures and programme of audit. However, auditors have
right to pass their audit qualified and non-qualified audit report to the company. This shows
the legal compliance and recording frameworks of company in their prepared financial
statements.
Main body
Time line of events and factual issues that caused Enron Scandal
It is also a matter of interest in this case that top management created a false growth bubble
and stated the false earning in market by providing the financial statements that were
misrepresented. So in order to check this kind of frauds from happening and it’s important to

maximise the quality of auditors and raising their standards. The Enron scandal was one of
the most scandalous act on the Wall Street and shook it to its core. Enron was one of the most
successful business in country but this scandal brought company on his knees overnight. Due
to bankruptcy, the shares of company fell to 0.26% from $90.75. Everything happened like
chain reaction due to series of events which no one foresee (Nelson, Price & Rountree, 2018).
The given scandal focuses on the failure of company to maintain the transparency in the
recorded items and meet its liabilities in the market. However, all the auditors while making
strategy, needs to maintain integrity and avoid conflict of interest of any sort with company.
Nonetheless, all the strategies should have been supported by the GAAP rules within
company to strengthen the true and fair view of the recorded items.
The events started when Jeffery Skilling took over as head of newly incorporated Enron
Finance Cooperation in 1990. Those were the times when the regulatory requirements were
almost next to none which lead to the growth of Enron and its becoming one of the most
profitable company. Jeffery introduced the mark-to-market accounting method also known as
MTM which leads to downfall of the company (Pentrice, 2002).
In this method estimation and expectations were taken into the account prepare reports
instead of real numbers, thereby inflating of accounts. However, company failed to comply
with the accounting standards and laws to prepare the recorded items in the books of
accounts. In coming years, Enron made a bad decision of investing huge sum of money on
high speed broadband project which was unsuccessful and its returns were zero. Skiling hid
all these losses along with trading ones behind the MTM accounting method. It was done by
reporting estimated profits of newly purchased or built asset, even when return were zero
(Sanchez & Zhang, 2012). The losses due to the difference in actual and estimated revenues

was hit by transferring the assets to undisclosed corporation. Thus the activities with zero
profits were write off without anyone’s notice.
The profits of Enron Were depicted higher than actuals because of these activities and further
fuelled by CFO, Andrew Fastow through Special Purpose Vehicle (SPV) (Boje,
Rosile,Durant & Luhman, 2014). Arthur Andersen, an audit firm which was known quality
work and professional standards in world is however considered responsible for this scandal
due to lack of professional diligence and negligence on their part. This shows the negligent
part of the company in recording of the financial records in the books of account of company.
Even when financials shows the inflated figures and wrongdoing in accounting practices,
firm keep approving the financials of Enron and accounts related to it. For years Arthur
Andersen LLP provided Enron with approval stamps and doesn’t report the illegitimate
practices. All came into light when Enron filed for bankruptcy on and December 2001 under
chapter 11. New York Stock Exchange suspended Enron’s shares In January, 2002 (Moohr,
2013). The recorded items shows that all the recorded items in the books of account reveal
Penalties imposed on involved parties
Arthur Andersen LLP: the firm was found guilty of destroying physical and electronic
documents which shows misrepresentation of financials by Enron in June, 2002. It was stated
that due to misrepresentation of true financial state of Enron, Arthur Andersen LLP has
involved in unprofessional practice and thus penalty of $ 500,000 along with probation of 5
years was imposed on it. Without the support and misrepresentation of firm, scandal of Enron
wouldn’t have happened. However, the penalties imposed in this LLP was way too low as
compared to the penalties imposed on other related parties.

