Review case 4.1 Enron Corporation and Andersen, LLP.

Complete the following Required questions related to this case, 1-5, in approximately 75 to 90 words.

QUESTIONS TO BE ANSWERED: Review case 4.1 Enron Corporation and Andersen, LLP. Complete the following Required questions related to this case, 1-5, in approximately 75 to 90 words. [1] Research the difference between American Depositary Shares and American Depositary Receipts. Then, visit the SEC's website (www.sec.gov) to locate the final SEC rule Release No. 33-8879 issued on December 21, 2007 and research whether foreign issuers must file with the SEC financial statements in conformity with generally accepted accounting principles (GAAP). [2] Research auditing standards and other guidance on effective internal control to answer the following questions: [a] What are IT general controls and what type(s) of IT general controls were compromised in the Satyam fraud? [b] What is meant by the term management override and how was that revealed in the Satyam fraud? [3] Research PCAOB auditing standards (which can be found on the PCAOB's website - www.pcaob.org) related to the use of confirmations and document the specific requirements related to maintaining control of the confirmation process. [a] Based on what you learn, provide an assessment of deficiencies in the confirmation approach Satyam's auditors took related to cash and accounts receivable. [b] Do auditing standards require the use of confirmations in the audits of cash balances and accounts receivable balances? [4] The Satyam auditors attempted to confirm both cash and accounts receivable balances with external parties. Which of the audit assertions for cash and accounts receivable would confirmations be most relevant? [5] Research the PCAOB's website (www.pcaob.org) to learn about the PCAOB's inspection process. How often are firms inspected by the PCAOB and to what extent are the inspection findings available to the investing public? [6] Research PCAOB auditing standards (which can be found on the PCAOB's website - www.pcaob.org) related to the use of audit documentation and identify specific requirements related to deadlines for including audit documentation in the engagement workpapers, such as the documentation completion date. Also, identify requirements related to what must be documented on the workpaper, including the date of preparation of audit documentation and the identification of the preparers of the documentation. Based on your findings, provide your assessment of how PW Bangalore violated these requirements. [7] Research the AICPA's Code of Professional Conduct (which is available on the AICPA's website - www.aicpa.org) to research what it means to be in a \"network\" of firms. How might the actions of one of the accounting firms in the network impact other members of the network? [8] Locate the PCAOB's Settled Disciplinary Order against the auditors of the Satyam financial statements, which can be found on the PCAOB's website under the link for \"Enforcement\" (see PCAOB Release No. 105-2011-002 dated April 5, 2011), and review the sanctions imposed on the audit firms within the PW India network. You will see that the PCAOB censured all five firms in the PW India network, even though three of those firms did not participate in the audit of Satyam's financial statements. Discuss why the PCAOB charged all five firms rather than only charge PW Bangalore and Lovelock & Lewes? PROFESSIONAL JUDGMENT QUESTIONS It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following questions. [9] One of the judgment shortcuts that can lead to bias in professional judgments is the \"confirmation tendency.\" Briefly describe what is meant by confirmation tendency and where was that evident in the auditor's judgment process in the Satyam case? CASE 4.1 Enron Corporation and Andersen, LLP Analyzing the Fall of Two Giants MARK S. BEASLEY FRANK A. BUCKLESS STEVEN M. GLOVER DOUGLAS F. PRAWITT LEARNING OBJECTIVES After completing and discussing this case you should be able to [1] Understand the events leading to Enron's bankruptcy and Andersen's downfall [2] Appreciate the importance of understanding an audit client's core business strategies [3] Recognize potential conflicts arising from auditor relationships with their clients [4] Understand how accounting standards may have contributed to the Enron debacle and describe how some in the accounting profession are seeking to change the fundamental nature of those standards [5] Understand the difference between \"rule-based\" and \"principle-based\" accounting standards to better appreciate some of the issues involved in the movement toward international financial reporting standards (IFRS). [6] Consider challenges facing the accounting profession and evaluate alternative courses of action for overcoming these obstacles INTRODUCTION 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 burnoff 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 3year period preceding the failure. What did he know? When did he know it? And why didn't we?1 1 Rep. Richard H. Baker (R-LA), December 12, 2001 Hearing of the Capital Markets, Insurance, and Government sponsored enterprises subcommittee and oversight and investigations subcommittee of the House Financial Services Committee, \"The Enron Collapse: Impact on Investors and Financial Markets.