1 – What were the business risks Enron faced, and how did those risks increase the likelihood of material misstatements in Enron’s financial statements?
The business risks that Enron faced included foreign currency risks and price instability, which is common for the energy industry. In addition, Enron faced pressure to perform well so that the stock price would rise.
These risks increased the likelihood of material misstatements in the financial statements for several reasons. Since Enron operated in other countries, there would be a foreign currency risks and those could lead to gains/losses not being properly calculated or accrued on hedging activities. By operating in foreign countries, there are political risks such as policy changes, lack of understanding of culture and business practices. The biggest risk is having the pressure to report good financial results. The deals with the special purpose entities (“SPE’s”) depended on a high stock price. The company used its stock as collateral if the stock price fell below a certain price. At that point, Enron would have to use the stock to pay out the investors. The company also had pressure from its business partners to perform well and meet it’s future obligations. If the company performed poorly, the investors may hesitate to do business with Enron.
3 – In your own words, summarize how Enron used SPEs to hide large amounts of company debt.
Enron created SPE’s (usually other LLP’s) in order to create cash inflow but did not record the investments and related liabilities (the loans used to create the SPE). Enron used outside investors to secure the new SPE’s. The new investors would bear the risk of the investment and Enron used its company stock as collateral to entice the investors and saying that Enron would basically bear the risk if the investment should turn sour. Enron used large investment bankers to take loans but these looked more like hedging activities instead of debt. Once the stock price began to drop, and Enron was losing money, they were unable to use their stock to cover the losses. To put it simply, a company sells a product for a stellar price to another entity. However, that entity doesn’t have the cash flow to buy the product. So, the seller issues a loan to the buyer in order to sell the product. Now if the buyer defaults on the loan, the seller loses the cash it lent out and the product it sold. This is how Enron set up the SPE’s, and they used the large investment banks to hold the loans that should have been reported on Enron’s balance sheet.
4 – What are the auditor independence issues surrounding the provision of external auditing services, internal auditing services, and management consulting services for the same client? Develop arguments for why auditors should be allowed to perform these services for the same client. Develop separate arguments for why auditors should not be allowed to perform non- audit services for their audit clients. What do you believe?
The independence issues that arise when an auditor provides external auditing, internal auditing and management consulting services include whether or not the auditors can be independent and exercise good professional judgment when it comes to the audit. The auditors should not be affected by any influences that would impede their professional judgment. If the auditor is performing all of the functions, then how can they remain unbiased during the external audit?
Arguments for why auditors should be allowed to perform these services for the same client include:
Auditors can increase audit realization by becoming more efficient during the external audit since they would be basically auditing their own work.
When auditors find material weaknesses or significant deficiencies, they can use their consulting role to improve these issues.
Auditors would already have a good working relationship with the client and
be able to save time on the procedures performed as opposed to having to “start fresh” with a new engagement client.
Arguments for why auditors should not be allowed to perform these services for the same client include:
Auditors may not be able to act independently, and may not use the best professional judgment when performing the external audit.
The company should hire it’s own internal auditor’s to ensure that the staff understand the company’s accounting procedures. This also helps the external auditor as it give the external auditor another viewpoint when assessing fraud risks. The internal auditors are apart of those charged with governance and that helps take the pressure off of the external auditor if a fraud should be discovered.
5 – Explain how “rules-based” accounting standards differ from “principles-based” standards. How might fundamentally changing accounting standards from bright-line rules to principle- based standards help prevent another Enron-like fiasco in the future? Some argue that the trend toward adoption of international accounting standards represents a move toward more “principles-based” standards. Are there dangers in removing “bright-line” rules? What difficulties might be associated with such a change?
Rule based accounting standards are difference from principle based standards in that rule based standards are just that – rules. For instance, the Internal Revenue code is rule based. There are things you can do and things you can’t. When rules are broken, there is a specific “punishments” that are to be enforced.
Principle based accounting standards are more like guidelines and can be open to interpretation. Auditors are given a bit of leeway and are told to use their “professional judgment”. This also means that the auditors should exercise good judgment and have high moral and ethical standards.
Principle based rules can prevent another Enron-like fiasco because it hold the accountant and auditors to a higher standards than “just following the code”. Sometimes the code has loopholes, which is what allowed Enron to create the SPE’s in the first place, and the company can rely on that. However, if auditors are required to hold themselves to a higher moral and ethical code, then they may not be swayed by a company’s questionable practices, even if they are following the letter of the law.
If “bright line” rules are not relied on at all, and only principle based rules are followed, then the interpretation of these principles can cause issues such as aggressive accounting treatments such as in the Enron case. If there are no hard rules, then companies can say that the aggressive accounting treatments are not prohibited.