PROFESSIONAL ISSUES

When a company looks too good to be true, it usually is.• ; • • i - I

The Rise and Fall of EnronB Y C . W I L L I A M T H O M A S

f you''re like most, you've been astonished, disillusioned and angered asyou learned of the meteoric rise and fall of Enron Corp. Remember the

company's television commercial of not so long ago, ending with the rever-berating phrase, "Ask why, why, why?" That question is now on everyone'slips. The Enron case is a dream for acad-emics who conduct research and teach.For those currently or formerly involvedwith the company, such as creditors, au-ditors, the SEC and accounting regula-tors, it's a nightmare that will continuefor a long time.

Formal investigations of Enron arenow under way, headed hy the compa-ny's hoard, the SEC, the Justice Depart-ment and Congress. The exact causesand details of the disaster may not beknown for months. The purpose of thisarticle is to summarize preliminary ob-servations about the collapse, as well aschanges in financial reporting, auditingand corporate governance that are beingproposed in response by Big Five ac-counting firms, the AICPA and the SEC.

IN A WAY IT'S SIMPLE, IN A WAY IT'S NOTOn the surface, the motives and attitudes behind decisions andevents leading to Enron's eventual downfall appear simpleenough: individual and collective greed horn in an atmosphereof market euphoria and corporate arrogance. Hardly anyone—the company, its employees, analysts or individual investors-—wanted to heheve the company was too good to be true. So,for a while, hardly anyone did. Many kept on buying thestock, the corporate mantra and the dream. In the meantime,the company made many high-risk deals, some of which wereoutside the company's t>'pical asset risk control process. Manywent sour in the early months of 2001 as Enron's stock priceand debt rating imploded because of loss of investor and credi-tor trust. Methods the company used to disclose (or creatively

obscure) its comphcated financial deal-ings were erroneous and, in the view ofsome, downright deceptive. The compa-ny's lack of transparency in reporting itsfinancial affairs, followed by financial re-statements disclosing billions of dollars ofoinitted Habihties and losses, contributedto its demise. The whole affair happenedunder the watchful eye of Arthur An-dersen LLP, which kept a whole floor ofauditors assigned at Enron year-round.

THE BEGINNING PRESAGES THE ENDIn 1985, after federal deregulation ofnatural gas pipelines, Enron was hornfrom the merger of Houston NaturalGas and InterNorth, a Nebraska pipelinecompany. In the process of the merger,

Enron incurred massive deht and, as the result of deregulation,no longer had exclusive rights to its pipelines. In order to sur-vive, the company had to come up with a new and innovativebusiness strategy to generate profits and cash flow. Kenneth Lay,CEO, hired McKinsey & Co. to assist in developing Enron'sbusiness strategy. It assigned a young consultant named JeffreySkiUing to the engagement. Skilling, who had a hackground inbanking and asset and liability management, proposed a revolu-tionary solution to Enron's credit, cash and profit woes in thegas pipeline business: create a "gas bank" in which Enronwould buy gas from a network of suppliers and sell it to a net-work of consumers, contractually guaranteeing both the supplyand the price, charging fees for the transactions and assumingthe associated risks. Thanks to the young consultant, the com-pany created both a new product and a new paradigm for theindustry—the energy derivative. (continued on page 42}

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Lay was so impressed with Skilling's genius that hecreated a new division in 1990 called Enron FinanceCorp. and hired Skilling to run it. Under SkUHng'sleadership, Enron Finance Corp. soon dominat-ed the market for natural gas contracts, withmore contacts, more access to supplies andmore customers than any of its competitors.With its market power, Enron could predictfuture prices with great accuracy, thereby guar-anteeing superior profits.

THE BEST, THE BRIGHTEST AND THEDREADED PRCSkilling began to change the corporateculture of Enron to match the company'stransformed image as a trading business.He set out on a quest to hire the best andbrightest traders, recruiting associates fix)mthe top MBA schools in the country andcompeting with the largest and most pres-tigious investment banks for talent. In ex-change for grueling schedules, Enronpampered its associates with a long list ofcorporate perks, including concierge services and a companygym. SkiUing rewarded production with merit-based bonusesthat had no cap, permitting traders to "eat what they killed."