\" The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation. 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 without recording liabilities on the company's balance sheet. Instead, the inflow of funds was made to look like it came from the sale of assets. 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 call 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 undermined 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. Skilling 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 companyultimately 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. 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. Because of the Congressional hearings and intense media coverage, along with the tremendous impact the company's collapse had on the corporate community and on the accounting profession, the name \"Enron\" will reverberate for decades to come. Here is a brief analysis of the fall of these two giants. 2 Skilling, Jeffrey, \"Prepared Witness Testimony: Skilling, Jeffrey, K.\" House Energy Subcommittee. See the following website: http://energycommerce.house.gov/107/hearings/02072002Hearing485/Skilling797.htm ENRON IN THE BEGINNING Enron Corporation, based in Houston, Texas, was formed as the result of the July 1985 merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In its early years, Enron was a natural gas pipeline company whose primary business strategy involved entering into contracts to deliver specified amounts of natural gas to businesses or utilities over a given period of time. In 1989, Enron began trading natural gas commodities. After the deregulation of the electrical power markets in the early 1990sa change for which senior Enron officials lobbied heavilyEnron swiftly evolved from a conventional business that simply delivered energy, into a \"new economy\" business heavily involved in the brokerage of speculative energy futures. Enron acted as an intermediary by entering into contracts with buyers and sellers of energy, profiting by arbitraging price differences. Enron began marketing electricity in the U.S. in 1994, and entered the European energy market in 1995. In 1999, at the height of the Internet boom, Enron furthered its transformation into a \"new economy\" company by launching Enron Online, a Web-based commodity trading site. Enron also broadened its technological reach by entering the business of buying and selling access to high-speed Internet bandwidth. At its peak, Enron owned a stake in nearly 30,000 miles of gas pipelines, owned or had access to a 15,000-mile fiber optic network, and had a stake in several electricity-generating operations around the world. In 2000, the company reported gross revenues of $101 billion. Enron continued to expand its business into extremely complex ventures by offering a wide variety of financial hedges and contracts to customers. These financial instruments were designed to protect customers against a variety of risks, including events such as changes in interest rates and variations in weather patterns. The volume of transactions involving these \"new economy\" type instruments grew rapidly and actually surpassed the volume of Enron's traditional contracts involving delivery of physical commodities (such as natural gas) to customers. To ensure that Enron managed the risks related to these \"new economy\" instruments, the company hired a large number of experts in the fields of actuarial science, mathematics, physics, meteorology, and economics.3 Within a year of its launch, Enron Online was handling more than $1 billion in transactions daily. The website was much more than a place for buyers and sellers of various commodities to meet. Internetweek reported that, \"It was the market, a place where everyone in the gas and power industries gathered pricing data for virtually every deal they made, regardless of whether they executed them on the site.\"4 The site's success depended on cutting-edge technology and more importantly on the trust the company developed with its customers and partners who expected Enron to follow through on its price and delivery promises. When the company's accounting shenanigans were brought to light, customers, investors, and other partners ceased trading through the energy giant when they lost confidence in Enron's ability to fulfill its obligations and act with integrity in the marketplace.5 ENRON'S COLLAPSE On August 14, 2001, Kenneth Lay was reinstated as Enron's CEO after Jeffrey Skilling resigned for \"purely personal\" reasons after having served for only a six-month period as CEO. Skilling joined Enron in 1990 after leading McKinsey & Company's energy and chemical consulting practice and became Enron's president and chief operating officer in 1996. Skilling was appointed CEO in early 2001 to replace Lay, who had served as chairman and CEO since 1986.6 3 \"Understanding Enron: Rising Power.