ACTIVITY 2: Enron Scandal (40 points)

NAME: Noela P. Soneja DATE: March 19, 2021

YEAR/BLOCK: BSA-3A SCORE:

ENRON AND ARTHUR ANDERSEN LLP

Enron was an energy company based in Houston, Texas that made energy trades. It was formed in
1985 with the merger of Houston Natural Gas and InterNorth. After an aggressive expansion plan that
involved risky financing transactions outside the original fundamental business model of the company, Enron
was billions of dollars in debt. Enron concealed this debt through hidden transactions with related party
partnerships, fraudulent accounting, and illegal loans. Enron is considered to be one of the largest and most
important financial reporting frauds in history. The company ultimately filed for bankruptcy in 2001.

One of the reasons that Enron was able to get away with the fraud for some time was because of a
low-quality audit by its external audit firm, Arthur Andersen. Prior to the failure of Enron in 2001, Arthur
Andersen had been involved in two other major audit failures. These failed audits, related to frauds at Waste
Management (1996) and Sunbeam (1997), should have raised red flags for management and any outside
observers that some of the audit firm’s internal quality assurance processes were not working. When the
federal government uncovered Enron’s fraud along with the string of poor-quality audits at Arthur Andersen,
the government forced the audit firm out of business.

Internal documentation at Arthur Andersen showed that there were conflicts between the auditors
and the audit committee of Enron, and that even though there were many individuals concerned about the
accounting and disclosure practices at Enron, nothing was done by Andersen to report these problems. In
fact, the leading partner on the audit, David Duncan, actively worked to ensure that Enron’s fraudulent
financial reporting went uncovered. It appears that Duncan was motivated by the fact that Arthur Andersen
was earning enormous consulting fees on the Enron engagement; Enron was a hugely important client for
him personally and for the Houston office of Arthur Andersen. Together, these conflicts of interest clouded
his independent judgment and professional skepticism.

Around the time that Enron declared bankruptcy in late 2001, Arthur Andersen personnel in the
Houston office began aggressively destroying documentation relating to the Enron engagement. This action
enabled the federal government to file charges against Arthur Andersen that ultimately led to the downfall of
the audit firm. The Sarbanes-Oxley Act of 2002 was enacted partially in response to the Enron fraud and the
revelation of the poor audit conducted by Arthur Andersen, which is why this case is of particular historical
relevance. Considering these facts, answer the following questions:

a. Members of Enron management were the individuals who perpetrated the financial statement fraud.
Given this, why do you think auditors were held responsible when they are not the ones actually
making the fraudulent journal entries? (10 points)

Basically, auditors are only required to express an opinion on the fairness and accuracy of
management's claims on their own activities, they are not responsible for the financial statement
preparation and presentation. In the case of the ENRON scandal, auditors were still held liable
because, from the beginning of their agreement, they had access over the company's information and
records, deciding whether to tolerate or expose the fraud discovered. Also, the auditors are expected
to be the public's voice, ensuring higher assurance as to whether the financial statements are accurate
or not, and the public trusts their reports. It is true, they are not the ones who establish the fraudulent
organizations in this case, but because of the reason mentioned above, it is their duty to uncover any
fraudulent act on the part of the management. Arthur Andersen, as the auditing firm in charge of
 reviewing and certifying the accuracy of Enron's financial statements, permitted the standardized
procedures required by auditing standards to be disregarded in its transactions with Enron, making
them involved in Enron's fraudulent acts.

b. Explain why the consulting fees and importance of Enron to David Duncan and the Houston office of
Arthur Andersen might have affected Duncan’s independence, and thus the quality of the audits he
supervised. (10 points)

Mr. David Duncan may have formed close relations with Enron, their client. His office was also
located in an Enron mansion and he is paid enormous consulting fees. However, since there were no
standards in place at the time about independence, Arthur Andersen was able to offer various audit
and assurance services as an auditing company. As a result, Andersen maintained its freedom from
Enron, their client. Having such high consultancy fees, however, could create some public confusion as
to the auditor's independence of mind or appearance in assessing the fairness and reliability of Enron's
financial statements. In this situation, Mr. Duncan's view of his Enron service may have implications for
his actions; Mr. Duncan was an advocate for his client's accounting choices, and as a client talker, he
wants to retain his well-paid auditing and consulting services.

c. Describe the likely users of Enron’s audited financial statements. How were these various user groups
likely affected by the fraud? (10 points)

The Enron and Arthur Andersen scandal involved a few people. Even so, the consequences of
these individuals' actions impacted a large number of people, including a wide range of users:

 Employees - Many workers lose their jobs as a result of the Enron scandal, and if they do
work for another corporation, their qualifications or resumes will be affected because they
will be accused of being involved in Enron's fraud.
 Stockholders - The sudden drop in Enron's stock price came as a shock to the company's
shareholders, who lost a large portion of their investment. Potential shareholders were also
impacted by the decrease in stock price because they questioned the company's financial
statements.
 Creditors - Unpaid loans could no longer be collected due to the end of Enron's operations. It
will be difficult for creditors to collect if they are given assets rather than cash.
 Suppliers and customers – Due to end of Enron’s operations, some transactions made by
Enron to their customers and suppliers were left unfinished.
 Government - Enron is a well-known corporation that makes a lot of money, and its abrupt
failure affected the government where they lost tax revenue, lost public confidence in its
ability to defend the public interest, and had to shoulder the burden of prosecuting
corporate lawbreakers.
 Public - The community where Enron is situated has suffered unemployment, a decline in tax
revenue, a damaged reputation, and a loss of charitable giving, which had a huge impact on
their way of life.
 Arthur Andersen Auditing Firm - The auditors from Arthur Andersen who were not assigned
to audit the financial statements were also humiliated because of the fraud David Duncan
has committed. Andersen workers were forced to leave because they have to stop their
practice of profession.
d. How might the sequential list of frauds perpetrated by Arthur Andersen clients (Waste Management,
Sunbeam, and finally Enron) have affected the decision by the SEC and federal prosecutors to
aggressively seek Arthur Andersen’s legal demise? (10 points)

Because of a series of high-profile frauds that exposed audit irregularities by Andersen, the SEC
and federal regulators were likely doubtful of the overall audit quality of the company. This, combined
with the document shredding, most certainly led to the fact that this audit company needed to be
stopped before it continued to perform poorly.