One of Skilling's eadiest hires in 1990 was Andrew Eastow,a 29-year-old Kellogg MBA who had been working on lever-aged buyouts and other complicated deals at Continental Illi-nois Bank in Chicago. Fastow hecame Skilling's protege in thesame way Skilhng had become Lay's. Fastow moved swiftlythrough the ranks and was promoted to chief financial officerin 1998. As Skilling oversaw the building of the company'svast trading operation, Fastow oversaw its financing hy evermore complicated means.

As Enron's reputation with the outside world grew, the inter-nal culture apparently began to take a darker tone. Skilling insti-tuted the performance review committee (PRC), which hecameknovm as the harshest employee-rankir^ system in the country Itwas known as the "360-degree review" based on the values ofEnron—respect, integrity, communication and excellence(RICE). However, associates came to feel that the only real per-formance measure was the amount of profits they could produce.In order to achieve top ratings, everyone in the organization he-came instantly motivated to "do deals" and post earnings. Em-ployees were regularly rated on a scale of 1 to 5, with 5s usuallybeing fired within six months. The lower an employee's PRCscore, the closer he or she got to Skilling, and the higher thescore, the closer he or she got to being shown the door. Skilling'sdivision was known for replacing up to 15% of its workforceevery year. Fierce internal competition prevailed and immediategratification was prized above long-term potential. Paranoia flour-ished and trading contracts began to contain highly restrictiveconfidentiality clauses. Secrecy became the order of the day formany of the company's trading contracts, as well as its disclosures.

HOW HIGH THEY FLYCoincidentally, but not inconsequentially, the U.S. economyduring the 1990s was experiencing the longest bull market in

Skiiling institutedthe PRC, which

became known as theharshest employee-ranking system in

the country.

its history. Enron's corporate leadership. Lay excluded,comprised mostly young people who had never

experienced an extended bear market. Newinvestment opportunities were opening upeverywhere, including markets in energy fu-tures. Wall Street demanded double-digit

growth from practically every venture, andEnron was determined to deliver.In 1996 Skilling became Enron's chief operat-

ing officer. He convinced Lay the gasbank model could be apphed to the mar-ket for electric energy as well. Skilling andLay traveled widely across the country,selling the concept to the heads of powercompanies and to energy regulators. Thecompany became a major political playerin the United States, lobbying for deregu-lation of electric utilities. In 1997 Enronacquired electric utility company PortlandGeneral Electric Corp. for about $2 bil-lion. By the end of that year, Skilling haddeveloped the division by then known asEnron Capital and Trade Resources into

the nation's largest wholesale buyer and seller of natural gasand electricity. Revenue grew to $7 billion from $2 billion,and the number of employees in the division skyrocketed tomore than 2,000 from 200. Using the same concept that hadbeen so successful with the gas bank, they were ready to createa market for anything that anyone was willing to trade: fiaturescontracts in coal, paper, steel, water and even weather.

Perhaps Enron's most exciting development in the eyes ofthe financial world was the creation of Enron Online (EOL)in Octoher 1999. EOL, an electronic commodities tradingWeb site, was significant for at least two reasons. First, Enronwas a counterparty to every transaction conducted on theplatform. Traders received extremely valuable information re-garding the "long" and "short" parties to each trade as well asthe products' prices in real-time. Second, given that Enronwas either a buyer or a seller in every transaction, credit riskmanagement was crucial and Enron's credit was the corner-stone that gave the energy community the confidence thatEOL provided a safe transaction environment. EOL becamean overnight success, handling $335 hillion in online com-modity trades in 2000.

