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Consult Paragraphs 21-22 of PCAOB Auditing Standard No. 5. 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. According to paragraph #21 of PCAOB Auditing Standard No. 5, \"The auditor should use a top-down approach to the audit of internal control over financial reporting to select the controls to test. A top-down approach begins at the financial statement level and with the auditor's understanding of the overall risks to internal control over financial reporting. The auditor then focuses on entity-level controls and works down to significant accounts and disclosures and their relevant assertions. This approach directs the auditor's attention to accounts, disclosures, and assertions that present a reasonable possibility of material misstatement to the financial statements and related disclosures.\" In paragraph #22, the PCAOB states that the \"auditor must test those entitylevel controls that are important to the auditor's conclusion about whether the company has effective internal control over financial reporting. The auditor's evaluation of entity-level controls can result in increasing or decreasing the testing that the auditor otherwise would have performed on other controls.\" The absolute goal of this process is to help the auditor focus on those controls that really matter in supporting the goal of reliable financial reporting. While it is difficult to glean information that would allow for a complete evaluation of Enron's control environment and entity level controls, the case does provide enough detail to conclude that the integrity of Enron's management, their leadership style, and their compensation philosophy should raise concern about their control environment and perhaps other entity level controls. Overall, by the end of class discussion, it should be clear that a proper functioning control environment and strong entity level controls provide a foundation for the entire internal control system. Consult Sections 302 and 305 and Title IX of SARBOX. Do you believe that these provisions could help to deter fraudulent financial reporting by an upper management group? Why or why not? According to section 302 of SOX, in the post-Sarbanes audit environment, the CEO and CFO of each issuer must now prepare a statement to accompany the audit report to certify the \"appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer.\" If a CEO or CFO violates this section, he/she can be held criminally liable. Essentially this statement holds the CEO and the CFO personally liable for the assertions that they have made within the financial statements. And, under Title IX of SOX, the maximum penalty for filing false financial statements with the SEC \"for willful and knowing violations\" are \"a fine of not more than $5,000,000 and/or imprisonment of up to 20 years.\" This is an absolutely critical point that must be made to answer this question. The bottom line is that crime does not pay! Imprisonment and financial penalties have been established to deter an upper management group from committing fraudulent activity. Given the changes brought upon by SOX, these new provisions are likely to deter fraudulent behavior. Stated simply, the penalties are severe and if it is found that such an upper manager did profit from a fraudulent act, the law now provides a clear mechanism to get the money back; not only to repay the financial benefit but also to incur punitive penalties as well, amounting to financial penalty and jail time. Consult Paragraphs 65-69 of PCAOB Auditing Standard No. 12. 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? At Enron, as evidenced by the case information, the incentives and pressure was the most dominant factor. Executives had incentive to achieve high revenue growth because their salary and bonus levels were directly linked to reported revenues. In addition, they also had incentive to achieve high revenues and earnings targets because of the shares of stock they held. Enron made significant use of stock options as a means to provide incentives for its executives to achieve growth. As of December 31, 2000, Enron dedicated 96 million of its outstanding shares that is at almost 13% of its common shares outstanding to stock option plans. When a senior manager holds a quantity of stock options, it is in their personal best interest to see the value of the share go up even if it means overstating income fraudulently. This is precisely the type of condition that may lead to a fraud