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Governance, Accounting, andAuditing Reform, Post-Enron

Chapter Two

Purpose of the ChapterEnron and the subsequent Arthur Andersen and WorldCom fiascoes have trig-gered a sea change of new expectations for governance and the accountingprofession in United States and Canada, and are in the process of informingexpectations around the world. These fiascoes created such a serious crisis ofcredibility in the corporate accounting, reporting, and governance processesthat that U.S. politicians created new frameworks of accountability and gover-nance within the Sarbanes-Oxley Act to restore sufficient confidence to allowcapital markets to return to normal functioning. In essence, the fiascoes acceler-ated and then the Sarbanes-Oxley Act crystallized heightened expectations forethical behavior by businesspeople and members of the accounting profession.

Understanding the issues, principles, and practices involved in these new expec-tations is essential to the anticipation and consideration of what will be appropriatefuture governance and behavior for corporations and professional accountants.Faced with applying a stream of new guidelines and regulations, including manyspawned by the Sarbanes-Oxley Act, businesspeople and professional accountantswill find their task facilitated by understanding their essencethe ethical under-pinningsof the new initiatives.

Governance and Accountability Reform

Overview and Timeline of Events and DevelopmentsMultiple huge shocks generated a crisis of investor confidence in corporate andprofessional ethics that underpin North American capital market values and thetrust that allows modern commerce. President Bush and leaders around the worldwere calling for answers and solutions to ensure compliance with fair values thatthe public could support and the public interest demanded. Ultimately, corporategovernance and the accounting profession were shown to need reform to restorethe trust and credibility needed for financial markets to work effectively.

In mid-October 2001, vaunted giant Enron restated manipulated earnings, andon December 2 filed for bankruptcy, destroying billions in valueespecially of retirement investmentin the process. Amid stories of huge shamand fraudulent off-statement transactions, it became clear that senior executivesenriched themselves beyond belief while the board of directors and ArthurAndersen, the auditor, apparently were unaware or worse. Frequently, Enronexecutives claimed bad memories, ignorance, or the Fifth Amendment in front of

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Senate and Congressional committees. Government and the SEC seemed at a lossto deal with the situation.

Stories also began to surface about a blatant, self-interested, and apparently in-your-face shredding of Enron audit documents by Arthur Andersen that ultimatelyproduced charges on March 7, 2002, and, after protracted jury deliberations, anobstruction of justice conviction on June 15, 2002. Throughout the period fromOctober 2001 to June 2002, Arthur Andersens client base and practice disintegrated.A firm of 85,000 worldwide was essentially gone. In the United States, 24,000 employ-ees lost their jobs because of the decisions of probably less than 100 colleagues.

Finally, on June 25 when Senate and Congress hearings were well along andsome governance changes were starting to be considered, came the incrediblespecter of giant WorldCom also applying for bankruptcy protection. When itbecame known that executives had again manipulated profits through accountingshenanigans and the CEO had essentially loaned himself over $400 million withoutthe apparent oversight of the board, the Congress and Senate were galvanized bygrowing public outrage to produce the Sarbanes-Oxley Act (SOX) on July 30, 2002.

SOX provides frameworks for reform of the corporate governance system basedon integrity and accountability, and for the accounting profession based on inde-pendence and fiduciary duty to the public interest. The provisions of SOX will beobserved by U.S. SEC registrants, and probably by the worlds largest corporationsthat want access to U.S. capital markets and their auditors.

The worlds of corporate governance, governance of the accounting profession,and of business ethics have entered a time warp on fast-forward. Understandingwhat happened and why, and what the impact will be on corporations, theaccounting profession, and upon business ethics will assist in interpreting andplanning for future developments. See Figure 2.1.

