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Cases from prior editions of Michael C. Knapp’s Contemporary Auditing are available exclusively online via www.CengageBrain.com. In addition to the option to purchase the current edition in multiple formats, CengageBrain.com offers the following cases from prior editions for purchase as an eBook or as individual eChapters. This range of options allows you the flexibility to choose the content that best fits your needs! Comprehensive Cases 1A Jamaica Water Properties 1B AMRE, Inc. 1C United States Surgical Corporation audits of high-risk aCCounts 2A CapitalBanc Corporation 2B Dollar General Stores, Inc. 2C General Technologies Group Ltd. 2D SmarTalk Teleservices, Inc. 2E Campbell Soup Company 2F Perry Drug Stores, Inc. 2G Rocky Mount Undergarment Company, Inc. internal Control issues 3A Saks Fifth Avenue 3B Triton Energy Ltd. 3C Troberg Stores ethiCal responsibilities of aCCountants 4A Oak Industries, Inc. 4B Thomas Forehand, CPA 4C Laurel Valley Estates 4D Jack Bass, Accounting Professor ethiCal responsibilities of independent auditors 5A Mallon Resources Corporation 5B The PTL Club 5C Zaveral Boosalis Raisch 5D Koger Properties, Inc. professional roles 6A David Myers, WorldCom Controller professional issues 7A HealthSouth Corporation 7B PricewaterhouseCoopers Securities, LLC 7C Stephen Gray, CPA 7D Scott Fane, CPA 7E National Medical Transportation Network international Cases 8A Royal Ahold, N.V. 8B Australian Wheat Board 8C Tata Finance Limited 8D Baan Company, N.V. ClassiC litigation Cases 9A National Student Marketing Corporation 9B Equity Funding Corporation of America Discover why CengageBrain.com is your one-stop solution! CengageBrain.com offers students a wealth of options in both price and format of their course materials. To access additional course materials, visit www.cengagebrain.com. At the CengageBrain.com home page, fill in the author or ISBN of your textbook. This will take you to the product page where you will find various purchasing options and access to free companion study resources. This page intentionally left blank This page intentionally left blank Contemporary auditing� Real Issues and Cases Ninth Edition This is an electronic version of the print textbook. Due to electronic rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it. For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest. Contemporary auditing� Real Issues and Cases Ninth Edition Michael C. Knapp University of Oklahoma Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Contemporary Auditing: Real Issues and Cases, Ninth Edition Michael C. Knapp Vice President of Editorial, Business: Jack W. 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Locate your local office at: international.cengage.com/region Cengage Learning products are represented in Canada by Nelson Education, Ltd. For your course and learning solutions, visit www.cengage.com. ­ urchase any of our products at your local college store or at our P ­preferred online store www.cengagebrain.com. Printed in the United States of America 1 2 3 4 5 6 7 15 14 13 12 11 DEDICATION� To Paula, Suzie, and Becky� This page intentionally left blank BRIEF CONTENTS� Preface SECTION 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 SECTION 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 SECTION 3 3.1 3.2 3.3 3.4 3.5 3.6 3.7 SECTION 4 4.1 4.2 4.3 4.4 4.5 4.6 4.7 xxi Comprehensive Cases Enron Corporation Lehman Brothers Holdings, Inc. Just for FEET, Inc. Health Management, Inc. The Leslie Fay Companies NextCard, Inc. Lincoln Savings and Loan Association Crazy Eddie, Inc. ZZZZ Best Company, Inc. Gemstar-TV Guide International, Inc. New Century Financial Corporation Madoff Securities 1� 3� 23� 39� 53� 71� 83� 93� 107� 117� 131� 143� 161� Audits of High-Risk Accounts Jack Greenberg, Inc. Golden Bear Golf, Inc. Happiness Express, Inc. General Motors Company Lipper Holdings, LLC CBI Holding Company, Inc. Geo Securities, Inc. Belot Enterprises Regina Company, Inc. 171� 173� 181� 189� 197� 203� 211� 217� 221� 227� Internal Control Issues The Trolley Dodgers Howard Street Jewelers, Inc. United Way of America First Keystone Bank Goodner Brothers, Inc. Buranello’s Ristorante Foamex International Inc. 235� 237� 239� 241� 247� 251� 259� 265� Ethical Responsibilities of Accountants Creve Couer Pizza, Inc. F&C International, Inc. Suzette Washington, Accounting Major Freescale Semiconductor, Inc. Wiley Jackson, Accounting Major Arvel Smart, Accounting Major David Quinn, Tax Accountant 269� 271� 275� 279� 281� 285� 287� 289� ix x Brief Contents SECTION 5 5.1 5.2 5.3 5.4 5.5 5.6 SECTION 6 6.1 6.2 6.3 6.4 6.5 6.6 SECTION 7 7.1 7.2 7.3 7.4 7.5 7.6 SECTION 8 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12 8.13 8.14 Ethical Responsibilities of Independent Auditors Cardillo Travel Systems, Inc. American International Group, Inc. The North Face, Inc. Waverly Holland, Audit Senior Phillips Petroleum Company American Fuel & Supply Company, Inc. 293� 295� 301� 305� 313� 319� 323� Professional Roles Leigh Ann Walker, Staff Accountant Bill DeBurger, In-Charge Accountant Hamilton Wong, In-Charge Accountant Tommy O’Connell, Audit Senior Avis Love, Staff Accountant Charles Tollison, Audit Manager 327� 329� 331� 335� 339� 343� 347� Professional Issues Ligand Pharmaceuticals Sarah Russell, Staff Accountant Bud Carriker, Audit Senior Hopkins v. Price Waterhouse Fred Stern & Company, Inc.� (Ultramares Corporation v. Touche et al.) First Securities Company of Chicago� (Ernst & Ernst v. Hochfelder et al.) 351� 353� 359� 363� 369� International Cases Livent, Inc. Parmalat Finanziaria, S.p.A. Kansayaku Registered Auditors, South Africa Zuan Yan Kaset Thai Sugar Company Republic of Somalia OAO Gazprom Societe Generale Institute of Chartered Accountants of India Republic of the Sudan Shari’a Mohamed Salem El-Hadad, Internal Auditor Tae Kwang Vina 391� 393� 407� 421� 431� 443� 455� 459� 463� 477� 493� 505� 511� 521� 527� Index Summary of Topics by Case Summary of Cases by Topic 377� 385� 533� 543� 555� CONTENTS� Preface xxi SECTION 1 Comprehensive Cases 1 Case 1.1 Enron Corporation 3 Arthur Edward Andersen established a simple motto that he required his subordinates and clients to invoke: “Think straight, talk straight.” For decades, that motto served Arthur Andersen & Co. well. Unfortunately, the firm’s association with one client, Enron Corporation, abruptly ended Andersen’s long and proud history in the public accounting profession. Key topics: history of the public accounting profession in the United States, scope of professional services provided to audit clients, auditor independence, and retention of audit workpapers. Case 1.2 Lehman Brothers Holdings Inc. 23 Wall Street was stunned in September 2008 when this iconic investment banking firm filed for bankruptcy. Lehman’s bankruptcy examiner charged that the company had en� gaged in tens of billions of dollars of “accounting-motivated” transactions to enhance its apparent financial condition. Key topics: “accounting-motivated” transactions, materiality decisions by auditors, responsibility of auditors to investigate whistleblower allegations, auditors’ legal exposure, communications with audit committee. Case 1.3 Just for FEET, Inc. 39 In the fall of 1999, just a few months after reporting a record profit for fiscal 1998, Just for FEET collapsed and filed for bankruptcy. Subsequent investigations by law enforce� ment authorities revealed a massive accounting fraud that had grossly misrepresented the company’s reported operating results. Key features of the fraud were improper accounting for “vendor allowances” and intentional understatements of the company’s inventory valuation allowance. Key topics: applying analytical procedures, identifying inherent risk and control risk factors, need for auditors to monitor key developments within the client’s industry, assessing the health of a client’s industry, and receivables confirmation procedures. Case 1.4 Health Management, Inc. 54 The Private Securities Litigation Reform Act (PSLRA) of 1995 amended the Securities Exchange Act of 1934. This new federal statute was projected to have a major impact on auditors’ legal liability under the 1934 Act. The first major test of the PSLRA was triggered by a class-action lawsuit filed against BDO Seidman for its 1995 audit of Health Management, Inc., a New York–based pharmaceuticals distributor. Key topics: inventory audit procedures, auditor independence, content of audit work- papers, inherent risk factors, and auditors’ civil liability under the federal securities laws. Case 1.5 The Leslie Fay Companies 71 Paul Polishan, the former chief financial officer of The Leslie Fay Companies, received a nine-year prison sentence for fraudulently misrepresenting Leslie Fay’s financial xi xii Contents statements in the early 1990s. Among the defendants in a large class-action lawsuit stemming from the fraud was the company’s audit firm, BDO Seidman. Key topics: applying analytical procedures, need for auditors to assess the health of a client’s industry, identifying fraud risk factors, control environment issues, and auditor independence. Case 1.6 NextCard, Inc. 83 In January 2005, Thomas Trauger became the first partner of a major accounting firm to be sent to prison for violating the criminal provisions of the Sarbanes-Oxley Act of 2002. Key topics: identifying fraud risk factors, nature and purpose of audit workpapers, understanding a client’s business model, criminal liability of auditors under the Sarbanes-Oxley Act, and collegial responsibilities of auditors. Case 1.7 Lincoln Savings and Loan Association 93 Charles Keating’s use of creative accounting methods allowed him to manufacture huge paper profits for Lincoln. Key topics: substance-over-form concept, detection of fraud, identification of key management assertions, collegial responsibilities of auditors, assessment of control risk, and auditor independence. Case 1.8 Crazy Eddie, Inc. 107 “Crazy Eddie” Antar oversaw a profitable chain of consumer electronics stores on the East Coast during the 1970s and 1980s. After new owners discovered that the com� pany’s financial data had been grossly misrepresented, Antar fled the country, leaving behind thousands of angry stockholders and creditors. Key topics: auditing inventory, inventory control activities, management integrity, the use of analytical procedures, and the hiring of former auditors by audit clients. Case 1.9 ZZZZ Best Company, Inc. 117 Barry Minkow, the “boy wonder” of Wall Street, created a $200,000,000 company that existed only on paper. Key topics: identification of key management assertions, limitations of audit evi� dence, importance of candid predecessor successor auditor communications, client confidentiality, and client imposed audit scope limitations. Case 1.10 Gemstar-TV Guide International, Inc. 131 In 2000, U.S. News and World Report predicted that Henry Yuen, the chief executive of Gemstar-TV Guide International, would become the “Bill Gates of television” thanks to the innovative business model that he had developed for his company. When that business model proved to be a “bust,” Yuen used several accounting gimmicks to em� bellish his company’s reported operating results. Key topics: conditions commonly associated with “audit failures,” revenue recognition principle, quantitative and qualitative materiality assessments, and “legal” vs.