The world of technology opened up the Internet, andthe IPO market for technology and broadband communica-tions companies started to take off. In January 2000 Enronannounced an ambitious plan to build a high-speed broad-band telecommunications network and to trade network ca-pacity, or bandwidth, in the same way it traded electricity ornatural gas. In July of that year Enron and Blockbuster an-nounced a deal to provide video on demand to customersthroughout the world via high-speed Internet lines. As En-ron poured hundreds of millions into hroadband with verylittle return. Wall Street rewarded the strategy with as muchas $40 on the stock price—a factor that would have to bediscounted later when the broadband bubble burst. In Au-gust 2000 Enron's stock hit an all-time high of $90.56, andthe company was being touted by Fortune and other business

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publications as one of the most admired and innovative com-panies in the world. j

THE ROLE OF MARK TO-MARKET ACCOUNTINGEnron incorporated "mark-to-market accounting" for the en-ergy trading husiness in the mid-1990s and used it on an un-precedented scale for its trading transactions. Undermark-to-market rules, whenever companies have outstandingenergy-related or other derivative contracts (either assets or lia-hilities) on their balance sheets at the end of a particular quar-ter, they must adjust them to fair market value, bookingunrealized gains or losses to the income statement of the peri-od. A difficulty with application of these rules in accountingfor long-term futures contracts in commodities such as gas isthat there are often no quoted prices upon which to hase valu-ations. Companies having these t 'pes of derivative instrumentsare free to develop and use discretionary valuation modelsbased on their own assumptions and methods.

The Financial Accounting Standards Board's (FASB)emerging issues task force has debated the suhject of how tovalue and disclose energy-related contracts for several years. Ithas been able to conclude only that a one-size-fits-all approachwill not work and that to require companies to disclose all ofthe assumptions and estimates underlying earnings would pro-duce disclosures that were so voluminous they would be of lit-tle value. For a company such as Enron, under continuouspressure to beat earnings estimates, it is possible that valuationestimates might have considerably overstated earnings. Further-more, unrealized trading gains accounted for slightly more thanhalf of the company's $1.41 billion reported pretax profit for2000 and about one-third of its reported pretax profit for 1999.

CAPITALISM AT WORKIn the latter part of the 1990s, companies such as Dynegy, DukeEnergy, El Paso and Williams began following Enron's lead. En-ron's competitive advantage, as well as its huge profit margins,had begun to erode by the end of 2000. Each new market en-trant's successes squeezed Enron's profit margins further. It ranvv-ith increasing leverage, thus becoming more like a hedge fundthan a trading company. Meanwhile, energ)' prices began to fallin the first quarter of 2001 and the world economy headed intoa recession, thus dampening energy market volatility' and reduc-ing the opportunity for the large, rapid trading gains that hadformerly made Enron so profitable. Deals, especially in the fi-nance division, were done at a rapid pace without much regardto whether diey aligned with the strategic goals of the companyor whether they complied with the company's risk manage-ment policies. As one knowledgeable Enron employee put it:"Good deal vs. bad deal? Didn't matter. If it had a positive netpresent value (NPV) it could get done. Sometimes positiveNPV didn't even matter in the name of strategic significance."Enron's foundations were developing cracks and Skilling's houseof paper built on the stilts of trust had begun to crumble.

RELATED PARTIES AND COMPLEX SPECIAL PURPOSEENTITIESIn order to satisfy Moody's and Standard & Poor's credit ratingagencies, Enron had to make sure the company's leverage ratioswere within acceptable ranges. Fastow continually lobbied the

ratings agencies to raise Enron's credit rating, apparently to noavail. That notwithstanding, there were other ways to lower diecompany's debt ratio. Reducing hard assets while earning in-creasing paper profits served to increase Enron's return on assets(ROA) and reduce its debt-to-total-assets ratio, making thecompany more attracdve to credit rating agencies and investors.

Enron, like many other companies, used "special purposeentities" (SPEs) to access capital or hedge risk. By using SPEssuch as limited partnerships with outside parties, a company ispermitted to increase leverage and ROA without having to re-port deht on its balance sheet. The company contributes hardassets and related debt to an SPE in exchange for an interest.The SPE then horrows large sums of money from a financialinstitution to purchase assets or conduct other business with-out the deht or assets showing up on the company's financialstatements. The company can also sell leveraged assets to theSPE and hook a profit. To avoid classification of the SPE as asubsidiary (thereby forcing the entit}' to include the SPE's fi-nancial position and results of operations in its financial state-ments), FASB guidelines require that only 3% of the SPE beowned by an outside investor.

