case study

Cases from prior editions of Michael C. Knapp’s Contemporary Auditing are available exclusively online
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Comprehensive Cases
1A Jamaica Water Properties
1B AMRE, Inc.
1C United States Surgical Corporation
audits of high-risk aCCounts
2A CapitalBanc Corporation
2B Dollar General Stores, Inc.
2C General Technologies Group Ltd.
2D SmarTalk Teleservices, Inc.
2E Campbell Soup Company
2F Perry Drug Stores, Inc.
2G Rocky Mount Undergarment
Company, Inc.
internal Control issues
3A Saks Fifth Avenue
3B Triton Energy Ltd.
3C Troberg Stores
ethiCal responsibilities
of aCCountants
4A Oak Industries, Inc.
4B Thomas Forehand, CPA
4C Laurel Valley Estates
4D Jack Bass, Accounting Professor
ethiCal responsibilities
of independent auditors
5A Mallon Resources Corporation
5B The PTL Club
5C Zaveral Boosalis Raisch
5D Koger Properties, Inc.
professional roles
6A David Myers, WorldCom Controller
professional issues
7A HealthSouth Corporation
7B PricewaterhouseCoopers Securities, LLC
7C Stephen Gray, CPA
7D Scott Fane, CPA
7E National Medical Transportation Network
international Cases
8A Royal Ahold, N.V.
8B Australian Wheat Board
8C Tata Finance Limited
8D Baan Company, N.V.
ClassiC litigation Cases
9A National Student Marketing Corporation
9B Equity Funding Corporation of America
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Contemporary auditing�
Real Issues and Cases
Ninth Edition
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Contemporary auditing�
Real Issues and Cases
Ninth Edition
Michael C. Knapp
University of Oklahoma
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Contemporary Auditing: Real Issues
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Michael C. Knapp
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DEDICATION�
To Paula, Suzie, and Becky�
This page intentionally left blank
BRIEF CONTENTS�
Preface
SECTION 1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
SECTION 2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
SECTION 3
3.1
3.2
3.3
3.4
3.5
3.6
3.7
SECTION 4
4.1
4.2
4.3
4.4
4.5
4.6
4.7
xxi
Comprehensive Cases
Enron Corporation
Lehman Brothers Holdings, Inc.
Just for FEET, Inc.
Health Management, Inc.
The Leslie Fay Companies
NextCard, Inc.
Lincoln Savings and Loan Association
Crazy Eddie, Inc.
ZZZZ Best Company, Inc.
Gemstar-TV Guide International, Inc.
New Century Financial Corporation
Madoff Securities
1�
3�
23�
39�
53�
71�
83�
93�
107�
117�
131�
143�
161�
Audits of High-Risk Accounts
Jack Greenberg, Inc.
Golden Bear Golf, Inc.
Happiness Express, Inc.
General Motors Company
Lipper Holdings, LLC
CBI Holding Company, Inc.
Geo Securities, Inc.
Belot Enterprises
Regina Company, Inc.
171�
173�
181�
189�
197�
203�
211�
217�
221�
227�
Internal Control Issues
The Trolley Dodgers
Howard Street Jewelers, Inc.
United Way of America
First Keystone Bank
Goodner Brothers, Inc.
Buranello’s Ristorante
Foamex International Inc.
235�
237�
239�
241�
247�
251�
259�
265�
Ethical Responsibilities of Accountants
Creve Couer Pizza, Inc.
F&C International, Inc.
Suzette Washington, Accounting Major
Freescale Semiconductor, Inc.
Wiley Jackson, Accounting Major
Arvel Smart, Accounting Major
David Quinn, Tax Accountant
269�
271�
275�
279�
281�
285�
287�
289�
ix
x
Brief Contents
SECTION 5
5.1
5.2
5.3
5.4
5.5
5.6
SECTION 6
6.1
6.2
6.3
6.4
6.5
6.6
SECTION 7
7.1
7.2
7.3
7.4
7.5
7.6
SECTION 8
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
8.14
Ethical Responsibilities of Independent Auditors
Cardillo Travel Systems, Inc.
American International Group, Inc.
The North Face, Inc.
Waverly Holland, Audit Senior
Phillips Petroleum Company
American Fuel & Supply Company, Inc.
293�
295�
301�
305�
313�
319�
323�
Professional Roles
Leigh Ann Walker, Staff Accountant
Bill DeBurger, In-Charge Accountant
Hamilton Wong, In-Charge Accountant
Tommy O’Connell, Audit Senior
Avis Love, Staff Accountant
Charles Tollison, Audit Manager
327�
329�
331�
335�
339�
343�
347�
Professional Issues
Ligand Pharmaceuticals
Sarah Russell, Staff Accountant
Bud Carriker, Audit Senior
Hopkins v. Price Waterhouse
Fred Stern & Company, Inc.�
(Ultramares Corporation v. Touche et al.)
First Securities Company of Chicago�
(Ernst & Ernst v. Hochfelder et al.)
351�
353�
359�
363�
369�
International Cases
Livent, Inc.
Parmalat Finanziaria, S.p.A.
Kansayaku
Registered Auditors, South Africa
Zuan Yan
Kaset Thai Sugar Company
Republic of Somalia
OAO Gazprom
Societe Generale
Institute of Chartered Accountants of India
Republic of the Sudan
Shari’a
Mohamed Salem El-Hadad, Internal Auditor
Tae Kwang Vina
391�
393�
407�
421�
431�
443�
455�
459�
463�
477�
493�
505�
511�
521�
527�
Index
Summary of Topics by Case
Summary of Cases by Topic
377�
385�
533�
543�
555�
CONTENTS�
Preface
xxi
SECTION 1
Comprehensive Cases
1
Case 1.1
Enron Corporation
3
Arthur Edward Andersen established a simple motto that he required his subordinates
and clients to invoke: “Think straight, talk straight.” For decades, that motto served Arthur
Andersen & Co. well. Unfortunately, the firm’s association with one client, Enron Corporation,
abruptly ended Andersen’s long and proud history in the public accounting profession.
Key topics: history of the public accounting profession in the United States, scope of
professional services provided to audit clients, auditor independence, and retention
of audit workpapers.
Case 1.2
Lehman Brothers Holdings Inc.
23
Wall Street was stunned in September 2008 when this iconic investment banking firm
filed for bankruptcy. Lehman’s bankruptcy examiner charged that the company had en�
gaged in tens of billions of dollars of “accounting-motivated” transactions to enhance
its apparent financial condition.
Key topics: “accounting-motivated” transactions, materiality decisions by auditors,
responsibility of auditors to investigate whistleblower allegations, auditors’ legal
exposure, communications with audit committee.
Case 1.3
Just for FEET, Inc.
39
In the fall of 1999, just a few months after reporting a record profit for fiscal 1998, Just
for FEET collapsed and filed for bankruptcy. Subsequent investigations by law enforce�
ment authorities revealed a massive accounting fraud that had grossly misrepresented
the company’s reported operating results. Key features of the fraud were improper
accounting for “vendor allowances” and intentional understatements of the company’s
inventory valuation allowance.
Key topics: applying analytical procedures, identifying inherent risk and control risk
factors, need for auditors to monitor key developments within the client’s industry,
assessing the health of a client’s industry, and receivables confirmation procedures.
Case 1.4
Health Management, Inc.
54
The Private Securities Litigation Reform Act (PSLRA) of 1995 amended the Securities
Exchange Act of 1934. This new federal statute was projected to have a major impact
on auditors’ legal liability under the 1934 Act. The first major test of the PSLRA was
triggered by a class-action lawsuit filed against BDO Seidman for its 1995 audit of
Health Management, Inc., a New York–based pharmaceuticals distributor.
Key topics: inventory audit procedures, auditor independence, content of audit work-
papers, inherent risk factors, and auditors’ civil liability under the federal securities laws.
Case 1.5
The Leslie Fay Companies
71
Paul Polishan, the former chief financial officer of The Leslie Fay Companies, received
a nine-year prison sentence for fraudulently misrepresenting Leslie Fay’s financial
xi
xii
Contents
statements in the early 1990s. Among the defendants in a large class-action lawsuit
stemming from the fraud was the company’s audit firm, BDO Seidman.
Key topics: applying analytical procedures, need for auditors to assess the health
of a client’s industry, identifying fraud risk factors, control environment issues, and
auditor independence.
Case 1.6
NextCard, Inc.
83
In January 2005, Thomas Trauger became the first partner of a major accounting firm to
be sent to prison for violating the criminal provisions of the Sarbanes-Oxley Act of 2002.
Key topics: identifying fraud risk factors, nature and purpose of audit workpapers,
understanding a client’s business model, criminal liability of auditors under the
Sarbanes-Oxley Act, and collegial responsibilities of auditors.
Case 1.7
Lincoln Savings and Loan Association
93
Charles Keating’s use of creative accounting methods allowed him to manufacture
huge paper profits for Lincoln.
Key topics: substance-over-form concept, detection of fraud, identification of key
management assertions, collegial responsibilities of auditors, assessment of control
risk, and auditor independence.
Case 1.8
Crazy Eddie, Inc.
107
“Crazy Eddie” Antar oversaw a profitable chain of consumer electronics stores on the
East Coast during the 1970s and 1980s. After new owners discovered that the com�
pany’s financial data had been grossly misrepresented, Antar fled the country, leaving
behind thousands of angry stockholders and creditors.
Key topics: auditing inventory, inventory control activities, management integrity, the
use of analytical procedures, and the hiring of former auditors by audit clients.
Case 1.9
ZZZZ Best Company, Inc.
117
Barry Minkow, the “boy wonder” of Wall Street, created a $200,000,000 company that
existed only on paper.
Key topics: identification of key management assertions, limitations of audit evi�
dence, importance of candid predecessor successor auditor communications, client
confidentiality, and client imposed audit scope limitations.
Case 1.10
Gemstar-TV Guide International, Inc.
131
In 2000, U.S. News and World Report predicted that Henry Yuen, the chief executive
of Gemstar-TV Guide International, would become the “Bill Gates of television” thanks
to the innovative business model that he had developed for his company. When that
business model proved to be a “bust,” Yuen used several accounting gimmicks to em�
bellish his company’s reported operating results.
