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1. Consult Paragraph 9 of PCAOB Auditing Standard No. 5. Based on your understanding of inherent risk assessment and the case information, identify three specific factors about Enron's business model in the late 1990s that might cause you to elevate inherent risk at Enron. At the entity and at the financial statement assertion level, inherent risk refers to the exposure or susceptibility of an assertion within an entity's financial statements to a material misstatement, without regard to the system of internal controls. A detailed understanding of an audit client's business model, including their products and services is an essential part of an auditor's inherent risk assessment process at both the entity level and the financial statement assertion level. Inherent risk assessment guides the auditor to allocating resources towards testing specific accounts as well as what planning what substantive tests will be employed during testing. Paragraph #9 of PCAOB Auditing Standard No. 5 relates to the planning of the audit of internal control over financial reporting. Specifically, the paragraph says that such audit should be properly planned and assistants, if any, are to be properly supervised. The paragraph then goes on to explicitly identify matters that will impact the auditor's procedures. Several of the relevant factors include: 1) Matters affecting the industry in which the company operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes; 2) Matters relating to the company's business, including its organization, operating characteristics, and capital structure; 3) Legal or regulatory matters of which the company is aware; and 4) The relative complexity of the company's operations. Importantly, the factors that are likely to impact the audit of internal control over financial reporting mirror the factors that are likely to impact the assessment of inherent risk in a financial statement audit. This is a key learning point for this question. In the 1980s, while employing an asset heavy strategy, Enron was a relatively simple enterprise, with a straight forward business model. As such, the inherent risk assessment is likely to have been much lower in the 1980s than in the late 1990s. In the late 1990s, there were a number of factors that would result in a higher inherent risk assessment by the independent auditor, including: Significant changes to its industry environment due to the government's decision to de-regulate their industry. Specifically, the government decided to allow the market forces of supply and demand to dictate prices and volumes sold (previously the government had dictated the price pipeline companies paid for gas and the price they could charge their customers). This represents a significant change for the market and the business practices employed by Enron. Dramatic changes in the industry environment increase inherent risk in a client. Since Enron was now contracting with other pipeline companies to get their gas to certain customer (e.g., Brooklyn Union), Enron was assuming added risks related to the transportation of the gas. Enron's assumption of additional operational risk increases the overall inherent risk level for Enron. Enron entered into many long term contracts with their clients. Because the terms of the contract (e.g. price) was purely speculative, Enron was assuming additional risk that the future price of their products (e.g. gas) would rise above the contract price. The nature of many of their long-term contracts was now riskier because prices could rise to a level that would make the contract unprofitable. Enron became regularly involved with the trading and financing of natural gas contracts. The accounting for such contracts is complex. In addition, the natural gas contracts it devised were quite complex and variable, depending on different pricing, capacity, and transportation parameters. Complex business transactions require complex accounting. As a result, inherent risk increases for complex transactions because it requires the independent auditor to possess complex technical knowledge regarding the appropriate accounting for the transaction. Enron decided to apply its \"trading model\" to other commodity markets, including electricity, paper and chemicals. Due to the fact that these commodity markets were a new focus for Enron, there is risk associated with the possibility that the \"trading models\" would not be fundamentally appropriate for the other commodity markets. Enron undertook international projects involving the construction and management of energy facilities outside the United Statesin the United Kingdom, Eastern Europe, Africa, the Middle East, India, China, and Central and South America. When a company employs a globalization strategy, they assume an increased inherent risk associated with the reliance upon foreign economies, exchange rates, as well as a number of potential political and cultural barriers. Enron began using mark to market (MTM) accounting for its trading business. Enron was the first company outside the financial services industry to use MTM accounting. MTM accounting involves a series of subjective valuations that require management discretion. Enron also began establishing several \"special purpose entities,\" which were formed to accomplish specific tasks, such as building gas pipelines. An SPE could be utilized by a company hoping to achieve certain accounting purposes, such as hiding debt or certain assets. 2. Consult Paragraphs .03-.06 of AU Section 311. Comment about how your understanding of the inherent risks identified at Enron (in Question 1) would influence the nature, timing, and extent of your audit work at Enron. According to paragraph #5 of AU Section 311 \"In planning the audit, the auditor should consider the nature, extent, and timing of work to be performed and should prepare a written audit program (or set of written audit programs) for every audit. The audit program should set forth in reasonable detail the audit procedures that the auditor believes are necessary to accomplish the objectives of the audit. The form of the audit program and the extent of its detail will vary with the circumstances. In developing the program, the auditor should be guided by the results of the planning considerations and procedures. As the audit progresses, changed conditions may make it necessary to modify planned audit procedures.\" As a general rule, the lower the risk of material misstatement, the less audit attention is needed during the audit. It therefore follows that the higher the risk of material misstatement; the more audit attention is needed during the audit. Although this is somewhat obvious, it is a basic point that needs to be driven home to students. Clearly the nature, timing and extent of audit work should change as a result of the auditor's risk assessment. Specifically, \"if the risk is lower, the persuasiveness of the evidence that the auditor needs to obtain also decreases.