Jeffrey Skilling: Skilling was sentenced for 24 years because he was found guilty for
conspiracy, insider trading and fraud. Skiling actually suffered imprisonment for 12 years
only out of 24 because Enron paid $42 million to all fraud victims of Enron so that they don’t
challenge the cease of his convection by 10 years. This company has had issue in its business
process due to the case of insider trading.
Kenneth Lay: who died of heart attack even before the materialization of imprisonment
sentence was found guilty of conspiracy, wire frauds, securities fraud, false financial
statements and bank frauds. The frauds wouldn’t have been possible or would have been
detected early if Lay had adopted fair practice and remained true to his authoritative post
(Palmrose & Scholz, 2014).
Andrew Fastow: All the fraud and corruption was made possible because of the practice
introduced by Andrew as CFO. He was found guilty of promoting these fraudulent practices,
wire fraud and securities fraud and thus sentenced imprisonment of five years. He was aware
if all the misrepresentation of financial statements as CFO, but choose to promote them by
keeping his silent. He was responsible pressurising Arthur Andersen to hide these illegitimate
activities and stamp wrong financials.
Bankers: the Merrill Lynch, Citigroup and JP Morgan Chase were penalised $80 million,
$101 million and $135 million respectively as they were pleaded guilty. The amount was paid
to get settlement of Enron enquiry. In addition $50 million paid in aggregate by these banks
for settling charges of city and state.

Relevant issues in Auditing and Accounting raised by the case
Enron Scandal raised many issues that were prevailing in audit and accounting in that era and
hence brought many major changes in auditing and accounting field which led to more
transparent processes of now. Following are the issues brought in limelight with this case.
 All the organizations listed as public entities requires an independent and professional auditor
to certify their financial under The Federal Securities laws of US (Macey & Sale, 2013).
Enron had Arthur Andersen as its auditor but they instead of pointing out the deceptive
practices, misrepresented financials and illegitimate accounting practices, they promoted it
and thus were guilty of professional negligence. The accounts of all the firms needs to follow
up with Generally Accepted Accounting Principles (GAAP) and auditors need to certify that
but Arthur Andersen overlooked this fact and still stamped the financials of Enron (Epstein,
Nach & Bragg, 2009).
 There is need to periodically implement the impairment test in the books of account of
company to assess the impairment loss in the recorded intangible assets in the organization.
However, auditor will assess whether the impairment testing has been implemented as per the
IAS 136 or not.
 The lack of transparency, clarity and consistency in Enron increased the financial risk of
investors and led them to make uninformed decisions. The MTM approach of company hid
the losses and presented the inflated numbers of profit in company.
 The bankers of company, JP Morgan Chase and Citigroup also stayed lenient due to conflict
of interest and thus contributed to frauds.
New Act by congress was enacted in 2002 to address these issues known as Sarbanes- Oxley
Act of 2002. Public Company Accounting Oversight Board had been incorporated to regulate
the auditors who audit public trading companies (Dye, 2013). Due to enactment of this law

the quality standard of audit is increased and the criminal penalties were also increased for
several frauds. Therefore, it put a big question mark on the audit work program whether the
penalties should be set off by the auditors if they fails to deliver their duties or not. After
assessing the case, it is found that auditors stands in the fiduciary position and helps company
to assess the financial items recorded in the books of account. It helps organization to identify
the issues in the recorded items. These auditors issue qualified and non-qualified audit report
based on the recorded financial details.
Root cause of the issues
Due to these wrong practices the financial statements of company were compromised and
lead to misrepresentation. Since the auditors were not concerned with wrongdoing and keep
authorizing the financial statements which are not correct, Enron continued its fraud activities
and provided shareholders with the statements that were misrepresented (Petrick & Scherer,
20013). In this assignment, all the activities and frauds done by Enron have been time lined
and briefed. There were several causes of accounting and auditing issues in Enron which are
listed below:
 Organisation culture: the relationship between management and employees determines the
nature and culture of any organization. There was no trust, openness, communication and
shared vision between management and employees (Kelly & Earley, 2009). The environment
was more deceptive, corruptive, and full of greed, suspicion and secrecy between
management and employees. The dictator management hindered the innovative and creative
side of employees and any employee who reports of wrong doing was fired. This lead to the
continuous misrepresentation of financials on the part of company (Geriesh, 2013). The
organizational culture of the company was not transparent and all the recorded items in the
financial statements were not supported by the proper invoices and material.