\" The Washington Post. May 11, 2002. See the following website: http://www.washingtonpost.com/wp-srv/business/enron/front.html 4 Preston, Robert. \"Enron's Demise Doesn't Devalue Model It Created.\" Internetweek. December 10, 2001. 5 Ibid. 6 \"The Rise and Fall of Enron: The Financial Players.\" The Washington Post. May 11, 2002. See the following website: http://www.washingtonpost.com/wp-srv/business/daily/articles/keyplayers_financial.htm Skilling's resignation proved to be the beginning of Enron's collapse. The day after Skilling resigned, Enron's vice president of corporate development, Sherron Watkins, sent an anonymous letter to Kenneth Lay (see Exhibit 1). In the letter, Ms. Watkins detailed her fears that Enron \"might implode in a wave of accounting scandals.\" When the letter later became public, Ms. Watkins was celebrated as an honest and loyal employee who tried to save the company through her whistle-blowing efforts. image Two months later, Enron reported a 2001 third quarter loss of $618 million and a reduction of $1.2 billion in shareholder equity related to partnerships run by chief financial officer (CFO), Andrew Fastow. Fastow had created and managed numerous off-balance-sheet partnerships for Enron, which also benefited him personally. In fact, during his tenure at Enron, Fastow collected approximately $30 million in management fees from various partnerships related to Enron. News of the company's third quarter losses resulted in a sharp decline in Enron's stock value. Lay even called U.S. Treasury Secretary, Paul O'Neill, on October 28 to inform him of the company's financial difficulties. Those events were then followed by a November 8th company announcement of even worse newsEnron had overstated earnings over the previous four years by $586 million and owed up to $3 billion for previously unreported obligations to various partnerships. This news sent the stock price further on its downward slide. Despite these developments, Lay continued to tell employees that Enron's stock was undervalued. Ironically, he was also allegedly selling portions of his own stake in the company for millions of dollars. Lay was one of the few Enron employees who managed to sell a significant portion of his stock before the stock price collapsed completely. In August 2001, he sold 93,000 shares for a personal gain of over $2 million. Sadly, most Enron employees did not have the same chance to liquidate their Enron investments. Most of the company employees' personal 401(k) accounts included large amounts of Enron stock. When Enron changed 401(k) administrators at the end of October 2001, employee retirement plans were temporarily frozen. Unfortunately, the November 8th announcement of prior period financial statement misstatements occurred during the freeze, paralyzing company employee 401(k) plans. When employees were finally allowed access to their plans, the stock had fallen below $10 per share from earlier highs exceeding $100 per share. Corporate \"white knights\" appeared shortly thereafter, spurring hopes of a rescue. Dynegy Inc. and ChevronTexaco Corp. (a major Dynegy shareholder) almost spared Enron from bankruptcy when they announced a tentative agreement to buy the company for $8 billion in cash and stock. Unfortunately, Dynegy and ChevronTexaco later withdrew their offer after Enron's credit rating was downgraded to \"junk\" status in late November. Enron tried unsuccessfully to prevent the downgrade, and allegedly asked the Bush administration for help in the process. After Dynegy formally rescinded its purchase offer, Enron filed for Chapter 11 bankruptcy on December 2, 2001. This announcement pushed the company's stock price down to $0.40 per share. On January 15, 2002, the New York Stock Exchange suspended trading in Enron's stock and began the process to formally de-list it. It is important to understand that a large portion of the earnings restatements may not technically have been attributable to improper accounting treatment. So, what made these enormous restatements necessary? In the end, the decline in Enron's stock price triggered contractual obligations that were never reported on the balance sheet, in some cases due to \"loopholes\" in accounting standards, which Enron exploited. An analysis of the nuances of Enron's partnership accounting provides some insight into the unraveling of this corporate giant. Unraveling the \"Special Purpose Entity\" Web The term \"special purpose entity\" (SPE) has become synonymous with the Enron collapse because these entities were at the center of Enron's aggressive business and accounting practices. SPEs are separate legal entities set up to accomplish specific company objectives. For example, SPEs are sometimes created to help a company sell off assets. After identifying which assets to sell to the SPE, under the rules existing in 2001, the selling company would secure an outside investment of at least three percent of the value of the assets to be sold to the SPE.7 The company would then transfer the identified assets to the SPE. The SPE would pay for