“ethical” conduct. Contents Case 1.11 New Century Financial Corporation 143 The collapse of New Century Financial Corporation in April 2007 signaled the beginning of the subprime mortgage crisis in the United States, a crisis that would destabilize securities and credit markets around the globe. A federal bankruptcy exam� iner has maintained that New Century’s independent audits were inadequate. Key topics: auditing loan loss reserves, Section 404 audit procedures, material inter� nal control weaknesses, auditor independence, and audit staffing issues. Case 1.12 Madoff Securities 161 As an adolescent, Bernie Madoff dreamed of becoming a “key player” on Wall Street. Madoff realized his dream by overseeing the world’s largest and possibly longest run� ning Ponzi scheme. Madoff’s auditor pled guilty to various criminal charges for his role in that fraud. Key topics: factors common to financial frauds, regulatory role of Securities and Exchange Commission (SEC), nature and purpose of peer reviews, audit procedures for investments, and the importance of the independent audit function. SECTION 2 Audits of High-Risk Accounts 171 Case 2.1 Jack Greenberg, Inc. 173 A federal judge criticized Greenberg’s independent auditors for failing to realize the impact that pervasive internal control problems had on the reliability of the company’s inventory accounting records. Case 2.2 Golden Bear Golf, Inc. 181 Jack Nicklaus, the “Golden Bear,” endured public embarrassment and large financial losses when key subordinates misapplied the percentage-of-completion accounting method to numerous golf course development projects. Case 2.3 Happiness Express, Inc. 189 To compensate for flagging sales of their Mighty Morphin Power Rangers toys, this company’s executives booked millions of dollars of bogus sales. Deficiencies in the audit procedures applied by Happiness Express’s auditors resulted in the bogus sales and receivables going undetected. Case 2.4 General Motors Company 197 In early 2009, the SEC released the results of a lengthy investigation of GM’s accounting and financial reporting decisions over the previous decade. A major focus of that investiga� tion was GM’s questionable accounting for its massive pension liabilities and expenses. Case 2.5 Lipper Holdings, LLC 203 Lipper’s auditors were criticized for failing to uncover a fraudulent scheme used by a portfolio manager to materially inflate the market values of investments owned by three of the company’s largest hedge funds. xiii xiv Contents Case 2.6 CBI Holding Company, Inc. 211 This case focuses on audit procedures applied to accounts payable, including the search for unrecorded liabilities and the reconciliation of year-end vendor statements to recorded payables balances. Case 2.7 Geo Securities, Inc. 217 The SEC sanctioned GEO Securities’ audit engagement partner for failing to apply proper audit procedures to a material loss contingency faced by the company. Case 2.8 Belot Enterprises 221 Understating discretionary expense accruals is a common method used by selfinterested corporate executives to enhance their company’s financial statements. In this case, Belot “juggled” the period-ending balances of five major expense accruals to achieve an earnings goal established by the company’s new chief operating officer. Case 2.9 Regina Company 227 To reach forecasted sales and earnings targets, Regina executives used several accounting gimmicks that violated the revenue recognition principle. SECTION 3 Internal Control Issues 235 Case 3.1 The Trolley Dodgers 237 Control deficiencies in the Dodgers’ payroll transaction cycle allowed an accounting manager to embezzle several hundred thousand dollars. Case 3.2 Howard Street Jewelers, Inc. 239 Given the susceptibility of cash to theft, retail companies typically establish rigorous internal controls for their cash processing functions. This case documents the high price of failing to implement such controls. Case 3.3 United Way of America 241 Weak or nonexistent internal controls have resulted in this prominent charitable orga� nization, as well as numerous other charities nationwide, being victimized by opportu� nistic employees. Case 3.4 First Keystone Bank 247 Three tellers of a First Keystone Bank branch embezzled more than $100,000 from the branch’s ATM. The district attorney who prosecuted the tellers commented on the need for businesses to not only establish internal controls to protect their assets but also on the importance of ensuring that those controls are operational. Case 3.5 Goodner Brothers, Inc. 251 An employee of this tire wholesaler found himself in serious financial trouble. To remedy this problem, the employee took advantage of his employer’s weak internal Contents controls by stealing a large amount of inventor y, which he then sold to other parties. Case 3.6 Buranello’s Ristorante 259 The general manager of Buranello’s set up a “sting” operation–with the owner’s approval–to test the honesty of the employee who he believed was stealing from the business. But the plan backfired, and Buranello’s eventually found itself on the wrong end of a “malicious prosecution” lawsuit. Case 3.7 Foamex International Inc. 265 Foamex’s auditors repeatedly reported internal control problems to the company’s management and audit committee. Because the company’s management refused to adopt effective and timely measures to remediate those problems, Foamex became the first public company sanctioned by the SEC solely for having inadequate internal controls. SECTION 4 Ethical Responsibilities of Accountants 269 Case 4.1 Creve Couer Pizza, Inc. 271 Intrigue and espionage seem far removed from accounting . . . but not in this case. Creve Couer’s CPA was actually a double agent. While providing accounting ser� vices to his client, the CPA also supplied incriminating evidence regarding the client to the IRS. Case 4.2 F&C International, Inc. 275 A financial fraud spelled the end of a company with a proud history and tested the ethics of several of its key management and accounting personnel. Case 4.3 Suzette Washington, Accounting Major 279 Suzette Washington was a college senior majoring in accounting when she came face-to-face with an important ethical decision. Since accounting majors are entering a profession with a rigorous code of ethics, do they have a greater responsibility than other students to behave ethically? Case 4.4 Freescale Semiconductor, Inc. 281 Partners and employees of accounting firms often have access to confidential client information that they could use to gain an unfair advantage over other investors. In recent years, law enforcement authorities have filed insider trading charges against several public accountants, including a partner assigned to a professional services engagement for Freescale. Case 4.5 Wiley Jackson, Accounting Major 285 “To tell or not to tell” was the gist of an ethical dilemma faced by Wiley Jackson while completing a pre-employment document for his future employer, a major accounting firm. xv xvi Contents Case 4.6 Arvel Smart, Accounting Major 287 Should an accounting major accept an internship position with one firm when he has already decided to accept a job offer for a permanent position with another firm upon graduation? Case 4.7 David Quinn, Tax Accountant 289 The responsibility to maintain the confidentiality of client information obtained during a professional services engagement is at the center of a nasty disagreement that arises between two friends employed by a major accounting firm. SECTION 5 Ethical Responsibilities of Independent Auditors 293 Case 5.1 Cardillo Travel Systems, Inc. 295 A top executive of Cardillo pressured and manipulated three accountants, the compa� ny’s controller and two partners of public accounting firms, in an unsuccessful attempt to conceal the true nature of a fraudulent entry in the company’s accounting records. Case 5.2 American International Group, Inc. 301 AIG is best known as the company that received more federal “bailout” funds than any other during the economic crisis that engulfed the U.S. economy beginning in the fall of 2008. Several years earlier, AIG had been widely criticized for marketing customized special purpose entities (SPEs). Surprisingly, Ernst & Young helped AIG develop and market this controversial service. Case 5.3 The North Face, Inc. 305 North Face’s independent auditors altered prior-year workpapers to conceal question� able decisions made by an audit partner, decisions that involved several large barter transactions that inflated the company’s reported operating results. Case 5.4 Waverly Holland, Audit Senior 313 A few months after leaving public accounting, “Dutch” Holland is pressured to become involved in a class-action lawsuit involving a former audit client of his. If he cooperates with the plaintiff attorneys, he will alienate his former colleagues. If he doesn’t cooperate, he may be named as a defendant in that lawsuit. What will Dutch choose to do? Case 5.5 Phillips Petroleum Company 319 Rather than compromise the confidentiality of his client’s accounting records, the part� ner in charge of the annual Phillips audit was found in contempt of court and jailed. Case 5.6 American Fuel & Supply Company, Inc. 323 This case focuses on the responsibility of auditors to recall an audit report when they discover previously undetected errors in a client’s audited financial statements. Contents SECTION 6 Professional Roles 327 Case 6.1 Leigh Ann Walker, Staff Accountant 329 A staff accountant employed by a large accounting firm is dismissed after serious questions arise regarding her integrity. Case 6.2 Bill DeBurger, In-Charge Accountant 331 To “sign off” or “not sign off” was the issue Bill DeBurger wrestled with after he completed the audit procedures for a client’s most important account. An angry confrontation with the audit engagement partner made Bill’s decision even more difficult. Case 6.3 Hamilton Wong, In-Charge Accountant 335 “Eating time,” or underreporting time worked on audit engagements, has serious ­implications for the quality of audit services and for the quality of auditors’ work ­environment. Hamilton Wong came face-to-face with these issues when a colleague insisted on understating the hours she worked on her assignments. Case 6.4 Tommy O’Connell, Audit Senior 339 A new audit senior is quickly exposed to the challenging responsibilities of his professional work role when he is assigned to supervise a difficult audit engagement. During the audit, the senior must deal with the possibility that a staff accountant is not completing his assigned audit procedures. Case 6.5 Avis Love, Staff Accountant 343 Auditors sometimes develop close friendships with client personnel. Such friendships can prove problematic for auditors, as demonstrated in this case. Case 6.6 Charles Tollison, Audit Manager 347 Audit managers occupy an important role on audit engagements and are a critical link in the employment hierarchy of public accounting firms. SECTION 7 Professional Issues 351 Case 7.1 Ligand Pharmaceuticals 353 Ligand’s auditor was the first Big Four firm sanctioned by the Public Company ­Accounting Oversight Board (PCAOB). Case 7.2 Sarah Russell, Staff Accountant 359 Sexual harassment is a sensitive subject that many companies and professional firms have been forced to contend with in recent years. This case recounts the experiences of a staff accountant who was harassed by an audit partner. xvii xviii Contents Case 7.3 Bud Carriker, Audit Senior 363 An executive of an audit client informs the audit partner that he is not “comfortable” working with the senior assigned to the engagement. Why? Because the senior is a member of a minority group. Will the partner assign another senior to the engagement? Case 7.4 Hopkins v. Price Waterhouse 369 This case explores the unique problems faced by women pursuing a career in public accounting. Case 7.5 red Stern & Company, Inc. F (Ultramares Corporation v. Touche et al.) 377 This 1931 legal case established the Ultramares Doctrine that decades later has a pervasive influence on auditors’ civil liability under the common law. Case 7.6 irst Securities Company of Chicago F (Ernst & Ernst v. Hochfelder et al.) 385 In this case, the Supreme Court defined the degree of