Under Fastow's leadership, Enron took the use of SPEs tonew heights of complexity and sophistication, capitalizingtheni with not only a variety of hard assets and hahilities, butalso extremely complex derivative financial instruments, itsown restricted stock, rights to acquire its stock and related ha-bilities. As its financial dealings became more complicated, thecompany apparently also used SPEs to "park" troubled assetsthat were falling in value, such as certain overseas energy facili-ties, the broadband operation or stock in companies that hadbeen spun off to the public. Transferring these assets to SPEsmeant their losses would be kept off Enron's books. To com-pensate partnership investors for downside risk, Enronpromised issuance of additional shares of its stock. As the valueof the assets in these partnerships fell, Enron began to incurlarger and larger obligations to issue its own stock later downthe road. Compounding the problem toward the end was theprecipitous fall in the value of Enron stock. Enron conductedbusiness through thousands of SPEs. The most controversial ofthem were LJM Cayman LP and LJM2 Co-Investment LP,run by Fastow himself. From 1999 through July 2001, theseentities paid Fastow more than $30 million in managementfees, far more than his Enron salary, supposedly with the ap-proval of top management and Enron's hoard of directors. Inturn, the LJM partnerships invested in another group of SPEs,known as the Riptor vehicles, which were designed in part tohedge an Enron investment in a bankrupt broadband compa-ny. Rhythm NetConnections. As part of the capitalization ofthe P^ptor entities, Enron issued common stock in exchangefor a note receivable of $1.2 billion. Enron increased notes re-ceivable and shareholders' equity to reflect this transaction,which appears to violate generally accepted accounting princi-ples. Additionally, Enron failed to consolidate the LJM andP^ptor SPEs into their financial statements when subsequentinformation revealed they should have been consolidated.

OBSCURE DISCLOSURES REVEALEDA very confusing footnote in Enron's 2000 financial statementsdescribed the above transactions. Douglas Carmichael, the

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Wollman Distinguished Professor of Accounting atBaruch College in New York City, told the WallStreet Journal in November of 2001 that most peo-ple would be hard pressed to understand the ef-fects of these disclosures on the financialstatements, casting doubt on both the qualityof the company's earnings as well as the busi-ness purpose of the transaction. By April2001 other skeptics arrived on the scene. Anumber of analysts questioned the lack oftransparency of Enron's disclosures. Oneanalyst was quoted as saying, "The notesjust don't make sense, and we read notesfor a living." Skilling was very quick to re-ply with arrogant comments and, in onecase, even called an analyst a derogatoryname. What Skilling and Fastow appar-ently underestimated was that, because ofsuch actions, the market was beginning toperceive the company with greater andgreater skepticism, thus eroding its trustand the company's reputation.

Senior managementcontinued to exit,

coliectively hundredsof millions of dollars

richer for theexperience.

IT ALL COMES TUMBLING DOWNIn Fehruary 2001 Lay announced his retirement and namedSkiUing president and CEO of Enron. In Fehruary Skillingheld the company's annual conference with analysts, braggingthat the stock (then valued around $80) should be trading ataround $126 per share.

In March Enron and Blockbuster announced the cancella-tion of their video-on-demand deal. By that time the stockhad fallen to the mid-$60s. Throughout the spring and sum-mer, risky deals Enron had made in underperforming invest-ments of various kinds began to unravel, causing it to suffer ahuge cash shortfall. Senior management, which had heen vot-ing with its feet since August 2000, selling Enron stock in thebull market, continued to exit, collectively hundreds of mil-hons of dollars richer for the experience. On August 14, justsix months after being named CEO, Skilling himself resigned,citing "personal reasons." The stock price slipped below $40that week and, except for a brief recovery in early October af-ter the sale of Portland General, continued its slide to helow$30 a share.

