Enron was a US based energy company that still remains to be one of the biggest bankruptcy cases to have hit the corporate world. Prior to its collapse, the company with the assistance of Arthur Andersen manipulated its success by the application of unacceptable accounting practices that boosted its financial position in the market and attracted many shareholders. But such strategies cannot sustain a business for long because sooner or later they will be subjected to the inevitable downfall. This paper will discuss the various auditing issues surrounding the Enron Scandal.
Following the collapse of Enron and trials that ensued, there were many individuals accused of malpractices that were exposed. The following are the parties that shouldered the greatest responsibility in scandal:
Kenneth Lay served separately both as chief executive officer and chairman in the period leading to the collapse of Enron. During his tenure as chairman, he was well aware of the accounting malpractices being undertaken by both Fastow and Skilling but failed to stop them in their tracks. When the investors and analysts questioned the company’s status, he misrepresented to them that the company was fine and its business structure was so complex that they could not understand. After he was sure of the inevitable collapse, he quickly offloaded his shares manifesting his lack of concern for the company and stakeholders yet he was a top official.
Jeff Skilling served separately in various capacities as Enron president, chief executive officer, and chief operations officer. He was the most vocal among the other responsible members and would always assure the public of the company’s good financial health while it was not true. All his actions were directed at manipulating the financial statement to build investor confidence in the market to continue attracting more to invest into the company.
Andrew Fastow was the chief financial officer during that period. He is responsible for introducing the accounting malpractices at the company that overstated the revenues while simultaneously understating or hiding the debts (Yuhao, 39). In his capacity as chief financial officer, he misrepresented to the audit committee and board of directors as well about the company’s high-risk accounting issues leading to their inaction in resolving the crisis. He also convinced Andersen auditors not take into account of the gross accounting malpractices that were taking place at Enron.
Arthur Andersen was the contracted auditor for Enron but failed to perform its duty that could have prevented the entire crisis. Its auditors engaged in unethical practices by failing to state the company’s true financial position. Perhaps Andersen was more concerned about the revenues it earned from Enron which constituted almost a quarter of its annual revenues that it decided not to act. With rising concerns about Enron’s malpractices, its auditors also quelled the critics by assuring them that their records were in order.
In the recent years, auditing firms have been providing consulting services to their clients some which pose threats to their independence. As external auditors, they are strictly prohibited from engaging in any practice that might jeopardize their stand either directly or indirectly. The following are some of the three services that have been identified in relation to this:
Designing and implementing financial information systems
Audit firms might sometimes be tasked with the process of designing and implementing financial information systems for their clients. With the implementation of the systems, they have to train all the departments on its effective uses. But the problem comes when auditors from the same firm also have to review these systems and its functions. From a theoretical point of view, one could argue that the auditors would be independent but practically they are not. The firm has to review the audit that has been undertaken by its staff and it would be difficult to explain malfunctions that might have resulted from the utilization of its own system. This presents conflict of interests where the firm will seek to protect its reputation while simultaneously also provide true statement of affairs of their clients (Basioudis, 1398).
Management or human resource functions
The top management in an organization is in most cases responsible for chartering its strategic direction. They formulate polices and strategies that are for the long term benefits of its stakeholders but might sometimes face opposition from mainly the staffs. There are cases when unpopular but necessary decisions have been undertaken by the top management which employees might feel are against their interests. In such cases, an audit firm might be contracted to appraise these decisions so as to increase the level of understanding and support from the employees. Its auditors might also perform their tasks dutifully but the recommendations they make draw the firm into internal politics of a client.
Should the report approve the management’s decision, the employees will perceive the firm as siding with the management whereas the management could also feel the same way in the contrary scenario.
Internal audit services
Internal audits bear the greatest risks of them all. Internal auditors often conduct systematic and periodic audits of their organizations. Organizations are aware of the crucial role that auditors play in their quest to attain success in the market and will only hire the best qualified. In the event that a firm is contracted to audit the result from previous audits, negative feedbacks can put them in direct collisions with either the management or internal auditors. The management could be so assured of the effectiveness of their internal employees especially when they have proven track records that they start doubting the firm’s independence. On the other hand, the internal auditors might question their independence identifying them as hired professionals out to ruin their careers or taint their image.
The role of Arthur Anderson in the accounting malpractices at Enron
As a professional audit firm, Arthur Andersen was accused of serious breaches of the regulations governing the profession. The following are the specific violations that were conducted by Arthur Andersen:
Rule 101: Independence
This rule requires auditors to exercise independence when conducting their tasks. They are supposed to be free from any influence that might discredit their reports but clearly Andersen was under the heavy influence of the top officials at Enron. It even colluded with accountants to doctor the report on the raptor that played a crucial role in the value of its shares.