auditor misconduct that must be present before a client can recover damages from an auditor in a lawsuit filed under the Securities Exchange Act of 1934. SECTION 8 International Cases 391 Case 8.1 Livent, Inc. 393 Garth Drabinsky built Livent, Inc., into a major force on Broadway during the 1990s. A string of successful Broadway productions resulted in numerous Tony Awards for the Canadian company. Despite Livent’s theatrical success, its financial affairs were in disarray. Drabinsky and several of his top subordinates used abusive accounting practices to conceal Livent’s financial problems from their independent auditors. Case 8.2 Parmalat Finanziaria, S.p.A. 407 Parmalat’s executives used a simple accounting ruse, a “double-billing scheme,” to produce billions of dollars of bogus receivables, sales, and profits for the company. The fraud unraveled in a matter of weeks after the company admitted that it would have difficulty paying off a small bond issue that was coming due. Lawsuits filed in this case raised a troubling legal issue that could potentially threaten the financial viability of major accounting firms. Case 8.3 Kansayaku 421 Like the United States, Japan has recently made significant changes in the regulatory infrastructure for its financial reporting system. Many of these changes have directly impacted Japan’s accounting profession and independent audit function. An accounting and auditing scandal involving a large cosmetics and apparel company, Kanebo Limited, posed the first major challenge of that new regulatory framework. Contents Case 8.4 Registered Auditors, South Africa 431 The South African economy was rocked in recent years by a series of financial reporting scandals. To restore the credibility of the nation’s capital markets, the South African Parliament passed a controversial new law, the Auditing Profession Act (APA). The APA established a new auditing regulatory agency and a new professional credential for independent auditors. The APA also mandated that independent auditors immediately disclose to the new auditing agency any “reportable irregularities” committed by an audit client. Case 8.5 Zuan Yan 443 The Big Four accounting firms view China as one of the most lucrative markets for accounting and auditing services worldwide. However, those firms face major challenges in that market. Among these challenges are an increasing litigation risk and the difficulty of coping with the often heavy-handed tactics of China’s authoritarian central government. Case 8.6 Kaset Thai Sugar Company 455 This case focuses on the 1999 murder of Michael Wansley, a partner with Deloitte ­Touche Tohmatsu. Wansley was supervising a debt-restructuring engagement in a ­remote region of Thailand when he was gunned down by a professional assassin. Case 8.7 Republic of Somalia 459 PricewaterhouseCoopers (PwC) accepted a lucrative, unusual, and very controversial engagement for the transitional government established for Somalia by the United Nations. The case questions require students to consider the significant risks and thorny ethical issues that engagement poses for PwC. Case 8.8 OAO Gazprom 463 Business Week referred to the huge Gazprom debacle as “Russia’s Enron.” For the first time in the history of the new Russian republic, a Big Four accounting firm was sued for allegedly issuing improper audit opinions on a Russian company’s financial statements. Case 8.9 Societe Generale 477 This case addresses the surprising decision made by Societe Generale, France’s ­second largest bank, to backdate a 6.4 billion euro loss that resulted from unauthorized securities trades made by one of its employees. Although that huge loss occurred in 2008, the bank included the loss in its audited financial statements for 2007. To justify that decision, the bank’s management invoked a controversial provision of International Financial Reporting Standards (IFRS). Case 8.10 Institute of Chartered Accountants of India 493 The Institute of Chartered Accountants of India (ICAI) is the federal agency that oversees India’s accounting profession. In 2002, the ICAI commissioned a study of the alleged takeover of that profession by the major international accounting firms. xix xx Contents The ­resulting 900-page report charged that those firms had used a variety of illicit and even illegal methods to “colonize” India’s market for accounting, auditing, and related services to the detriment of the nation’s domestic accounting firms. Case 8.11 Republic of the Sudan 505 In 2004, the SEC began requiring domestic and foreign registrants to disclose any business operations within, or other relationships with, Sudan and other countries identified as state sponsors of terrorism. Three years later, the SEC included a Web page on its EDGAR website that listed all such companies. This SEC “blacklist” proved to be extremely controversial and triggered a contentious debate over the federal agency’s regulatory mandate and its definition of “materiality.” Case 8.12 Shari’a 511 Islamic companies are prohibited from engaging in transactions that violate Shari’a, that is, Islamic religious law. To ensure that they have complied with Shari’a, Islamic companies have their operations subjected to a Shari’a compliance audit each year. Recently, Big Four firms have begun offering Shari’a audit services. Case 8.13 Mohamed Salem El-Hadad, Internal Auditor 521 Accountants sometimes find themselves in situations in which they must report ­unethical or even illegal conduct by other members of their organization. This case examines the trials and tribulations of an internal auditor who “blew the whistle” on his immediate superior for embezzling large sums of cash from their employer, the Washington, D.C., embassy of the United Arab Emirates. Case 8.14 Tae Kwang Vina 527 “Environmental and labor practices” audits are one of many nontraditional services that major accounting firms have begun offering in recent years to generate new ­revenue streams. Ernst & Young provided such an audit for Nike, which had been accused of operating foreign “sweatshops” to produce its footwear products. This case documents the unexpected challenges and problems that accounting firms may face when they provide services outside their traditional areas of professional expertise. Index Summary of Topics by Case Summary of Cases by Topic 533 543 555 PREFACE The past decade has arguably been the most turbulent and traumatic in the history of the accounting profession and the independent audit function. Shortly after the turn of the century, the Enron and WorldCom fiascoes focused the attention of the investing public, the press, Wall Street, and, eventually, Congress on our profession. Those scandals resulted in the passage of the Sarbanes-Oxley Act of 2002 (SOX) and the creation of the Public Company Accounting Oversight Board (PCAOB). Next came the campaign to replace U.S. generally accepted accounting principles (GAAP) with International Financial Reporting Standards (IFRS). That campaign stalled when the subprime mortgage crisis in the United States caused global stock markets to implode and global credit markets to “freeze” during the fall of 2008. Many parties insisted that inadequate audits were a major factor that led to the onset of the most severe global economic downturn since the Great Depression. That economic downturn claimed many companies that had been stalwarts of the U.S. economy, most notably Lehman Brothers. The huge investment banking firm filed for bankruptcy in September 2008 just a few months after having had its annual financial statements “blessed” by its audit firm. As Congress and regulatory authorities struggled to revive the U.S. economy, news of the largest Ponzi scheme in world history grabbed the headlines in early 2009. Investors worldwide were shocked to learn that Bernie Madoff, an alleged “wizard of Wall Street,” was a fraud. Law enforcement authorities determined that billions of dollars of client investments supposedly being held by Madoff’s company, Madoff Securities, did not exist. The business press was quick to report that for decades Madoff Securities’ financial statements had been audited by a New York accounting firm and had received unqualified audit opinions each year from that firm. The auditing discipline absorbed another body blow in 2010 when a court-appointed bankruptcy examiner publicly singled out Lehman Brothers’ audit firm as one of the parties most responsible for the Lehman Brothers debacle. As academics, we have a responsibility to help shepherd our profession through these turbulent times. Auditing instructors, in particular, have an obligation to help restore the credibility of the independent audit function that has been adversely ­impacted by the events of the past decade. To accomplish this latter goal, one strategy we can use is to embrace the litany of reforms recommended several years ago by the ­Accounting Education Change Commission (AECC). Among the AECC’s recommendations was that accounting educators employ a broader array of instructional resources, particularly experiential resources, designed to stimulate active learning by students. In fact, the intent of my casebook is to provide auditing instructors with a source of such ­materials that can be used in both undergraduate and graduate auditing courses. This casebook stresses the “people” aspect of independent audits. If you review a sample of recent “audit failures,” you will find that problem audits seldom result from xxi x xii Preface inadequate audit technology. Instead, deficient audits typically result from the presence of one, or both, of the following two conditions: client personnel who intentionally subvert an audit and auditors who fail to carry out the responsibilities assigned to them. Exposing students to problem audits will help them recognize the red flags that often accompany audit failures. An ability to recognize these red flags and the insight gained by discussing and dissecting problem audits will allow students to cope more effectively with the problematic situations they are certain to encounter in their own careers. In addition, this experiential approach provides students with context-specific situations that make it much easier for them to grasp the relevance of important auditing topics, concepts, and procedures. The cases in this text also acquaint students with the work environment of auditors. After studying these cases, students will better appreciate how client pressure, peer pressure, time budgets, and related factors complicate the work roles of independent auditors. Also embedded in these cases are the ambiguity and lack of structure that auditors face each day. Missing documents, conflicting audit evidence, auditors’ dual obligations to the client and to financial statement users, and the lack of definitive professional standards for many situations are additional aspects of the audit environment woven into these cases. The ninth edition of my casebook contains the following eight sections of cases: Comprehensive Cases, Audits of High-Risk Accounts, Internal Control Issues, ­Ethical Responsibilities of Accountants, Ethical Responsibilities of Independent ­Auditors, Professional Roles, Professional Issues, and International Cases. This organizational structure is intended to help adopters readily identify cases best suited for their particular needs. In preparing this edition, I retained those cases that have been among the most widely used by adopters. These cases include, among many others, Crazy Eddie, Enron Corporation, Golden Bear Golf, Leigh Ann Walker, Lincoln Savings and Loan Association, Livent, The Trolley Dodgers, and ZZZZ Best Company. You will find that many of the “returning” cases have been updated for relevant circumstances and events that have occurred since the publication of the previous