The Enron Debacle

BackgroundWith hindsight, most observers agree that Enrons problems were caused by afailure of the board of directors to exercise adequate oversight. This allowed themisuse of special purpose entities (SPEs), a form of partnership, to manipulate

FIGURE 2.1 Governance Reform Timeline

EnronBankruptcy

December 2, 2001

Arthur AndersenCourt Case

Winter/Spring 2002

WorldCom RestatementJune 25, 2002;

BankruptcyJuly 21, 2002

Sarbanes-Oxley ActSigned

July 30, 2002

SECRegulations

Stock ExchangeGuidance

Public outrage grows, governance credibility falls

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Chapter Two Governance, Accounting, and Auditing Reform, Post-Enron 57

financial reports, mislead investors, and self-remunerate the perpetrators. ArthurAndersen, Enrons audit firm, has essentially disintegrated, and the accountingprofession, as well as corporate governance, will be forever altered. All of thiswas not apparent until almost the end of the story.

Throughout the late 1990s, Enrons stock rose slowly on the New York StockExchange, within a trading range from $20 to $40. Within a few months of thestart of the new millennium as shown in Figure 2.2, Enrons stock price leapt to$70, based upon the overall buoyancy of the stock markets in general, the favor-able assessment accorded the company by analysts, and Enrons own reports ofearnings and prospects.

During 2000, Enrons stock traded in a range of $60 to $90, peaked in Augustat $90.56, and closed the year close to $80. In 2001, however, the trend was pre-cipitously downward until an Enron share was virtually worthless. Rumors ofEnrons demise had been circulating for months when, on December 2, 2001, thecompany filed for protection from creditors under Chapter 11 of the U.S.Securities Act. On April 2, 2002, a share of Enron stock was worth only 24 centson the over-the-counter market.

How and why did this occur? Who was to blame? What were the repercussionsto be? Investors were scandalized, pensioners lost their life savings, the public wasoutraged, and the credibility of the financial markets and of the corporate worldwas shaken. How could the alleged financial manipulations have occurred underthe watchful eyes of Enrons auditor, Arthur Andersen, and a blue-ribbon boardof directors? Amid allegations that Enron alumni had infiltrated the U.S. govern-ment and its agencies, the ability and resolve of the Securities and ExchangeCommission (SEC) and of the U.S. Justice Department were questioned.

Officials and politicians hurriedly looked for answers that would restore thatcredibility and the trust that had been lost. So great was the concern that

FIGURE 2.2 Enron Stock Chart, Weekly Prices, 19972002

0.09

S

ENRNQ

80

60

40

20

0

US

Dol

lars

1998 1999 2000 2001 2002 2003

ENRNQ Weekly

1997

Reprinted courtesy of NAQ, Inc.

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58 Part One The Ethics Environment

President Bush himself pledged that the guilty would be punished aggressivelyby government agencies. Bush called for governance reforms and offered a 10-point plan for legislative action.1

After considerable delay and outcry, Enrons audit firm, Arthur AndersenLLP (AA), the fifth largest audit firm in the United States and one of the largestin the world, was charged on March 7, 2002, with obstruction of justice for shred-ding documents allegedly important to the governments investigation. As acondition of the charge, the SEC placed restrictions on AA to serve its SEC-reg-istered clients, thus jeopardizing the ability of AA to continue as a firm.Ultimately it disintegrated and was taken over piecemeal by competitors. A sep-arate section is included later that contains a full discussion of the troubles ofArthur Andersen, and how probably less than 100 AA people were responsiblefor the disaster that ruined a once-revered firm that employed 85,000 world-wide. In addition, the self-regulatory framework that the profession had enjoyedin the United States was further eroded.

Not surprisingly, the desire to know why the Enron disaster occurredspawned many investigations, including the following that are available forreview and download from www.thomsonedu.com/accounting/brooks.

The Powers Report by a specially formed subcommittee of Enrons BoardFebruary 1,2002 (Powers)

The Role of the Board of Directors in Enrons Collapse by the U.S. Senates PermanentSubcommittee on InvestigationsJuly 8, 2002 (Senate)

The Accounting Treatment of Prepays by Robert Roach, Counsel and ChiefInvestigator, U.S. Senates Permanent Subcommittee on InvestigationsJuly 27,2002 (Roach)

In addition, new governance initiatives continued to be