Key topics: conditions commonly associated with “audit failures,” revenue recognition
principle, quantitative and qualitative materiality assessments, and “legal” vs.“ethical”
conduct.
Contents
Case 1.11
New Century Financial Corporation
143
The collapse of New Century Financial Corporation in April 2007 signaled the
beginning of the subprime mortgage crisis in the United States, a crisis that would
destabilize securities and credit markets around the globe. A federal bankruptcy exam�
iner has maintained that New Century’s independent audits were inadequate.
Key topics: auditing loan loss reserves, Section 404 audit procedures, material inter�
nal control weaknesses, auditor independence, and audit staffing issues.
Case 1.12
Madoff Securities
161
As an adolescent, Bernie Madoff dreamed of becoming a “key player” on Wall Street.
Madoff realized his dream by overseeing the world’s largest and possibly longest run�
ning Ponzi scheme. Madoff’s auditor pled guilty to various criminal charges for his role
in that fraud.
Key topics: factors common to financial frauds, regulatory role of Securities and
Exchange Commission (SEC), nature and purpose of peer reviews, audit procedures
for investments, and the importance of the independent audit function.
SECTION 2
Audits of High-Risk Accounts
171
Case 2.1
Jack Greenberg, Inc.
173
A federal judge criticized Greenberg’s independent auditors for failing to realize the
impact that pervasive internal control problems had on the reliability of the company’s
inventory accounting records.
Case 2.2
Golden Bear Golf, Inc.
181
Jack Nicklaus, the “Golden Bear,” endured public embarrassment and large financial
losses when key subordinates misapplied the percentage-of-completion accounting
method to numerous golf course development projects.
Case 2.3
Happiness Express, Inc.
189
To compensate for flagging sales of their Mighty Morphin Power Rangers toys, this
company’s executives booked millions of dollars of bogus sales. Deficiencies in the
audit procedures applied by Happiness Express’s auditors resulted in the bogus sales
and receivables going undetected.
Case 2.4
General Motors Company
197
In early 2009, the SEC released the results of a lengthy investigation of GM’s accounting
and financial reporting decisions over the previous decade. A major focus of that investiga�
tion was GM’s questionable accounting for its massive pension liabilities and expenses.
Case 2.5
Lipper Holdings, LLC
203
Lipper’s auditors were criticized for failing to uncover a fraudulent scheme used by
a portfolio manager to materially inflate the market values of investments owned by
three of the company’s largest hedge funds.
xiii
xiv
Contents
Case 2.6
CBI Holding Company, Inc.
211
This case focuses on audit procedures applied to accounts payable, including the
search for unrecorded liabilities and the reconciliation of year-end vendor statements to
recorded payables balances.
Case 2.7
Geo Securities, Inc.
217
The SEC sanctioned GEO Securities’ audit engagement partner for failing to apply
proper audit procedures to a material loss contingency faced by the company.
Case 2.8
Belot Enterprises
221
Understating discretionary expense accruals is a common method used by selfinterested corporate executives to enhance their company’s financial statements. In this
case, Belot “juggled” the period-ending balances of five major expense accruals to
achieve an earnings goal established by the company’s new chief operating officer.
Case 2.9
Regina Company
227
To reach forecasted sales and earnings targets, Regina executives used several
accounting gimmicks that violated the revenue recognition principle.
SECTION 3
Internal Control Issues
235
Case 3.1
The Trolley Dodgers
237
Control deficiencies in the Dodgers’ payroll transaction cycle allowed an accounting
manager to embezzle several hundred thousand dollars.
Case 3.2
Howard Street Jewelers, Inc.
239
Given the susceptibility of cash to theft, retail companies typically establish rigorous
internal controls for their cash processing functions. This case documents the high
price of failing to implement such controls.
Case 3.3
United Way of America
241
Weak or nonexistent internal controls have resulted in this prominent charitable orga�
nization, as well as numerous other charities nationwide, being victimized by opportu�
nistic employees.
Case 3.4
First Keystone Bank
247
Three tellers of a First Keystone Bank branch embezzled more than $100,000 from the
branch’s ATM. The district attorney who prosecuted the tellers commented on the need
for businesses to not only establish internal controls to protect their assets but also on
the importance of ensuring that those controls are operational.
Case 3.5
Goodner Brothers, Inc.
251
An employee of this tire wholesaler found himself in serious financial trouble. To
remedy this problem, the employee took advantage of his employer’s weak internal
Contents
controls by stealing a large amount of inventor y, which he then sold to other
parties.
Case 3.6
Buranello’s Ristorante
259
The general manager of Buranello’s set up a “sting” operation–with the owner’s
approval–to test the honesty of the employee who he believed was stealing from the
business. But the plan backfired, and Buranello’s eventually found itself on the wrong
end of a “malicious prosecution” lawsuit.
Case 3.7
Foamex International Inc.
265
Foamex’s auditors repeatedly reported internal control problems to the company’s
management and audit committee. Because the company’s management refused to
adopt effective and timely measures to remediate those problems, Foamex became
the first public company sanctioned by the SEC solely for having inadequate internal
controls.
SECTION 4
Ethical Responsibilities of Accountants
269
Case 4.1
Creve Couer Pizza, Inc.
271
Intrigue and espionage seem far removed from accounting . . . but not in this case.
Creve Couer’s CPA was actually a double agent. While providing accounting ser�
vices to his client, the CPA also supplied incriminating evidence regarding the client
to the IRS.
Case 4.2
F&C International, Inc.
275
A financial fraud spelled the end of a company with a proud history and tested the
ethics of several of its key management and accounting personnel.
Case 4.3
Suzette Washington, Accounting Major
279
Suzette Washington was a college senior majoring in accounting when she came
face-to-face with an important ethical decision. Since accounting majors are entering
a profession with a rigorous code of ethics, do they have a greater responsibility than
other students to behave ethically?
Case 4.4
Freescale Semiconductor, Inc.
281
Partners and employees of accounting firms often have access to confidential client
information that they could use to gain an unfair advantage over other investors. In
recent years, law enforcement authorities have filed insider trading charges against
several public accountants, including a partner assigned to a professional services
engagement for Freescale.
Case 4.5
Wiley Jackson, Accounting Major
285
“To tell or not to tell” was the gist of an ethical dilemma faced by Wiley Jackson
while completing a pre-employment document for his future employer, a major
accounting firm.
xv
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Contents
Case 4.6
Arvel Smart, Accounting Major
287
Should an accounting major accept an internship position with one firm when he has
already decided to accept a job offer for a permanent position with another firm upon
graduation?
Case 4.7
David Quinn, Tax Accountant
289
The responsibility to maintain the confidentiality of client information obtained during
a professional services engagement is at the center of a nasty disagreement that arises
between two friends employed by a major accounting firm.
SECTION 5
Ethical Responsibilities of Independent Auditors
293
Case 5.1
Cardillo Travel Systems, Inc.
295
A top executive of Cardillo pressured and manipulated three accountants, the compa�
ny’s controller and two partners of public accounting firms, in an unsuccessful attempt
to conceal the true nature of a fraudulent entry in the company’s accounting records.
Case 5.2
American International Group, Inc.
301
AIG is best known as the company that received more federal “bailout” funds than any
other during the economic crisis that engulfed the U.S. economy beginning in the fall of
2008. Several years earlier, AIG had been widely criticized for marketing customized
special purpose entities (SPEs). Surprisingly, Ernst & Young helped AIG develop and
market this controversial service.
Case 5.3
The North Face, Inc.
305
North Face’s independent auditors altered prior-year workpapers to conceal question�
able decisions made by an audit partner, decisions that involved several large barter
transactions that inflated the company’s reported operating results.
Case 5.4
Waverly Holland, Audit Senior
313
A few months after leaving public accounting, “Dutch” Holland is pressured to
become involved in a class-action lawsuit involving a former audit client of his. If
he cooperates with the plaintiff attorneys, he will alienate his former colleagues. If he
doesn’t cooperate, he may be named as a defendant in that lawsuit. What will Dutch
choose to do?
Case 5.5
Phillips Petroleum Company
319
Rather than compromise the confidentiality of his client’s accounting records, the part�
ner in charge of the annual Phillips audit was found in contempt of court and jailed.
Case 5.6
American Fuel & Supply Company, Inc.
323
This case focuses on the responsibility of auditors to recall an audit report when they
discover previously undetected errors in a client’s audited financial statements.
Contents
SECTION 6
Professional Roles
327
Case 6.1
Leigh Ann Walker, Staff Accountant
329
A staff accountant employed by a large accounting firm is dismissed after serious questions arise regarding her integrity.
Case 6.2
Bill DeBurger, In-Charge Accountant
331
To “sign off” or “not sign off” was the issue Bill DeBurger wrestled with after he
completed the audit procedures for a client’s most important account. An angry
confrontation with the audit engagement partner made Bill’s decision even more
difficult.
Case 6.3
Hamilton Wong, In-Charge Accountant
335
“Eating time,” or underreporting time worked on audit engagements, has serious
­implications for the quality of audit services and for the quality of auditors’ work
­environment. Hamilton Wong came face-to-face with these issues when a colleague
insisted on understating the hours she worked on her assignments.
Case 6.4
Tommy O’Connell, Audit Senior
339
A new audit senior is quickly exposed to the challenging responsibilities of his professional work role when he is assigned to supervise a difficult audit engagement. During
the audit, the senior must deal with the possibility that a staff accountant is not completing his assigned audit procedures.
Case 6.5
Avis Love, Staff Accountant
343
Auditors sometimes develop close friendships with client personnel. Such friendships
can prove problematic for auditors, as demonstrated in this case.
Case 6.6
Charles Tollison, Audit Manager
347
Audit managers occupy an important role on audit engagements and are a critical link
in the employment hierarchy of public accounting firms.
SECTION 7
Professional Issues
351
Case 7.1
Ligand Pharmaceuticals
353
Ligand’s auditor was the first Big Four firm sanctioned by the Public Company
­Accounting Oversight Board (PCAOB).
