Enron Memorandum Assignment

Beginning on Page 427 of the textbook, the Enron case is discussed. You are a staff auditor working for Arthur Andersen. You discover the use of certain Special Purpose Entities (SPEs) by Enron and decide to mention it to your immediate supervisor, Anna Richardson. She indicates that she is unaware of what you are referring to, and would like more information.

Prepare a Memorandum to Ms. Richardson outlining the use of SPEs by Enron and your concerns with them from an auditing perspective. She has no knowledge about these entities and will need a thorough explanation of what they are, where they come from and how they work. Also, explain to her why you believe these SPEs are cause for concern and highlight the potential for use in materially influencing the financial statements of Enron as a whole.

In addition to the above, briefly outline the culture at Enron and how the creation and use of the SPEs is in keeping with or contrary to the overall ethical environment at Enron. Feel free to use examples of company policies to highlight the above. Be sure to be as complete as possible. Keep in mind that you are also attempting to convince your higher-ups that a problem exists. Utilize any or all of the following methods of ethical analysis in your memorandum to help highlight the issues at Enron:

The Fraud Triangle Giving Voice to Values framework Conflicts of Interest that may have arisen Possible weaknesses in Internal Controls The Seven Signs of Ethical Collapse

FASB issued Accounting Standards Update 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement, as part of its simplification initiative to reduce the diversity in practice and to reduce the costs and complexity of assessing fees paid in a cloud computing arrangement (CCA). While the new standard does not provide explicit guidance on how to account for fees paid in a CCA, it does provide guidance on which existing accounting model should be applied. For purposes of applying the new guidance, a CCA includes software-as-a-service (SaaS) and SaaS-type services. "Hosting" refers to situations in which the end user does not take possession of the software; instead, the software resides on the vendor's or a third party's hardware, and the customer accesses the software remotely, Under the new standard, fees paid by a customer in a CCA will be within the scope of the internal-use software guidance if both of the following criteria are met: - The customer has the contractual right to take possession of the software at any time during the CCA period without significant penalty. - It is feasible for the customer to run the software on its own hardware (or to contract with another party to host the software). of estimates. Management should consider all relevant information, such as information from the negotiation process with the vendor, in estimating the fair value of the license. More observable inputs might be available to estimate the fair value of the hosting element. The Story of Enron The uniqueness of the decisions and manipulations at Enron and its link to the passage of SOX warrants a detailed discussion. The background details on the company and its shenanigans appears in Exhibit 7.7. EXHIBIT 7.7 Enron Accounting Fraud In the Beginning Enron was created in 1985 through Omaha-based InterNorth Inc.'s takeover of Houston Natural Gas Corporation. InterNorth paid a huge premium for Houston Natural Gas, creating $5 million in debt. The company's debt payments of $50 million a month quickly led to the selloff of billions of dollars' worth of assets. Its debt load was so high that it forced the company into financing projects with borrowings that were kept off the balance sheet. Former Enron CEO Jeff Skilling suggested that Enron's problems were due to a fluid market for natural gas; the industry needed long-term supply contracts. But prices were volatile, and contracts were available only for 30-day spot deals. Producers were unwilling to commit to the long term, always believing the price could go up. Skilling's "Gas Bank" Idea Enron needed to find a way to bridge the gap between what the producers and big gas users wanted. Skilling discussed ways to pool the investments in gas-supply contracts and then sell long-term deals to utilities through a Gas Bank. The Gas Bank called for Enron to write long-term contracts that enabled it to start accounting for those contracts differently. Traditionally, accounting would book revenue from a long-term contract when it came in. But Skilling wanted Enron to book all anticipated revenue immediately, as if it was writing up a marketable security. The technique lends itself to earnings management because of the subjectivity involved in estimating future market value. Counting all expected profits immediately meant a huge earnings kick for a company that was getting deeply in debt. But it also put Enron on a treadmill: To keep growing, it would have to book bigger and bigger deals every quarter. The result was to shift focus from developing economically sound partnerships to doing deals at all costs. The marketplace didn't seem to like the Enron deals. The initial Gas Bank plan hadn't persuaded gas producers to sell Enron their reserves. To entice the producers, the company needed to offer them money up-front for gas that would be delivered later. The problem was where to get the cash. Fastow's Special-Purpose Entities In 1991, to revitalize the Gas Bank, Enron's CFO, Andy Fastow, began creating a number of partnerships. The first series of deals was