At Enron executives had incentives to achieve high-revenue growth because their salary increases and cash bonus amounts were linked to reported revenues.

In the proxy statement filed in 1997, Enron wrote that “base salaries are targeted at the median of a competitor group that includes peer group companies . . . and general industry companies similar in size to Enron.”4 In the proxy statement filed in 2001, Enron wrote, “The [Compensation] Committee determined the amount of the annual incentive award taking into consideration the competitive pay level for a CEO of a company with comparable revenue size, and competitive bonus levels for CEOs [sic] in specific high performing companies.”5 Employees also had incentives to achieve high revenues and earnings targets because of the shares of stock they held. Enron made significant use of stock options as a further means of providing incentives for its executives to achieve growth. For example, Enron noted in its 2001 proxy statement that the following stock option awards would become exercisable as of February 15, 2001: 5,285,542 shares for Chair Kenneth Lay, 824,038 shares for President Jeffrey Skilling, and 12,611,385 shares for all officers and directors combined.6 In fact, as of December 31, 2000, Enron had dedicated 96 million of its outstanding shares (almost 13 percent of its common shares outstanding) to stock option plans.7 Enron’s Performance Review Committee Enron’s performance review committee (PRC) determined the salaries and bonuses of employees on a semiannual basis. The PRC was initially instituted in the gas services business during the early 1990s after the merger between Houston Natural Gas and InterNorth. One Enron employee said, “At the time, it was a great tool. . . . When we started the ranking process, we were trying to weed out the lower 5 or 6 percent of the company. We had some old dinosaurs, and we had some younger people who needed incentives.”8 The PRC was gradually instituted companywide when Jeffrey Skilling, a former McKinsey & Co. consultant who joined Enron in 1990 as the chief executive of the Enron finance division, was promoted to president and COO.
The PRC made its determinations based on feedback reports that assessed the performance of employees on a scale from 1 to 5. Those who received ratings of 1 received large bonuses, and a rating of 2 or 3 could cost a vice president a six-figure sum.9 Those who ranked in the bottom 10 percent of the review had until the next semiannual review to improve or they would be fired. Those in categories 2 and 3 were also given notice that they could be fired within the next year.10............

Case Questions

1. Based on your understanding of fraud risk assessment, what three conditions are likely to be present when a fraud occurs (the fraud triangle)? Based on the information provided in the case, which of these three conditions appears to have been the most prevalent at Enron, and why?
2. Define what is meant by control environment. Why is the control environment so important to effective internal control over financial reporting at an audit client like Enron?
3. Comment on how your understanding of Enron’s control environment and other entitylevel controls would help you implement a top-down approach for an internal control audit at Enron.
4. What is the role of the audit committee in the financial reporting process? Do you believe that an audit committee can be effective in providing oversight of a management team like Enron’s?
5. Do you believe that these provisions could help deter fraudulent financial reporting by an upper management group? Why or why not?