Case 7.2
Sarah Russell, Staff Accountant
359
Sexual harassment is a sensitive subject that many companies and professional firms
have been forced to contend with in recent years. This case recounts the experiences of
a staff accountant who was harassed by an audit partner.
xvii
xviii
Contents
Case 7.3
Bud Carriker, Audit Senior
363
An executive of an audit client informs the audit partner that he is not “comfortable”
working with the senior assigned to the engagement. Why? Because the senior is a
member of a minority group. Will the partner assign another senior to the engagement?
Case 7.4
Hopkins v. Price Waterhouse
369
This case explores the unique problems faced by women pursuing a career in public
accounting.
Case 7.5
 red Stern & Company, Inc.
F
(Ultramares Corporation v. Touche et al.)
377
This 1931 legal case established the Ultramares Doctrine that decades later has a pervasive influence on auditors’ civil liability under the common law.
Case 7.6
 irst Securities Company of Chicago
F
(Ernst & Ernst v. Hochfelder et al.)
385
In this case, the Supreme Court defined the degree of auditor misconduct that must be
present before a client can recover damages from an auditor in a lawsuit filed under
the Securities Exchange Act of 1934.
SECTION 8
International Cases
391
Case 8.1
Livent, Inc.
393
Garth Drabinsky built Livent, Inc., into a major force on Broadway during the 1990s.
A string of successful Broadway productions resulted in numerous Tony Awards for
the Canadian company. Despite Livent’s theatrical success, its financial affairs were in
disarray. Drabinsky and several of his top subordinates used abusive accounting practices to conceal Livent’s financial problems from their independent auditors.
Case 8.2
Parmalat Finanziaria, S.p.A.
407
Parmalat’s executives used a simple accounting ruse, a “double-billing scheme,” to
produce billions of dollars of bogus receivables, sales, and profits for the company.
The fraud unraveled in a matter of weeks after the company admitted that it would
have difficulty paying off a small bond issue that was coming due. Lawsuits filed in
this case raised a troubling legal issue that could potentially threaten the financial viability of major accounting firms.
Case 8.3
Kansayaku
421
Like the United States, Japan has recently made significant changes in the regulatory
infrastructure for its financial reporting system. Many of these changes have directly
impacted Japan’s accounting profession and independent audit function. An accounting and auditing scandal involving a large cosmetics and apparel company, Kanebo
Limited, posed the first major challenge of that new regulatory framework.
Contents
Case 8.4
Registered Auditors, South Africa
431
The South African economy was rocked in recent years by a series of financial reporting scandals. To restore the credibility of the nation’s capital markets, the South African
Parliament passed a controversial new law, the Auditing Profession Act (APA). The
APA established a new auditing regulatory agency and a new professional credential
for independent auditors. The APA also mandated that independent auditors immediately disclose to the new auditing agency any “reportable irregularities” committed by
an audit client.
Case 8.5
Zuan Yan
443
The Big Four accounting firms view China as one of the most lucrative markets for
accounting and auditing services worldwide. However, those firms face major challenges in that market. Among these challenges are an increasing litigation risk and the
difficulty of coping with the often heavy-handed tactics of China’s authoritarian central
government.
Case 8.6
Kaset Thai Sugar Company
455
This case focuses on the 1999 murder of Michael Wansley, a partner with Deloitte
­Touche Tohmatsu. Wansley was supervising a debt-restructuring engagement in
a ­remote region of Thailand when he was gunned down by a professional assassin.
Case 8.7
Republic of Somalia
459
PricewaterhouseCoopers (PwC) accepted a lucrative, unusual, and very controversial
engagement for the transitional government established for Somalia by the United Nations. The case questions require students to consider the significant risks and thorny
ethical issues that engagement poses for PwC.
Case 8.8
OAO Gazprom
463
Business Week referred to the huge Gazprom debacle as “Russia’s Enron.” For the
first time in the history of the new Russian republic, a Big Four accounting firm was
sued for allegedly issuing improper audit opinions on a Russian company’s financial
statements.
Case 8.9
Societe Generale
477
This case addresses the surprising decision made by Societe Generale, France’s ­second
largest bank, to backdate a 6.4 billion euro loss that resulted from unauthorized securities trades made by one of its employees. Although that huge loss occurred in 2008,
the bank included the loss in its audited financial statements for 2007. To justify that
decision, the bank’s management invoked a controversial provision of International
Financial Reporting Standards (IFRS).
Case 8.10
Institute of Chartered Accountants of India
493
The Institute of Chartered Accountants of India (ICAI) is the federal agency that
oversees India’s accounting profession. In 2002, the ICAI commissioned a study of
the alleged takeover of that profession by the major international accounting firms.
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Contents
The ­resulting 900-page report charged that those firms had used a variety of illicit and
even illegal methods to “colonize” India’s market for accounting, auditing, and related
services to the detriment of the nation’s domestic accounting firms.
Case 8.11
Republic of the Sudan
505
In 2004, the SEC began requiring domestic and foreign registrants to disclose any business operations within, or other relationships with, Sudan and other countries identified as state sponsors of terrorism. Three years later, the SEC included a Web page on
its EDGAR website that listed all such companies. This SEC “blacklist” proved to be
extremely controversial and triggered a contentious debate over the federal agency’s
regulatory mandate and its definition of “materiality.”
Case 8.12
Shari’a
511
Islamic companies are prohibited from engaging in transactions that violate Shari’a,
that is, Islamic religious law. To ensure that they have complied with Shari’a, Islamic
companies have their operations subjected to a Shari’a compliance audit each year.
Recently, Big Four firms have begun offering Shari’a audit services.
Case 8.13
Mohamed Salem El-Hadad, Internal Auditor
521
Accountants sometimes find themselves in situations in which they must report
­unethical or even illegal conduct by other members of their organization. This case
examines the trials and tribulations of an internal auditor who “blew the whistle” on
his immediate superior for embezzling large sums of cash from their employer, the
Washington, D.C., embassy of the United Arab Emirates.
Case 8.14
Tae Kwang Vina
527
“Environmental and labor practices” audits are one of many nontraditional services that
major accounting firms have begun offering in recent years to generate new ­revenue
streams. Ernst & Young provided such an audit for Nike, which had been accused of
operating foreign “sweatshops” to produce its footwear products. This case documents
the unexpected challenges and problems that accounting firms may face when they
provide services outside their traditional areas of professional expertise.
Index
Summary of Topics by Case
Summary of Cases by Topic
533
543
555
PREFACE
The past decade has arguably been the most turbulent and traumatic in the history
of the accounting profession and the independent audit function. Shortly after the
turn of the century, the Enron and WorldCom fiascoes focused the attention of the
investing public, the press, Wall Street, and, eventually, Congress on our profession.
Those scandals resulted in the passage of the Sarbanes-Oxley Act of 2002 (SOX) and
the creation of the Public Company Accounting Oversight Board (PCAOB).
Next came the campaign to replace U.S. generally accepted accounting principles
(GAAP) with International Financial Reporting Standards (IFRS). That campaign
stalled when the subprime mortgage crisis in the United States caused global stock
markets to implode and global credit markets to “freeze” during the fall of 2008. Many
parties insisted that inadequate audits were a major factor that led to the onset of the
most severe global economic downturn since the Great Depression. That economic
downturn claimed many companies that had been stalwarts of the U.S. economy,
most notably Lehman Brothers. The huge investment banking firm filed for bankruptcy in September 2008 just a few months after having had its annual financial
statements “blessed” by its audit firm.
As Congress and regulatory authorities struggled to revive the U.S. economy, news of
the largest Ponzi scheme in world history grabbed the headlines in early 2009. Investors worldwide were shocked to learn that Bernie Madoff, an alleged “wizard of Wall
Street,” was a fraud. Law enforcement authorities determined that billions of dollars
of client investments supposedly being held by Madoff’s company, Madoff Securities,
did not exist. The business press was quick to report that for decades Madoff Securities’ financial statements had been audited by a New York accounting firm and had
received unqualified audit opinions each year from that firm. The auditing discipline
absorbed another body blow in 2010 when a court-appointed bankruptcy examiner
publicly singled out Lehman Brothers’ audit firm as one of the parties most responsible for the Lehman Brothers debacle.
As academics, we have a responsibility to help shepherd our profession through these
turbulent times. Auditing instructors, in particular, have an obligation to help restore
the credibility of the independent audit function that has been adversely ­impacted by
the events of the past decade. To accomplish this latter goal, one strategy we can use
is to embrace the litany of reforms recommended several years ago by the ­Accounting
Education Change Commission (AECC). Among the AECC’s recommendations was
that accounting educators employ a broader array of instructional resources, particularly experiential resources, designed to stimulate active learning by students. In fact,
the intent of my casebook is to provide auditing instructors with a source of such
­materials that can be used in both undergraduate and graduate auditing courses.
This casebook stresses the “people” aspect of independent audits. If you review a
sample of recent “audit failures,” you will find that problem audits seldom result from
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Preface
inadequate audit technology. Instead, deficient audits typically result from the presence of one, or both, of the following two conditions: client personnel who intentionally subvert an audit and auditors who fail to carry out the responsibilities assigned
to them. Exposing students to problem audits will help them recognize the red flags
that often accompany audit failures. An ability to recognize these red flags and the
insight gained by discussing and dissecting problem audits will allow students to
cope more effectively with the problematic situations they are certain to encounter
in their own careers. In addition, this experiential approach provides students with
context-specific situations that make it much easier for them to grasp the relevance
of important auditing topics, concepts, and procedures.
The cases in this text also acquaint students with the work environment of auditors.
After studying these cases, students will better appreciate how client pressure, peer
pressure, time budgets, and related factors complicate the work roles of independent
auditors. Also embedded in these cases are the ambiguity and lack of structure that
auditors face each day. Missing documents, conflicting audit evidence, auditors’ dual
obligations to the client and to financial statement users, and the lack of definitive
professional standards for many situations are additional aspects of the audit environment woven into these cases.