Also in August, in an internal memorandum to Lay, a com-pany vice-president, Sherron Watkins, described her reserva-tions about the lack of disclosure of the substance of therelated party transactions with the SPEs run by Fastow. Sheconcluded the memo by stating her fear that the companymight "implode under a series of accounting scandals." Laynotified the company's attorneys, Vinson & Elkins, as well asthe audit partner at Enron's auditing firm, Arthur AndersenLLP, so the matter could be investigated further. The prover-bial "ship" of Enron had struck the iceberg that would even-tually sink it.

On October 16 Enron announced its first quarterly loss inmore than four years after taking charges of $1 billion onpoorly performing businesses. The company terminated theRaptor hedging arrangements which, if they had continued,would have resulted in its issuing 58 million Enron shares to

of&et the company's private equity losses, severely di-luting earnings. It also disclosed the reversal of the

$1.2 billion entry to assets and equities it hadmade as a result of dealings with thesearrangements. It was this disclosure that gotthe SEC's attention.

On Octoher 17 the company announcedit had changed plan administrators for its em-

ployees' 401 (k) pension plan, thus hy law lock-ing their investments for a period of 30days and preventing workers from sellingtheir Enron stock. The company con-tends this decision had in fact been mademonths earlier. However true that mightbe, the timing of the decision certainlyhas raised suspicions.

On October 22 Enron announced theSEC was looking into the related partytransactions between Enron and the part-nerships owned by Fastow, who was firedtwo days later. On Novemher 8 Enronannounced a restatement of its financialstatements back to 1997 to reflect consoli-

dation of the SPEs it had omitted, as well as to hook Ander-sen's recommended adjustments from those years, which thecompany had previously "deemed immaterial." This restate-ment resulted in another $591 million in losses over the fouryears as well as an additional $628 million in liabilities as of theend of 2000. The equity markets immediately reacted to therestatement, driving the stock price to less than $10 a share.One analyst's report stated the company had burned through$5 hillion in cash in 50 days.

A merger agreement with smaller cross-town competitorDynegy was announced on Novemher 9, hut rescinded byDynegy on November 28 on the basis of Enron's lack of fulldisclosure of its off-balance-sheet debt, downgrading Enron'srating to junk status. On Novemher 30 the stock closed at anastonishing 26 cents a share. The company filed for bankrupt-cy protection on December 2.

THE AFTERMATHUnquestionahly, the Enron implosion has wreaked more havocon the accounting profession than any other case in U.S. histo-ry. Critics in the media. Congress and elsewhere are callinginto question not otily the adequacy of U.S. disclosure practiceshut also the integrity of the independent audit process. Thegeneral public still questions how CPA firms can maintain auditindependence while at the same time engaging in consultingwork, often for fees that dwarf those of the audit. Companiesthat deal in special purpose entities and complex financial in-struments similar to Enron's have suffered significant declines intheir stock prices. The scandal threatens to undermine confi-dence in financial markets in the United States and abroad.

In a characteristic move, the SEC and the public account-ing professioti have been among the first to respond to the En-ron crisis. Unfortunately, and sadly reminiscent of financialdisasters in the 1970s and 1980s, this response will likely beviewed by investors, creditors, lawmakers and employees ofEnron as "too little, too late."

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In an "op-ed" piece for tbe Wall Street Journal onDccetnber 11, SEC Cbairman Harvey Pitt called tbecurrent outdated reporting and financial disclosuresystem the financial "perfect storm." He statedthat under tbe current quarterly and annualreporting system, information is often staleon arrival and mandated financial disclosuresare often "arcane and impenetrable." To reas-sure investors and restore confidence in finan-cial reporting, Pitt called for a jointresponse from tbe public and private sec-tors that included, among other things,

• A system of "current" disclosures,supplementing and updating quarterly andannual information with disclosure of ma-terial information on a real-time basis.