Rule 102: Integrity and objectivity
Auditors are expected to conduct their tasks without conflicts of interest whatsoever and also not to misrepresent to any party. Andersen was supposed to evaluate the viability of the raptors but colluded with Enron officials in their structuring which were later used to misrepresent to the board. Its integrity was also at stake when it received $1 million for its services related to the same instruments.
Rule 201: General standards
This rule basically expects the highest form of professionalism from the auditors in their work and to pass well founded recommendations. Andersen failed to undertake its obligations in auditing Enron financial statements and did not utilize credible records to state their true financial position as well as in the structuring of raptors and special purposes entities.
Rule 202: Compliance with standards
The standards that have been constituted regarding auditors work must be strictly adhered to. This was perhaps Andersen major undoing as it sought high compensation to shield the company from malpractices at the expense of performing its obligations.
Rule 203: Accounting principles
The generally acceptable accounting standards shall form the basis of auditors’ issuance of reports. However, Andersen got involved in the manipulation of statements and other reports to show better standing for the firm against these accounting rules.
Rule 302: Contingent fees
This rule prohibits auditors in public service from conduct audits related to financial statements simultaneously as professional services to clients even for contingent fees. In two separate occasions, it billed Enron $1 million and $335,000 for preparing original statements for the raptors and special purpose entities which is against this requirement.
Rule 501: Acts discreditable
Auditors are expected to uphold all the values and regulations that have been outlined in relation to the profession. In all its dealing, no accounting or auditing rules were ever utilized and further went ahead to shield the company from critics by claiming no malpractices were undertaken. The company was getting paid not to reveal the rot that was within the management which auditors are obligated to the stakeholders and public.
The preparation and retention of audit work papers
After Arthur Andersen was said to have tampered with records in the Enron case, a number of requirements governing the preparation and retention of audit work papers were formulated to avoid the possibility of such cases in future. This next section seeks to discuss the key requirements to these processes.
The auditors are supposed to retain all the documentations that were utilized in the preparation of the report for a period not less than seven years after the release of the report. The rule still maintains even in cases where no report was issued. A good example is where an auditor withdraws or is terminated from the engagement even before they are through with the finalizing of the report. They are still required to retain all the work the have accomplished so far.
Furthermore, the procedures, evidences, results, recommendations, and conclusion must also be retained. These are the specific details that warrant the final position of a report and must be maintained for the specified period. In addition, all the correspondence regarding the preparation of the reports will also have to be included in the above documents.
The rules prohibit any person from distorting, deleting, or interfering with the documents and any person found guilty of these acts shall be imprisoned for a period not exceeding 20 years. At the expiry of the seven years an auditor can still retain the document in the even that a client requesting the documents has the intention of destroying the details. The rule will also punish any party that conspires in the act of mutilating the documents and therefore an auditor who is fully aware of the clients’ intentions should retain the work paper.
Even though the auditors are to retain the documents, they are owned by the client. The firm simply undertakes the tasks it has been contracted to undertake and nothing more. In this case, an auditor that declines to hand over the records belonging to the client shall have breached the requirements.
Independent audit function
The independence of the audit function has increasingly come under scrutiny following the Enron scandal that was partly orchestrated by the Andersen. The audit firm was not independent and was easily swayed by the management into acting unprofessionally. It has therefore been necessary that amendments are made that will enable audit functions gain more independence. The following are the five key recommendations that have been made to improve the independence of audit functions:
- The independent audit committees shall be constituted by independent members and at least one member must be knowledgeable about issues relating to finance. The purpose of the audit committee is to ensure that the financial statements are prepared according to the generally acceptable accounting procedures and it would be a great weakness of the committee not to be aware of the rules they are supposed to be safeguarding (Strengthening the SEC’s Auditor Independence Rules, 57). The Enron case partly arose due to the presence of an uninformed audit committee that trusted the management oblivious of the possible dangers that might have resulted.
- The members of the audit committee are also barred from holding any key managerial office in the client firm until the expiry of one year after they cease being members of the committee. This has been identified as one of the factors that could possibly stand in the way of the independence of the audit functions. However, the regulation does not bar them from holding less senior posts that have no direct link or role in the preparation of financial statements. This recommendation will go a long way in reducing chances of unethical practices. The audit committee members might be tempted to doctor the audit reports in manners only known to them before joining the organization to accomplish their personal interests. Furthermore, the members could still have relations some even financial with the remaining committee members thus higher chances of influencing the audit report.
