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The events were finally resulting the filing for bankruptcy in December 2001, started way much before fraud at Enron could be even suspected. Andersen played a major role in the collapse of Enron. Andersen failed two times regarding audit issues just a few years short time before the collapse of Enron, at Waste Management in 1996 and at Sunbeam in 1997. The two audit failures mentioned above should have been huge warning signs for Andersen to protect itself against another client failure but what they had to face regarding Enron was worse than they ever had. Some internal memos at Andersen made it clear that several conflicts existed between the auditors and the audit committee of Enron. These memos contained several e-mails as well which expressed concerns about accounting practices used by Enron. David B. Duncan as the leading partner on the audit tipped over these concerns. According to McNamee(2001) there is proof that Duncan’s team wrote memos fraudulently stating that the professional standards group approved of the accounting practices of Enron that hid debts and pumped up earnings. Andersen’s independence is also highly questionable due to the relationship between audit and non-audit fees. According to McLean(2001) the person who first spotted in 2001 that there wasn’t even any chance for Enron to make profit was Jim Chanos, the head of Kynikos Associates. He said that that parent company had technically become nothing more than a hedging entity for all of its subsidiaries and affiliates. In 2001 the operating margin of Enron went down significantly to 2% from the previous year’s figure of 5% which is more than interesting because this kind of a decrease in one year is unheard of in the utilities industry. Chanos also pointed out that Enron was still aggressively selling stocks, despite there was hardly any capital to back up the shares they were selling.
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To be professional and effective, auditors must be independent of management and evaluate the financial representations of management for all users of financial statements. Less than 30% of the fees that Andersen received from Enron came from auditing, with the balance of fees coming from consulting. Andersen acted as Enron’s external auditor and as its internal auditor. Andersen’s work as a consultant raises several questions. It appears that Andersen’s audit team, when faced with accounting issues, chose to ignore them, acquiesced in silence to unsound accounting, or embraced accounting schemes as an advocate for its client.
Internal Control Weaknesses at Enron
Auditors assess the internal controls of a client to determine the extent to which they can rely on a client’s accounting system. Enron had too many internal control weaknesses to be given here. Two serious weaknesses were that the CFO was exempted from a conflicts of interest policy, and internal controls over SPEs were a sham, existing in form but not in substance. Many financial officials lacked the background for their jobs, and assets, notably foreign assets, were not physically secured. The tracking of daily cash was lax, debt maturities were not scheduled, off balance sheet debt was ignored although the obligation remained, and company-wide risk was disregarded. Internal controls were inadequate; contingent liabilities were not disclosed; and, Andersen ignored all of these weaknesses.
Evaluation of Accounting — Materiality
Auditors focus on material misrepresentations. A misrepresentation is material if knowledge of the misrepresentation would change the decisions of the user of financial statements. When Enron began to restate its financial statements and investors began to grasp its misrepresentations, the response of the market is indisputable as to materiality. Many errors were known, but were dismissed by Andersen as immaterial. Other errors may not have been known, but should have been known if reasonable inquiry would have revealed them.
Business Model, Experiences, and Organizational Culture
At Enron and at Andersen, the business model and the organizational culture were changing. Enron was moving to a new business model dominated by intangible assets, the rights to buy and sell commodities. This change in assets was driven by a new organizational culture which then aggressively cultivated its own growth. As auditors moved to become part of a consulting industry, their business model and organizational culture were changing too. It is likely that both the changes at Enron and at Andersen were increasing risks for investors. Enron’s movement away from the dominance of fixed assets to the dominance of intangible assets was likely to increase volatility, and this prospect was compounded by the use of mark-to-market accounting. Also, Andersen’s movement away from the professionalization of auditing to the commercialization of consulting was likely to weaken auditors as monitors of management. Into the mix of changing business models and cultures, add people who were not equipped for the changes. The young trading executives at Enron chased the deal for earnings, while failing to grasp the risks attached to the intangibles that were driving growth in earnings. Likewise, young auditors at Andersen embraced consulting, while failing to understand the risk of audit failure.
Many accounting firms and independent CPAs reacted to these events and implemented changes in procedure voluntarily. The biggest change that accounting firms made was a move made by the four remaining members of the big five, KPMG, Ernst and Young, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers. These four companies decided to break all ties with Andersen in an attempt to avoid being dragged down with the selling controversy surrounding the Enron scandal. This distancing was also due to the major changes mandated to Andersen as a way to get back on their feet after the scandal broke, and the other firms were afraid that these changes would be forced on them as well.
The government reacted aggressively when they became aware of the Enron scandal, and a flurry of legislation and proposals emanated from Congress and the SEC about how best to deal with this situation. President Bush even announced one post-Enron plan. This plan was to make disclosures in financial statements more informative and in the management’s letter of representation. This plan would also include higher levels of financial responsibility for CEOs and accountants. Bush’s goal was to be tough, but not to put an undue burden upon the honest accountants in the industry.
