Enron was an energy company based in Houston, Texas that made energy trades. It was formed in 1985 with the merger of Houston Natural Gas and InterNorth. After an aggressive expansion plan that involved risky financing transactions outside the original, fundamental business model of the company, Enron was billions of dollars in debt. Enron concealed this debt through hidden transactions with related party partnerships, fraudulent accounting, and illegal loans. Enron is considered to be one of the largest and most important financial reporting frauds in history. The company ultimately filed for bankruptcy in 2001.

One of the reasons that Enron was able to get away with the fraud for some time was because of a low quality audit by its external audit firm, Arthur Andersen. Prior to the failure of Enron in 2001, Arthur Andersen had been involved in two other major audit failures. These failed audits, related to frauds at Waste Management (1996) and Sunbeam (1997), should have raised red flags for management and any outside observers that some of the audit firm's internal quality assurance processes were not working. When the federal government uncovered Enron's fraud along with the string of poor quality audits at Arthur Andersen, the government forced the audit firm out of business.

Internal documentation at Arthur Andersen showed that there were conflicts between the auditors and the audit committee of Enron, and that even though there were many individuals concerned about the accounting and disclosure practices at Enron, nothing was done by Andersen to report these problems. In fact, the leading partner on the audit, David Duncan, actively worked to ensure that Enron's fraudulent financial reporting went uncovered. It appears that Duncan was motivated by the fact that Arthur Andersen was earning enormous consulting fees on the Enron engagement; Enron was a hugely important client for him personally and for the Houston office of Arthur Andersen. Together, these conflicts of interest clouded his independent judgment and professional skepticism.

Around the time that Enron declared bankruptcy in late 2001, Arthur Andersen personnel in the Houston office began aggressively destroying documentation relating to the Enron engagement. This action enabled the federal government to file charges against Arthur Andersen that ultimately led to the downfall of the audit firm. The Sarbanes-Oxley Act of 2002 was enacted partially in response to the Enron fraud and the revelation of the poor audit conducted by Arthur Andersen, which is why this case is of particular historical relevance. Considering these facts, answer the following questions:

a. Members of Enron management were the individuals who perpetrated the financial statement fraud. Given this, why do you think auditors were held responsible when they are not the ones actually making the fraudulent journal entries?

b. Explain why the consulting fees and importance of Enron to David Duncan and the Houston office of Arthur Andersen might have affected Duncan's independence, and thus the quality of the audits he supervised.

c. Describe the likely users of Enron's audited financial statements. How were these various user groups likely affected by the fraud?

d. How might the sequential list of frauds perpetrated by Arthur Andersen clients (Waste Management, Sunbeam, and finally Enron) have affected the decision by the SEC and federal prosecutors to aggressively seek Arthur Andersen's legal demise?

Answer rating: 100% (QA)

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