edition. New To This Edition This edition features 13 new cases. Two of these cases are included in the international section. Easily the most dramatic trend in the business world over the past few decades has been the “globalization” of markets, including the market for professional accounting services. Business schools have responded to this dramatic trend by establishing new international majors, study-abroad programs, and a slew of international courses across all business disciplines. Accounting may very well be the business discipline that has been the slowest to “internationalize” its curriculum. The 14 international cases in this edition provide auditing ­instructors with an efficient and cost-effective way to introduce their students to a wide range of important issues within the global accounting profession that will have far-reaching implications for their careers. Preface The new Parmalat Finanziaria case provides an opportunity for students to compare and contrast the independent audit functions of Italy and the United States. This case demonstrates the significant impact that cultural norms and influences can have on the nature and effectiveness of a nation’s independent audit function. Another important focus of the Parmalat case is a legal issue that has become very troublesome for the major international accounting firms in recent years. This issue is whether those firms’ global organizations should face joint and several liability for the malfeasance of any one national practice unit. The other international case new to this edition is The Republic of Somalia, which transports students to one of the most troubled “hotspots” in the world. For more than 20 years, anarchy has reigned in Somalia, a country that sits astride one of the world’s most important oceanic trade routes. In 2009, the world’s largest accounting firm, PricewaterhouseCoopers (PwC), accepted a controversial professional services ­engagement in Somalia. Under the terms of that engagement, PwC serves as an overseer of the financial affairs for the provisional government that the United Nations established for the war-torn country. The Somalia case requires students to consider the significant risks and thorny ethical issues that engagement poses for PwC. Eight of the new cases in this edition are included in two sections of my casebook that historically have been among the most popular: Audits of High-Risk Accounts and Internal Control Issues. New cases in the Audits of High-Risk Accounts section include ­General Motors Company, Lipper Holdings, Geo Securities, Belot Enterprises, and ­Regina Company. The General Motors case examines the controversy surrounding GM’s pension-related accounting decisions and the role of the company’s longtime audit firm, Deloitte, in those decisions. Hedge funds have been among the most controversial and mysterious investment vehicles on Wall Street over the past ­decade and have presented major challenges for the firms that audit them. In the ­Lipper Holdings case, the organization’s audit firm was criticized for failing to uncover a fraudulent scheme that materially inflated the market values of investments held by three Lipper hedge funds. In the present business environment, many, if not most, companies routinely deal with the worrisome problems posed by material loss contingencies. Loss contingencies also pose major challenges for independent auditors. Geo Securities’ audit engagement partner faced SEC sanctions for the decisions he made regarding a pending loss contingency for that company. Client executives who face pressure to meet unrealistic earnings goals are often tempted to understate period-ending expense accruals. A senior auditor assigned to the audit engagement team for Belot Enterprises faced the unpleasant task of challenging the client’s decision to implement a new approach for estimating its periodending discretionary expense accruals. That decision by client management coincided with the end of a promotional campaign intended to boost Belot’s sagging operating ­results. The final new “High-Risk” case, Regina Company, is actually a ­refurbished version of a case that appeared in earlier editions of my casebook. This case, which ­focuses on a high-profile financial fraud involving revenue recognition issues, was not previously available in the custom publishing database for my casebook. x xiii x xiv Preface First Keystone Bank, Buranello’s Ristorante, and Foamex International are the three new cases in the Internal Controls Issues section. The First Keystone case revolves around a collusive fraud involving three employees of a small branch of a ­Pennsylvania-based bank. The case questions require students to examine internal control and audit issues linked to a device that plays an important role in many, if not most, of their everyday lives, namely, the local ATM. In the Buranello’s case, the central focus is internal controls for cash receipts. A frustrated manager of a popular restaurant organized a “sting” operation to snag red-handed a subordinate who he believed was stealing from the business. Unfortunately, the sting went awry leaving the manager red-faced and his employer on the wrong end of a malicious prosecution lawsuit. Finally, Foamex International became the first company in the post-SOX era to be sanctioned by the SEC for the sole reason that it had inadequate internal controls. Lehman Brothers Holdings is a new comprehensive case in the ninth edition of my casebook. The principal source for this case is the massive 2,200-page report prepared by the bankruptcy examiner for this former iconic investment banking firm. ­L ehman played a leading and notorious role in the global economic crisis of ­2008–2009. To enhance their company’s apparent financial condition, Lehman’s ­executives engaged in tens of billions of dollars of “accounting-motivated” financing transactions referred to as Repo 105s. Lehman’s controversial actions prompted a debate within the profession regarding whether “intent matters” in accounting and financial reporting decisions. The final two new cases in this edition are the Freescale Semiconductor and ­Phillips Petroleum Company cases. Freescale Semiconductor appears in Section 4, Ethical Responsibilities of Accountants, while Phillips Petroleum is included in Section 5, ­Ethical Responsibilities of Independent Auditors. The Freescale case provides an overview of a series of recent insider trading incidents involving partners or employees of the major international accounting firms, including the former vice chairman of one of those firms. In the Phillips Petroleum case, the partner in charge of the ­company’s annual audit was found in contempt of court by a federal judge and jailed when he refused to compromise the confidentiality of his client’s accounting records. My casebook can be used in several different ways. Professors can use the casebook as a supplemental text for an undergraduate auditing course or as a primary text for a graduate-level seminar in auditing. The instructor’s manual contains a syllabus for a graduate auditing course organized around this text. This casebook can also be used in the capstone professional practice course incorporated in many five‑year ­accounting programs. Customized versions of this casebook are suitable for a wide range of accounting courses as explained later. Organization of Casebook Listed next are brief descriptions of the eight groups of cases included in this text. The casebook’s Table of Contents presents an ­annotated description of each case. Preface Comprehensive Cases Most of these cases deal with highly publicized problem audits performed by the major international accounting firms. Among the clients involved in these audits are Enron Corporation, The Leslie Fay Companies, Lincoln Savings and Loan Association, Madoff Securities, and ZZZZ Best Company. Each of these cases addresses a wide range of auditing, accounting, and ethical issues. Audits of High-Risk Accounts In contrast to the cases in the prior section, these cases highlight contentious accounting and auditing issues posed by a single ­account or group of accounts. For example, the Jack Greenberg case focuses primarily on inventory audit procedures. The Happiness Express case raises audit issues relevant to accounts receivable, while the Golden Bear case examines a series of revenue recognition issues. Internal Control Issues In recent years, leading authorities in the public accounting profession have emphasized the need for auditors to thoroughly understand their clients’ internal control policies and procedures. The cases in this section introduce students to control issues in a variety of contexts. For example, the Goodner ­Brothers case examines control issues for a wholesaler, while the Howard Street Jewelers case raises important control issues relevant to retail businesses. Ethical Responsibilities of Accountants Integrating ethics into an auditing course requires much more than simply discussing the AICPA’s Code of Professional Conduct. This section presents specific scenarios in which accountants have been forced to deal with perplexing ethical dilemmas. By requiring students to study ­actual situations in which important ethical issues have arisen, they will be better prepared to resolve similar situations in their own professional careers. Three of the cases in this section will “strike close to home” for your students since they involve accounting majors. For example, in the Wiley Jackson case, a soon-to-graduate ­accounting major must decide whether to disclose in a pre-employment document a minor-in-possession charge that is pending against him. Another case in this section, F&C International, profiles three corporate executives who had to decide whether to compromise their personal code of ethics in the face of a large-scale fraud masterminded by their company’s chief executive. Ethical Responsibilities of Independent Auditors The cases in this section highlight ethical dilemmas encountered by independent auditors. In the Cardillo Travel Systems case, two audit partners face an ethical dilemma that most audit practitioners will experience at some point during their careers. The two partners are forced to decide whether to accept implausible explanations for a suspicious client transaction given to them by client executives or, alternatively, whether to “complicate” the given engagement by insisting on fully investigating the transaction. Professional Roles Cases in this section examine specific work roles in the ­accounting profession. These cases explore the responsibilities associated with those roles and related challenges that professionals occupying them commonly x xv x xvi Preface ­ ncounter. The Tommy O’Connell case involves a young auditor recently promoted e to audit senior. Shortly following his promotion, Tommy finds himself assigned to ­supervise a small but challenging audit. Tommy’s sole subordinate on that engagement happens to be a young man whose integrity and work ethic have been questioned by seniors he has worked for previously. Two cases in this section spotlight the staff a ­ ccountant work role, which many of your students will experience firsthand following graduation. Professional Issues The dynamic nature of the public accounting profession continually impacts the work environment of public accountants and the nature of the services they provide. The cases in this section highlight important issues presently facing accounting firms. For example, the Hopkins v. Price Waterhouse case explores the unique problems that women face in pursuing careers in public accounting, while the Ligand Pharmaceuticals case addresses the responsibility accounting firms have to ensure that their audit partners are qualified to supervise audit engagements. Finally, the Fred Stern and