the contributed assets through a new debt or equity issuance. The selling company could then recognize the sale of the assets to the SPE and thereby remove the assets and any related debts from its balance sheet. The validity of such an arrangement is, of course, contingent on the outside investors bearing the risk of their investment. In other words, the investors are not permitted to finance their interest through a note payable or other type of guarantee that might absolve them from accepting responsibility if the SPE suffers losses or fails.8 7 Since the collapse of Enron, the FASB has changed the requirements for consolidations and now requires a ten percent minimum outside investment among other requirements designed to prevent abuses (See the FASB's Accounting Standard Codification (ASC) 805 and ASC 810) 8 The FEI Research Foundation. 2002. Special Purpose Entities: Understanding the Guidelines. Accessed at http://www.fei.org/download/SPEIssuesAlert.pdf While SPEs are fairly common in corporate America, they have been controversial. Some argued at the time that SPEs represented a \"gaping loophole in accounting practice.\"9 Accounting rules dictate that once a company owns 50% or more of another, the company must consolidate, thus including the related entity in its own financial statements. However, as the following quote from BusinessWeek demonstrates, such was not the case with SPEs in 2001: The controversial exception that outsiders need invest only three percent of an SPE's capital for it to be independent and off the balance sheet came about through fumbles by the Securities & Exchange Commission and the Financial Accounting Standards Board. In 1990, accounting firms asked the SEC to endorse the three percent rule that had become a common, though unofficial, practice in the '80s. The SEC didn't like the idea, but it didn't stomp on it, either. It asked the FASB to set tighter rules to force consolidation of entities that were effectively controlled by companies. FASB drafted two overhauls of the rules but never finished the job, and (as of May 2002) the SEC is still waiting.10 While SPEs can serve legitimate business purposes, it is now apparent that Enron used an intricate network of SPEs, along with complicated speculations and hedgesall couched in dense legal languageto keep an enormous amount of debt off the company's balance sheet. Enron had literally hundreds of SPEs. Through careful structuring of these SPEs that took into account the complex accounting rules governing their required financial statement treatment, Enron was able to avoid consolidating the SPEs on its balance sheet. Three of the Enron SPEs have been made prominent throughout the congressional hearings and litigation proceedings. These SPEs were widely known as \"Chewco,\" \"LJM2,\" and \"Whitewing.\" Chewco was established in 1997 by Enron executives in connection with a complex investment in another Enron partnership with interests in natural gas pipelines. Enron's CFO, Andrew Fastow, was charged with managing the partnership. However, to prevent required disclosure of a potential conflict of interest between Fastow's roles at Enron and Chewco, Fastow employed Michael Kopper, managing director of Enron Global Finance, to \"officially\" manage Chewco. In connection with the Chewco partnership, Fastow and Kopper appointed Fastow relatives to the board of directors of the partnership. Then, in a set of complicated transactions, another layer of partnerships was established to disguise Kopper's invested interest in Chewco. Kopper originally invested $125,000 in Chewco and was later paid $10.5 million when Enron bought Chewco in March 2001.11 Surprisingly, Kopper remained relatively unknown throughout the subsequent investigations. In fact, Ken Lay told investigators that he did not know Kopper. Kopper was able to continue in his management roles through January 2002.12 The LJM2 partnership was formed in October 1999 with the goal of acquiring assets chiefly owned by Enron. Like Chewco, LJM2 was managed by Fastow and Kopper. To assist with the technicalities of this partnership, LJM2 engaged PricewaterhouseCoopers, LLP and the Chicago-based law firm, Kirkland & Ellis. Enron used the LJM2 partnership to deconsolidate its less-productive assets. These actions generated a 30 percent average annual return for the LJM2 limited-partner investors. The Whitewing partnership, another significant SPE established by Enron, purchased an assortment of power plants, pipelines, and water projects originally purchased by Enron in the mid-1990s that were located in India, Turkey, Spain, and Latin America. The Whitewing partnership was crucial to Enron's move from being an energy provider to becoming a trader of energy contracts. Whitewing was the vehicle through which Enron sold many of its physical energy production assets. 9 Source: \"Who Else is Hiding Debt?\" by David Henry, Businessweek. May 11, 2002. Used with the permission of Bloomberg L.P. Copyright 2014. All rights reserved. 10 Ibid. 11 The Fall of Enron; Enron Lawyer's Qualms Detailed in New Memos. The Los Angeles Times. February 7, 2002. Richard Simon, Edmund Sanders, Walter Hamilton. 