Enron Corporation entered 2001 as the seventh largest public company in the United States only to later exit the year as the largest company to ever declare bankruptcy in U.S history. Investors who lost millions and lawmakers seeking to prevent similar reoccurrences were shocked by these unbelievable events. The following testimony of Rep. Richard H. Baker, chair of the House Capital Markets Subcommittee, exemplified these feelings:

We are here today to examine and begin the process of understanding the most stunning business reversal in recent history. One moment an international corporation with a diversified portfolio enjoying an incredible run-up of stock prices, the darling of financial press and analysts, which, by the way, contributed to the view that Enron had indeed become the new model for business of the future, indeed, a new paradigm. One edition of Fortune magazine called it the best place in America for an employee to work. Analysts gave increasingly creative praise, while stock prices soared.... Now in retrospect, it is clear, at least to me, that while Enron executives were having fun, it actually became a very large hedge fund, which just happened to own a power company. While that in itself does not warrant criticism, it was the extraordinary risk-taking by powerful executives which rarely added value but simply accelerated the cash burn-off rate. Executives having Enron fun are apparently very costly and, all the while, they were aggressive in the exercise of their own [Enron] stock options, flipping acquisitions for quick sale. One executive sold a total of $353 million in the 3-year period preceding the failure. What did he know? When did he know it? And why didn’t we?1 Although company executives were involved in questionable business practices and even fraud; Enron’s failure was ultimately due to a collapse of investor; customer; and trading partner confidence. In the boom years of the late 1990’s; Enron entered into a number of aggressive transactions involving “special purpose entities” (SPEs) for which the underlying accounting was questionable or fraudulent. Some of these transactions essentially involved Enron receiving borrowed funds that were made to look like revenues, without recording liabilities on the company s balance sheet. The “loans” were guaranteed with Enron stock, trading at over $100 per share at the time. The company found itself in real trouble when, simultaneously, the business deals underlying these transactions went sour and Enron’s stock price plummeted. Debt holders began to recall the loans due to Enron’s diminished stock price, and the company found its accounting positions increasingly problematic to maintain.

The August 2001 resignation of Enron’s chief executive officer (CEO), Jeffrey Skilling, only six months after beginning his “dream job” further fueled Wall Street skepticism and scrutiny over company operations. Shortly thereafter, The Wall Street Journal's “Heard on the Street column of August 28, 2001 drew further attention to the company, igniting a public firestorm of controversy that quickly led to the loss of the company’s reputation. The subsequent loss of confidence by trading partners and customers quickly dried up Enron’s trading volume, and the company found itself facing a liquidity crisis by late 2001.

Jeffrey Skilling, former CEO, summed it up this way when he testified before the House Energy Commerce Committee on February 7, 2002:

It is my belief that Enron's failure was due to a classic ‘run on the bank:' a liquidity crisis spurred by a lack of confidence in the company. At the time of Enron's collapse, the company was solvent and highly profitable - but, apparently, not liquid enough. That is my view of the principal cause of its failure.2 Public disclosure of diminishing liquidity and questionable management decisions and practices destroyed the trust Enron had established within the business community. This caused hundreds of trading partners, clients, and suppliers to suspend doing business with the company— ultimately leading to its downfall.

Enron’s collapse, along with events related to the audits of Enron’s financial statements, caused a similar loss of reputation, trust, and confidence in Big-5 accounting firm, Andersen, LLP. Enron’s collapse and the associated revelations of alleged aggressive and inappropriate accounting practices caused major damage for this previously acclaimed firm. News about charges of inappropriate destruction of documents at the Andersen office in Houston, which housed the Enron audit, and the subsequent unprecedented federal indictment was the kiss of death for this former Big-5 accounting firm. Andersen’s clients quickly lost confidence in the firm, and by June 2002, more than 400 of its largest clients had fired the firm as their auditor, leading to the sale or desertion of various pieces of Andersen’s U.S. and international practices. On June 15th, a federal jury in Houston convicted Andersen on one felony count of obstructing the SEC’s investigation into Enron’s collapse. Although the Supreme Court later overturned the decision in May 2005, the reversal came nearly three years after Andersen was essentially dead. Soon after the June 15, 2002 verdict, Andersen announced it would cease auditing publicly owned clients by August 31. Thus, like Enron, in an astonishingly short period of time Andersen went from being one of the world’s largest and most respected business organizations into oblivion.

Despite its inclusion in the Fortune 500, few people outside of Texas had heard of Enron prior to its fall and the subsequent Congressional investigation. However, because of the Congressional hearings and intense media coverage, along with the tremendous impact the company’s collapse had on the corporate community and accounting profession, the name “Enron” will reverberate for decades to come. Here is a brief analysis of the fall of these two giants..........

REQUIRED [1] What were the business risks Enron faced, and how did those risks increase the likelihood of material misstatements in Enron’s financial statements?
[2]

(a) What are the responsibilities of a company’s board of directors?

(b) Could the board of directors at Enron—especially the audit committee—have prevented the fall of Enron?

(c) Should they have known about the risks and apparent lack of independence with Enron’s SPEs? What should they have done about it?
[3] In your own words, summarize how Enron used SPEs to hide large amounts of company debt.
[4] What are the auditor independence issues surrounding the provision of external auditing services, internal auditing services, and management consulting services for the same client? Develop arguments for why auditors should be allowed to perform these services for the same client. Develop separate arguments for why auditors should not be allowed to perform non¬ audit services for their audit clients. What do you believe?
[5] Explain how “rules-based” accounting standards differ from “principles-based” standards. How might fundamentally changing accounting standards from “bright-line” rules to principle-based standards help prevent another Enron-like fiasco in the future? Some argue that the trend toward adoption of international accounting standards represents a move toward more “principles- based” standards. Are there dangers in removing “bright-line” rules? What difficulties might be associated with such a change?
[6] Enron and Andersen suffered severe consequences because of their perceived lack of integrity and damaged reputations. In fact, some people believe the fall of Enron occurred because of a form of “run on the bank.” Some argue that Andersen experienced a similar “run on the bank” as many top clients quickly dropped the firm in the wake of Enron’s collapse. Is the “run on the bank” analogy valid for both firms? Why or why not?
[7] A perceived lack of integrity caused irreparable damage to both Andersen and Enron. How can you apply the principles learned in this case personally? Generate an example of how involvement in unethical or illegal activities, or even the appearance of such involvement, might adversely affect your career. What are the possible consequences when others question your integrity? What can you do to preserve your reputation throughout your career?
[8] Why do audit partners struggle with making tough accounting decisions that may be contrary to their client’s position on the issue? What changes should the profession make to eliminate these obstacles?
[9] What has been done, and what more do you believe should be done to restore the public trust in the auditing profession and in the nation’s financial reporting system?