First Securities cases examine the most important legal liability issues within the public accounting profession. International Cases The purpose of these cases is to provide your students with an introduction to important issues facing the global accounting profession and auditing discipline. After studying these cases, students will discover that most of the technical, professional, and ethical challenges facing U.S. practitioners are shared by auditors and accountants across the globe. Then again, some of these cases document unique challenges that must be dealt with by auditors and accountants in certain countries or regions of the world. For example, the Chinese case (Zuan Yan) demonstrates the problems that an authoritarian central government can present for independent auditors and accounting practitioners. Likewise, the Kaset Thai Sugar Company case vividly demonstrates that auditors and accountants may be forced to cope with hostile and sometimes dangerous working conditions in developing countries where their professional roles and responsibilities are not well understood or appreciated. Customize Your Own Casebook To maximize your flexibility in using these cases, South-Western/Cengage Learning has included Contemporary Auditing: Real Issues and Cases in its customized publishing program, Make It Yours. Adopters have the option of creating a customized version of this casebook ideally suited for their specific needs. At the University of Oklahoma, a customized selection of my cases is used to add an ethics component to the undergraduate managerial accounting course. In fact, since the cases in this text examine ethical issues across a wide swath of different contexts, adopters can develop a customized ethics casebook to ­supplement almost any accounting course. This casebook is ideally suited to be customized for the undergraduate auditing course. For example, auditing instructors who want to add a strong international component to their courses can develop a customized edition of this text that ­includes Preface a series of the international cases. Likewise, to enhance the coverage of ethical issues in the undergraduate auditing course, instructors could choose a series of cases from this text that highlight important ethical issues. Following are several examples of customized versions of this casebook that could be easily integrated into the undergraduate auditing course. International Focus: Parmalat Finanziaria (8.2), Kansayaku (8.3), Registered Auditors, South Africa (8.4), Zuan Yan (8.5), OAO Gazprom (8.8), Institute of Chartered Accountants of India (8.10). This custom casebook would provide your students with an in-depth understanding of the current state of the auditing discipline in several of the world’s most important countries. Ethics Focus (I): Suzette Washington, Accounting Major (4.3), Wiley Jackson, Accounting Major (4.5), Arvel Smart, Accounting Major (4.6), Leigh Ann Walker, Staff Accountant (6.1), Hamilton Wong, In-Charge Accountant (6.3), Avis Love, Staff Accountant (6.5). The first three of these cases give your students an opportunity to discuss and debate ethical issues directly pertinent to them as accounting majors. The final three cases expose students to important ethical issues they may encounter shortly after graduation if they choose to enter public accounting. Ethics Focus (II): Creve Couer Pizza, Inc. (4.1), F&C International, Inc. (4.2), Freescale Semiconductor (4.4), David Quinn, Tax Accountant (4.7), American International Group (5.2), Waverly Holland, Audit Senior (5.4). This selection of cases is suitable for auditing instructors who have a particular interest in covering a variety of ethical topics relevant to the AICPA’s Code of Professional Conduct, several of which are not directly or exclusively related to auditing. Applied Focus: Enron Corporation (1.1), NextCard, Inc. (1.6), ZZZZ Best Company, Inc. (1.9), Belot Enterprises (2.8), American Fuel & Supply Company, Inc. (5.6), Livent, Inc. (8.1). This series of cases will provide students with a broad-brush introduction to the real world of independent auditing. These cases raise a wide range of technical, professional, and ethical issues in a variety of client contexts. Professional Roles Focus: Leigh Ann Walker, Staff Accountant (6.1), Bill DeBurger, In-Charge Accountant (6.2), Tommy O’Connell, Audit Senior (6.4), Avis Love, Staff Accountant (6.5), Charles Tollison, Audit Manager (6.6), Bud Carriker, Audit Senior (7.3). This custom casebook would be useful for auditing instructors who choose to rely on a standard textbook to cover key technical topics in auditing–but who also want to expose their students to the everyday ethical and professional challenges faced by individuals occupying various levels of the employment hierarchy within auditing firms. High-Risk Accounts Focus: Each of the cases in Section 2, Audits of High-Risk Accounts. This series of cases will provide your students with relatively intense homework assignments that focus almost exclusively on the financial statement line items that pose the greatest challenges for auditors. Of course, realize that you are free to choose any “mix” of my cases to include in a customized casebook for an undergraduate auditing course or another accounting x xvii x xviii Preface course that you teach. For more information on how to design your customized casebook, please contact your South-Western/Cengage Learning sales representative or visit the textbook website: www.cengage.com/custom/makeityours/knapp. Acknowledgements I greatly appreciate the insight and suggestions provided by the following reviewers of earlier editions of this text: Alex Ampadu, University at Buffalo; Barbara Apostolou, Louisiana State University; Sandra A. Augustine, Hilbert College; Jane Baird, Mankato State University; Jason Bergner, University of Kentucky; James Bierstaker, Villanova University; Ed Blocher, University of North Carolina; ­Susan Cain, Southern Oregon University; Kurt Chaloupecky, Missouri State University; Ray Clay, University of North Texas; Jeffrey Cohen, Boston College; Mary Doucet, University of Georgia; Rafik Elias, California State University, Los Angeles; Ruth Engle, Lafayette College; Diana Franz, University of Toledo; Chrislynn Freed, University of Southern California; Carolyn Galantine, Pepperdine University; Soha Ghallab, ­Brooklyn College; Russell Hardin, University of South Alabama; Michele C. Henney, University of Oregon; Laurence Johnson, Colorado State University; Donald McConnell, University of Texas at Arlington; Heidi Meier, Cleveland State University; Don Nichols, Texas Christian University; Marcia Niles, University of Idaho; Thomas ­Noland, University of South Alabama; Les Nunn, University of Southern Indiana; ­Robert J. Ramsay, Ph.D., CPA, University of Kentucky; John Rigsby, Mississippi State University; Mike Shapeero, Bloomsburg University of Pennsylvania; Edward F. Smith, Boston College; Dr. Gene Smith, Eastern New Mexico University; Rajendra Srivastava, University of Kansas; Richard Allen Turpen, University of Alabama at Birmingham; T. Sterling Wetzel, Oklahoma State University; and Jim Yardley, Virginia Polytechnic University. This project also benefitted greatly from the editorial assistance of my ­sister, Paula Kay Conatser, my wife, Carol Ann Knapp, and my son, John William Knapp. I would also like to thank Glen McLaughlin for his continuing generosity in funding the development of instructional materials that highlight important ethical issues. Finally, I would like to acknowledge the contributions of my students, who have provided invaluable comments and suggestions on the content and use of these cases. Michael C. Knapp McLaughlin Chair in Business Ethics, David Ross Boyd ­Professor, and Professor of Accounting University of Oklahoma SECTION 1 COMPREHENSIVE CASES Case 1.1 Enron Corporation Case 1.2 Lehman Brothers Holdings, Inc. Case 1.3 Just for FEET, Inc. Case 1.4 Health Management, Inc. Case 1.5 The Leslie Fay Companies Case 1.6 NextCard, Inc. Case 1.7 Lincoln Savings and Loan Association Case 1.8 Crazy Eddie, Inc. Case 1.9 ZZZZ Best Company, Inc. Case 1.10 Gemstar-TV Guide International, Inc. Case 1.11 New Century Financial Corporation Case 1.12 Madoff Securities 1 This page intentionally left blank CASE 1.1 Enron Corporation John and Mary Andersen immigrated to the United States from their native Norway in 1881. The young couple made their way to the small farming community of Plano, ­Illinois, some 40 miles southwest of downtown Chicago. Over the previous few decades, hundreds of Norwegian families had settled in Plano and surrounding communities. In fact, the aptly named Norway, Illinois, was located just a few miles away from the couple’s new hometown. In 1885, Arthur Edward Andersen was born. From an early age, the Andersens’ son had a fascination with numbers. Little did his parents realize that Arthur’s interest in numbers would become the driving force in his life. Less than one century after he was born, an accounting firm bearing Arthur Andersen’s name would become the world’s largest professional services organization with more than 1,000 partners and operations in dozens of countries scattered across the globe. Think Straight, Talk Straight Discipline, honesty, and a strong work ethic were three key traits that John and Mary Andersen instilled in their son. The Andersens also constantly impressed upon him the importance of obtaining an education. Unfortunately, Arthur’s parents did not survive to help him achieve that goal. Orphaned by the time he was a young teenager, Andersen was forced to take a fulltime job as a mail clerk and attend night classes to work his way through high school. After graduating from high school, Andersen attended the University of Illinois while working as an accountant for Allis-Chalmers, a Chicago-based company that manufactured tractors and other farming equipment. In 1908, Andersen accepted a position with the Chicago office of Price Waterhouse. At the time, Price Waterhouse, which was organized in Great Britain during the early nineteenth century, easily qualified as the United States’ most prominent public accounting firm. At age 23, Andersen became the youngest CPA in the state of Illinois. A few years later, Andersen and a friend, Clarence Delany, established a partnership to provide accounting, auditing, and related services. The two young accountants named their firm Andersen, Delany & Company. When Delany decided to go his own way, Andersen renamed the firm Arthur Andersen & Company. In 1915, Arthur Andersen faced a dilemma that would help shape the remainder of his professional life. One of his audit clients was a freight company that owned and operated several steam freighters that delivered various commodities to ports located on Lake Michigan. Following the close of the company’s fiscal year but before Andersen had issued his audit report on its financial statements, one of the client’s ships sank in Lake Michigan. At the time, there were few formal rules for companies to follow in preparing their annual financial statements and certainly no rule that required the company to report a material “subsequent event” occurring after the close of its fiscal year-such as the loss of a major asset. Nevertheless, Andersen insisted that his client disclose the loss of the ship. Andersen reasoned that third parties who would use the company’s financial statements, among them the company’s banker, would want to be informed of the loss. Although unhappy with Andersen’s position, the client eventually acquiesced and reported the loss in the footnotes to its financial statements. 