12 Fry, Jennifer. \"Low-Profile Partnership Head Stayed on Job until Judge's Order.\" The Washington Post. February 7, 2002. In creating this partnership, Enron quietly guaranteed investors in Whitewing that if Whitewing's assets (transferred from Enron) were sold at a loss, Enron would compensate the investors with shares of Enron common stock. This obligation unknown to Enron's shareholderstotaled $2 billion as of November 2001. Part of the secret guarantee to Whitewing investors surfaced in October 2001, when Enron's credit rating was downgraded by credit agencies. The credit downgrade triggered a requirement that Enron immediately pay $690 million to Whitewing investors. It was when this obligation surfaced that Enron's talks with Dynegy failed. Enron was unable to delay the payment and was forced to disclose the problem, stunning investors and fueling the fire that led to the company's bankruptcy filing only two months later. In addition to these partnerships, Enron created financial instruments called \"Raptors,\" which were backed by Enron stock and were designed to reduce the risks associated with Enron's own investment portfolio. In essence, the Raptors covered potential losses on Enron investments as long as Enron's stock market price continued to do well. Enron also masked debt using complex financial derivative transactions. Taking advantage of accounting rules to account for large loans from Wall Street firms as financial hedges, Enron hid $3.9 billion in debt from 1992 through 2001. At least $2.5 billion of those transactions arose in the three years prior to the Chapter 11 bankruptcy filing. These loans were in addition to the $8 to $10 billion in long and short-term debt that Enron disclosed in its financial reports in the three years leading up to its bankruptcy. Because the loans were accounted for as a hedging activity, Enron was able to explain away what looked like an increase in borrowings, (which would raise red flags for creditors), as hedges for commodity trades, rather than as new debt financing.13 The Complicity of Accounting Standards. Limitations in generally accepted accounting principles (GAAP) are at least partly to blame for Enron executives' ability to hide debt, keeping it off the company's financial statements. These technical accounting standards lay out specific \"bright-line\" rules that read much like the tax or criminal law codes. Some observers of the profession argue that by attempting to outline every accounting situation in detail, standard-setters are trying to create a specific decision model for every imaginable situation. However, very specific rules create an opportunity for clever lawyers, investment bankers, and accountants to create entities and transactions that circumvent the intent of the rules while still conforming to the \"letter of the law.\" In his congressional testimony, Robert K. Herdman, SEC Chief Accountant at the time, discussed the difference between rule and principle-based accounting standards: Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. Examples of rule-based accounting guidance include the accounting for derivatives, employee stock options, and leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.14 In some cases it is clear that Enron neither abode by the spirit nor the letter of these accounting rules (for example, by securing outside SPE investors against possible losses). It also appears that the company's lack of disclosure regarding Fastow's involvement in the SPEs fell short of accounting rule compliance. 13 Altman Daniel. \"Enron Had More Than One Way to Disguise Rapid Rise in Debt,\" The New York Times, February 17, 2002 14 Herdman, Robert K. \"Prepared Witness Testimony: Herdman, Robert K., US House of Representatives. See the following website: http://energycommerce.house.gov/107/hearings/02142002Hearing490/Herdman802.htm These \"loopholes\" allowed Enron executives to keep many of the company's liabilities off the financial statements being audited by Andersen, LLP, as highlighted by the BusinessWeek article summarized in Exhibit 2. Given the alleged abuse of the accounting rules, many asked, \"Where was Andersen, the accounting firm that was to serve as Enron's public 'watchdog,' while Enron allegedly betrayed and misled its shareholders?