The ninth edition of my casebook contains the following eight sections of cases:
Comprehensive Cases, Audits of High-Risk Accounts, Internal Control Issues, ­Ethical
Responsibilities of Accountants, Ethical Responsibilities of Independent ­Auditors,
Professional Roles, Professional Issues, and International Cases. This organizational
structure is intended to help adopters readily identify cases best suited for their particular needs.
In preparing this edition, I retained those cases that have been among the most
widely used by adopters. These cases include, among many others, Crazy Eddie,
Enron Corporation, Golden Bear Golf, Leigh Ann Walker, Lincoln Savings and Loan
Association, Livent, The Trolley Dodgers, and ZZZZ Best Company. You will find that
many of the “returning” cases have been updated for relevant circumstances and
events that have occurred since the publication of the previous edition.
New To This Edition This edition features 13 new cases. Two of these cases are
included in the international section. Easily the most dramatic trend in the business
world over the past few decades has been the “globalization” of markets, including
the market for professional accounting services. Business schools have responded to
this dramatic trend by establishing new international majors, study-abroad programs,
and a slew of international courses across all business disciplines. Accounting may
very well be the business discipline that has been the slowest to “internationalize”
its curriculum. The 14 international cases in this edition provide auditing ­instructors
with an efficient and cost-effective way to introduce their students to a wide range of
important issues within the global accounting profession that will have far-reaching
implications for their careers.
Preface
The new Parmalat Finanziaria case provides an opportunity for students to compare
and contrast the independent audit functions of Italy and the United States. This case
demonstrates the significant impact that cultural norms and influences can have on
the nature and effectiveness of a nation’s independent audit function. Another important focus of the Parmalat case is a legal issue that has become very troublesome for
the major international accounting firms in recent years. This issue is whether those
firms’ global organizations should face joint and several liability for the malfeasance
of any one national practice unit.
The other international case new to this edition is The Republic of Somalia, which
transports students to one of the most troubled “hotspots” in the world. For more than
20 years, anarchy has reigned in Somalia, a country that sits astride one of the
world’s most important oceanic trade routes. In 2009, the world’s largest accounting
firm, PricewaterhouseCoopers (PwC), accepted a controversial professional services
­engagement in Somalia. Under the terms of that engagement, PwC serves as an overseer of the financial affairs for the provisional government that the United Nations
established for the war-torn country. The Somalia case requires students to consider
the significant risks and thorny ethical issues that engagement poses for PwC.
Eight of the new cases in this edition are included in two sections of my casebook that
historically have been among the most popular: Audits of High-Risk Accounts and Internal Control Issues. New cases in the Audits of High-Risk Accounts section include
­General Motors Company, Lipper Holdings, Geo Securities, Belot Enterprises, and
­Regina Company. The General Motors case examines the controversy surrounding GM’s
pension-related accounting decisions and the role of the company’s longtime audit firm,
Deloitte, in those decisions. Hedge funds have been among the most controversial and
mysterious investment vehicles on Wall Street over the past ­decade and have presented
major challenges for the firms that audit them. In the ­Lipper Holdings case, the organization’s audit firm was criticized for failing to uncover a fraudulent scheme that materially
inflated the market values of investments held by three Lipper hedge funds.
In the present business environment, many, if not most, companies routinely deal with
the worrisome problems posed by material loss contingencies. Loss contingencies also
pose major challenges for independent auditors. Geo Securities’ audit engagement partner faced SEC sanctions for the decisions he made regarding a pending loss contingency
for that company. Client executives who face pressure to meet unrealistic earnings goals
are often tempted to understate period-ending expense accruals. A senior auditor assigned to the audit engagement team for Belot Enterprises faced the unpleasant task of
challenging the client’s decision to implement a new approach for estimating its periodending discretionary expense accruals. That decision by client management coincided
with the end of a promotional campaign intended to boost Belot’s sagging operating
­results. The final new “High-Risk” case, Regina Company, is actually a ­refurbished
version of a case that appeared in earlier editions of my casebook. This case, which
­focuses on a high-profile financial fraud involving revenue recognition issues, was not
previously available in the custom publishing database for my casebook.
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Preface
First Keystone Bank, Buranello’s Ristorante, and Foamex International are the
three new cases in the Internal Controls Issues section. The First Keystone case revolves around a collusive fraud involving three employees of a small branch of a
­Pennsylvania-based bank. The case questions require students to examine internal
control and audit issues linked to a device that plays an important role in many, if
not most, of their everyday lives, namely, the local ATM. In the Buranello’s case, the
central focus is internal controls for cash receipts. A frustrated manager of a popular
restaurant organized a “sting” operation to snag red-handed a subordinate who he
believed was stealing from the business. Unfortunately, the sting went awry leaving
the manager red-faced and his employer on the wrong end of a malicious prosecution lawsuit. Finally, Foamex International became the first company in the post-SOX
era to be sanctioned by the SEC for the sole reason that it had inadequate internal
controls.
Lehman Brothers Holdings is a new comprehensive case in the ninth edition of
my casebook. The principal source for this case is the massive 2,200-page report
prepared by the bankruptcy examiner for this former iconic investment banking
firm. ­L ehman played a leading and notorious role in the global economic crisis of
­2008–2009. To enhance their company’s apparent financial condition, Lehman’s
­executives engaged in tens of billions of dollars of “accounting-motivated” financing
transactions referred to as Repo 105s. Lehman’s controversial actions prompted a
debate within the profession regarding whether “intent matters” in accounting and
financial reporting decisions.
The final two new cases in this edition are the Freescale Semiconductor and ­Phillips
Petroleum Company cases. Freescale Semiconductor appears in Section 4, Ethical
Responsibilities of Accountants, while Phillips Petroleum is included in Section 5,
­Ethical Responsibilities of Independent Auditors. The Freescale case provides an overview of a series of recent insider trading incidents involving partners or employees of
the major international accounting firms, including the former vice chairman of one
of those firms. In the Phillips Petroleum case, the partner in charge of the ­company’s
annual audit was found in contempt of court by a federal judge and jailed when he
refused to compromise the confidentiality of his client’s accounting records.
My casebook can be used in several different ways. Professors can use the casebook
as a supplemental text for an undergraduate auditing course or as a primary text for
a graduate-level seminar in auditing. The instructor’s manual contains a syllabus for
a graduate auditing course organized around this text. This casebook can also be
used in the capstone professional practice course incorporated in many five‑year
­accounting programs. Customized versions of this casebook are suitable for a wide
range of accounting courses as explained later.
Organization of Casebook Listed next are brief descriptions of the eight
groups of cases included in this text. The casebook’s Table of Contents presents an
­annotated description of each case.
Preface
Comprehensive Cases Most of these cases deal with highly publicized problem
audits performed by the major international accounting firms. Among the clients involved in these audits are Enron Corporation, The Leslie Fay Companies, Lincoln
Savings and Loan Association, Madoff Securities, and ZZZZ Best Company. Each of
these cases addresses a wide range of auditing, accounting, and ethical issues.
Audits of High-Risk Accounts In contrast to the cases in the prior section, these
cases highlight contentious accounting and auditing issues posed by a single ­account
or group of accounts. For example, the Jack Greenberg case focuses primarily on inventory audit procedures. The Happiness Express case raises audit issues relevant
to accounts receivable, while the Golden Bear case examines a series of revenue
recognition issues.
Internal Control Issues In recent years, leading authorities in the public accounting profession have emphasized the need for auditors to thoroughly understand their
clients’ internal control policies and procedures. The cases in this section introduce
students to control issues in a variety of contexts. For example, the Goodner ­Brothers
case examines control issues for a wholesaler, while the Howard Street Jewelers case
raises important control issues relevant to retail businesses.
Ethical Responsibilities of Accountants Integrating ethics into an auditing
course requires much more than simply discussing the AICPA’s Code of Professional
Conduct. This section presents specific scenarios in which accountants have been
forced to deal with perplexing ethical dilemmas. By requiring students to study
­actual situations in which important ethical issues have arisen, they will be better
prepared to resolve similar situations in their own professional careers. Three of
the cases in this section will “strike close to home” for your students since they involve accounting majors. For example, in the Wiley Jackson case, a soon-to-graduate
­accounting major must decide whether to disclose in a pre-employment document a
minor-in-possession charge that is pending against him. Another case in this section,
F&C International, profiles three corporate executives who had to decide whether to
compromise their personal code of ethics in the face of a large-scale fraud masterminded by their company’s chief executive.
Ethical Responsibilities of Independent Auditors The cases in this section
highlight ethical dilemmas encountered by independent auditors. In the Cardillo
Travel Systems case, two audit partners face an ethical dilemma that most audit practitioners will experience at some point during their careers. The two partners are
forced to decide whether to accept implausible explanations for a suspicious client
transaction given to them by client executives or, alternatively, whether to “complicate” the given engagement by insisting on fully investigating the transaction.
Professional Roles Cases in this section examine specific work roles in the
­accounting profession. These cases explore the responsibilities associated with
those roles and related challenges that professionals occupying them commonly
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Preface
­ ncounter. The Tommy O’Connell case involves a young auditor recently promoted
e
to audit senior. Shortly following his promotion, Tommy finds himself assigned to
­supervise a small but challenging audit. Tommy’s sole subordinate on that engagement happens to be a young man whose integrity and work ethic have been questioned by seniors he has worked for previously. Two cases in this section spotlight
the staff a
­ ccountant work role, which many of your students will experience firsthand following graduation.
Professional Issues The dynamic nature of the public accounting profession continually impacts the work environment of public accountants and the nature of the
services they provide. The cases in this section highlight important issues presently
facing accounting firms. For example, the Hopkins v. Price Waterhouse case explores
the unique problems that women face in pursuing careers in public accounting,
while the Ligand Pharmaceuticals case addresses the responsibility accounting firms
have to ensure that their audit partners are qualified to supervise audit engagements.
Finally, the Fred Stern and First Securities cases examine the most important legal
liability issues within the public accounting profession.