\" On the other hand, as the risk increases, the persuasiveness of the evidence that the auditor needs to obtain also increases. Regarding the timing of testing for controls, \"as the risk associated with the control being tested decreases, the testing may be performed farther from the as-of date; on the other hand, as the risk associated with the control increases, the testing should be performed closer to the as-of date.\" Finally, regarding extent of testing for controls, \"as the risk associated with a control decreases, the extensiveness of the auditor's testing should decrease; as the risk associated with a control increases, the extensiveness of the auditor's testing also should increase.\" In addition, Paragraph #46 of PCAOB Auditing Standard No. 5 also provides some relevant guidance for this question. Specifically, the paragraph states that \"the evidence necessary to persuade the auditor that the control is effective depends upon the risk associated with the control.\" Specifically, if the risk is lower, the evidence needed to persuade the auditor about its effectiveness decreases. On the other hand, as the risk increases, the evidence needed to persuade the auditor will clearly increase. 3. Consult Paragraphs 28-30 of PCAOB Auditing Standard No. 5. Next, consider how the change in industry regulation and Enron's resulting strategy shift would impact your inherent risk assessment for the relevant assertions about revenue. Finally, identify the most relevant assertion for revenue before and after Enron's resulting strategy shift and briefly explain why. Among other matters, paragraphs #28-30 of PCAOB Auditing Standard No. 5 focuses the auditor's attention on the importance of identifying each of the relevant financial statement assertions related to significant accounts and disclosures. Indeed, the identification of relevant assertions is a critical component of the audit of internal control over financial reporting. Specifically, according to Paragraph # 28, \"relevant assertions are those financial statement assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.\" In paragraph #30, auditors might \"determine the likely sources of potential misstatements by asking himself or herself \"what could go wrong?\" within a given significant account or disclosure.\" It is clear that certain financial statement assertions are \"more\" relevant than others for a particular set of financial statements. When Enron shifted from the \"asset heavy\" strategy to the \"asset light\" strategy, Enron essentially was operating in a \"new\" industry because it faced an entirely new business environment, with new industry regulations. As a result, the likelihood that a material misstatement could occur has increased due to the possibility of Enron (or Andersen) not fully understanding all aspects of the new regulated industry environment and the relevant accounting guidance. This change in business environment and a necessary understanding of the related aspects of a new industry represents an increase in inherent risk that material misstatement could occur. For the Revenue account, among others, there are two relevant assertions that stand out. Specifically, the resulting strategy change at Enron would significantly increase inherent risk assessment related to the Valuation or Allocation assertion for revenue recognized on contracts when using mark-to-market accounting. That is, given the number of estimates used when determining the specific amount of revenue to be recognized, inherent risk would be elevated. In addition, the inherent risk related to the Occurrence assertion would also be elevated since it is not entirely clear whether the revenue related to such contracts should have been recognized under GAAP. In addition, the Existence or Occurrence assertion related to revenue recognized from international subsidiaries and/or SPEs would also be elevated. The implementation of several international subsidiaries and/or SPEs increases the likelihood that revenue fraud through related party transactions could occur. As such, an elevation of the level of inherent risk occurs. 4. Consult Paragraphs .14-.16 of AU Section 316. Consider how a revenue recognition fraud might occur under Enron's strategy in the late 1990s. Next, identify an internal control procedure that would either prevent, detect, or deter such a fraudulent scheme? According to paragraph #14 of AU Section 316, on each audit engagement \"members of the audit team should discuss the potential for material misstatement due to fraud.\" According to paragraph #15 of AU Section 316, this discussion \"should include a consideration of the known external and internal factors affecting the entity that might (a) create incentives/pressures for management and others to commit fraud, (b) provide the opportunity for fraud to be perpetrated, and (c) indicate a culture or environment that enables management to rationalize committing fraud.\" Of course, these three factors are commonly referred to as the \"fraud triangle\". The first condition (incentives/pressure) recognizes that an employee or a manager of a company is likely to either have incentives in place (e.g., bonus compensation) or be under significant pressure to achieve meet specific estimates, forecasts, or expectations. The second condition (opportunity) recognizes that in order for a fraud to be perpetrated, the internal control environment must provide an opportunity for an employee or a manager of a company to commit a fraudulent act. Finally, the third condition (rationalization) recognizes that for an employee or a manager of a company to perpetrate a fraud, the individual (or individuals) must possess an \"attitude\" that allows them to rationalize that they are knowingly committing a crime. Clearly, there are a number of allowable answers to this question. The absolute key is that students show that they have tried to \"brainstorm\" about how a fraud might occur at Enron. As long as this has been demonstrated, we recommend that credit be awarded for this question. Importantly, this question is also designed to help the students understand the differences between preventive controls and detective controls and the importance of each in a wellfunctioning internal control system. The absolute key to answering this part of the question is to focus on a relevant financial statement assertion. That is, in the post-Sarbanes environment, students must be able to identify a control procedure that would prevent specific misstatements from occurring related to specific assertions. For example, one control procedure that could be designed to prevent a fraud related to the valuation or allocation assertion related to revenue would be to have an appropriate manager approve all relevant assumptions used to estimate the amount of revenue to record related to a particular contract. In addition, another possible revenue fraud would involve side agreements within related party transactions. As Enron began to implement international subsidiaries and/or SPEs, there is an increased likelihood that not all revenue transactions were completed as an \"arm's length transaction.\" As such, a prevention control would be to implement control activities such as documentation and appropriate approvals for all related party transactions. This would help ensure proper disclosure in the financial statements