ACCT 622 Week 1 Discussion Board Forum 1 Thread/Case Study Example

Independence for Sale? Arthur Andersen's Audit of Enron Measured Against the Auditor's Ethical Duties

Background

Enron Corporation grew in the 1990s from a pipeline company into an energy trader and, by 2000, reported revenue above $100 billion. Much of its reported profit depended on transactions with special purpose entities, several managed by its chief financial officer, that kept debt off the balance sheet and recorded gains on assets Enron effectively still controlled. In November 2001, Enron restated its financial statements for 1997 through 2000, reducing reported income by about $586 million, and in December it filed for bankruptcy. Healy and Palepu (2003) describe a collapse produced by aggressive management, a board that approved conflicts of interest and gatekeepers, including the auditor, who failed to check either. Arthur Andersen had audited Enron since its formation, and its 2000 fees were about $25 million for the audit and $27 million for other services.

Threats to Independence

An auditor's first ethical duty is to be independent in fact and in appearance, because the public relies on the opinion only if the auditor has no stake in what it says. The Enron engagement created at least three threats. The first was self-interest. Non-audit fees exceeded audit fees, and the Houston office treated Enron as one of the firm's most valuable relationships. When a client provides that much revenue, every difficult accounting judgment carries a commercial cost for the partner who makes it. The second was self-review. Andersen had taken over much of Enron's internal audit function, so the external auditors were evaluating controls their own firm partly operated. The third was familiarity. Andersen staff worked in Enron's offices for years, and several moved to senior finance roles at the company, which blurred the line between auditor and client.

The standards of the time did not prohibit most of these arrangements outright, which is part of the lesson. The rules relied on the firm's judgment about whether a service impaired independence. Congressional investigators later documented that a member of Andersen's own technical standards group who had objected to parts of Enron's accounting was removed from oversight of the engagement after Enron complained, which shows how the judgment-based rules could bend under client pressure. An independence rule that depends on the auditor's judgment is only as strong as the auditor's willingness to lose the client.

Skepticism and the Partnerships

The accounting for the special purpose entities also tested the auditors' skepticism. Under the rules then in force, an entity could stay off a sponsor's balance sheet if an independent outside party had supplied at least 3 percent of the capital and bore its risk. That is a bright-line test, and it invited structuring right up to the line. When Enron restated in November 2001, it consolidated several entities, including one called Chewco, because their outside equity had never met the test. An auditor exercising professional skepticism would have traced the outside equity to its source and asked who bore the risk if the assets lost value. The answer in several cases was Enron itself, through guarantees and its own stock. Following the form of the rule rather than its purpose was a technical failure, but it was also an ethical one, because the auditors had the information to see that the substance did not match the form.

The Destruction of Documents

In October 2001, after the Securities and Exchange Commission began asking questions, Andersen personnel in Houston destroyed large volumes of Enron audit documents, citing the firm's document retention policy. Andersen was convicted of obstruction of justice in June 2002. The Supreme Court reversed the conviction in 2005, holding that the jury instructions had failed to require proof that the firm knew its conduct was wrongful (Arthur Andersen LLP v. United States, 2005). By then the firm had surrendered its licenses and ceased auditing public companies. The market had already passed its own verdict: Chaney and Philipich (2002) found that other Andersen clients' stock prices fell significantly when the firm admitted the shredding, with larger declines for clients of the Houston office, evidence that investors had treated Andersen's reputation as part of the value of its opinions.

What the Research Says About Non-Audit Fees

It is common to say that consulting fees corrupted Andersen. The evidence is more mixed. Frankel et al. (2002) found that firms paying larger non-audit fees were more likely to meet earnings targets and to report larger discretionary accruals, which is consistent with impaired independence. DeFond et al. (2002), however, found that auditors earning larger non-audit fees were no less willing to give struggling clients going-concern opinions. The fairest reading is that large non-audit fees create a real threat but do not prove that independence was lost in any particular audit. In Enron's case, the threat combined with a weak culture and a dominant client, and the result was failure.

A Christian Worldview Assessment

Scripture warns that no one can serve two masters (English Standard Version Bible, 2001/2016, Matthew 6:24). An auditor's master is the truth owed to the public that relies on the opinion; the client pays the fee, but the auditor's loyalty runs to the readers of the financial statements. By the evidence available, Andersen's Houston partners tried to serve both and ended by serving the client. A Christian worldview does not ask auditors to be suspicious of everyone. It asks them to be faithful when faithfulness is costly, to tell a valuable client that its accounting will not be accepted and to accept the commercial loss. The destruction of documents, whatever its legal status, was the opposite of that faithfulness, because it put the firm's interest ahead of the truth others were trying to find.

Conclusion

The Enron failure led directly to the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board, barred auditors from providing internal audit outsourcing and most consulting services to audit clients, and required audit partner rotation (Sarbanes-Oxley Act of 2002, 2002). Those rules replaced judgment with prohibition in exactly the areas where Andersen's judgment failed. They are a reminder that professional standards are written in response to people, and that the best protection against the next Enron is still an auditor willing to lose a client. Rules can forbid particular services, but they cannot supply the courage to say no, which is why the course begins with ethics before it turns to fraud, regulation and liability.

References

Arthur Andersen LLP v. United States, 544 U.S. 696 (2005).

Chaney, P. K., & Philipich, K. L. (2002). Shredded reputation: The cost of audit failure. Journal of Accounting Research, 40(4), 1221-1245. https://doi.org/10.1111/1475-679X.00087

DeFond, M. L., Raghunandan, K., & Subramanyam, K. R. (2002). Do non-audit service fees impair auditor independence? Evidence from going concern audit opinions. Journal of Accounting Research, 40(4), 1247-1274. https://doi.org/10.1111/1475-679X.00088

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Frankel, R. M., Johnson, M. F., & Nelson, K. K. (2002). The relation between auditors' fees for nonaudit services and earnings management. The Accounting Review, 77(s-1), 71-105. https://doi.org/10.2308/accr.2002.77.s-1.71

Healy, P. M., & Palepu, K. G. (2003). The fall of Enron. Journal of Economic Perspectives, 17(2), 3-26. https://doi.org/10.1257/089533003765888403

Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).