 Market pressure: Being nominated six times for best innovative company in US, the market
pressure to stay one of the profiteering organization was extreme. Top management used
inflated profit numbers, complex financial statement and illegitimate accounting practices to
keep the share prices inflated and high level of stock prices (Hooks, Kaplan, Schultz &
Ponemon, 2014). Forging of share prices became transparent during the enquiries and it was
found that all was done to sustain the lead in market and pressure for that was extreme.
 Environment of fraud: It was found that there was no real money in Enron, stock prices
were maintained excessively, earning targets were set up and illegitimate accounting
practices were going on in company. There were many risk factors involved including
significant amount of transactions with party, no sufficient cash flows and unrealistic targets
for financials which points towards the fraud by management (Zahra, Priem & Rasheed,
2007). All the parties and other stakeholders will keep the recorded items separate and asses
the risk factors in the books of account.
Judgement for the defendants
The thing which made Enron case grand is other than mistakes done by guilty parties related
to frauds, no other problem was created by them during trials and judgement (Lennox &
Pittman, 2010). All the involved parties and defendants who plead guilty were subjected to
trials and then penalised with fine and/or imprisonment. There were no mistakes or problems
which resulted in adverse judgement or awarding of damage. This judgment was passed with
a view to assess the problem faced by the stakeholders and deliver the best possible outcomes
in the best interest of the defendant.

Recommendations and possible improvements to:
 The audit strategy
It was recommended that the strategies of audit should become more transparent (Sridharan,
Caines, McMillan & Summers, 2002), improved and involve a well-drawn plan. The auditor
should be independent and strategies must considers the nature, extent and timing of audit
and not only limited to audit of financial statements only. All the auditors while making
strategy should maintain integrity and avoid conflict of interest of any sort with company. All
the accounting policies must follow GAAP within company and auditors should question
company if it’s not the case.
 The audit programme
The increase in reporting requirement by audit team members, promotion of peer check to
identify inefficiency at early stage and their resolution, communication with accountants
regarding complexity or ambiguity are some of the points involved in efficient audit
programme. Along with external environment, Internal operations and internal environment
of organization should be mandatory check for auditors. There should be rotation of audit
team members at periodic durations to avoid conflict of interest with organization (Singleton
& Singleton, 2010). Audit programme must be reviewed and amended and updated time to
time to keep them with changes in time and economy. Since the frauds in case of Enron were
more in transactions of related parties than ordinary one, more and specific consideration
must be paid to them. The audit program of company helps in strengthen the transparency in
the recorded items (Sevin, Schroeder & Bhamornsiri, 2007).
 Other effective measures
Other recommendation and measures which are considered are as follows:

o New set of rules for accounting system must be introduced in order to eradicate manipulative
systems and providing real and transparent information to users.
o Prohibition of provision which allows auditors to provide non audit services like book
keeping, system design and internal audits (Jones, 2011). Only an audit committee should
allow provision of tax services.
o Proper transparency should be set up in the recorded assets to strengthen the overall
outcomes.
o All the internal and external auditors should be qualified for the independent if they are
getting appointed in the organization for the auditing work.
o Financial statements must reflect and report any material adjustment auditor has made.
o Mention of relationship between unconsolidated entities of organization should be there in
audit clearly. Everything should be transparent and crystal clear. Material items and off
balance sheet items must be disclosed (Francis, Khurana, Pereria, 2011).
o The audit firm also should be reviewed from time to time.
o There should be proper code of conduct for the auditors and legal standards should be given
to auditors to strengthen their audit work in the multinational companies. It will make audit
work strong and force company to comply with the applicable laws and regulation.
o There were many risk factors involved including significant amount of transactions with
party, no sufficient cash flows and unrealistic targets for financials which points towards the
fraud by management. Therefore, proper cash matching concept should be supported by the
auditors in the business to mitigate these inherent risk.
o Auditors should have set a proper audit risk model to strengthen the audit risk program which
helps company to lower down its legal compliance issues and set up strong financial
recording framework.