International Cases The purpose of these cases is to provide your students with
an introduction to important issues facing the global accounting profession and auditing discipline. After studying these cases, students will discover that most of the
technical, professional, and ethical challenges facing U.S. practitioners are shared by
auditors and accountants across the globe. Then again, some of these cases document unique challenges that must be dealt with by auditors and accountants in certain countries or regions of the world. For example, the Chinese case (Zuan Yan)
demonstrates the problems that an authoritarian central government can present for
independent auditors and accounting practitioners. Likewise, the Kaset Thai Sugar
Company case vividly demonstrates that auditors and accountants may be forced to
cope with hostile and sometimes dangerous working conditions in developing countries where their professional roles and responsibilities are not well understood or
appreciated.
Customize Your Own Casebook To maximize your flexibility in using these
cases, South-Western/Cengage Learning has included Contemporary Auditing: Real
Issues and Cases in its customized publishing program, Make It Yours. Adopters
have the option of creating a customized version of this casebook ideally suited for
their specific needs. At the University of Oklahoma, a customized selection of my
cases is used to add an ethics component to the undergraduate managerial accounting course. In fact, since the cases in this text examine ethical issues across a wide
swath of different contexts, adopters can develop a customized ethics casebook to
­supplement almost any accounting course.
This casebook is ideally suited to be customized for the undergraduate auditing
course. For example, auditing instructors who want to add a strong international component to their courses can develop a customized edition of this text that ­includes
Preface
a series of the international cases. Likewise, to enhance the coverage of ethical issues in the undergraduate auditing course, instructors could choose a series of cases
from this text that highlight important ethical issues. Following are several examples
of customized versions of this casebook that could be easily integrated into the undergraduate auditing course.
International Focus: Parmalat Finanziaria (8.2), Kansayaku (8.3), Registered
Auditors, South Africa (8.4), Zuan Yan (8.5), OAO Gazprom (8.8), Institute of
Chartered Accountants of India (8.10). This custom casebook would provide
your students with an in-depth understanding of the current state of the auditing
discipline in several of the world’s most important countries.
Ethics Focus (I): Suzette Washington, Accounting Major (4.3), Wiley Jackson,
Accounting Major (4.5), Arvel Smart, Accounting Major (4.6), Leigh Ann Walker,
Staff Accountant (6.1), Hamilton Wong, In-Charge Accountant (6.3), Avis Love,
Staff Accountant (6.5). The first three of these cases give your students an
opportunity to discuss and debate ethical issues directly pertinent to them as
accounting majors. The final three cases expose students to important ethical
issues they may encounter shortly after graduation if they choose to enter public
accounting.
Ethics Focus (II): Creve Couer Pizza, Inc. (4.1), F&C International, Inc. (4.2),
Freescale Semiconductor (4.4), David Quinn, Tax Accountant (4.7), American
International Group (5.2), Waverly Holland, Audit Senior (5.4). This selection of
cases is suitable for auditing instructors who have a particular interest in covering
a variety of ethical topics relevant to the AICPA’s Code of Professional Conduct,
several of which are not directly or exclusively related to auditing.
Applied Focus: Enron Corporation (1.1), NextCard, Inc. (1.6), ZZZZ Best
Company, Inc. (1.9), Belot Enterprises (2.8), American Fuel & Supply Company,
Inc. (5.6), Livent, Inc. (8.1). This series of cases will provide students with a
broad-brush introduction to the real world of independent auditing. These cases
raise a wide range of technical, professional, and ethical issues in a variety of
client contexts.
Professional Roles Focus: Leigh Ann Walker, Staff Accountant (6.1), Bill DeBurger,
In-Charge Accountant (6.2), Tommy O’Connell, Audit Senior (6.4), Avis Love,
Staff Accountant (6.5), Charles Tollison, Audit Manager (6.6), Bud Carriker, Audit
Senior (7.3). This custom casebook would be useful for auditing instructors
who choose to rely on a standard textbook to cover key technical topics in
auditing–but who also want to expose their students to the everyday ethical and
professional challenges faced by individuals occupying various levels of the
employment hierarchy within auditing firms.
High-Risk Accounts Focus: Each of the cases in Section 2, Audits of High-Risk
Accounts. This series of cases will provide your students with relatively intense
homework assignments that focus almost exclusively on the financial statement
line items that pose the greatest challenges for auditors.
Of course, realize that you are free to choose any “mix” of my cases to include in a
customized casebook for an undergraduate auditing course or another accounting
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Preface
course that you teach. For more information on how to design your customized casebook, please contact your South-Western/Cengage Learning sales representative or
visit the textbook website: www.cengage.com/custom/makeityours/knapp.
Acknowledgements I greatly appreciate the insight and suggestions provided
by the following reviewers of earlier editions of this text: Alex Ampadu, University
at Buffalo; Barbara Apostolou, Louisiana State University; Sandra A. Augustine,
Hilbert College; Jane Baird, Mankato State University; Jason Bergner, University of
Kentucky; James Bierstaker, Villanova University; Ed Blocher, University of North
Carolina; ­Susan Cain, Southern Oregon University; Kurt Chaloupecky, Missouri State
University; Ray Clay, University of North Texas; Jeffrey Cohen, Boston College; Mary
Doucet, University of Georgia; Rafik Elias, California State University, Los Angeles;
Ruth Engle, Lafayette College; Diana Franz, University of Toledo; Chrislynn Freed,
University of Southern California; Carolyn Galantine, Pepperdine University; Soha
Ghallab, ­Brooklyn College; Russell Hardin, University of South Alabama; Michele C.
Henney, University of Oregon; Laurence Johnson, Colorado State University; Donald
McConnell, University of Texas at Arlington; Heidi Meier, Cleveland State University;
Don Nichols, Texas Christian University; Marcia Niles, University of Idaho; Thomas
­Noland, University of South Alabama; Les Nunn, University of Southern Indiana;
­Robert J. Ramsay, Ph.D., CPA, University of Kentucky; John Rigsby, Mississippi State
University; Mike Shapeero, Bloomsburg University of Pennsylvania; Edward F. Smith,
Boston College; Dr. Gene Smith, Eastern New Mexico University; Rajendra Srivastava,
University of Kansas; Richard Allen Turpen, University of Alabama at Birmingham; T.
Sterling Wetzel, Oklahoma State University; and Jim Yardley, Virginia Polytechnic University. This project also benefitted greatly from the editorial assistance of my ­sister,
Paula Kay Conatser, my wife, Carol Ann Knapp, and my son, John William Knapp. I
would also like to thank Glen McLaughlin for his continuing generosity in funding
the development of instructional materials that highlight important ethical issues.
Finally, I would like to acknowledge the contributions of my students, who have provided invaluable comments and suggestions on the content and use of these cases.
Michael C. Knapp
McLaughlin Chair in Business
Ethics, David Ross Boyd ­Professor,
and Professor of Accounting
University of Oklahoma
SECTION 1
COMPREHENSIVE
CASES
Case 1.1
Enron Corporation
Case 1.2
Lehman Brothers Holdings, Inc.
Case 1.3
Just for FEET, Inc.
Case 1.4
Health Management, Inc.
Case 1.5
The Leslie Fay Companies
Case 1.6
NextCard, Inc.
Case 1.7
Lincoln Savings and Loan Association
Case 1.8
Crazy Eddie, Inc.
Case 1.9
ZZZZ Best Company, Inc.
Case 1.10
Gemstar-TV Guide International, Inc.
Case 1.11
New Century Financial Corporation
Case 1.12
Madoff Securities
1
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CASE 1.1
Enron Corporation
John and Mary Andersen immigrated to the United States from their native Norway
in 1881. The young couple made their way to the small farming community of Plano,
­Illinois, some 40 miles southwest of downtown Chicago. Over the previous few decades, hundreds of Norwegian families had settled in Plano and surrounding communities. In fact, the aptly named Norway, Illinois, was located just a few miles away
from the couple’s new hometown. In 1885, Arthur Edward Andersen was born. From
an early age, the Andersens’ son had a fascination with numbers. Little did his parents realize that Arthur’s interest in numbers would become the driving force in his
life. Less than one century after he was born, an accounting firm bearing Arthur
Andersen’s name would become the world’s largest professional services organization with more than 1,000 partners and operations in dozens of countries scattered
across the globe.
Think Straight, Talk Straight
Discipline, honesty, and a strong work ethic were three key traits that John and Mary
Andersen instilled in their son. The Andersens also constantly impressed upon him
the importance of obtaining an education. Unfortunately, Arthur’s parents did not
survive to help him achieve that goal. Orphaned by the time he was a young teenager,
Andersen was forced to take a fulltime job as a mail clerk and attend night classes
to work his way through high school. After graduating from high school, Andersen
attended the University of Illinois while working as an accountant for Allis-Chalmers,
a Chicago-based company that manufactured tractors and other farming equipment.
In 1908, Andersen accepted a position with the Chicago office of Price Waterhouse.
At the time, Price Waterhouse, which was organized in Great Britain during the early
nineteenth century, easily qualified as the United States’ most prominent public accounting firm.
At age 23, Andersen became the youngest CPA in the state of Illinois. A few years
later, Andersen and a friend, Clarence Delany, established a partnership to provide
accounting, auditing, and related services. The two young accountants named
their firm Andersen, Delany & Company. When Delany decided to go his own way,
Andersen renamed the firm Arthur Andersen & Company.
In 1915, Arthur Andersen faced a dilemma that would help shape the remainder of
his professional life. One of his audit clients was a freight company that owned and operated several steam freighters that delivered various commodities to ports located on
Lake Michigan. Following the close of the company’s fiscal year but before Andersen
had issued his audit report on its financial statements, one of the client’s ships sank
in Lake Michigan. At the time, there were few formal rules for companies to follow
in preparing their annual financial statements and certainly no rule that required the
company to report a material “subsequent event” occurring after the close of its fiscal
year-such as the loss of a major asset. Nevertheless, Andersen insisted that his client
disclose the loss of the ship. Andersen reasoned that third parties who would use the
company’s financial statements, among them the company’s banker, would want to be
informed of the loss. Although unhappy with Andersen’s position, the client eventually
acquiesced and reported the loss in the footnotes to its financial statements.