• Public company disclosure of signifi-cant current "trend" and "evaluative" datain addition to bistorical information.

ti Identification of "most critical ac-coutiting principles" by all pubUc compa-tiies in their annual reports.

• More timely aiid responsive account-ing standard setting on the part of the private sector.

• An environment of cooperation between tbe SEC andregistrants that encourages public companies and their auditorsto seek advice on disclosure issues in advance.

• An effective and transparent system of self-reguiatioti fortbe accounting profession, subject to SECs rigorous, butnondupHcative, oversigbt.

• More proactive oversigbt by audit committees who un-derstand financial accounting principles as weU as how they areapphed.

The CEOs of tbe Big Five accounting firms made a jointstatement on December 4 committing to develop improvedguidance on disclosure of related party transactions, SPEs andmarket risks for derivatives including energy contracts for tbe2001 reporting period. In addition, tbe Big Five called formodernization of tbe financial reporting system in the UnitedStates to make it more timely and relevant, including morenonfmancial information on entity performance. They alsovowed to streamline the accountitig standard-setting process tomake it more responsive to the rapid changes that occur in atechnology-driven economy.

Since the Enron debacle, tbe AICPA bas been engaged insignificant damage control measures to restore confidence intbe profession, displaying tbe banner "Enron: Tbe AICPA,tbe Profession, and tbe Public Interest" on its Web site. It hasannounced the imminent issuance of an exposure draft on anew audit standard on fraud (the third in five years), provid-ing more specific guidance than currently found in SAS no.82, Consideration of Fraud in a Financial Statement Audit. TheInstitute has also protnised a revised standard on reviews ofquarterly financial statements, as w-ell as the issuatice, in tbesecond quarter of 2002, of an exposure draft of a standard toimprove tbe audit process. These standards had already beenon the drawing board as part of tbe AlCPA's response to tbereport of tbe Blue Ribbon Panel on Audit EfTectiveness, is-sued in 2000.

The AICPA has beenengaged in significant

damage controlmeasures to restoreconfidence in the

profession.

In late December the AICPA issued a tool kit forauditors to use in identifying and auditing related

party transactions. While it breaks no newground, the tool kit provides, in one place,an overview of the accounting and auditingliterature, SEC requirements and best prac-

tice guidance concerning related party trans-actions. It also includes checklists and other

tools for auditors to use in gathering evidence anddisclosing related party transactions.

In January the AICPA board of direc-tors announced tbat it would cooperatefully with the SECs proposal for newrules for the peer review and disciplinaryprocess for CPA firms of SEC registrants.The new system would be managed by aboard, a inajority of which would bepublic members, enbancing tbe peer re-view process for tbe largest firms and re-quiring more rigorous and continuousmonitoring. Tbe staff of tbe new boardwould administer tbe reviews. In protest,the Public Oversight Board informed Pitt

that it would terminate its existence in March 2002, leavingthe future peer review process in a state of uncertainty. TheSEC and the AICPA are now engaged in talks with tbe POBto reassure tbe board it wiU continue to be a vital part of tbepeer review process in the future.

The AICPA bas also approved a resolution to support pro-hibitions tbat would prevent audit firms from performing sys-tems design and implementation as well as internal auditoutsourcing for public audit clients. Wbile asserting tbat itdoes not believe prohibition of these services will make auditsmore effective or prevent financial failures, the board bas statedit feels tbe move is necessary to restore public confidence intbe profession. These prohibitions were at the center of thecontroversy last year between the profession and the SEC un-der the direction of former Chairman Arthur Levitt. Big FiveCPA firtns and the AICPA lobbied heavily and prevailed inthat controversy, winning tbe right to retain tbese services andbeing required only to disclose their fees.

Tbe impact of Enron is now being felt at the highest levelsof government as legislators engage in endless debate and ac-cusation, quarreling over the influence of money in politics.The GAO bas requested tbat the White House disclose docu-tnents concerning appointments to President George WBush's Task Force on Energy, chaired by Vice-President DickCheney, former CEO of Halliburton. The White House hasrefused, and the GAO has filed suit, tbe first of its kind in his-tory. Congressional investigations are expected to continuewell into 2002 and beyond. Lavv'niakers are expected to inves-tigate not only disclosure practices at Enron, but for all publiccompanies, concernitig SPEs, related party transactions anduse of "mark-to-niarket" accounting.