3 4 Section One Comprehensive Cases Two decades after the steamship dilemma, Arthur Andersen faced a similar ­situation with an audit client that was much larger, much more prominent, and much more profitable for his firm. Arthur Andersen & Co. served as the independent auditor for the giant chemical company, du Pont. As the company’s audit neared completion one year, members of the audit engagement team and executives of du Pont quarreled over how to define the company’s operating income. Du Pont’s management insisted on a liberal definition of operating income that included income earned on certain investments. Arthur Andersen was brought in to arbitrate the dispute. When he sided with his subordinates, du Pont’s management team dismissed the firm and hired another auditor. Throughout his professional career, Arthur E. Andersen relied on a simple, fourword motto to serve as a guiding principle in making important personal and professional decisions: “Think straight, talk straight.” Andersen insisted that his partners and other personnel in his firm invoke that simple rule when dealing with clients, potential clients, bankers, regulatory authorities, and any other parties they interacted with while representing Arthur Andersen & Co. He also insisted that audit clients “talk straight” in their financial statements. Former colleagues and associates often described ­Andersen as opinionated, stubborn and, in some cases, “difficult.” But even his critics readily admitted that Andersen was point-blank honest. “Arthur Andersen wouldn’t put up with anything that wasn’t complete, 100% integrity. If anybody did anything otherwise, he’d fire them. And if clients wanted to do something he didn’t agree with, he’d either try to change them or quit.”1 As a young professional attempting to grow his firm, Arthur Andersen quickly ­recognized the importance of carving out a niche in the rapidly developing accounting services industry. Andersen realized that the nation’s bustling economy of the 1920s depended heavily on companies involved in the production and distribution of energy. As the economy grew, Andersen knew there would be a steadily increasing need for electricity, oil and gas, and other energy resources. So he focused his practice development efforts on obtaining clients involved in the various energy industries. Andersen was particularly successful in recruiting electric utilities as clients. By the early 1930s, Arthur Andersen & Co. had a thriving practice in the upper Midwest and was among the leading regional accounting firms in the nation. The U.S. economy’s precipitous downturn during the Great Depression of the 1930s posed huge financial problems for many of Arthur Andersen & Co.’s audit clients in the electric utilities industry. As the Depression wore on, Arthur Andersen personally worked with several of the nation’s largest metropolitan banks to help his clients obtain the financing they desperately needed to continue operating. The bankers and other leading financiers who dealt with Arthur Andersen quickly learned of his commitment to honesty and proper, forthright accounting and financial reporting practices. Andersen’s reputation for honesty and integrity allowed lenders to use with confidence financial data stamped with his approval. The end result was that many troubled firms received the financing they needed to survive the harrowing days of the 1930s. In turn, the respect that Arthur Andersen earned among leading financial executives nationwide resulted in Arthur Andersen & Co. receiving a growing number of referrals for potential clients located outside of the Midwest. During the later years of his career, Arthur Andersen became a spokesperson for his discipline. He authored numerous books and presented speeches throughout the nation regarding the need for rigorous accounting, auditing, and ethical standards for the emerging public accounting profession. Andersen continually urged his fellow 1. R. Frammolino and J. Leeds, “Andersen’s Reputation in Shreds,” Los Angeles Times (online), 30 January 2002. Case 1.1 E nron Corporation accountants to adopt the public service ideal that had long served as the underlying premise of the more mature professions such as law and medicine. He also lobbied for the adoption of a mandatory continuing professional education (CPE) requirement. Andersen realized that CPAs needed CPE to stay abreast of developments in the business world that had significant implications for accounting and financial reporting practices. In fact, Arthur Andersen & Co. made CPE mandatory for its employees long before state boards of accountancy adopted such a requirement. By the mid-1940s, Arthur Andersen & Co. had offices scattered across the eastern one-half of the United States and employed more than 1,000 accountants. When ­Arthur Andersen died in 1947, many business leaders expected that the firm would disband without its founder, who had single-handedly managed its operations over the previous four decades. But, after several months of internal turmoil and dissension, the firm’s remaining partners chose Andersen’s most trusted associate and protégé to replace him. Like his predecessor and close friend who had personally hired him in 1928, ­Leonard Spacek soon earned a reputation as a no-nonsense professional—an auditor’s auditor. He passionately believed that the primary role of independent auditors was to ensure that their clients reported fully and honestly regarding their financial affairs to the investing and lending public. Spacek continued Arthur Andersen’s campaign to improve accounting and auditing practices in the United States during his long tenure as his firm’s chief executive. “Spacek openly criticized the profession for tolerating what he considered a sloppy patchwork of accounting standards that left the investing public no way to compare the financial performance of different companies.”2 Such criticism compelled the accounting profession to develop a more formal and rigorous rule-making process. In the late 1950s, the profession created the Accounting Principles Board (APB) to study contentious accounting issues and develop appropriate new standards. The APB was replaced in 1973 by the Financial Accounting Standards Board (FASB). Another legacy of Arthur Andersen that Leonard Spacek sustained was requiring the firm’s professional employees to continue their education throughout their careers. During Spacek’s tenure, Arthur Andersen & Co. established the world’s largest private university, the Arthur Andersen & Co. Center for Professional Education, located in St. Charles, Illinois, not far from Arthur Andersen’s birthplace. Leonard Spacek’s strong leadership and business skills transformed Arthur ­Andersen & Co. into a major international accounting firm. When Spacek retired in 1973, Arthur Andersen & Co. was arguably the most respected accounting firm not only in the United States, but worldwide as well. Three decades later, shortly after the dawn of the new millennium, Arthur Andersen & Co. employed more than 80,000 professionals, had practice offices in more than 80 countries, and had annual revenues approaching $10 billion. However, in late 2001, the firm, which by that time had adopted the one-word name “Andersen,” faced the most significant crisis in its history since the death of its founder. Ironically, that crisis stemmed from Andersen’s audits of an energy company, a company founded in 1930 that, like many of Arthur Andersen’s clients, had struggled to survive the Depression. The World’s Greatest Company Northern Natural Gas Company was founded in Omaha, Nebraska, in 1930. The principal investors in the new venture included a Texas-based company, Lone Star Gas Corporation. During its first few years of existence, Northern wrestled with the problem 2. Ibid. 5 6 Section One Comprehensive Cases of persuading consumers to use natural gas to heat their homes. Concern produced by several unfortunate and widely publicized home “explosions” caused by natural gas leaks drove away many of Northern’s potential customers. But, as the Depression wore on, the relatively cheap cost of natural gas convinced increasing numbers of cold-stricken and shallow-pocketed consumers to become Northern customers. The availability of a virtually unlimited source of cheap manual labor during the 1930s allowed Northern to develop an extensive pipeline network to deliver natural gas to the residential and industrial markets that it served in the Great Plains states. As the company’s revenues and profits grew, Northern’s management launched a campaign to acquire dozens of its smaller competitors. This campaign was prompted by management’s goal of making Northern the largest natural gas supplier in the United States. In 1947, the company, which was still relatively unknown outside of its geographical market, reached a major milestone when its stock was listed on the New York Stock Exchange. That listing provided the company with greater access to the nation’s capital markets and the financing needed to continue its growth-through­acquisition strategy over the following two decades. During the 1970s, Northern became a principal investor in the development of the Alaskan pipeline. When completed, that pipeline allowed Northern to tap vast natural gas reserves it had acquired in Canada. In 1980, Northern changed its name to InterNorth, Inc. Over the next few years, company management extended the scope of the company’s operations by investing in ventures outside of the natural gas industry, including oil exploration, chemicals, coal mining, and fuel-trading operations. But the company’s principal focus remained the natural gas industry. In 1985, InterNorth purchased Houston Natural Gas Company for $2.3 billion. That acquisition resulted in InterNorth controlling a 40,000-mile network of natural gas pipelines and allowed it to achieve its long-sought goal of becoming the largest natural gas company in the United States. In 1986, InterNorth changed its name to Enron. Kenneth Lay, the former chairman of Houston Natural Gas, emerged as the top executive of the newly created firm that chose Houston, Texas, as its corporate headquarters. Lay quickly adopted the aggressive growth strategy that had long dominated the management policies of InterNorth and its predecessor. Lay hired Jeffrey Skilling to serve as one of his top subordinates. During the 1990s, Skilling developed and implemented a plan to transform Enron from a conventional natural gas supplier into an energy-trading company that served as an intermediary between producers of energy products, principally natural gas and electricity, and end users of those commodities. In early 2001, Skilling assumed Lay’s position as Enron’s chief executive officer (CEO), although Lay retained the title of chairman of the board. In the management letter to shareholders included in ­Enron’s 2000 annual report, Lay and Skilling explained the metamorphosis that Enron had undergone over the previous 15 years: Enron hardly resembles the company we were in the early days. During our 15-year history, we have stretched ourselves beyond our own expectations. We have metamorphosed from an asset-based pipeline and power generating company to a marketing and logistics company whose biggest assets are its well-established business approach and its innovative people. Enron’s 2000 annual report discussed the company’s four principal lines of business. Energy Wholesale Services ranked as the company’s largest revenue producer. That division’s 60 percent increase in transaction volume during 2000 was fueled by the rapid development of EnronOnline, a B2B (business-to-business) electronic marketplace for the energy industries created in late 1999 by Enron. During fiscal 2000 Case 1.1 E nron Corporation 7 2000 1999 1998 1997 1996 $100,789 $40,112 $31,260 $20,273 $13,289 1,266 957 698 515 493 (287) 979 (64) 893 5 703 (410) 105 91 584 1.47 1.18 1.00 .87 .91 (.35) 1.12 (.08) 1.10 .01 1.01 (.71) .16 .17 1.08 .50 .50 .48 .46 .43 Total Assets: 