called Cactus. The Cactus ventures eventually took in money from banks and gave it to energy producers in return for a portion of their existing gas reserves. That gave the producers money up-front and Enron gas over time. Fastow worked to structure ventures that met the conditions under GAAP to keep the partnership activities off Enron's books and on the separate books of the partnership. To do so, the equity financing of the partnership venture had to include a minimum of 3% outside ownership. Control was not established through traditional means, which was the ownership of a majority of voting equity and combining of the partnership entity into the sponsoring organization (Enron), as is done with parent and subsidiary entities in a consolidation. Instead, the independent third parties were required to have a controlling and substantial interest in the entity. Control was established by the third-party investors exercising management rights over the entity's operations. There were a lot of "Monday morning quarterbacks" in the accounting profession who questioned the economic logic of attributing even the possibility of control to those who owned only 3% of the capital. Bethany McLean and Peter Elkind are two Fortune magazine reporters credited with prompting the inquiries and investigations that brought down the Enron house of cards. McLean had written a story posing the simple question: "How, exactly, does Enron make its money?" Well, in the go-go years of the 1990 s, all too often no one asked these kinds of questions (or, perhaps, did not want to know the answers). According to McLean and Elkind, a small group of investors were pulled together, known internally as the Friends of Enron. When Enron needed the 3\% of outside ownership, it turned to the friends. However, these business associates and friends of Fastow and others were independent only in a technical sense. Though they made money on their investment, they didn't control the entities or the assets within them. "This, of course, was precisely the point," McLean and Elkind say. 79 The 3% investments triggered a "special-purpose vehicle or special-purpose entity (SPE)." The advantage of the independent partnership relationship was that the SPE borrowed money from banks and other financial institutions that were willing to loan money to it with an obligation to repay the debt. The SPE enabled Enron to keep debt off its books while benefiting from the transfer and use of the cash borrowed by the SPE. The money borrowed by the SPE was often "transferred" to Enron in a sale of an operating asset no longer needed by Enron. The sale transaction typically led to a recorded gain because the cash proceeds exceeded the book value of the asset sold. The result was increased cash flow and liquidity and inflated earnings. The uniqueness of the transactions engaged in by Enron was that they initially didn't violate GAAP. Instead, Enron took advantage of the rules to engineer transactions that enabled it to achieve its goals for enhanced liquidity and profitability. The Growth of Special-Purpose Entities Eventually, Enron would grow addicted to these arrangements because they hid debt. Not only did the company turn to its "friends," but, increasingly, it had to borrow from banks and financial institutions that it did business with. These entities did not want to turn down a company like Enron, which was, at its peak, the seventh largest corporation in the United States. But Enron let the risk-shifting feature of the partnerships lapse, thus negating their conformity to GAAP. Over time, the financial institutions that were involved in providing the 3% for the SPEs became skeptical of the ability of the SPEs to repay the interest when due. These institutions asked Enron to relieve the risk of the SPEs' failure to repay the investments. Later, partnership deals were backed by promises of Enron stock. Thus, if something went wrong. Enron would be left holding the bag. Therefore, there was no true transfer of economic risk to the SPE, and, according to GAAP, the SPE should have been consolidated into Enron's financial statements. The Culture at Enron The tension in the workplace grew with employees working later and later-first until 6 p.m. and then 11 p.m. and sometimes even into the next morning. Part of the pressure resulted from Skilling's new employee-evaluation policy. Workers called it "rank and yank." Employees were evaluated in groups, with each person rated on a scale of 1 to 5. The goal was to remove the bottom 15% of each group every year. Ultimately, the system was seen as a tool for managers to reward loyalists and punish dissenters. It was seen as a cutthroat system and encouraged a "yes" culture, in which employees were reluctant to question their bosses-a fear that many would later come to regret. Let the Force Be With You In late 1997, Enron entered a number of partnerships to improperly inflate earnings and hide debt. Enron created Chewco, named after the Star Wars character Chewbacca, to buy out its partner in another venture called JEDI, which was legally kept off the books. For JEDI to remain off the balance sheet, however, Chewco had to meet certain accounting requirements. But Enron skirted the already-weak rules required to keep Chewco off its books. JEDI helped overstate Enron's profits by $405 million and understate debt by $2.6 billion. Because Enron needed to close the deal by year's end, Chewco was a rush job. Enron's executive committee presented the Chewco proposal to the board of directors on November 5. But