Question

Regarding the Enron Scandal:

1. Description of the related party transactions reported on by Arthur Andersen & Co.

2. Description and evaluation of the flaw in the accounting firm's logic.

3.Proposed checklist for special projects performed by external auditors to limit errors and risks.

4.Proposed rules or laws to prevent similar occurrences in the future.

Answer 1

1). The report by Arthur Andersen & Co. on Enron’s core transactions was a report that put a lot emphasize on the fundamental aspects and core of Enron’s accounting methods, Corporate Governance, Management core values and principles, and culture. The company’s financial statements disclosure was presented to the Board of Directors by the company’s special investigative committee. Andersen and Co., reporting on its client, Enron was a source of information gathered from third parties through a series of interviews and documents. The Chewco and LJMs transactions were the related- party transactions reported in the reporting. One of the transaction is explained below.
Chewco Transaction.
Michael Kooper managed Chewco Investment L.P, a limited partnership venture. During the period 1993 to 1996, Joint Energy Development Investment (JEDI), a $500 million dollar worth joint investment was formed from a partnership agreement between Enron Corp. and California Public Employees’ Retirement System (CalPERS). Since both Enron and CalPERS exercised joint control over JEDI, Enron could not include JEDI into its consolidated Financial Statements. It thus recorded its share of gains or losses arising from JEDI (as contracted) in its Financial Statement Footnotes, without showing JEDI’S debt on its Statement of Financial Position.
Enron wanted to rekindle CalPERS’ interest in JEDI since it did not wish to consolidate the latter into its Consolidated Financial Statements. Enron thus assisted Kooper in forming Chewco to purchase CalPERS interest, making Chewco’s founder and manager. Enron primary objective was to cause CalPERS to invest in a larger group. However, according to the internationally accepted SPE (Special Purpose Entity) rules, Enron could only succeed in excluding JEDI from its Consolidated Financial Statements if Chewco had some degree of independent ownership, with a minimum of 3% equity capital risk.
Enron and Kooper found it difficult to attract external investors and thus went ahead to finance Chewco’s purchase with a vast proportion of debt than equity, which was a violation of the accounting principles for non-consolidation. Eventually, Enron failed to consolidate JEDI into its consolidated Financial Statements.

2).According to the Powers report, there were several flaws in the accounting of Enron and consulting services provided by Arthur Anderson. These flaws definitely distorted the perception of the company’s value for many years, until 2001, when key transactions came up to public and culminated with restating five years of financial statements and eventually Enron’s bankruptcy. Anderson’s actions, or lack thereof, were negligent and malicious to the public’s interest. Anderson’s accountants had several opportunities to notify the Board of Directors of the aggressive and improper accounting techniques used by Enron’s senior management for reporting for SPE’s and conflict of interests. Anderson also should have informed the Board about the going concern issues as soon as its auditors discovered the inconsistencies with earnings and debt restructuring. However, Anderson had no incentive to apply professional skepticism regarding Enron’s transactions because they charged over $5.7 million above and beyond normal audit fees specifically for consulting services particularly on the accounting treatment for SPE’s. As a result, Anderson’s greed and negligence helped Enron with misrepresenting Special Purpose Entities for financial reporting. The non-consolidation with other group companies arguably was the main flaw on Enron’s accounting. According to the Powers report (2002), Enron executives sought out advice regarding the accounting treatment for SPE’s. Enron executives stated Anderson accountants informed them the SPEs created met the GAAP criteria to treat them as SPE’s and avoid recording the transactions in its consolidated financial statements. Enron purposely worked to circumvent the requirements of consolidation by sometimes only consolidating its investments, but not the debts of the related parties. The problem was that Enron chose to consolidate investment and earnings and not consolidate debts and losses of related parties.

3). The report states the depicted consequences of the above related-party transactions and accounting errors were a direct result of greed by Enron ‘s management, lack of oversight on the part of the Board and negligence by Arthur Anderson. To limit errors and risks when auditing special projects, external auditors should make sure that the company provides detailed disclosures of the transactions featured in the special projects, with detailed substantial communication, that adequately describes the relevancy of the financial interest involved. One thing that a company should advocate is strict adherence to proper corporate governance principles. This will allow senior leadership to act in the interest of the company’s shareholders as opposed to their own self-interest.

4).Enron's collapse and the financial havoc it wreaked on its shareholders and employees led to new regulations and legislation to promote the accuracy of financial reporting for publicly held companies. In July of 2002, President George W. Bush signed into law the Sarbanes-Oxley Act. The Act heightened the consequences for destroying, altering or fabricating financial statements, and for trying to defraud shareholders.