65,503 33,381 29,350 22,552 16,137 Cash from Operating    Activities: 3,010 2,228 1,873 276 742 Capital Expenditures and    Equity Investments: 3,314 3,085 3,564 2,092 1,483 NYSE Price Range:    High    Low    Close, December 31 90.56 41.38 83.12 44.88 28.75 44.38 29.38 19.06 28.53 22.56 17.50 20.78 23.75 17.31 21.56 Revenues Net Income:    Operating Results    Items Impacting      Comparability        Total Earnings Per Share:    Operating Results    Items Impacting      Comparability        Total Dividends Per Share: alone, EnronOnline processed more than $335 billion of transactions, easily making Enron the largest e-commerce company in the world. Enron’s three other principal lines of business included Enron Energy Services, the company’s retail operating unit; Enron Transportation Services, which was responsible for the company’s pipeline operations; and Enron Broadband Services, a new operating unit intended to be an intermediary between users and suppliers of broadband (Internet access) services. Exhibit 1 presents the five-year financial highlights table included in Enron’s 2000 annual report. The New Economy business model that Enron pioneered for the previously staid energy industries caused Kenneth Lay, Jeffrey Skilling, and their top subordinates to be recognized as skillful entrepreneurs and to gain superstar status in the business world. Lay’s position as the chief executive of the nation’s seventh-largest firm gave him direct access to key political and governmental officials. In 2001, Lay served on the “transition team” responsible for helping usher in the administration of Presidentelect George W. Bush. In June 2001, Skilling was singled out as “the No. 1 CEO in the entire country,” while Enron was hailed as “America’s most innovative company.”3 3. K. Eichenwald and D. B. Henriques, “Web of Details Did Enron In as Warnings Went Unheeded,” The New York Times (online), 10 February 2002. Exhibit 1 Enron Corporation 2000 A nnual R eport Financial Highlights Table (in millions except for per share amounts) 8 Section One Comprehensive Cases ­ nron’s chief financial officer (CFO) Andrew Fastow was recognized for creating the E financial infrastructure for one of the nation’s largest and most complex companies. In 1999, CFO Magazine presented Fastow the Excellence Award for Capital Structure Management for his “pioneering work on unique financing techniques.”4 Throughout their tenure with Enron, Kenneth Lay and Jeffrey Skilling continually focused on enhancing their company’s operating results. In the letter to shareholders in Enron’s 2000 annual report, Lay and Skilling noted that “Enron is laser-focused on earnings per share, and we expect to continue strong earnings performance.” Another important goal of Enron’s top executives was to increase their company’s stature in the business world. During a speech in January 2001, Lay revealed that his ultimate goal was for Enron to become “the world’s greatest company.”5 As Enron’s revenues and profits swelled, its top executives were often guilty of a certain degree of chutzpah. In particular, Skilling became known for making brassy, if not tacky, comments concerning his firm’s competitors and critics. During the crisis that gripped California’s electric utility industry during 2001, numerous elected officials and corporate executives criticized Enron for allegedly profiteering by selling electricity at inflated prices to the Golden State. Skilling brushed aside such criticism. During a speech at a major business convention, Skilling asked the crowd if they knew the difference between the state of California and the Titanic. After an appropriate pause, Skilling provided the punch line: “At least when the Titanic went down, the lights were on.”6 Unfortunately for Lay, Skilling, Fastow, and thousands of Enron employees and stockholders, Lay failed to achieve his goal of creating the world’s greatest company. In a matter of months during 2001, Enron quickly unraveled. Enron’s sudden collapse panicked investors nationwide, leading to what one Newsweek columnist described as the “the biggest crisis investors have had since 1929.”7 Enron’s dire financial problems were triggered by public revelations of questionable accounting and financial reporting decisions made by the company’s accountants. Those decisions had been reviewed, analyzed, and apparently approved by Andersen, the company’s independent audit firm. Debits, Credits, and Enron Throughout 2001, Enron’s stock price drifted lower. Publicly, Enron executives blamed the company’s slumping stock price on falling natural gas prices, concerns regarding the long-range potential of electronic marketplaces such as EnronOnline, and overall weakness in the national economy. By mid-October, the stock price had fallen into the mid-$30s from a high in the lower $80s earlier in the year. On October 16, 2001, Enron issued its quarterly earnings report for the third quarter of 2001. That report revealed that the firm had suffered a huge loss during the quarter. Even more problematic to many financial analysts was a mysterious $1.2 billion reduction in Enron’s owners’ equity and assets that was disclosed seemingly as an afterthought in the earnings press release. This write-down resulted from the reversal of previously recorded transactions involving the swap of Enron stock for notes receivable. Enron had acquired the notes receivable from related third parties who had invested in limited partnerships organized and sponsored by the company. After studying those transactions in more depth, Enron’s accounting staff and its Andersen auditors concluded 4. E. Thomas, “Every Man for Himself,” Newsweek, 18 February 2002, 25. 5. Eichenwald and Henriques, “Web of Details.” 6. Ibid. 7. N. Byrnes, “Paying for the Sins of Enron,” Newsweek, 11 February 2002, 35. Case 1.1 E nron Corporation that the notes receivable should not have been reported in the assets section of the company’s balance sheet but rather as a reduction to owners’ equity. The October 16, 2001, press release sent Enron’s stock price into a free fall. Three weeks later on November 8, Enron restated its reported earnings for the previous five years, wiping out approximately $600 million of profits the company had reported over that time frame. That restatement proved to be the death knell for Enron. On December 2, 2001, intense pressure from creditors, pending and threatened litigation against the company and its officers, and investigations initiated by law enforcement authorities forced Enron to file for bankruptcy. Instead of becoming the nation’s greatest company, Enron laid claim to being the largest corporate bankruptcy in U.S. history, imposing more than $60 billion of losses on its stockholders alone. Enron’s “claim to fame” would be eclipsed the following year by the more than $100 billion of losses produced when another Andersen client, WorldCom, filed for bankruptcy. The massive and understandable public outcry over Enron’s implosion during the fall of 2001 spawned a mad frenzy on the part of the print and electronic media to determine how the nation’s seventh-largest public company, a company that had posted impressive and steadily rising profits over the previous few years, could crumple into insolvency in a matter of months. From the early days of this public drama, skeptics in the financial community charged that Enron’s balance sheet and earnings restatements in the fall of 2001 demonstrated that the company’s exceptional financial performance during the late 1990s and 2000 had been a charade, a hoax orchestrated by the company’s management with the help of a squad of creative accountants. Any doubt regarding the validity of that theory was wiped away—at least in the minds of most members of the press and the general public—when a letter that an Enron accountant had sent to Kenneth Lay in August 2001 was discovered. The contents of that letter were posted on numerous websites and lengthy quotes taken from it appeared in virtually every major newspaper in the nation. Exhibit 2 contains key excerpts from the letter that Sherron Watkins wrote to ­Kenneth Lay in August 2001. Watkins’ job title was vice president of corporate development, but she was an accountant by training, having worked previously with ­Andersen, Enron’s audit firm. The sudden and unexpected resignation of Jeffrey Skilling as Enron’s CEO after serving in that capacity for only six months had prompted Watkins to write the letter to Lay. Before communicating her concerns to Lay, Watkins had attempted to discuss those issues with one of Lay’s senior subordinates. When Watkins offered to show that individual a document that identified significant problems in accounting decisions made previously by Enron, Watkins reported that he rebuffed her. “He said he’d rather not see it.”8 Watkins was intimately familiar with aggressive accounting decisions made for a series of large and complex transactions involving Enron and dozens of limited partnerships created by the company. These partnerships were so-called SPEs or special purpose entities that Enron executives had tagged with a variety of creative names, including Braveheart, Rawhide, Raptor, Condor, and Talon. Andrew Fastow, Enron’s CFO who was involved in the creation and operation of several of the SPEs, named a series of them after his three children. SPEs—sometimes referred to as SPVs (special purpose vehicles)—can take several legal forms but are commonly organized as limited partnerships. During the 1990s, hundreds of large corporations began establishing SPEs. In most cases, SPEs 8. T. Hamburger, “Watkins Tells of ‘Arrogant’ Culture; Enron Stifled Staff Whistle-Blowing,” The Wall Street Journal (online), 14 February 2002. 9 10 Exhibit 2 Selected E xcerpts from Sherron Watkins’ August 2001 Letter to K enneth L ay Section One Comprehensive Cases Dear Mr. Lay, Has Enron become a risky place to work? For those of us who didn’t get rich over the last few years, can we afford to stay? Skilling’s abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting—most notably the Raptor transactions and the Condor vehicle. . . . We have recognized over $550 million of fair value gains on stocks via our swaps with Raptor, much of that stock has declined significantly. . . . The value in the swaps won’t be there for Raptor, so once again Enron will issue stock to offset these losses. Raptor is an LJM entity. It sure looks to the layman on the street that we are hiding losses in a related company and will compensate that company with Enron stock in the future. I am incredibly nervous that we will implode in a wave of scandals. My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successes as nothing but an elaborate accounting hoax. Skilling is resigning now for “personal reasons” but I think he wasn’t having fun, looked down the road and knew this stuff was unfixable and would rather abandon ship now than resign in shame in 2 years. Is there a way our accounting gurus can unwind these deals now? I have thought and thought about how to do this, but I keep bumping into one big problem—we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed a wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001 and it’s a bit like robbing the bank in 1 year and trying to pay it back 2 years later. . . . I realize that we have had a lot of smart people looking at this and a lot of accountants including AA & Co. have blessed the accounting treatment. None of this will protect Enron if these transactions are ever disclosed in the bright light of day. . . . The overriding basic principle of accounting is that if you explain the “accounting treatment” to a man on the street, would you influence his investing decisions? Would he sell or buy the stock based on a thorough understanding of the facts? My concern is that the footnotes don’t adequately explain the transactions. If adequately explained, the investor would know that the “Entities” described in our related party footnote are thinly capitalized, the equity holders have no skin in the game, and all the value in the entities comes from the underlying value of the derivatives (unfortunately in this case, a big loss) AND Enron stock and N/P. . . . The related party footnote tries to explain these transactions. Don’t you think that several interested companies, be they stock analysts, journalists, hedge fund managers, etc., are busy trying to discover the reason Skilling left? Don’t you think their smartest people are pouring [sic] over that footnote disclosure right now? I can just hear the discussions—”It looks like they booked a $500 million gain from this related party company and I think, from all the undecipherable 1/2 page on Enron’s contingent contributions to this related party entity, I think the related party entity is capitalized with Enron stock.” . . . “No, no, no, you must have it all wrong, it can’t be that, that’s just too bad, too fraudulent, surely AA & Co. wouldn’t let them get away with that?” Case 1.1 E nron Corporation were used to finance the acquisition of an asset or fund a construction project or related activity. Regardless, the underlying motivation for creating an SPE was nearly always “debt avoidance.” That is, SPEs provided large companies with a mechanism to raise needed financing for various purposes without being required to report the debt in their balance sheets. Fortune magazine charged that corporate CFOs were using SPEs as scalpels “to perform cosmetic surgery on their balance sheets.” 