Kenneth Lay resigned as Enron's CEO, under pressurefrom creditor groups. Lay, Skilling and Fastovi still have muchto explain. In addition, Enron's board of directors, and espe-cially tbe audit committee, will be in tbe "hot seat" andrigbtfijlly so. (continmd on pa^e 47)

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The Justice Department opened a criminal investi-gation and formed a national task force made up offederal prosecutors in Houston, San Francisco,New York and several other cities to investigatethe possibility of fi"aud in tbe company's deal-ings. Interestingly, to illustrate bow far-reach-ing Enron's ties are to government andpolitical sources at all levels, US. AttorneyGeneral John Asbcroft, as well as his entireHouston office, disqualified thctnselvesfrom the investigation because of eitberpolitical, economic or family ties.

It appears tbat 2002 is shaping up to bea year of unprecedented cbanges for .1profession that is already coping with anidentity crisis.

WHERE WERE THE AUDITORS?Arthur Andersen LLP, after settling twoother massive lawsuits earlier in 2001, ispreparing for a storm of Utigation as wellas a possible criminal investigation in thewake of tbe Enron collapse. Enron wastbe firm's second-largest client. Anderseti, who had the jobnot only of Enron's external but also its internal autlits for theyears in question, kept a staff on permanent assigtiment atEnron's offices. Many of Enron's internal accountants, CFOsand controUers were former Andersen executives. Because ofthese relationships, as weU as Andersen's extensive concurrentconsulting practice, members of Congress, tbe press and oth-ers are calling Andersen's audit independence into question.Indeed, they are using tbe case to raise doubts about thecredibility of the audit process for al! Big Five firms who dosuch work.

So far, Andersen bas acknowledged its role in tbe fiasco,while defending its accounting and audititig practices. In aWall Street Journal editorial on December 4, as well as in testi-mony before Congress tbe following week, Josepb Berardino,CEO, was forthright in his views. He committed the firm tofuU cooperation in the investigations as well as to a leadershiprole in potential solutions.

Enron dismissed Andersen as its auditor on January 17,2002, citing document destruction and lack of guidance onaccounting policy issues as tbe reasons. Andersen counteredwitb tbe contention tbat in its mind tbe relationship bad ter-minated on December 2, 2001, the day the firm filed forChapter II bankruptcy protection.

The fact that Andersen is no longer officially associatedwith Enron will, unfortunately, have little impact on forcesnow in place tbat may, in tbe eyes of some, determine tbefirm's very future. Anderseti is novt' under formal investiga-tion by tbe SEC as well as various committees of both theU.S. Setiate and House of Representatives of the U.S. Coti-gress. To make tiiatters worse for it, and to the astonishmentof many, Andersen admitted it destroyed perhaps thousands ofdocuments and electronic files related to tbe engagement, inaccordance with "firm policy," supposedly before the SEC is-sued a subpoena for them. The firm's lawT,'ers issued an inter-nal memorandum on October 12 retninding employees of

Some of the classicrisk factors associated

with managementfraud outiined in SASno. 82 are evident in

the Enron case.

tbe firm's document retention and destruction poU-cies. The firm fired David B. Duncan, parttier iti

charge of the Enron cngagemetit, placed fourother partners on leave and replaced tbeentire management team of tbe Houstonoffice. Duncan invoked his Eifth Amend-

ment rights against self-incrimination at acongressional hearing in January. Several other

Andersen partners testified that Duncan and hisstaff acted in violation of firm policy.However, in view of the timing of theOctober 12 memorandum. Congress andthe press are questioning whether the de-cision to shred documents extended far-ther up the chaiti of command. Andersenhas suspended its firm policy for reten-tion of records and asked former U.S.Senator Jobti Danfortb to conduct acomprehensive review of the firm'srecords management policy and to rec-ommend improvements.

