This assignment showcases your ability to understand and the multi-faceted nature of ethical dilemmas and how to apply appropriate decision-making in the real world. The critical assignment is two parts: a ten-minute presentation and a three-page paper, both arguing for three sides of a case from Book "Called to Account" ( Paul M. Clikeman), noted below. You will pick the three sides by using the subjects in your case.

Please include the following concepts in your analysis:

1. Fraud triangle
2. Professional judgment
3. Internal controls
4. Professional expectations/rules of CPAs: both implied and written

Use creativity and any resources available for your presentation.

Case Reading: Enron:

We're on the side of angels. We're taking on the entrenched monopolies. In every business we've been in, we're the good guys.Enron President Jeffrey K. Skilling

Fortune magazine named Enron America's "most innovative" company six years in a row.2 Industry observers marveled at Enron's transformation from traditional natural gas distributor to high-flying commodities broker. CEO Ken Lay boasted in an August 1996 interview that 40 percent of Enron's 1995 earnings came from businesses that did not exist in 1985. And Lay expected the trend to continue. "We expect that five years from now, over 40 percent of our earnings will come from businesses that did not exist five years ago. It's a matter of re-creating the company and the businesses we're in," Lay explained.3

Enron's innovation led to phenomenal growth. Revenues increased from $13.3 billion in 1996 to $100.8 billion four years later. Enron's fiscal 2000 revenues ranked seventh among U.S. companies. When the stock price peaked at $90 in August 2000, Enron's market capitalization approached $80 billion.

But on December 2, 2001, less than ten months after being voted one of the 25 most admired companies in the world, Enron filed for Chapter 11 bankruptcy protection. The company had been accounting for its energy contracts and special purpose entities (SPEs) in ways that were certainly innovative but not at all admirable. The bankruptcy trustee blamed Enron's board of directors for failing to exercise proper oversight over the company's finances. More than two dozen Enron executives were indicted on charges of conspiracy, fraud, and insider trading.

Ken Lay and Enron's founding: Kenneth ("Ken") Lay was born and raised in rural Missouri. His father, a Baptist minister and failed shopkeeper, sold farm equipment and worked in a feed store to support the family. Lay spent many hours of his youth sitting on a tractor, dreaming of becoming the next John D. Rockefeller.

Lay earned a master's degree in economics from the University of Missouri in 1965. After working briefly as a speechwriter for the president of Humble Oil, Lay enlisted in the Navy where he was assigned to study the economic impact of a U.S. withdrawal from Vietnam. His research led to a doctorate in economics from the University of Houston.

Lay entered the natural gas business shortly after his discharge from the Navy. He began at Florida Gas and spent several years at Transco Energy before Houston Natural Gas (HNG) recruited him in 1981 to serve as chairman and CEO.

HNG was acquired by rival InterNorth in 1985. Although InterNorth was the larger company and the dominant partner in the merger, Lay emerged as chairman and CEO of the combined company. Shortly after the merger, Lay announced with great fanfare that HNG/InterNorth would change its name to "Enteron." Several days later, a chagrined Lay shortened the new name to "Enron" after learning that "enteron" is a medical term for the digestive tract from the intestines to the anus, making it an especially bad name for a company in the natural gas business.

The InterNorth/HNG merger created the most extensive natural gas pipeline system in North America. Enron's 40,000 miles of pipe stretched from Canada to Mexico and from the Atlantic to the Pacific. Enron, with the ability to buy gas wherever prices were lowest and sell gas wherever prices were highest, was uniquely positioned to take advantage of deregulation in the natural gas market.

