ENRON AND ARTHUR ADNDERSEN: THE CASE OF THE CROOKED E AND THE FALLEN A

Global Perspectives on Accounting Education, 2006 by Cunningham, Gary M, Harris, Jean E

ABSTRACT

Outside the US, the failures of Enron and Arthur Andersen remain puzzles. How could the accounting and audit failures associated with Enron and Arthur Andersen happen in the US where auditing is sophisticated, accounting principles are strong, and disclosure is emphasized? This is a teaching case for persons outside the US to review the financial reporting and auditing issues related to Enron and to explain the regulation of accounting and auditing in the US. It has broad implications for corporate governance and accounting regulation in other countries as well.

In the years after the Enron Corporation declared bankruptcy in 2001 and Arthur Andersen failed in 2002, people are still asking, especially those outside the US, how could this happen? What went wrong? The US has a well-developed set of Generally Accepted Accounting Principles (GAAP) that requires extensive disclosures in audited financial statements, and a well-established federal agency, the Securities and Exchange Commission (SEC) that monitors financial reporting.

This case is written for accounting students and others, who are outside the US, to explore the financial reporting and auditing issues related to the debacles at Enron and Andersen and to explain the financial reporting environment in the US. The case is presented in four parts. Part I presents general information about Enron and Andersen. In Part II, the government and legal system of the US, and the regulation of financial reporting and auditing, is described. In Part III, US accounting principles and disclosures are discussed. Finally, in Part IV, the specific financial reporting and auditing aspects of Enron are analyzed, including a review of reforms in the aftermath of Enron. Exhibit 1 provides a list of accounting terminology that may be a useful reference. Introductory observations presented in Exhibit 2 give insight to start the case.

PART I ENRON AND ANDERSEN - A UNIQUE AND INNOVATIVE COMPANY WITH A PRESTIGIOUS AUDITOR

Enron was a leading energy commodities and service company with revenue of US $101 billion in 2000. It employed about 21,000 people, mostly at its headquarters in Houston, Texas. Enron began in 1985 with the merger of two companies, Houston Natural Gas and InterNorth, which sold and transported natural gas. After the merger, Enron was applauded for being innovative in opening new markets. To create new markets, Enron acted as a bank for commodities, buying a commodity from suppliers and selling it to buyers. For example, it would contract to sell natural gas for future delivery at a fixed price. Then if it wanted to hedge the transaction, it would contract again to buy natural gas at the same future date. These types of future contracts are among those called derivatives. To deal with the buyers and sellers who were central to a "trading partners" strategy, sound credit and liquidity were essential. Enron had to deliver cash when buy transactions were settled financially. Therefore, it became important for Enron to generate cash flow and report cash flow internally. Throughout its existence, Enron relied crucially on borrowed cash for its day-to-day operations.

With past success, bull markets, debt, inexperienced employees, and diverse businesses, Enron raced to become anything and everything. Its businesses were foreign and domestic, low-tech and high-tech, commercial and residential, wholesale and retail, and regulated and unregulated. It is unlikely that any company could have developed the expertise required. So, it is not surprising that weaknesses emerged.

As Enron grew, it began to trade commodities about which its employees knew little. Its commodity banking expanded from natural gas into electricity, Internet broadband, weather futures, and other goods and services. As Enron's trading grew, its assets shifted from fixed assets such as pipelines, to intangibles, especially contractual rights to commodities, a form of derivatives. Often budgetary and other basic controls were abandoned. Enron did not have a unified strategy. As a result, its aggressive dealmakers transformed Enron from an operating company to an investment fund. Enron's management and its auditors were not prepared for this transformation and unable to recognize the risks. For many top executives, business was not about selling goods and services; it was about managing earnings, managing reported cash flow, and managing the numbers.

Andersen was among the most prestigious international accounting firms in the world. Accounting students in the US often viewed it as the most glamorous and desirable employer. Andersen marketed itself as having fewer offices than its competitors because it operated with larger offices to serve prominent clients. Although Andersen's client base was diversified, it often had "high flying" companies such as Enron and WorldCom as clients. Enron was Andersen's second largest client, and the largest client in Andersen's Houston office. Players in Enron and in Andersen are presented in Exhibit 3 and the downfall is described in Exhibit 4.