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

In the US, there is no expectation that a company would use the same accounting principles for external financial reporting as for income tax reporting. For income tax purposes, companies tend to minimize taxable income. Thus, it is common and ethical for companies to report less taxable income than financial statement income. This differs from a substantial number of other industrialized countries in which income tax reporting and financial reporting are expected to be the same, and failure to report the same amounts would be unethical and usually illegal.

Nature of US GAAP

GAAP in the US are a complex set of principles, opinions, and statements, both unwritten and written, that have evolved over time. Some, such as the principles of fairness, conservatism, full disclosure, and entity, and basic concepts such as bad debts and depreciation, have never been fully committed to writing and are found in written form only in literature written about them, such as textbooks. Written GAAP began in the 1930s as described in Exhibit 6. In addition to FASB statements, certain documents of the FASB, e.g. Emerging Issue Task Force (EITF) statements, are interim GAAP until the FASB issues a formal statement, if at all. Also, SEC position statements on financial reporting issues are interim GAAP until a formal pronouncement of the FASB occurs. US GAAP for consolidated financial reporting (group accounting) and the equity method of accounting, which are central to the Enron-Andersen case, are presented in Exhibit 7.

The Fairness Principle

Recently, the SEC has emphasized the fairness principle of GAAP and the economic substance of transactions over the legal form. One major example involves the equity method of accounting (discussed in Exhibit 7), in which some companies were limiting investments to 19.9% in order to avoid what was perceived as a 20% rule for applying the equity method. The SEC emphasized that the 20% amount is only a guideline and that fairness requires the equity method if significant influence exists.

Guidelines, not Regulations

In the US, written GAAP are strong and powerful guidelines, but they are not absolute requirements and do not have the force of law. There is a strong expectation that GAAP will be followed, and failure to follow them can lead to serious questions about fairness of financial reporting. Nonetheless, written standards do not cover every possible circumstance, and are often designed to allow flexibility.

Compliance with US GAAP per se is not a defense against criminal charges. In a landmark US federal court case, the so-called Continental Vending case, U.S. v. Simon (425 F. 2nd 796 [1969]), the criminal defendants claimed they had complied with US GAAP (and also GAAS) while auditing financial reports and produced expert witnesses who supported their position. The judge ruled that it was irrelevant whether the auditor complied with GAAP or not; the issue was whether the financial information was fair and whether the defendants benefited fraudulently from the misleading information. The defendants were convicted of the crime, the first time practicing public accountants had been held criminally liable under US federal securities law. Continental Vending was a decision of a US federal appeals court. Under English common law, the decision is a legal precedent for other judges in US federal courts in which Enron-related cases might be tried. Subsequent court decisions have followed the Continental Vending precedent. The news media, in reporting the trials of top Enron executives in early 2006, have commented that the Continental Vending case applies to the Enron trial.