Jeffrey Skilling and Enron's transformation: Jeffrey Skilling was born in Pittsburgh in 1953. When he was only 13 years old, Skilling served briefly as the production manager of a community cable-access TV station after the previous manager quit unexpectedly and Skilling was the only other person who knew how to operate the equipment. He earned a business degree from Southern Methodist University in Dallas before entering Harvard University's MBA program where he graduated in the top 5 percent of his class. "I've never not been successful in business or workever," Skilling told a reporter from Business Week. 4

Skilling's first job out of Harvard was with the energy and chemical consulting practice of McKinsey & Co. While working on a consulting engagement with Enron, Skilling sold Ken Lay on the idea of creating a "gas bank"a place where consumers and producers of natural gas could enter into long-term contracts to purchase or sell fixed quantities of gas at stable prices. Companies that consumed large quantities of natural gas jumped at the opportunity to hedge against the risk of future price increases. Gas producers eventually recognized the wisdom of guarding against future price declines.

Skilling joined Enron as a full-time employee in 1990. Ten years later, Enron was an entirely different company. Only 3 percent of the company's revenues came from delivering natural gas to customers via Enron's pipeline network. More than 90 percent of the revenues were generated by Enron's Wholesale division, which bought and sold energy-related derivative contracts.

Enron was truly innovative in introducing new types of contracts. The company even wrote contracts tied to changes in the weather. It turns out that many companies are interested in protecting themselves from the effects of unfavorable weather conditions. A clothing cataloger who sells a lot of winter outerwear, for example, suffers reduced sales if temperatures are mild. Enron created a derivative contract wherein Enron agreed to pay the cataloger a certain dollar amount for every degree above normal temperature during a given time period; the retailer promised to pay Enron for every degree below normal. Enron then hedged its exposure to high temperatures by entering into a complementary contract with a soft drink manufacturer who feared unusually cold weather. By the end of the decade, Enron earned most of its revenues selling "risk positions" rather than selling tangible products such as gas or electricity.

Enron was also an innovator in electronic commerce. In October 1999, Enron launched Enron Online (EOL), an Internet-based marketplace through which traders could buy and sell commodities such as paper, plastics, and metals. Within a year, EOL was the largest e-commerce website in the world, offering 1,150 products related to 35 commodities in 13 currencies.

Andy Fastow and Enron's accounting: Andy Fastow joined Continental Illinois Bank shortly after earning his MBA from Northwestern University's Kellogg School of Business. He worked on leveraged buyouts and asset securitizations until Jeffrey Skilling recruited him in 1990 to join Enron. The two became close friends. Fastow was named Enron's CFO in 1998 when he was only 36 years old.

During the late 1990s, Enron expanded into new industries and new geographic markets. The Houston-based natural gas company purchased Portland [Oregon] General Electric in 1997 for $3.2 billion. A year later, Enron spent $2.4 billion to acquire a water treatment company in England and paid $1.3 billion to buy an electricity distributor in Sao Paulo, Brazil. In 1999, Enron began constructing a $1.2 billion nationwide fiber optic network. The plan was to sell high-speed Internet access to companies during the day and on-demand movies to households in the evening.

Enron's enormous capital budget created a financial dilemma. "We couldn't just issue equity and dilute shareholders in the near term," Fastow explained to a reporter from CFO magazine. "On the other hand, we couldn't jeopardize our [debt] rating by issuing debt, which would raise the cost of capital and hinder our trading operations."5

Fastow's solution was to raise capital through more than 3,000 special purpose entities (SPEs). SPEs were a popular tool for raising capital and isolating risk. If Enron wanted, for example, to build a new power plant, it would sponsor an SPE dedicated to that purpose. The SPE would borrow the necessary funds, build the power plant, and then lease the plant to Enron who would operate it. Accounting rules permitted Enron to exclude an SPE's assets and liabilities from its consolidated financial statements as long as at least three percent of the SPE's equity was owned by an outside investor. In the above example, Enron would not list the power plant among its assets but neither would it report a liability for the money borrowed to build the plant. If Enron had borrowed the funds and built the power plant itself, without the SPE, Enron's debt-to-asset ratio would have increased.

Although SPEs were both legal and common, Enron abused the accounting rules. Many of Enron's SPEs were not independent entities because they were controlled by related parties and because Enron promised to reimburse losses suffered by the SPEs. Thus Enron, not the SPE's nominal owners, bore most of the risk. And Enron's financial statements did not adequately disclose the extent of Enron's commitments or the amounts for which Enron was contingently liable.