By far the biggest change brought about is the Sarbanes-Oxley Act. The Sarbanes-Oxley Act requires companies to revaluate their internal audit procedures and make sure that everything is running up to or exceeding the expectations of the auditors. It also requires higher level employees, like the CEO and CFO to have an understanding of the workings of the companies that they head and to affirm the fact that they don’t know of any fraud being committed by the company. Sarbanes-Oxley also brought with it new requirements for disclosures. These requirements included reporting of transactions called reportable transactions. These transactions are broken down into several categories, which impact every aspect of a business. One of these categories is listed transactions-which are by far the worst. They are transactions that are actually written out in a list, each one pertaining to one specific situation. Another is transactions with a book-to-tax difference of more than ten million dollars. There are several others, however these two will have the greatest effect. Accompanying these requirements are strict penalties if these transactions are not reported and discovered later. This act will mean significant additional work for accountants over the next several years.
For many years the SEC Chairman, then Arthur Levitt Jr., had been calling for the separation of auditing and consulting services within one company. However big firms like Andersen would apply their proverbial weight to attempt to show that consulting did not interfere with an auditor’s independence. Since the major concern of Andersen’s role in the controversy centres on their independence, and because of the large monetary consulting fees being paid to them by Enron, the push has been started anew by Paul Volcker the former Federal Reserve Chairman. Realistically, few think that the big firms will be able to dissuade the SEC from actually implementing such a rule. Many companies who use auditors believe that this is not the answer, because of the fact that it will cause them to hire one firm to do auditing work, and another to do non-audit work like taxes and other filings. In an attempt to not get damaged by any imminent government action, many business-including Disney and Apple Computer Inc. have already begun splitting their audit and non-audit work between different firms.
Effects on other Commercial Organisations
After the bewildering complexity of Enron’s SPEs and prepays, Worldcom’s fraud is simplicity itself. During the 1990s, WorldCom became a global telecommunication giant by acquiring companies such as MCI and building a large telecommunications network.
In addition, WorldCom entered into long-term, fixed-rate line leases to connect its network with the networks of incumbent local exchange carriers.
Faced with the telecom downturn and intense pressures on earnings, WorldCom undertook a series of measures to inflate earnings37. The largest and simplest of these related to line costs. WorldCom simply recharacterized its sizeable line costs as “Prepaid Capacity” and transferred them from the Company’s income statements to its balance sheets. The result was that over $3.8 billion of line costs that should have been shown as expense were capitalized as assets. WorldCom’s income was overstated by the same amount.
There were no SPEs and no complex accounting tricks. There was simply a journal entry passed under the directions of the Chief Financial Officer, Scott Sullivan, that reclassified expenses as assets without any supporting documentation whatsoever. When this was finally discovered by the internal audit department, Sullivan offered an equally brazen explanation38 which is worth quoting at length:
At the time of the cost deferral, management had determined that future economic benefit would be derived from these contractual commitments as the revenues from these service offerings reached projected levels. At that time, management fully believed that the projected revenue increases would more than offset the future lease commitments and deferred costs under the agreements. Therefore, the cost deferrals for the unutilized portion of the contract was considered to be an appropriate inventory of this capacity and would ultimately be fully amortized prior to the termination of the contractual commitment.
(FASB CON No. 6, par. 26).”
In a series of disclosures40 between March 2002 and June 2002, Adelphia Communications Corporation announced that it had concealed $2.6 billion of its indebtedness. At the time, Adelphia was the sixth largest cable television operator in the United States. The Rigas family that owned a controlling stake in Adelphia also owned several other companies (“Rigas entities”) that were also in the cable telivision business.
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The Rigas entities were managed by Adelphia. Moreover, Adelphia subsidiaries and the Rigas entities borrowed money under a co-borrowing agreement with that made all parties jointly and severally liable for the borrowing regardless of who had drawn down the money. This meant that the debt had to be shown as a debt of the Adelphia subsidiaries (and therefore as part of Adelphia’s consolidated debt) and not as a contingent liability. The following footnote in Adelphia’s December 31, 2000 balance sheet would have led everybody to believe that this liability was included in the consolidated debt:
In fact, however, this amount was not included in Adelphia’s consolidated debt. The footnote was thus calculated to conceal this debt completely. At least, if the note had disclosed a contingent liability, readers would have known that that this debt was in addition to the debt on the balance sheet. Of course, even that would have been inaccurate from an accounting point of view as the co-borrowing needed to be disclosed as debt and not as a contingent liability. The SEC stated: “The omission of these liabilities was a deliberate scheme to under-report Adelphia’s overall debt, portray Adelphia as de-leveraging, and conceal Adelphia’s inability to comply with debt ratios in loan covenants.”
