Enron and Arthur Andersen UP
Enron was an energy comp any based in Houston, Texas, that made energy trades. It was formed in 1985 with the merger of Houston Natural Gas and lnterNorth. After an aggressive expansion plan that involved risky financing transactions outside the original, fundamental business model of the company, Enron was billions of dollars in debt. Enron concealed this debt through hidden transactions with related-party
One of the reasons that Enron was able to get away with the fraud for some rime was because of a low-quality audit by its external audit firm, Arthur Andersen. Prior to the failure of Enron in 2001, Arthur Andersen had been involved in two other major audit failures. These failed audits, related to frauds at Waste Management (1996) and Sunbeam (1997), should have raised red flags for management and any outside observers that some of the audit firm’s internal quality assurance processes were not working. When the federal government uncovered Enron’s fraud along with the string of poor quality audits at Arthur Andersen, the government forced the audit firm out of business.
Internal documentation at Arthur Andersen showed that there were conflicts between the auditors and the audit committee of Enron, and that even though there were many individuals concerned about the accounting and disclosure practices at Enron, nothing was done by Andersen to report these problems. In fact, the leading partner on the audit, David Duncan, actively worked to ensure that Enron’s fraudulent financial reporting went uncovered. It appears that Duncan was motivated by the fact that Arthur Andersen was earning enormous consulting fees on the Enron engagement; Enron was a hugely important client for him personally and for the Houston office of Arthur Andersen. Together, these conflicts of interest clouded his independent judgment and professional skepticism.
Around the time that Enron declared bankruptcy in late 2001, Arthur Andersen personnel in the Houston office began aggressively destroying documentation relating to the Enron engagement. This action enabled the federal government to file charges against Arthur Andersen that ultimately led to the downfall of the audit firm. The Sarbanes-Oxley Act of 2002 was enacted partially in response to the Enron fraud and the revelation of the poor audit conducted by Arthur Andersen, which is why this case is of particular historical relevance. Considering these facts, answer the following questions:
a. Members of Enron management were the individuals who perpetrated the financial statement fraud, this, why do you think the auditors were held responsible when they are not the ones actually making the fraudulent
b. Explain why the consulting fees and importance of Enron to David Duncan and the Houston office of Arthur Andersen might have affected Duncan’s independence, and thus the quality of the audits he supervised.
c. Describe the likely users of Enron’s audited financial statements. How were these various user groups likely affected by the fraud?
d. How might the sequential list of frauds perpetrated by Arthur Andersen client (Wage Management, Sunbeam, and finally Enron) have affected the decision by the SEC and federal prosecutors to aggressively seek Arthur Andersen’s legal demise?
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Chapter 1 Solutions
EBK AUDITING: A RISK BASED-APPROACH TO
- Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy in light of a recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was ultimately renewed, the scare has forced Johnson to examine carefully each component of RR’s working capital to make sure it is needed, with the goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well aware that reducing working capital will improve free cash flow. Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnson’s efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about the cash and securities balances. However, with the recent credit scare, this resistance has become unacceptable and Johnson has undertaken a company-wide examination of cash, marketable securities, inventory, and accounts receivable levels. Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, and free cash flow would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stockouts and loss of sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Johnson has begun her investigation by collecting the ratios shown here. (The partial cash budget shown after the ratios is used later in this mini case.) Johnson plans to use the preceding ratios as the starting point for discussions with RR’s operating team. Based on the data, does RR seem to be following a relaxed, moderate, or restricted current asset usage policy?arrow_forwardKPMG LLP served as the external auditor for some of the largest subprimemortgage lenders in the U.S. leading up to and during the housingmarket crisis of the mid to late-2000s. The audits of two of theirlargest lending clients, New Century Financial Corporation and Countrywide,ultimately led the firm to settle litigation charges in 2010 for$44.7 and $24 million, respectively. The business model of these twosubprime mortgage lenders consisted of providing loans to borrowerswith weak credit histories. The business model had begun to fail during2007, when the economy weakened, borrowers began defaulting, andhome prices declined drastically. New Century filed for bankruptcy andCountrywide was purchased by Bank of America, which subsequentlysuffered massive losses related to business failures at Countrywide.Just before the housing crash of 2007 put the companies in severefinancial crises, KPMG had given both companies unqualified auditopinions.In both cases, KPMG was subsequently accused of…arrow_forwardHatfield Industries is a large manufacturing conglomerate based in the United States with annual sales in excess of $300 million. Hatfield is currently under investigation by the Securities and Exchange Commission (SEC) for accounting irregularities and possible legal violations in the presentation of the company’s financial statements. A due diligence team from the SEC has been sent to Hatfield’s corporate headquarters in Philadelphia for a complete audit in order to further assess the situation.Several unique circumstances at Hatfield are discovered by the SEC due diligence team during the course of the investigation:∙ Management has been involved in ongoing negotiations with the local labor union, of which approximately 40% of its full-time labor force are members. Labor officials are seeking increased wages and pension benefits, which Hatfield’s management states is not possible at this time due to decreased profitability and a tight cash flow situation. Labor officials have…arrow_forward
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