The second significant accounting issue at Enron was the company's practice of marking its energy contracts to "market value" at the end of each quarter. Enron petitioned the SEC in 1991 for permission to use mark-to-market accounting. Ironically, Enron's request came at the same time the nation's banks were fiercely resisting SEC efforts to get them to mark their financial instruments to market. The SEC, chaired by fair-value advocate Richard Breeden, approved Enron's request.

Mark-to-market accounting enabled Enron to book future anticipated profits in the current year. For example, a typical energy contract obligated Enron to supply a fixed quantity of natural gas to a customer at a price of, say, $3.00 per thousand cubic feet for the next ten years. Ordinarily, a gas supplier would record revenue each year as the gas was delivered to the customer. With mark-to-market accounting, Enron could simply "assume" that it would be able to supply the gas at an average cost of $2.80 per thousand cubic feet and immediately recognize revenue equal to the present value of the $.20 per thousand cubic feet expected future profit. If gas prices fell in a subsequent year, Enron recorded additional revenue on the basis that the contract had increased in value.

Mark-to-market accounting works well in situations where market prices are readily observable. But there was no established market for many of the contracts Enron entered into. Valuing Enron's contracts each quarter required estimates and assumptions about future commodity prices, transportation costs, and discount rates. And FASB provided no detailed guidance on how the values should be calculated. "There are just too many models and too many different types of instruments for us to have a one-size-fits-all type of model," said the FASB's director of research.6 Consequently, Enron had wide discretion over how to value its contracts and when to recognize holding gains.

Enron's use of mark-to-market accounting was not a secret. It was disclosed with the rest of Enron's accounting policies in the company's annual reports. Wall Street Journal reporter Jonathan Weil warned readers in September 2000 that much of Enron's reported profits were unrealized.7 In fact, unrealized gains on derivative contracts comprised one-third of Enron's 1999 net income and approximately one-half of the company's 2000 profits. Enron would have reported a loss in the second quarter of 2000 absent the estimated holding gains.

Enron's collapse: Enron's troubles began in 2000. British regulators cut the rates Enron's water utility was permitted to charge, slashing the entity's profits. And the largest customer of Enron's $3 billion power plant in Dabhol, India stopped paying for service. Indian politicians, who had complained for years that Enron's rates were too high, sided with the customer in the dispute. Many of Enron's recent South American acquisitions proved unprofitable.

Enron's stock price, which reached $90 in the summer of 2000, declined with each piece of bad news. The price dipped below $60 in March 2001 when Blockbuster backed out of its agreement to distribute on-demand movies via Enron's fiber optic network.

California's 2000-2001 energy crisis was a mixed blessing for Enron. The company reaped huge profits supplying electricity at wholesale prices as much as 900 percent higher than the previous year. But Enron also made some powerful enemies. "Every trading company in the country has been feasting on California, and Enron is the shrewdest of them all. They are like sharks in a feeding frenzy," complained the executive director of the Utility Consumers' Action Network in San Diego.8 The City of San Francisco joined other plaintiffs in a civil lawsuit alleging that Enron engaged in unlawful market manipulation. Governor Gray Davis instructed his attorney general to investigate allegations of illegal price fixing.

Skilling, who had served as Enron's president and chief operating officer since 1997, succeeded Lay as CEO in February 2001. Although even Skilling's harshest critics acknowledge his intelligence and creativity, Skilling lacked the diplomacy and tact necessary to lead a highly visible company in troubled times. During an April 2001 conference call with Wall Street analysts, Skilling called fund manager Richard Grubman an "asshole" after Grubman asked why Enron was slow releasing a balance sheet and cash flow statement for the first quarter. It was a juvenile and dangerous comment coming from the CEO of a public corporation whose stock price depended on the goodwill of analysts and institutional investors.