CFO Fastow left out a few key details. He maintained that Chewco was not affiliated with Enron, but failed to mention that there was virtually no outside ownership in it. Nor did he reveal that one of his protgs, Michael Kopper, was managing the partnership. Indirectly (if not directly), Fastow would control the partnership through Kopper. Enron had a code of ethics that prohibited an officer from becoming involved with another entity that did business with Enron. Involvement by Fastow in these related-party entities was forbidden by the code. Nevertheless, the board of directors waived that requirement so Fastow could become involved with Chewco. The board approved the deal even though Enron's law firm Vinson \& Elkins prepared the requisite documents so quickly that very few people actually read it before approving it. Arthur Andersen, the firm that both audited Enron and did significant internal audit work for the company (pre-SOX), claimed that Enron withheld critical information. The firm billed the company only $80,000 for its review of the transaction, indicating a cursory review at best. Chewco, Fastow's involvement, the board approval, and a rapid approval process all were allowed because of a lack of internal controls. The Star Wars transactions were the beginning of the end for Enron. Chewco was inappropriately treated as a separate entity. Other SPE transactions eventually led to Enron's guaranteeing the debt of the SPE, using its stock as collateral. When Enron finally collapsed, its offbalance-sheet financing stood at an estimated $17 billion. Enron Just Keeps on Going The greatest pressures were in Fastow's finance group. In 1999, he constructed two partnerships called LJM Cayman and LJM2 that readily passed through the board, the lawyers, and the accountants. They were followed by four more, known as the Raptors. They did it once, it worked, and then they did it again. It didn't take long to blur the lines between what was legal and what was not. When asked by a student during an interview for a position with Enron what he did at the company, one Enron employee in the finance group answered by saying, "I remove numbers from our balance sheet and inflate earnings." As Enron pushed into new directions-wind power, water, high-speed Internet, paper, metals, data storage, advertising, etc-it became a different company almost every quarter. Entrepreneurship was encouraged; innovation was the mantra. The quarter-by-quarter scramble to post ever-better numbers became all-consuming. Enron traders were encouraged to use "prudence reserves"-to essentially put aside some revenue until another quarter (Contimued) when it might be needed. Long-term energy contracts were evaluated using an adjustable curve to forecast energy prices. When a quarter looked tight, analysts were told to simply adjust the curve in Enron's favor. Executive Compensation Enron's goal of setting its executive pay in the 75th percentile of its peer group-including companies like Duke Energy, Dynegy, and PG\&E, which it compared itself with to assess overall corporate performance-was easily exceeded. In 2000 , Enron exceeded the peer group average base salary by 51%. In bonus payments. it outdistanced its peers by 383%. The stock options granted in 2000 -valued at the time at $86.5 millionexceeded the number granted by peers by 484%. Top management became accustomed to the large payouts, and the desire for more became a part of the culture of greed at Enron. While Enron was the first player into the new energy market, enabling it to score huge gains, competitors caught on over time, and profit margins shrank. Skilling began looking for new pastures, and, in 1996, he set his sights on electricity. Enron would do for power what it had done for natural gas. The push into electricity only added to the pressures mounting inside Enron. Earlier in 1996, Ken Lay, Enron's CEO before Skilling took over, had predicted that the company's profits would double by 2000 . This was a statement that would come back to haunt Lay in his civil trial in 2006, which alleged that he hyped Enron's stock to keep funds flowing, even though he knew the company was coming apart at the seams. Lay pushed on as if nothing was wrong. Enron instituted a stock-option plan that promised to double employee salaries after eight years. Fresh off a $2.1 billion takeover of Portland General Corporation, an electric utility, Lay said his goal was nothing less than to make Enron the "world's greatest energy company." Growth at all costs was the mantra at Enron. It encouraged executives to buy into this philosophy by giving out stock options that would provide cash over time and added the sweetener that if profits and the stock price went up enough, the schedule for those options would be sharply accelerated. It provided the incentive to find ways of increasing profits and improving stock price. It looked the other way when questions about ethics came up. Clearly, Enron and its officers pursued their self-interests to the detriment of all other interests and created a culture of greed. The environment at Enron reminds us of the famous quote by Gordon Gekko in the 1987 movie Wall Street: "Greed is good. Greed captures the essence of the evolutionary spirit." Congressional Investigation and Skilling's Departure In 2000 , Skilling was granted 867,880 options to buy shares, in addition to his salary and bonus that totaled \$6.45 million. In that year, he exercised and sold over 1.1 million shares from options he received from prior years, and he pocketed $62.48 million. Skilling testified before Congress that he did not dump Enron shares as he told others to buy because he knew or suspected that the company was in financial trouble. Skilling's holdings of Enron shares increased because his number of options increased. Even under Enron's option plan, in which options vested fully in three years (an unusually quick rate), Skilling wound up holding many Enron shares that he couldn't legally sell. Lay and Skilling used as their defense in the 2006 civil trial that Enron was a successful company brought down by a crisis of confidence in the market. The government contended that Enron appeared successful but actually hid its failures through dubious, even criminal, accounting tricks. In fact, Enron by most measures wasn't particularly profitable-a fact obscured by its share price until late in its history. But there was one area in which it succeeded like few others: executive compensation. As the stock market began to decline in the late 1990s, Enron's stock followed the downward trend. The never-ending number of deals, even as business slowed, gave Wall Street pause. By April 2001, concerns mounted whether the company was disclosing financial information from its off-balance-sheet financing transactions adequately. The pressure continued both internally and externally from a slowing economy, competition from other entities that were catching on to Enron's gimmicks, and stock market declines. Differences of opinion exist as to why he made the decision, but on August 14, 2001, Skilling, who just six months prior had been named the CEO of Enron, resigned. He gave as his public reason the ever-popular "I need to spend more time with my family." The Final Days In November 2001, Enron announced it had overstated earnings by $586 million since 1997 . In December 2001, Enron made the largest bankruptcy filing ever at that time. By January 2002, the U.S. Department of Justice (DOJ) confirmed an investigation of Enron. The very next day, Andersen admitted to shredding documents related to its audit of Enron, an act of obstructing justice that would doom the firm following a DOJ lawsuit. It hardly mattered what the outcome of the lawsuit would be; Enron's clients started to abandon the firm in droves after the announcement of the lawsuit. Ultimately, the jury decided that the firm had obstructed justice, a decision that would be overturned later due to a technicality. The Lay-Skilling Criminal Trial Following the unanimous jury verdict on May 26, 2006, that found both Lay and Skilling guilty of fraud and conspiracy, Lay was quoted as saying, "Certainly we're surprised," and Skilling commented, "I think it's more appropriate to say we're shocked. This is not the outcome we expected." 80 Skilling was convicted of 19 counts of fraud, conspiracy, and insider trading. Lay was convicted on 6 counts in the joint trial and four charges of bank fraud and making false statements to banks in a separate nonjury trial before U.S. District Judge Sam Lake related to Lay's personal finances. The sentencing for Lay and Skilling in the case, somewhat ironically, was set for September 11, 2006. Skilling faced a maximum of 185 years in prison. For Lay, the fraud and conspiracy convictions carried a combined maximum punishment of 45 years. The bank fraud case added 120 years, 30 years for each of the four counts. However, Ken Lay passed away just weeks after the verdict. Skilling's Efforts to Overturn the Verdict On October 23, 2006, Skilling was sentenced to 24 years and 4 months in prison, and fined $45 million. Skilling has fought to overturn that sentence almost from the beginning. On June 21, 2013, it was announced by the U.S. Department of Justice that Skilling will be freed 10 years early. This means he would spend a total of 14 years in jail and get release in 2020 . Skilling is eligible for parole in 2017. Below we discuss the accounting techniques used by Enron to cook the books. It's important to remember that Enron shares were worth $90.75 at their peak in August 2000 and dropped to $0.67 in January 2002. When everything was said and done, shareholders lost $64 billion. The Enron fraud caused more harm than any other and is remembered as the daddy of all frauds. The Enron fraud was relatively simple. The company structured financial transactions in such a way to keep partnerships that were formed to borrow funds on behalf of Enron off Enron's books. These so-called "off-balance-sheet entities" (i.e., special-purpose entity/SPE) grew in size and number over the years. For many years, Enron was successful in setting them up and borrowing funds from financial institutions through the SPEs, after which Enron would concoct a transaction with these entities to take under-performing assets from Enron in return for the cash from the borrowing. Enron padded their cash account without carrying the debt and even recorded gains on some of the transactions. Exhibit 7.8 depicts the typical transaction between Enron and the SPE. Sherron Watkins' Role One Enron executive tried to do the right thing-Sherron Watkins. Watkins was dubious, and she sent an anonymous letter to Ken Lay, the chair of the board of directors, warning him of an impending scandal. It said in part, "Has Enron become a risky place to work? For those of us who didn't get rich over the last few years, can we afford to stay?" She described in detail problems with Enron's partnerships, problems that the letter claimed would cause huge financial upheavals at the company in as little as a year. "I am