Chronology of the Enron Auditing Scandal

Introduction

Enron Corporation was founded from unexpected terms of a merger between two natural gas pipeline companies in outskirts of Omaha and Houston; with the initial intention to avoid being targeted for a financial takeover. Enron will go on to become the largest natural gas pipeline owner in the United States, and a dominant force in the energy market on a global front.

Summiting to the forefront of global FORTUNE 500 through their unorthodox and fraudulent aggressive accounting techniques, Enron would become the target of investigations not only by the US Securities and Exchange Commission (SEC) but also US Department of Justice. As a direct result of misleading financial statements, it led to the largest bankruptcy in US history at the time and recognised as the biggest financial and auditing failure.

Background

Enron Corporation was formed back in July 1985 as a result of a merger between two American natural gas pipeline companies; InterNorth - located in Omaha, Nebraska and Houston Natural Gas (HNG) located in Houston, Texas. InterNorth was soon becoming a target for financial takeovers due to the firm achieving its success with low levels of debt; thus looked to acquire another pipeline company with higher levels of debt to discourage a takeover. Although InterNorth had the clear leverage and the sheer firm size advantages over HNG. Somehow, the final deal that was arrived at upon was for InterNorth paying around 40% higher than the market value of the shares of HNG; along with the promise that in 18 months' time, the management controls of Enron held by Sam Segnar - InterNorth CEO to be handed over to HNG's executive Kenneth Lay (Watkins, n.d.).

Overview of Events

Rise of Enron

Enron quickly became a dominant force within the natural gas market; it became the largest seller in North America in 1992. Enron launched ‘EnronOnline'; the first online-based energy commodities trading platform in 1999. Which rapidly grew to become the largest business site in the world and to go forth to make up around 90% of Enron's earnings.

Enron was seen as the world's largest energy trader and largest natural gas pipeline owner in the US, claimed to have made over $100 billion in revenue in the year of 2000, ranking 7th in the United States and employing over 20,000 staff (FORTUNE, 2001). This would be the pinnacle and yet pivot point of Enron's success.

Downfall of Enron

In October 2001, Enron reported a $618 million loss; the first quarterly loss in four years (CBC News, 2006). It was in the same month that the SEC began its formal investigation on Enron. In December 2001, Enron declared bankruptcy; of which at the time was the largest in US history. In January 2002, US Department of Justice began a criminal investigation into Enron's collapse; of which would widen to also include the chief auditor of the firm.

Ultimately a various of charges ranging from securities fraud to money laundering and conspiracy were issued against the different key management individuals of Enron; where length trial and legal proceedings were carried out. From the years 2003 to 2006 each either plead guilty or were found guilty for a large majority of the numerous charges placed against them, and received sentencing ranging from 12 months to over 24 years in prison (CNN Library, 2016).

Fraud

The most noticeable fraudulent act was seen through their aggressive accounting policies on revenue recognition. Enron decided to use the more aggressive approach of realising the entire value of a trade. Instead of the common method of all trading firms at the time which was to only recognise a proportion of the value through fees for the service.

By applying this fraudulent and misleading revenue recognition policy, Enron was fundamentally severely overstating/inflating their trading revenues. This could be easily seen in Enron's most notable years of success being conveyed through their financial statements from 1996 to 2000 where revenue leapt from $13.3 billion to $100.8 billion in a brief four years, and it had seemed that the firm's revenue made a 750% gain in this period. Where it was also reporting annual expansions of around 65%, which is unprecedented given the industry average is around 2-3%. (Dharan & Bufkins, 2008).

Stakeholders

With Enron's continuous conveyance of inflated and ultimately fraudulent revenue recognition on their financial statements, it, therefore, made investors think that Enron was more profitable than it was. Following on from their rapid growth, by the end of 2000, Enron's stock would go on to peak at $90US, with a market capitalisation exceeding $60 billion; this was in fact 70 times the earnings and six times the book value of Enron's capital. Which simply goes to show how much their fraudulent revenue techniques manipulated investors into having such high prospects for the future. After filing for bankruptcy and further information came into light from the investigations, Enron's shares were practically worthless; falling to $0.12US. The total accumulated loss for shareholders suffered was estimated to be around $74 billion; with even over 9,000 employees losing their retirement superannuation as it was all invested in Enron shares (Healy & Palepu, 2003).

However, shareholders were not the only stakeholder to have suffered from Enron's fraud. At the time of bankruptcy, Enron still owed $67 billion to creditors. Amongst there were large banks such as Citibank, but also competitors such as Dynegy; California Power Exchange was also amongst these creditors left with Enron's outstanding debt (Gerth & Oppel Jr, 2001).

Auditors

Arthur Andersen was the appointed auditor firm for Enron, receiving a fee of $52 million in 2000 for their services. Been given the reasonability to carry out reasonable care and skill in providing assurance for the public users of the financial statement, it would later be deemed that this was not carried diligently. As one of the main social benefits of an audit is for shareholders to be protected from misleading or inaccurate information, from which they can make informed decisions when choosing to invest in the firm.

From the conclusion that was arrived at from the investigation of the auditors arrived at was that the auditing methods were deemed to be either solely for the receiving of fees or sheer lack of expertise when it came to analysing the various aggressive accounting techniques Enron applied. It would be later discovered that once the news was heard of Enron's investigation, it was believed that managers of Andersen instructed the destruction of several tonnes of relevant documentation; along with 30,000 emails and computer files (Healy & Palepu, 2003). Which ultimately led to their conviction of obstruction of justice, terminating their ability to carry out any further auditing work.

Current Situation

Following through with the liquidation procedures of the bankruptcy, creditors were the first to be repaid. This was mainly done through the auction of the remaining large and valuable assets for Enron; pipelines. However, compensation for stakeholders such as shareholders and employees who have lost their retirement fund would only come at a fraction of the loss they suffered, after lengthy legal proceedings to finally arrive at a settlement.

As for regulatory improvements, soon after Enron's scandal came to light; the Sarbanes-Oxley Act was passed. From which the Act established the Public Company Accounting Oversight Board which would go on to develop numerous new standards for auditing and put in place restrictions to prevent such major audit failure to occur.

Conclusion

Arthur Andersen's failure to fulfil their professional responsibilities to provide a reliable, reasonable assurance to the stakeholders held them socially accountable for this audit failure. Although their conviction would be reversed in later years, this scandal has destroyed their reputation as their audits would no longer provide any form of reliable assurance for any firms. Arthur Andersen would eventually follow suit with Enron, declared bankrupt; even though they were allowed to carry out audits after the conviction was vacated. Demonstrating the significance of auditor's liability in the event of an audit failure.