Two months later, Skilling asked an audience at a technology conference in Las Vegas if they knew the difference between the state of California and the Titanic. "At least when the Titanic went down, the lights were on," Skilling joked.9 Millions of Californians were not amused. California's attorney general responded that he would love to escort Ken Lay to an 8 ft. by 10 ft. prison cell and introduce him to a tattooed inmate named Spike.10

Skilling shocked Wall Street by resigning from Enron on August 14, 2001. His meager explanationthat he wanted to travel, learn a foreign language, and master dirt-bike ridingraised more questions than it answered. Enron's stock price dropped 14 percent from $43 to $37 within the week amid speculation that undisclosed internal problems had driven Skilling from his post.

Shortly after Ken Lay resumed his old job as Enron's CEO, he received a disturbing letter from Sherron Watkins, the company's vice-president of corporate development. "I am incredibly nervous that we will implode in a wave of accounting scandals," Watkins wrote. "Skilling's abrupt departure will raise suspicions of accounting improprieties and valuation issues. Enron has been very aggressive in its accounting ..."11 Watkins went on to complain that Enron had booked undeserved profits on inadequately disclosed transactions with related parties.

Lay asked Arthur Andersen and Enron's lawyers Vinson & Elkins to investigate Watkins's allegations. Their investigation revealed that two of Enron's SPEs did not qualify as independent entities because they were not adequately capitalized. The accountants also concluded that Enron had improperly accounted for $1.2 billion of notes receivable issued by an SPE in exchange for Enron stock. Enron had included the notes among its assets when they should have been reported as a reduction of stockholders' equity.

On October 16, 2001 Enron announced a $638 million loss for the quarter ended September 30. The loss resulted from $1.01 billion of non-recurring expenses including $180 million of severance costs and restructuring charges in Enron's broadband division; $287 million of asset impairments at its water treatment facilities in England; and $544 million of investment losses resulting from the consolidation of the two inadequately capitalized SPEs. Lay downplayed the losses, pointing out that excluding the special charges, Enron's third quarter profits were 35 percent higher than the previous year. "As these numbers show, Enron's core energy business fundamentals are excellent," Lay told analysts.12

As analysts and journalists scrutinized Enron's surprising earnings announcement, their attention soon focused on two partnerships established by CFO Andy Fastow in 1999. The partnerships, LJM1 and LJM2, were capitalized with a few million dollars of Fastow's money and more than $400 million raised from financial institutions that did business with Enron. From 1999 to 2001, the LJM partnerships bought tens of millions of dollars of assets from Enron. The transactions created an obvious conflict of interest for Fastow. As Enron's CFO, he had a fiduciary duty to the corporation's shareholders to negotiate a high selling price. But, as an investor in the LJM partnerships, he profited by purchasing the assets at the lowest possible price.

Fears of financial chicanery heightened when the Wall Street Journal reported on October 19 that Fastow had personally earned more than $7 million in management fees plus $4 million in capital gains on an investment of only $3 million.13 Fastow resigned from Enron on October 24, two days after the SEC asked Enron for information about its dealings with the Fastow-run partnerships. Subsequent investigation revealed that Fastow earned more than $30 million from the partnerships during their two-year existence.

Enron's stock traded at $34 shortly after the third quarter loss was announced on October 16. Ten days later it was trading at $16. The price dropped below $9 on November 8 when Enron restated its 1997 through 2001 earnings, cutting previously reported profits by $586 million or 20 percent. The restatement corrected improper accounting for transactions with partnerships headed by Andy Fastow and Michael Kopper, a former member of Fastow's staff. The adjustments also increased Enron's liabilities by $628 million at the end of 2000.

Ken Lay spent much of November trying desperately to negotiate a merger with cross-town rival Dynegy. When Dynegy backed away from the troubled company, Enron was forced to declare bankruptcy.

Enron and Arthur Andersen: Enron was Arthur Andersen's second largest client at the turn of the twenty-first century. Andersen's Houston office billed Enron $52 million in 2000$25 million for auditing Enron's financial statements plus $27 million for nonaudit services. Andersen employees, many of whom were assigned to the Enron engagement year-round, occupied nearly an entire floor of Enron's 50-story headquarters. So many Andersen employees accepted jobs with Enron that members of Enron's accounting department jokingly referred to Arthur Andersen as "Enron Prep."