3
4
Section One
Comprehensive Cases
Two decades after the steamship dilemma, Arthur Andersen faced a similar ­situation
with an audit client that was much larger, much more prominent, and much more profitable for his firm. Arthur Andersen & Co. served as the independent auditor for the
giant chemical company, du Pont. As the company’s audit neared completion one year,
members of the audit engagement team and executives of du Pont quarreled over how
to define the company’s operating income. Du Pont’s management insisted on a liberal
definition of operating income that included income earned on certain investments.
Arthur Andersen was brought in to arbitrate the dispute. When he sided with his subordinates, du Pont’s management team dismissed the firm and hired another auditor.
Throughout his professional career, Arthur E. Andersen relied on a simple, fourword motto to serve as a guiding principle in making important personal and professional decisions: “Think straight, talk straight.” Andersen insisted that his partners
and other personnel in his firm invoke that simple rule when dealing with clients,
potential clients, bankers, regulatory authorities, and any other parties they interacted with while representing Arthur Andersen & Co. He also insisted that audit clients “talk straight” in their financial statements. Former colleagues and associates
often described ­Andersen as opinionated, stubborn and, in some cases, “difficult.”
But even his critics readily admitted that Andersen was point-blank honest. “Arthur
Andersen wouldn’t put up with anything that wasn’t complete, 100% integrity. If anybody did anything otherwise, he’d fire them. And if clients wanted to do something
he didn’t agree with, he’d either try to change them or quit.”1
As a young professional attempting to grow his firm, Arthur Andersen quickly
­recognized the importance of carving out a niche in the rapidly developing accounting services industry. Andersen realized that the nation’s bustling economy of the
1920s depended heavily on companies involved in the production and distribution
of energy. As the economy grew, Andersen knew there would be a steadily increasing need for electricity, oil and gas, and other energy resources. So he focused his
practice development efforts on obtaining clients involved in the various energy industries. Andersen was particularly successful in recruiting electric utilities as clients. By the early 1930s, Arthur Andersen & Co. had a thriving practice in the upper
Midwest and was among the leading regional accounting firms in the nation.
The U.S. economy’s precipitous downturn during the Great Depression of the 1930s
posed huge financial problems for many of Arthur Andersen & Co.’s audit clients in
the electric utilities industry. As the Depression wore on, Arthur Andersen personally
worked with several of the nation’s largest metropolitan banks to help his clients obtain the financing they desperately needed to continue operating. The bankers and
other leading financiers who dealt with Arthur Andersen quickly learned of his commitment to honesty and proper, forthright accounting and financial reporting practices. Andersen’s reputation for honesty and integrity allowed lenders to use with
confidence financial data stamped with his approval. The end result was that many
troubled firms received the financing they needed to survive the harrowing days of
the 1930s. In turn, the respect that Arthur Andersen earned among leading financial
executives nationwide resulted in Arthur Andersen & Co. receiving a growing number of referrals for potential clients located outside of the Midwest.
During the later years of his career, Arthur Andersen became a spokesperson for
his discipline. He authored numerous books and presented speeches throughout the
nation regarding the need for rigorous accounting, auditing, and ethical standards
for the emerging public accounting profession. Andersen continually urged his fellow
1. R. Frammolino and J. Leeds, “Andersen’s Reputation in Shreds,” Los Angeles Times (online),
30 January 2002.
Case 1.1 E nron Corporation
accountants to adopt the public service ideal that had long served as the underlying
premise of the more mature professions such as law and medicine. He also lobbied
for the adoption of a mandatory continuing professional education (CPE) requirement. Andersen realized that CPAs needed CPE to stay abreast of developments in
the business world that had significant implications for accounting and financial reporting practices. In fact, Arthur Andersen & Co. made CPE mandatory for its employees long before state boards of accountancy adopted such a requirement.
By the mid-1940s, Arthur Andersen & Co. had offices scattered across the eastern
one-half of the United States and employed more than 1,000 accountants. When
­Arthur Andersen died in 1947, many business leaders expected that the firm would
disband without its founder, who had single-handedly managed its operations over
the previous four decades. But, after several months of internal turmoil and dissension, the firm’s remaining partners chose Andersen’s most trusted associate and protégé to replace him.
Like his predecessor and close friend who had personally hired him in 1928, ­Leonard
Spacek soon earned a reputation as a no-nonsense professional—an auditor’s auditor. He passionately believed that the primary role of independent auditors was to
ensure that their clients reported fully and honestly regarding their financial affairs
to the investing and lending public. Spacek continued Arthur Andersen’s campaign
to improve accounting and auditing practices in the United States during his long tenure as his firm’s chief executive. “Spacek openly criticized the profession for tolerating
what he considered a sloppy patchwork of accounting standards that left the investing
public no way to compare the financial performance of different companies.”2 Such
criticism compelled the accounting profession to develop a more formal and rigorous
rule-making process. In the late 1950s, the profession created the Accounting Principles Board (APB) to study contentious accounting issues and develop appropriate
new standards. The APB was replaced in 1973 by the Financial Accounting Standards
Board (FASB). Another legacy of Arthur Andersen that Leonard Spacek sustained was
requiring the firm’s professional employees to continue their education throughout
their careers. During Spacek’s tenure, Arthur Andersen & Co. established the world’s
largest private university, the Arthur Andersen & Co. Center for Professional Education, located in St. Charles, Illinois, not far from Arthur Andersen’s birthplace.
Leonard Spacek’s strong leadership and business skills transformed Arthur
­Andersen & Co. into a major international accounting firm. When Spacek retired in
1973, Arthur Andersen & Co. was arguably the most respected accounting firm not
only in the United States, but worldwide as well. Three decades later, shortly after the
dawn of the new millennium, Arthur Andersen & Co. employed more than 80,000
professionals, had practice offices in more than 80 countries, and had annual revenues approaching $10 billion. However, in late 2001, the firm, which by that time
had adopted the one-word name “Andersen,” faced the most significant crisis in its
history since the death of its founder. Ironically, that crisis stemmed from Andersen’s
audits of an energy company, a company founded in 1930 that, like many of Arthur
Andersen’s clients, had struggled to survive the Depression.
The World’s Greatest Company
Northern Natural Gas Company was founded in Omaha, Nebraska, in 1930. The principal investors in the new venture included a Texas-based company, Lone Star Gas Corporation. During its first few years of existence, Northern wrestled with the problem
2. Ibid.
5
6
Section One
Comprehensive Cases
of persuading consumers to use natural gas to heat their homes. Concern produced
by several unfortunate and widely publicized home “explosions” caused by natural
gas leaks drove away many of Northern’s potential customers. But, as the Depression
wore on, the relatively cheap cost of natural gas convinced increasing numbers of
cold-stricken and shallow-pocketed consumers to become Northern customers.
The availability of a virtually unlimited source of cheap manual labor during the
1930s allowed Northern to develop an extensive pipeline network to deliver natural
gas to the residential and industrial markets that it served in the Great Plains states.
As the company’s revenues and profits grew, Northern’s management launched a
campaign to acquire dozens of its smaller competitors. This campaign was prompted
by management’s goal of making Northern the largest natural gas supplier in the
United States. In 1947, the company, which was still relatively unknown outside of
its geographical market, reached a major milestone when its stock was listed on the
New York Stock Exchange. That listing provided the company with greater access to
the nation’s capital markets and the financing needed to continue its growth-through­acquisition strategy over the following two decades.
During the 1970s, Northern became a principal investor in the development of the
Alaskan pipeline. When completed, that pipeline allowed Northern to tap vast natural gas reserves it had acquired in Canada. In 1980, Northern changed its name to
InterNorth, Inc. Over the next few years, company management extended the scope
of the company’s operations by investing in ventures outside of the natural gas industry, including oil exploration, chemicals, coal mining, and fuel-trading operations.
But the company’s principal focus remained the natural gas industry. In 1985, InterNorth purchased Houston Natural Gas Company for $2.3 billion. That acquisition resulted in InterNorth controlling a 40,000-mile network of natural gas pipelines and
allowed it to achieve its long-sought goal of becoming the largest natural gas company in the United States.
In 1986, InterNorth changed its name to Enron. Kenneth Lay, the former chairman
of Houston Natural Gas, emerged as the top executive of the newly created firm that
chose Houston, Texas, as its corporate headquarters. Lay quickly adopted the aggressive growth strategy that had long dominated the management policies of InterNorth
and its predecessor. Lay hired Jeffrey Skilling to serve as one of his top subordinates.
During the 1990s, Skilling developed and implemented a plan to transform Enron
from a conventional natural gas supplier into an energy-trading company that served
as an intermediary between producers of energy products, principally natural gas
and electricity, and end users of those commodities. In early 2001, Skilling assumed
Lay’s position as Enron’s chief executive officer (CEO), although Lay retained the
title of chairman of the board. In the management letter to shareholders included
in ­Enron’s 2000 annual report, Lay and Skilling explained the metamorphosis that
Enron had undergone over the previous 15 years:
Enron hardly resembles the company we were in the early days. During our 15-year
history, we have stretched ourselves beyond our own expectations. We have metamorphosed from an asset-based pipeline and power generating company to a marketing and logistics company whose biggest assets are its well-established business
approach and its innovative people.
Enron’s 2000 annual report discussed the company’s four principal lines of business. Energy Wholesale Services ranked as the company’s largest revenue producer.