In a move to bolster its image, Ander-sen also bas retained former Federal Re-

serve Chairman Paul Volcker to lead an outside board thatwill advise it in making "fundamental change" iti its auditprocess. Other members of the board include P. Roy Vagelos,former cbairman and CEO of Merck & Co., and Cbarles A.Bowsher, current chairman of the Public Oversight Board,which disbanded iti March. Volcker also tianied a seven-member advisory panel made up of prominent corporate andaccounting executives that will review proposed reforms totbe firm's audit process.

Hincisight is so clear that it sometimes belies the complexityof the problem. Altbough fraud bas not yet been proven to bea factor in Enron's misstatetnents, some of tbe classic risk fac-tors associated with management firaud outlined in SAS no. 82are evident in the Etiroti case. Those include managementcharacteristics, industry conditions and operating cbaracteris-tics of tbe company. Altbougb written five years ago, tbe listalmost looks as if it was excerpted from Enron's case:

• Unduly aggressive earnings targets and managementbonus compensation based on tbose targets.

• Excessive interest by management in maintaining stockprice or earnings trend tbrougb tbe use of unusually aggressiveaccounting practices.

• Management setting unduly aggressive financial targetsand expectations for operating personnel.

• Inability to generate sufficient cash flow frotn operationswliile reporting earnings and earnings growth.

• Assets, liabilities, revenues or expenses based on signifi-cant estimates that involve unusually subjective judgments sucbas.. .reliability of financial instruments.

• Significant related party transactions.Tbese factors are cotiimon threads in the tapestry that is

described of tbe environment leading to fraud. They •wereincorporated into SAS no. 82 oti the basis of research intofraud cases of the 1970s and 1980s in the hope that auditorswould learn from the past. Andersen will have to explainwhen and bow it identified these factors, as well as how it re-

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sponded and how it communicated with Enron's boardabout them.

More important, Andersen will have to explain why it de-layed notifying the SEC after learning of the internal Enronmemo warning of problems. In addition, it will bave to ex-plain why the Houston office destroyed the thousands of doc-uments related to the Enron audits for 1997 through 2000.Only time wiU tell, but it appears the firm is in serious trouble.In the end, and also characteristic of cases like this, the chiefparties likely to benefit from this process are the attorneys.

THE HUMAN FACTORThe Enron story has produced many victims, tbe most tragic ofwhich is a former vice-chairman of the company who com-mitted suicide, apparently in cotinection witb bis role in thescandal Another 4,500 individuals have seen their careers end-ed abruptly by tbe reckless acts of a few. Enron's core values ofrespect, integrity, communication and excelletice stand in satir-ical contrast to allegations now being made public. Personally, Ibad referred several of our best and brightest accounting, fi-nance and MBA graduates to Enron, hoping they could gainvaluable experience from seeing things done right. These in-

cluded a very bright training consultant who had lost her job in2000 witb a Houston consulting firm as a result of a reductionin force. She has lost ber secondjob in \S niontbs tbrougb nofault of her own. Other former students still hanging on at En-ron face an tmcertain fijture as the company fights for survival.

The old saying goes, "Lessons learned hard are learnedbest." Some former Enron employees are embittered by theway they have been treated by tbe company that was once"the best in tbe business." Otbers disagree. In the words of oneof my former students who is still hanging on: "Just for therecord, my time and experience at Enron have been nothingshort of fantastic. I could not bave asked for a better place tobe or better people to work with. Please, though, remetnberthis: Never take customer and employee confidence for grant-ed. Tbat confidence is easy to lose and tough—to impossi-ble—to regain." •

C. WILLIAM THOMAS, CPA, PbD, is the J.E. Busb Professorof Accounting in tbe Hankaiiier School of Business at Baylor Uni-versity in Waco. Mr. Thomas can be reached at BiIl_Thomas@baylor.edu. This article originally appeared in the March/April2002 issue of Today's CPA, published by the Texas Society of CPAs.

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