Chief accounting officer Richard Causey was one of the nearly 90 Andersen alumni employed at Enron. While he was at Andersen, one of Causey's closest friends was a fellow auditor named David Duncan. Causey and Duncan maintained their friendship after Causey left to become Enron's CAO and Duncan took over as the engagement partner in charge of Enron's audit. Each spring, the duo led a group of Andersen and Enron "coworkers" on a tour of elite golf courses around the country.

Arthur Andersen's independence was called into question shortly after Enron disclosed that a large portion of the 1997 earnings restatement consisted of adjustments the auditors had proposed at the end of the 1997 audit but had allowed to go uncorrected. Congressional investigators wanted to know why Andersen tolerated $51 million of known misstatements during a year when Enron reported only $105 million of net income. Andersen chief executive Joseph F. Berardino explained that Enron's 1997 earnings were artificially low due to several hundred million dollars of non-recurring expenses and write-offs. The proposed adjustments were not material, Berardino testified, because they represented less than 8 percent of "normalized" earnings. Other accounting experts disputed Berardino's claim that the $51 million of misstatements were immaterial. Berardino's testimony served primarily to remind people of previous situations, such as Sunbeam and Waste Management, in which Andersen auditors discovered tens of millions of dollars of accounting errors but backed down after management declined to record the proposed adjustments.

Internal Andersen memorandums revealed that members of the firm's Professional Standards Group (PSG) questioned Enron's accounting as early as 1999. The PSG was an elite group of accounting experts who advised Andersen auditors on their clients' most complex accounting issues. PSG member Carl Bass wrote a memo in December 1999 objecting to Enron's accounting for the Blockbuster deal. Two months later, Bass questioned the legitimacy of one of Enron's partnerships. "This whole deal looks like there is no substance," Bass wrote in an email to PSG members at Andersen's Chicago headquarters.14

Bass continued resisting Enron's aggressive accounting practices until March 2001 when Enron management persuaded Andersen executives to remove Bass from the audit team. David Duncan, who didn't follow Bass's advice very often anyway, relayed Enron's complaints about Bass to Bass's superiors in Chicago. Duncan didn't want his office's most lucrative client relationship soured by an auditor Enron managers described as "caustic and cynical."

Lay and Skilling Charged: Federal prosecutors charged Ken Lay with six criminal counts of wire fraud and conspiracy to commit securities fraud. Most of the charges stemmed from allegations that Lay lied to employees, credit rating agencies and analysts by claiming Enron was healthy when he knew otherwise. Jeffrey Skilling was indicted on 28 counts of conspiracy, securities fraud, insider trading, and making false statements to auditors. Prosecutors alleged that Skilling filed false quarterly and annual reports with the SEC in 2000 and 2001 and sold $62 million of Enron stock at a time when he knew the price was inflated by false information.

Lay's and Skilling's trial commenced on January 30, 2006 in the U.S. District Court in Houston with Judge Simeon Lake presiding. Judge Lake demonstrated his no-nonsense approach to the showcase trial by seating the jury in only one day. Although Lay and Skilling were represented by the best legal talent $60 million could buy, Lake was determined not to let the high-powered defense team complicate the proceedings unnecessarily.

The government's star witness was Andy Fastow. The former CFO described in detail how Enron used related party transactions with the LJM partnerships to manipulate its reported earnings. In one illustrative transaction, Skilling approached Fastow near the end of a quarter in 1999 and offered to sell LJM an interest in an Enron power-plant project in Brazil. "That plant is a piece of shit," Fastow responded. "No one would buy it."15

Fastow changed his mind after Skilling promised to protect LJM from any losses on the transaction. Enron recognized a gain on the sale of the power-plant in 1999, enabling the company to meet its quarterly earnings target. A little more than a year later, Enron repurchased the power-plant interest from LJM at a higher price even though the plant continued to lose money.