That division’s 60 percent increase in transaction volume during 2000 was fueled by
the rapid development of EnronOnline, a B2B (business-to-business) electronic marketplace for the energy industries created in late 1999 by Enron. During fiscal 2000
Case 1.1 E nron Corporation
7
2000
1999
1998
1997
1996
$100,789
$40,112
$31,260
$20,273
$13,289
1,266
957
698
515
493
(287)
979
(64)
893
5
703
(410)
105
91
584
1.47
1.18
1.00
.87
.91
(.35)
1.12
(.08)
1.10
.01
1.01
(.71)
.16
.17
1.08
.50
.50
.48
.46
.43
Total Assets:
65,503
33,381
29,350
22,552
16,137
Cash from Operating
   Activities:
3,010
2,228
1,873
276
742
Capital Expenditures and
   Equity Investments:
3,314
3,085
3,564
2,092
1,483
NYSE Price Range:
   High
   Low
   Close, December 31
90.56
41.38
83.12
44.88
28.75
44.38
29.38
19.06
28.53
22.56
17.50
20.78
23.75
17.31
21.56
Revenues
Net Income:
   Operating Results
   Items Impacting
     Comparability
       Total
Earnings Per Share:
   Operating Results
   Items Impacting
     Comparability
       Total
Dividends Per Share:
alone, EnronOnline processed more than $335 billion of transactions, easily making
Enron the largest e-commerce company in the world. Enron’s three other principal
lines of business included Enron Energy Services, the company’s retail operating
unit; Enron Transportation Services, which was responsible for the company’s pipeline operations; and Enron Broadband Services, a new operating unit intended to
be an intermediary between users and suppliers of broadband (Internet access) services. Exhibit 1 presents the five-year financial highlights table included in Enron’s
2000 annual report.
The New Economy business model that Enron pioneered for the previously staid
energy industries caused Kenneth Lay, Jeffrey Skilling, and their top subordinates to
be recognized as skillful entrepreneurs and to gain superstar status in the business
world. Lay’s position as the chief executive of the nation’s seventh-largest firm gave
him direct access to key political and governmental officials. In 2001, Lay served on
the “transition team” responsible for helping usher in the administration of Presidentelect George W. Bush. In June 2001, Skilling was singled out as “the No. 1 CEO in the
entire country,” while Enron was hailed as “America’s most innovative company.”3
3. K. Eichenwald and D. B. Henriques, “Web of Details Did Enron In as Warnings Went Unheeded,”
The New York Times (online), 10 February 2002.
Exhibit 1
Enron
Corporation
2000 A nnual
R eport Financial
Highlights Table
(in millions except
for per share
amounts)
8
Section One
Comprehensive Cases
­ nron’s chief financial officer (CFO) Andrew Fastow was recognized for creating the
E
financial infrastructure for one of the nation’s largest and most complex companies.
In 1999, CFO Magazine presented Fastow the Excellence Award for Capital Structure
Management for his “pioneering work on unique financing techniques.”4
Throughout their tenure with Enron, Kenneth Lay and Jeffrey Skilling continually
focused on enhancing their company’s operating results. In the letter to shareholders
in Enron’s 2000 annual report, Lay and Skilling noted that “Enron is laser-focused
on earnings per share, and we expect to continue strong earnings performance.”
Another important goal of Enron’s top executives was to increase their company’s
stature in the business world. During a speech in January 2001, Lay revealed that his
ultimate goal was for Enron to become “the world’s greatest company.”5
As Enron’s revenues and profits swelled, its top executives were often guilty of a
certain degree of chutzpah. In particular, Skilling became known for making brassy,
if not tacky, comments concerning his firm’s competitors and critics. During the crisis that gripped California’s electric utility industry during 2001, numerous elected officials and corporate executives criticized Enron for allegedly profiteering by selling
electricity at inflated prices to the Golden State. Skilling brushed aside such criticism.
During a speech at a major business convention, Skilling asked the crowd if they
knew the difference between the state of California and the Titanic. After an appropriate pause, Skilling provided the punch line: “At least when the Titanic went down,
the lights were on.”6
Unfortunately for Lay, Skilling, Fastow, and thousands of Enron employees and
stockholders, Lay failed to achieve his goal of creating the world’s greatest company.
In a matter of months during 2001, Enron quickly unraveled. Enron’s sudden collapse
panicked investors nationwide, leading to what one Newsweek columnist described
as the “the biggest crisis investors have had since 1929.”7 Enron’s dire financial problems were triggered by public revelations of questionable accounting and financial
reporting decisions made by the company’s accountants. Those decisions had been
reviewed, analyzed, and apparently approved by Andersen, the company’s independent audit firm.
Debits, Credits, and Enron
Throughout 2001, Enron’s stock price drifted lower. Publicly, Enron executives blamed
the company’s slumping stock price on falling natural gas prices, concerns regarding the long-range potential of electronic marketplaces such as EnronOnline, and
overall weakness in the national economy. By mid-October, the stock price had fallen
into the mid-$30s from a high in the lower $80s earlier in the year. On October 16,
2001, Enron issued its quarterly earnings report for the third quarter of 2001. That report revealed that the firm had suffered a huge loss during the quarter. Even more
problematic to many financial analysts was a mysterious $1.2 billion reduction in Enron’s owners’ equity and assets that was disclosed seemingly as an afterthought in the
earnings press release. This write-down resulted from the reversal of previously recorded transactions involving the swap of Enron stock for notes receivable. Enron had
acquired the notes receivable from related third parties who had invested in limited
partnerships organized and sponsored by the company. After studying those transactions in more depth, Enron’s accounting staff and its Andersen auditors concluded
4. E. Thomas, “Every Man for Himself,” Newsweek, 18 February 2002, 25.
5. Eichenwald and Henriques, “Web of Details.”
6. Ibid.
7. N. Byrnes, “Paying for the Sins of Enron,” Newsweek, 11 February 2002, 35.
Case 1.1 E nron Corporation
that the notes receivable should not have been reported in the assets section of the
company’s balance sheet but rather as a reduction to owners’ equity.
The October 16, 2001, press release sent Enron’s stock price into a free fall. Three
weeks later on November 8, Enron restated its reported earnings for the previous five years, wiping out approximately $600 million of profits the company had
reported over that time frame. That restatement proved to be the death knell for
Enron. On December 2, 2001, intense pressure from creditors, pending and threatened litigation against the company and its officers, and investigations initiated by
law enforcement authorities forced Enron to file for bankruptcy. Instead of becoming the nation’s greatest company, Enron laid claim to being the largest corporate
bankruptcy in U.S. history, imposing more than $60 billion of losses on its stockholders alone. Enron’s “claim to fame” would be eclipsed the following year by the
more than $100 billion of losses produced when another Andersen client, WorldCom, filed for bankruptcy.
The massive and understandable public outcry over Enron’s implosion during the
fall of 2001 spawned a mad frenzy on the part of the print and electronic media to determine how the nation’s seventh-largest public company, a company that had posted
impressive and steadily rising profits over the previous few years, could crumple into
insolvency in a matter of months. From the early days of this public drama, skeptics
in the financial community charged that Enron’s balance sheet and earnings restatements in the fall of 2001 demonstrated that the company’s exceptional financial performance during the late 1990s and 2000 had been a charade, a hoax orchestrated
by the company’s management with the help of a squad of creative accountants. Any
doubt regarding the validity of that theory was wiped away—at least in the minds
of most members of the press and the general public—when a letter that an Enron
accountant had sent to Kenneth Lay in August 2001 was discovered. The contents of
that letter were posted on numerous websites and lengthy quotes taken from it appeared in virtually every major newspaper in the nation.
Exhibit 2 contains key excerpts from the letter that Sherron Watkins wrote to
­Kenneth Lay in August 2001. Watkins’ job title was vice president of corporate development, but she was an accountant by training, having worked previously with
­Andersen, Enron’s audit firm. The sudden and unexpected resignation of Jeffrey Skilling as Enron’s CEO after serving in that capacity for only six months had prompted
Watkins to write the letter to Lay. Before communicating her concerns to Lay, Watkins had attempted to discuss those issues with one of Lay’s senior subordinates.
When Watkins offered to show that individual a document that identified significant
problems in accounting decisions made previously by Enron, Watkins reported that
he rebuffed her. “He said he’d rather not see it.”8
Watkins was intimately familiar with aggressive accounting decisions made for a
series of large and complex transactions involving Enron and dozens of limited partnerships created by the company. These partnerships were so-called SPEs or special
purpose entities that Enron executives had tagged with a variety of creative names,
including Braveheart, Rawhide, Raptor, Condor, and Talon. Andrew Fastow, Enron’s
CFO who was involved in the creation and operation of several of the SPEs, named a
series of them after his three children.
SPEs—sometimes referred to as SPVs (special purpose vehicles)—can take several legal forms but are commonly organized as limited partnerships. During the
1990s, hundreds of large corporations began establishing SPEs. In most cases, SPEs
8. T. Hamburger, “Watkins Tells of ‘Arrogant’ Culture; Enron Stifled Staff Whistle-Blowing,” The Wall
Street Journal (online), 14 February 2002.
9
10
Exhibit 2
Selected E xcerpts
from Sherron
Watkins’ August
2001 Letter to
K enneth L ay
Section One
Comprehensive Cases
Dear Mr. Lay,
Has Enron become a risky place to work? For those of us who didn’t get rich over the last few
years, can we afford to stay?
Skilling’s abrupt departure will raise suspicions of accounting improprieties and valuation
issues. Enron has been very aggressive in its accounting—most notably the Raptor
transactions and the Condor vehicle. . . .
We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor,
much of that stock has declined significantly. . . . The value in the swaps won’t be there for
Raptor, so once again Enron will issue stock to offset these losses. Raptor is an LJM entity.
It sure looks to the layman on the street that we are hiding losses in a related company and
will compensate that company with Enron stock in the future.
I am incredibly nervous that we will implode in a wave of scandals. My 8 years of Enron
work history will be worth nothing on my resume, the business world will consider the
past successes as nothing but an elaborate accounting hoax. Skilling is resigning now for
“personal reasons” but I think he wasn’t having fun, looked down the road and knew this
stuff was unfixable and would rather abandon ship now than resign in shame in 2 years.
Is there a way our accounting gurus can unwind these deals now? I have thought and thought
about how to do this, but I keep bumping into one big problem—we booked the Condor and
Raptor deals in 1999 and 2000, we enjoyed a wonderfully high stock price, many executives
sold stock, we then try and reverse or fix the deals in 2001 and it’s a bit like robbing the
bank in 1 year and trying to pay it back 2 years later. . . .
I realize that we have had a lot of smart people looking at this and a lot of accountants
including AA & Co. have blessed the accounting treatment. None of this will protect Enron
if these transactions are ever disclosed in the bright light of day. . . .