9 During the early 1990s, the Securities and Exchange Commission (SEC) and the FASB had wrestled with the contentious accounting and financial reporting issues posed by SPEs. Despite intense debate and discussions, the SEC and the FASB provided little in the way of formal guidance for companies to follow in accounting and reporting for SPEs. The most important guideline that the authoritative bodies implemented for SPEs, the so-called 3 percent rule, proved to be extremely controversial. This rule allowed a company to omit an SPE’s assets and liabilities from its consolidated financial statements as long as parties independent of the company provided a minimum of 3 ­percent of the SPE’s capital. Almost immediately, the 3 percent threshold became both a technical minimum and a practical maximum. That is, large companies using the SPE structure arranged for external parties to provide exactly 3 percent of an SPE’s total capital. The remaining 97 percent of an SPE’s capital was typically contributed by loans from external lenders, loans arranged and generally collateralized by the company that created the SPE. Many critics charged that the 3 percent rule undercut the fundamental principle within the accounting profession that consolidated financial statements should be prepared for entities controlled by a common ownership group. “There is a ­presumption that consolidated financial statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies.”10 Business Week chided the SEC and FASB for effectively endorsing the 3 percent rule. Because of a gaping loophole in accounting practice, companies can create arcane legal structures, often called special-purpose entities (SPEs). Then, the parent can bankroll up to 97 percent of the initial investment in an SPE without having to consolidate it. . . . The controversial exception that outsiders need invest only 3 percent of an SPE’s capital for it to be independent and off the balance sheet came about through fumbles by the Securities and Exchange Commission and the Financial Accounting Standards Board.11 Throughout the 1990s, many companies took advantage of the minimal legal and accounting guidelines for SPEs to divert huge amounts of their liabilities to off-­balance sheet entities. Among the most aggressive and innovative users of the SPE structure was Enron, which created hundreds of SPEs. Unlike most companies, Enron did not limit its SPEs to financing activities. In many cases, Enron used SPEs for the sole purpose of downloading underperforming assets from its financial statements to the financial statements of related but unconsolidated entities. For example, Enron would arrange for a third party to invest the minimum 3 percent capital required in an SPE and then sell assets to that SPE. The SPE would finance the purchase of those assets by loans collateralized by Enron common stock. In some cases, undisclosed side 9. J. Kahn, “Off Balance Sheet—And Out of Control,” Fortune, 18 February 2002, 84. 10. Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (New York: AICPA, 1959). 11. D. Henry, H. Timmons, S. Rosenbush, and M. Arndt, “Who Else Is Hiding Debt?” Business Week, 28 January 2002, 36–37. 11 12 Section One Comprehensive Cases ­ greements made by Enron with an SPE’s nominal owners insulated those individuals a from any losses on their investments and, in fact, guaranteed them a windfall profit. Even more troubling, Enron often sold assets at grossly inflated prices to their SPEs, allowing the company to manufacture large “paper” gains on those transactions. Enron made only nominal financial statement disclosures for its SPE transactions and those disclosures were typically presented in confusing, if not cryptic, language. One accounting professor observed that the inadequate disclosures that companies such as Enron provided for their SPE transactions meant that, “the nonprofessional [investor] has no idea of the extent of the [given firm’s] real liabilities.”12 The Wall Street Journal added to that sentiment when it suggested that Enron’s brief and obscure disclosures for its off-balance sheet liabilities and related-party transactions “were so complicated as to be practically indecipherable.”13 Just as difficult to analyze for most investors was the integrity of the hefty profits ­reported each successive period by Enron. As Sherron Watkins revealed in the letter she sent to Kenneth Lay in August 2001, many of Enron’s SPE transactions resulted in the company’s profits being inflated by unrealized gains on increases in the ­market value of its own common stock. In the fall of 2001, Enron’s board of directors ­appointed a Special Investigative Committee chaired by William C. Powers, dean of the University of Texas Law School, to study the company’s large SPE transactions. In February 2002, that committee issued a lengthy report of its findings, a document commonly referred to as the Powers Report by the press. This report discussed at length the “Byzantine” nature of Enron’s SPE transactions and the enormous and improper gains those ­transactions produced for the company. Accounting principles generally forbid a company from recognizing an increase in the value of its capital stock in its income statement. . . . The substance of the Raptors [SPE transactions] effectively allowed Enron to report gains on its income statement that were . . . [attributable to] Enron stock, and contracts to receive Enron stock, held by the Raptors.14 The primary motivation for Enron’s extensive use of SPEs and the related accounting machinations was the company’s growing need for capital during the 1990s. As Kenneth Lay and Jeffrey Skilling transformed Enron from a fairly standard natural gas supplier into a New Economy intermediary for the energy industries, the company had a constant need for additional capital to finance that transformation. Like most new business endeavors, Enron’s Internet-based operations did not produce positive cash flows immediately. To convince lenders to continue pumping cash into Enron, the company’s management team realized that their firm would have to maintain a high credit rating, which, in turn, required the company to release impressive financial statements each succeeding period. A related factor that motivated Enron’s executives to window dress their company’s financial statements was the need to sustain Enron’s stock price at a high level. Many of the SPE loan agreements negotiated by Enron included so-called price “triggers.” If the market price of Enron’s stock dropped below a designated level (trigger), ­Enron was required to provide additional stock to collateralize the given loan, to make ­significant cash payments to the SPE, or to restructure prior transactions with the SPE. 12. Ibid. 13. J. Emshwiller and R. Smith, “Murky Waters: A Primer on the Enron Partnerships,” The Wall Street Journal (online), 21 January 2002. 14. W. C. Powers, R. S. Troubh, and H. S. Winokur, “Report of Investigation by the Special Investigative ­Committee of the Board of Directors of Enron Corporation,” 1 February 2002, 129–130. Case 1.1 E nron Corporation In a worst-case scenario, Enron might be forced to dissolve an SPE and merge its assets and liabilities into the company’s consolidated financial statements. What made Enron’s stock price so important was the fact that some of the company’s most important deals with the partnerships [SPEs] run by Mr. Fastow—deals that had allowed Enron to keep hundreds of millions of dollars of potential losses off its books—were financed, in effect, with Enron stock. Those transactions could fall apart if the stock price fell too far.15 As Enron’s stock price drifted lower throughout 2001, the complex labyrinth of legal and accounting gimmicks underlying the company’s finances became a shaky house of cards. Making matters worse were large losses suffered by many of Enron’s SPEs on the assets they had purchased from Enron. Enron executives were forced to pour additional resources into many of those SPEs to keep them solvent. Contributing to the financial problems of Enron’s major SPEs was alleged self-dealing by Enron ­officials involved in operating those SPEs. Andrew Fastow realized $30 million in profits on his investments in Enron SPEs that he oversaw at the same time he was serving as the company’s CFO. Several of his friends also reaped windfall profits on investments in those same SPEs. Some of these individuals “earned” a profit of as much as $1 ­million on an initial investment of $5,800. Even more startling was the fact that Fastow’s friends realized these gains in as little as 60 days. By October 2001, the falling price of Enron’s stock, the weight of the losses suffered by the company’s large SPEs, and concerns being raised by Andersen auditors forced company executives to act. Enron’s management assumed control and ownership of several of the company’s troubled SPEs and incorporated their dismal financial statement data into Enron’s consolidated financial statements. This decision led to the large loss reported by Enron in the fall of 2001 and the related restatement of the company’s earnings for the previous five years. On December 2, 2001, the transformed New Age company filed its bankruptcy petition in New Age fashion—via the Internet. Only six months earlier, Jeffrey Skilling had been buoyant when commenting on Enron’s first quarter results for 2001. “So in conclusion, first-quarter results were great. We are very optimistic about our new businesses and are confident that our record of growth is sustainable for many years to come.”16 As law enforcement authorities, Congressional investigative committees, and business journalists rifled through the mass of Enron documents that became publicly available during early 2002, the abusive accounting and financial reporting practices that had been used by the company surfaced. Enron’s creative use of SPEs became the primary target of critics; however, the company also made extensive use of other accounting gimmicks. For example, Enron had abused the mark-to-market accounting method for its long-term contracts involving various energy commodities, primarily natural gas and electricity. Given the nature o…