1. Define the terms 'information asymmetry' and 'moral hazard'. DIscuss how the terms are related and their consequences.

2. Answer the question 3.10 problem

EXAMPLE 3.8 The Enron Audit Committee Enron's audit committee seemed to fulfil all of the requirements of best practice. It consisted of seven well-known and highly qualified board members who were all non-executive directors of the company. But, like many things at Enron, the reality was quite different. One member of this committee, John Wakeham, had in place a USD$72 000 per year consulting contract with Enron. Two other committee members had been employees of universities that had received significant charitable contributions from Enron or its chairman, Kenneth Lay (Lavelle 2002, p. 28). Specifically, one of these members, Jon Mendelsohn, was also president of the MD Andersen Cancer Centre at the University of Texas. Lavelle (2002, p. 29), reported that this centre had received USD$332 150 from Enron and Lay since 1999. Under disclosure rules at the time, it was not necessary to disclose this relationship to Enron's shareholders and there was no voluntary public disclosure of these arrangements. Another committee member, Wendy Gramm, was an employee at the Mercatus Centre at George Mason University. According to the university's records, USD$50 000 was collectively paid by Enron and Lay to this centre from 1997. Moreover, Wendy Gramm's spouse, Senator Phil Gramm (Republican, Texas) received USD$80 000 in political campaign donations from Enron and its employees from 1993, when she became a director of Enron (Lavelle 2002). It should also be noted that the chair of Enron's audit committee, Robert Jaedicke, was aged 72 years at the time of Enron's collapse. While he was eminently qualified for the role - he had worked at Stanford University as an accounting professor until his retirement some 10 years earlier - his advanced age and the complexity of Enron's finances and operations called into question his competence for this high-level role (Lavelle 2002). There were also concerns about the lack of action taken by the audit committee against questionable accounting practices by management. The minutes of an audit committee meeting held in February 1999 indicated that the senior audit partner had told the committee that accounting work relating to several areas, including 'highly structured transactions', was considered 'high risk' The accounting firm's (Arthur Andersen) legal counsel later testified that this risk rating was designed to convey to the audit committee that the company was using accounting practices that, due to their novel design, application in areas without established precedent or significant reliance on subjective judgements by management personnel, invited scrutiny and presented a high degree of risk of non-compliance with generally accepted accounting principles' (COGA 2002, pp. 15-16). The audit committee seemingly chose to ignore these warnings. The Enron case demonstrates that good governance is about far more than establishing board commit- tees. The members of each committee need to demonstrate independence and be prepared to stand up to management in the event of questionable practices. Moreover, they need to adopt a sceptical view of management submissions and be prepared to delve deeper when they do not receive the answers they want or they suspect something is not quite right. Clearly, the individual members of an audit committee are required to be competent, experienced and even courageous in adequately performing such a key role. QUESTION 3.10 Examine the Enron audit committee role and independence in light of the earlier discussion on the benefits and limitations of audit committees. Evaluate the effectiveness of the committee and list steps you would recommend to improve the Enron audit committee in this situation