The Brazilian power-plant transaction was not an isolated event. Between 1999 and 2001, Enron reported millions of dollars of improper gains from selling assets to SPEs at inflated prices. Enron also avoided reporting millions of dollars of losses by parking money-losing assets in off-balance sheet entities.

The defense attorneys tried to deflect Fastow's testimony by claiming that he was making up lies to earn a more lenient sentence for himself after pleading guilty to two counts of conspiracy to commit fraud. Skilling's lawyer said Fastow and other former Enron employees "had been robbed of their free will" and were saying "false things about Jeff and Ken" to satisfy prosecutors. "These witnesses were not unvarnished," Lay's attorney complained. "They were shellacked."16

Sherron Watkins's testimony was more difficult to refute. The former Enron vice president, who had earned international acclaim for blowing the whistle on Enron's accounting practices, testified that Lay had not done enough to investigate her allegations. She also said that some of Lay's public comments during Fall 2001 were misleading.

Lay and Skilling each testified in their own defense. Lay described himself as an extreme optimist who believed right up until the end that Enron was "one of the strongest companies" in America.17 Skilling insisted that he thought Enron was a healthy company when he resigned in August 2001 and when he sold $15 million of Enron stock the following month. Both men blamed the company's collapse on the bear market that followed the September 11 terrorist attacks in New York and Washington, "manipulative" trading practices by short-sellers, and panic caused by "irresponsible" news articles in the Wall Street Journal. 18

In their closing arguments, the defense attorneys denied that any crimes had occurred at Enron, other than those committed by Andy Fastow. SPEs were as "common as grass" the attorneys claimed. And every transaction had been approved by Enron's independent auditors and attorneys. "There was no evil," Skilling's lawyer said, adding that if what his client did was illegal, "we might as well put every CEO in jail."19

The prosecutors insisted it was "absurd" to claim that no crimes had taken place at Enron. Lay and Skilling conspired to cover up Enron's deteriorating financial condition while dumping millions of their own shares, the government claimed. Lead prosecutor Kathryn Ruemmler urged the jury to, "hold [Lay and Skilling] accountable for the choices they made and the lies they told."20

On the sixth day of deliberations, the jurors did exactly as Ms. Ruemmler asked. They convicted Ken Lay on all six counts of conspiracy and fraud. Jeffrey Skilling was acquitted on nine counts of insider trading, but convicted on 19 other felony charges. The jury didn't believe Skilling's claim that he was unaware of Enron's problems at the time he resigned. There were "red flags everywhere," one juror said. Nor did the jurors believe that Lay and Skilling were innocent victims of Fastow's deceit. They were "very controlling people" another juror said describing Enron's two top executives. At a news conference after the verdicts were announced, one juror said she hoped other corporate CEOs would realize that "those in charge have responsibility. There's too much hurt here. If something good can come out, companies can be aware that they must be conscientious."21

After listening to Enron investors and employees tearfully describe the harm Enron's collapse had caused them, Judge Lake sentenced Jeffrey Skilling to 24 years and four months in prison. Skilling had doomed many investors and employees to "a life sentence of poverty," Lake said in explaining the harsh verdict.22 Skilling will have to serve at least 85 percent of his sentence before becoming eligible for parole. His remaining assets, estimated at $45 million, went to a fund to compensate Enron victims.

Andy Fastow, who was originally charged with 98 felonies, was sentenced to only six years in prison followed by two years of community service. The government dropped the 98-count indictment in 2004 after Fastow pleaded guilty to two counts of conspiracy and agreed to testify against Lay and Skilling. Prosecutors praised Fastow's cooperation and called his testimony "critical" to winning the convictions of Enron's two top executives.

Ken Lay was never sentenced. He died of heart failure six weeks after the conclusion of his trial. His conviction was later vacated on the basis that a defendant who dies while his appeal is in process isn't considered convicted. Although Lay's criminal record was wiped clean, his legacy is marred forever. Enron's "Crooked E" will always be remembered as a symbol of corporate greed and corruption.