The overriding basic principle of accounting is that if you explain the “accounting treatment”
to a man on the street, would you influence his investing decisions? Would he sell or buy the
stock based on a thorough understanding of the facts?
My concern is that the footnotes don’t adequately explain the transactions. If adequately
explained, the investor would know that the “Entities” described in our related party footnote
are thinly capitalized, the equity holders have no skin in the game, and all the value in the
entities comes from the underlying value of the derivatives (unfortunately in this case, a big
loss) AND Enron stock and N/P. . . .
The related party footnote tries to explain these transactions. Don’t you think that several
interested companies, be they stock analysts, journalists, hedge fund managers, etc., are
busy trying to discover the reason Skilling left? Don’t you think their smartest people are
pouring [sic] over that footnote disclosure right now? I can just hear the discussions—”It
looks like they booked a $500 million gain from this related party company and I think, from
all the undecipherable 1/2 page on Enron’s contingent contributions to this related party
entity, I think the related party entity is capitalized with Enron stock.” . . . “No, no, no, you
must have it all wrong, it can’t be that, that’s just too bad, too fraudulent, surely AA & Co.
wouldn’t let them get away with that?”
Case 1.1 E nron Corporation
were used to finance the acquisition of an asset or fund a construction project
or related activity. Regardless, the underlying motivation for creating an SPE was
nearly always “debt avoidance.” That is, SPEs provided large companies with a
mechanism to raise needed financing for various purposes without being required
to report the debt in their balance sheets. Fortune magazine charged that corporate CFOs were using SPEs as scalpels “to perform cosmetic surgery on their balance sheets.” 9 During the early 1990s, the Securities and Exchange Commission
(SEC) and the FASB had wrestled with the contentious accounting and financial
reporting issues posed by SPEs. Despite intense debate and discussions, the SEC
and the FASB provided little in the way of formal guidance for companies to follow
in accounting and reporting for SPEs.
The most important guideline that the authoritative bodies implemented for SPEs,
the so-called 3 percent rule, proved to be extremely controversial. This rule allowed
a company to omit an SPE’s assets and liabilities from its consolidated financial
statements as long as parties independent of the company provided a minimum of
3 ­percent of the SPE’s capital. Almost immediately, the 3 percent threshold became
both a technical minimum and a practical maximum. That is, large companies using
the SPE structure arranged for external parties to provide exactly 3 percent of an
SPE’s total capital. The remaining 97 percent of an SPE’s capital was typically contributed by loans from external lenders, loans arranged and generally collateralized by
the company that created the SPE.
Many critics charged that the 3 percent rule undercut the fundamental principle within
the accounting profession that consolidated financial statements should be prepared for
entities controlled by a common ownership group. “There is a ­presumption that consolidated financial statements are more meaningful than separate statements and that they
are usually necessary for a fair presentation when one of the companies in the group
directly or indirectly has a controlling financial interest in the other companies.”10 Business Week chided the SEC and FASB for effectively endorsing the 3 percent rule.
Because of a gaping loophole in accounting practice, companies can create arcane
legal structures, often called special-purpose entities (SPEs). Then, the parent can
bankroll up to 97 percent of the initial investment in an SPE without having to consolidate it. . . . The controversial exception that outsiders need invest only 3 percent of an
SPE’s capital for it to be independent and off the balance sheet came about through
fumbles by the Securities and Exchange Commission and the Financial Accounting
Standards Board.11
Throughout the 1990s, many companies took advantage of the minimal legal and
accounting guidelines for SPEs to divert huge amounts of their liabilities to off-­balance
sheet entities. Among the most aggressive and innovative users of the SPE structure
was Enron, which created hundreds of SPEs. Unlike most companies, Enron did not
limit its SPEs to financing activities. In many cases, Enron used SPEs for the sole purpose of downloading underperforming assets from its financial statements to the financial statements of related but unconsolidated entities. For example, Enron would
arrange for a third party to invest the minimum 3 percent capital required in an SPE
and then sell assets to that SPE. The SPE would finance the purchase of those assets
by loans collateralized by Enron common stock. In some cases, undisclosed side
9. J. Kahn, “Off Balance Sheet—And Out of Control,” Fortune, 18 February 2002, 84.
10. Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (New York: AICPA, 1959).
11. D. Henry, H. Timmons, S. Rosenbush, and M. Arndt, “Who Else Is Hiding Debt?” Business Week,
28 January 2002, 36–37.
11
12
Section One
Comprehensive Cases
­ greements made by Enron with an SPE’s nominal owners insulated those individuals
a
from any losses on their investments and, in fact, guaranteed them a windfall profit.
Even more troubling, Enron often sold assets at grossly inflated prices to their SPEs,
allowing the company to manufacture large “paper” gains on those transactions.
Enron made only nominal financial statement disclosures for its SPE transactions
and those disclosures were typically presented in confusing, if not cryptic, language.
One accounting professor observed that the inadequate disclosures that companies
such as Enron provided for their SPE transactions meant that, “the nonprofessional
[investor] has no idea of the extent of the [given firm’s] real liabilities.”12 The Wall
Street Journal added to that sentiment when it suggested that Enron’s brief and obscure disclosures for its off-balance sheet liabilities and related-party transactions
“were so complicated as to be practically indecipherable.”13
Just as difficult to analyze for most investors was the integrity of the hefty profits ­reported each successive period by Enron. As Sherron Watkins revealed in the
letter she sent to Kenneth Lay in August 2001, many of Enron’s SPE transactions resulted in the company’s profits being inflated by unrealized gains on increases in the
­market value of its own common stock. In the fall of 2001, Enron’s board of directors
­appointed a Special Investigative Committee chaired by William C. Powers, dean of
the University of Texas Law School, to study the company’s large SPE transactions.
In February 2002, that committee issued a lengthy report of its findings, a document
commonly referred to as the Powers Report by the press. This report discussed at
length the “Byzantine” nature of Enron’s SPE transactions and the enormous and improper gains those ­transactions produced for the company.
Accounting principles generally forbid a company from recognizing an increase in
the value of its capital stock in its income statement. . . . The substance of the Raptors
[SPE transactions] effectively allowed Enron to report gains on its income statement
that were . . . [attributable to] Enron stock, and contracts to receive Enron stock, held
by the Raptors.14
The primary motivation for Enron’s extensive use of SPEs and the related accounting
machinations was the company’s growing need for capital during the 1990s. As Kenneth
Lay and Jeffrey Skilling transformed Enron from a fairly standard natural gas supplier into
a New Economy intermediary for the energy industries, the company had a constant need
for additional capital to finance that transformation. Like most new business endeavors,
Enron’s Internet-based operations did not produce positive cash flows immediately. To
convince lenders to continue pumping cash into Enron, the company’s management
team realized that their firm would have to maintain a high credit rating, which, in turn, required the company to release impressive financial statements each succeeding period.
A related factor that motivated Enron’s executives to window dress their company’s
financial statements was the need to sustain Enron’s stock price at a high level. Many
of the SPE loan agreements negotiated by Enron included so-called price “triggers.”
If the market price of Enron’s stock dropped below a designated level (trigger), ­Enron
was required to provide additional stock to collateralize the given loan, to make
­significant cash payments to the SPE, or to restructure prior transactions with the SPE.
12. Ibid.
13. J. Emshwiller and R. Smith, “Murky Waters: A Primer on the Enron Partnerships,” The Wall Street
Journal (online), 21 January 2002.
14. W. C. Powers, R. S. Troubh, and H. S. Winokur, “Report of Investigation by the Special Investigative
­Committee of the Board of Directors of Enron Corporation,” 1 February 2002, 129–130.
Case 1.1 E nron Corporation
In a worst-case scenario, Enron might be forced to dissolve an SPE and merge its assets and liabilities into the company’s consolidated financial statements.
What made Enron’s stock price so important was the fact that some of the company’s
most important deals with the partnerships [SPEs] run by Mr. Fastow—deals that
had allowed Enron to keep hundreds of millions of dollars of potential losses off its
books—were financed, in effect, with Enron stock. Those transactions could fall apart
if the stock price fell too far.15
As Enron’s stock price drifted lower throughout 2001, the complex labyrinth of legal and accounting gimmicks underlying the company’s finances became a shaky
house of cards. Making matters worse were large losses suffered by many of Enron’s
SPEs on the assets they had purchased from Enron. Enron executives were forced
to pour additional resources into many of those SPEs to keep them solvent. Contributing to the financial problems of Enron’s major SPEs was alleged self-dealing by
Enron ­officials involved in operating those SPEs. Andrew Fastow realized $30 million
in profits on his investments in Enron SPEs that he oversaw at the same time he was
serving as the company’s CFO. Several of his friends also reaped windfall profits on
investments in those same SPEs. Some of these individuals “earned” a profit of as
much as $1 ­million on an initial investment of $5,800. Even more startling was the
fact that Fastow’s friends realized these gains in as little as 60 days.
By October 2001, the falling price of Enron’s stock, the weight of the losses suffered
by the company’s large SPEs, and concerns being raised by Andersen auditors forced
company executives to act. Enron’s management assumed control and ownership
of several of the company’s troubled SPEs and incorporated their dismal financial
statement data into Enron’s consolidated financial statements. This decision led to
the large loss reported by Enron in the fall of 2001 and the related restatement of
the company’s earnings for the previous five years. On December 2, 2001, the transformed New Age company filed its bankruptcy petition in New Age fashion—via the
Internet. Only six months earlier, Jeffrey Skilling had been buoyant when commenting on Enron’s first quarter results for 2001. “So in conclusion, first-quarter results
were great. We are very optimistic about our new businesses and are confident that
our record of growth is sustainable for many years to come.”16
As law enforcement authorities, Congressional investigative committees, and business journalists rifled through the mass of Enron documents that became publicly available during early 2002, the abusive accounting and financial reporting practices that
had been used by the company surfaced. Enron’s creative use of SPEs became the primary target of critics; however, the company also made extensive use of other accounting gimmicks. For example, Enron had abused the mark-to-market accounting method
for its long-term contracts involving various energy commodities, primarily natural gas
and electricity. Given the nature o…