- In an audit committee, there are lead as well as concurring partners that are tasked with the responsibilities of spearheading the process and reviewing the report respectively. These partners are required to rotate their roles after five years and after which they are barred from being members of the committee before the expiry of five years. The other members are to rotate after seven years followed by a two year bar. This recommendation will help increase accountability in the audit committee by making all members directly responsible for their tasks. It would reduce chances of bias reports that could result the drafting of the report by a faction of the members that could have be easily influenced by third parties.
- The ownership interest is the next requirement which prohibits any financial relationships between the client and parties in the audit firm that can influence the results of the audit (Shafer, Jordan, and Timothy, 110). There should be no relationships especially that involving management and committee members as it could result in the easy influence of the audit. The financial position of a member could be used to coerce them into manipulating the report failure to which financial assistance towards them is terminated. With this kind of situation, the committees will have no other wise but to do as their godfathers please thus chances of an untrue report.
- The entire management body is also prohibited from paying the audit fees as this could interfere with the independence of the auditors. The audit fees should never be provided by the management of a client firm as it could be used as the bait by which committee members are forced to author the reports to the demands of the financing members of the management.
Evolution of accounting
Public accounting like many other disciplines has been experiencing evolutions. In the past few decades alone, the discipline has evolved and incorporated much more professionalism in the way procedures are undertaken. The present day accountants are equipped with the skills and knowledge to handle even the most difficult situation all thanks to the developments. The following are some of the factors that have been crucial in this process:
There are a number of procedures that have been utilized over long periods which function well until loopholes were discovered much later. Despite the dent they might have caused on the discipline, they have also been effective in increasing the effectiveness of the procedures with specific reference to the Enron Scandal. There are now more advanced and effective procedures such as the generally acceptable accounting procedures and International Financial Reporting Standards.
Accounting bodies have also emerged that govern the discipline as well as handling the various issues that are emerging in the field. Such body is the International Accounting Standards Board and the Security Exchange Commission which manage changes in the discipline (Zeff, 70). A number of international certificate are also available including the Certified Public Accountant which globalizes the discipline and any employee with the qualification can get employment throughout the world.
Computers and Software
The increased application of electronic media has also increased the professionalism of the discipline. Currently, records can be stored electronically as well as the undertaking of some procedures that are also supported by accounting software.
The explosion of the internet has been one of the major factors that have shaped the discipline. Accounting has been made more responsible as one need to access the internet to view various financial statements of different countries. Furthermore, online courses have also emerged increasing the flexibility by which people can learn various accounting principles.
Auditing quarterly financial statements
The law does not mandate the auditing of quarterly financial statements. This law is well founded as the entire process is time consuming and very costly to organizations to afford undertaking the process every three months. Furthermore, the audits would not be worth the expenses since three months is a relatively short duration for massive changes in the financial details of even the busiest company.
However, there might be cases when a company might need its statements audited. When applying for a loan for example, a bank might require a recent audit to be sure that the borrower meets the conditions for credit extension. This is one of the cases that might demand quarterly audits but mind you it is only for a special purpose.
Even for public companies, only their annual financial statements are audited with the SEC demanding filing of quarterly reports which are all aimed at protecting the shareholders. During the rest of the year, the audit firms should keep following their clients’ event from the quarterly reports to be aware more aware of the trends that could help in the audit at year end.
The Enron case has manifested the crucial role played by audit firms in the success or failure of their clients. This begs for closer attention to be paid especially to the specific details relating to audit firms and their operations before settling on one. One of the requirements of an audit firm is independence as this could influence the audit reports that are prepared. Therefore, organizations should insist on those firms that have demonstrated their independence and integrity as this is also what regulations governing the profession seek to uphold. They should also conduct their operations with reference to the ethical considerations and professionalism as this could go long ways in preserving their independence.
We have seen how audit firms can get caught up in tricky situations while conducting the other professional services to their clients. We have also seen how an audit firm’s reputation could mean gaining or losing business from the Enron case study. Therefore, their major concern should not be the short term revenues they stand to make or the clients they want to please but the upholding of the conduct required of an audit firm. The various recommendations that have been passed t increase the independence of audit functions should also be adhered to in order to increase the chances in the market. With this in place, they would never lack clients since everybody wants the services of a trust worthy audit firm.
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