In March 2002, while presenting the results for the last quarter of 2001, Adelphia for the first time disclosed the existence of $2.3 billion of hidden debt treating it as a contingent liability:
Subsequent disclosure made it very clear that the amount of $2.3 billion was not just a contingent liability but was very much a part of Adelphia’s debt. It turned out that there was not in fact any clear demarcation between the drawdowns by Adelphia and the Rigas Entities. The apportionment of the co-borrowing between them was an arbitrary reclassification carried out every quarter while preparing the financial statements. The SEC stated: “Adelphia management allocated and reallocated co-borrowing liabilities among Adelphia’s consolidated subsidiaries and unconsolidated Rigas Entities at will and through a single, quarterly cash management reconciliation of the inter-company receivables and payables outstanding at quarter end between or among Adelphia’s subsidiaries and Rigas Entities” In fact, Adelphia operated a Cash Management System (CMS) into which Adelphia, its subsidiaries and the Rigas Entities deposited their cash receipts (generated from operations or obtained from borrowings) and from which they withdrew cash for expenses, capital expenditure and debt repayment. This resulted in the commingling of funds between Adelphia and the Rigas Entities.
Adelphia’s fraud was not restricted to concealment of debt. “Between mid-1999 and the last quarter of 2001, Adelphia misrepresented its performance in three areas that are important in the metrics financial analysts use to evaluate cable companies: (a) the number of its basic cable subscribers, (b) the percentage of its cable plant ‘rebuild,’ or upgrade, and (c) its earnings, including its net income and quarterly EBITDA”. Most of this was accomplished by outright falsification or by fictitious transactions with the Rigas Entities through the CMS.
Xerox restated its income for the years from 1997 to 2002 partly to reflect incorrect accounting practices relating to the timing and allocation of revenue from bundled leases. Xerox sells most of its products and services under bundled contracts that contain multiple components – equipment, service, and financing components – for which the customer pays a single monthly-negotiated price as well as a variable service component for page volumes in excess of stated minimums. The SEC claimed that Xerox’s revenue-allocation methodology for these contracts did not comply with the accounting standards and forced Xerox to change its methodology. Under the original methodology, Xerox estimated the fair value of the financing component (using a discounted cash flow method based on the company’s cost of equity and debt) and of the service component (by using an estimate of service gross margins) and attributed the balance to equipment. In the new methodology, the fair value of the service component and the fair value of the equipment (using cash sale prices) are deducted from the total lease payment to arrive at the financing component as a balancing figure and the implicit financing rate is determined. Interestingly, the company’s previous auditor, KPMG regards the original accounting as correct and regards the new accounting adopted by the company and its new auditors, PricewaterhouseCoopers under pressure from the SEC as incorrect. KPMG stated that:
“KPMG remains firm in its conviction that the financial statements reported on by us in May 2001, including Xerox’s financial statements for 2000 and the restated financial statements for 1997-1999, were fairly presented in accordance with generally accepted accounting principles.
KPMG, Xerox and PricewaterhouseCoopers had it right the first time, when the company and three separate teams from PwC all agreed with us that Xerox’s lease accounting methodology was GAAP compliant. By contrast, today’s news reports lead us to believe that the restated financial statements defy economic reality. They apparently give Xerox the benefit of recognizing revenues in 2002 and in future years that it had already recognized in prior years.
AOL Time Warner
AOL Time Warner Inc. admitted50 in October 2002 that it had improperly inflated revenue by $190 million and profitability (EBITDA) by $97 million by improperly accounting for some online ad sales and other deals between July 2000 and June 2002. While AOL Time Warner did not identify the transactions involved, it is likely that these were the ones that the Washington Post had highlighted in two articles52 in July 2002. The Post had alleged that America Online (AOL) resorted to questionable accounting practices in an attempt to shore up advertising revenue at a time when it was in the process of acquiring Time Warner in a stock swap deal. From late 2000 onwards, stock markets were extremely worried about the sustainability of advertising revenue for internet companies. A weakness in advertising revenues could conceivably have led to a sharp fall in the AOL stock price that could have endangered the merger with Time Warner. The Washington Post alleged: “AOL converted legal disputes into ad deals. It negotiated a shift in revenue from one division to another, bolstering its online business. It sold ads on behalf of online auction giant eBay Inc., booking the sale of eBay’s ads as AOL’s own revenue. AOL bartered ads for computer equipment in a deal with Sun Microsystems Inc. AOL counted stock rights as ad and commerce revenue in a deal with a Las Vegas firm called PurchasePro.com Inc”. AOL’s accounting is under investigation by the SEC and by the Justice Department. While the restatements are small relative to AOL’s total revenues and profits, it could have had a disproportionate impact on the share price at a critical point of time when it was clinching the merger deal with Time Warner.
Enron and Andersen-What Went Wrong and Why Similar Audit Failures Could Happen Again by Matthew J. Barrett
Governance, Supervision and Market Discipline: Lessons from Enron by Jayanth R. Varma, Journal of the Indian School of Political Economy published (October-December 2002), Volume 14 Number 4, 559-632).
Arthur Andersen and Enron: Positive Influence on the Accounting Industry by Todd Stinson
McNamee, Mike and Harvy Pitt. If You Violate the Law You Will Pay for it. Business Week December 24, 2001: 33.
McLean, Bethany. Why Enron Went Bust. Fortune December 24, 2001: 59
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