\" image THE ROLE OF ANDERSEN It is clear that investors and the public believed that Enron executives were not the only parties responsible for the company's collapse. Many fingers also pointed to Enron's auditor, Andersen, LLP, which issued \"clean\" audit opinions on Enron's financial statements from 1997 to 2000 but later agreed that a massive earnings restatement was warranted. Andersen's involvement with Enron ultimately destroyed the accounting firmsomething the global business community would have thought next to impossible prior to 2001. Ironically, Andersen ceased to exist for the same essential reasons Enron failed-the company lost the trust of its clients and other business partners. Andersen in the Beginning Andersen was originally founded as Andersen, Delaney & Co. in 1913 by Arthur Andersen, an accounting professor at Northwestern University in Chicago. By taking tough stands against clients' aggressive accounting treatments, Andersen quickly gained a national reputation as a reliable keeper of the public's trust: In 1915, Andersen took the position that the balance sheet of a steamship-company client had to reflect the costs associated with the sinking of a freighter, even though the sinking occurred after the company's fiscal year had ended but before Andersen had signed off on its financial statements. This marked the first time an auditor had demanded such a degree of disclosure to ensure accurate reporting.15 15 Brown, K., et al., \"Andersen Indictment in Shredding Case Puts Its Future in Doubt as Clients Bolt,\" The Wall Street Journal, March 15, 2000. Although Andersen's storied reputation began with its founder, the accounting firm continued the tradition for years. An oft-repeated phrase at Andersen was, \"there's the Andersen way and the wrong way.\" Another was \"do the right thing.\" Andersen was the only one of the major accounting firms to back reforms in the accounting for pensions in the 1980s, a move opposed by many corporations, including some of its own clients.16 Ironically, prior to the Enron debacle, Andersen had also previously taken an unpopular public stand to toughen the very accounting standards that Enron exploited in using SPEs to keep debt off its balance sheets. Andersen's Loss of Reputation While Andersen previously had been considered the cream of the crop of accounting firms, just prior to the Enron disaster Andersen's reputation suffered from a number of high profile SEC investigations launched against the firm. The firm was investigated for its role in the financial statement audits of Waste Management, Global Crossing, Sunbeam, Qwest Communications, Baptist Foundation of Arizona, and WorldCom. In May 2001, Andersen paid $110 million to settle securities fraud charges stemming from its work at Sunbeam. In June 2001, Andersen entered a no-fault, noadmission-of-guilt plea bargain with the SEC to settle charges of Andersen's audit work on Waste Management, Inc. for $7 million. Andersen later settled with investors of the Baptist Foundation of Arizona for $217 million without admitting fault or guilt (the firm subsequently reneged on the agreement because the firm was in liquidation). Due to this string of negative events and associated publicity, Andersen found its once-applauded reputation for impeccable integrity questioned by a market where integrity, independence, and reputation are the primary attributes affecting demand for a firm's services. Andersen at Enron By 2001, Enron had become one of Andersen's largest clients. Despite the firm's recognition that Enron was a high-risk client, Andersen apparently had difficulty sticking to its guns at Enron. The accounting firm had identified $51 million of misstatements in Enron's financial statements but decided not to require corrections when Enron balked at making the adjustments Andersen proposed. Those adjustments would have decreased Enron's income by about half, from $105 million to $54 million--clearly a material amount-but Andersen gave Enron's financial statements a clean opinion nonetheless.17 Andersen's chief executive, Joseph F. Berardino, testified before the U.S. Congress that, after proposing the $51 million of adjustments to Enron's 1997 results, the accounting firm decided that those adjustments were not material.18 Congressional hearings and the business press allege that Andersen was unable to stand up to Enron because of the conflicts of interest that existed due to large fees and the mix of services Andersen provided to Enron. In 2000, Enron reported that it paid Andersen $52 million$25 million for the financial statement audit work and $27 million for consulting services. Andersen not only performed the external financial statement audit, but also carried out Enron's internal audit function, a relatively common practice in the accounting profession before the Sarbanes-Oxley Act of 2002. Ironically, Enron's 2000 annual report disclosed that one of the major projects Andersen performed in 2000 was to examine and report on management's assertion about the effectiveness of Enron's system of internal controls. Comments by investment billionaire, Warren E. Buffett, summarize the perceived conflict that often arises when auditors receive significant fees from clients: \"Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.\" Buffett continued by quoting an old saying: \"Whose bread I eat, his song I sing.\"19 16 Ibid 17 Hilzenrath, David S., \"Early Warnings of Trouble at Enron.\" The Washington Post. December 30, 2001 See the following website: http://www.washingtonpost.com/wp-dyn/articles/A40094-2001Dec29.html 18 Ibid 19 Hilzenrath, David S., \"Early Warnings of Trouble at Enron.\" The Washington Post. December 30, 2001. See the following website: http://www.washingtonpost.com/wp-dyn/articles/A40094-2001Dec29.html It also appears that Andersen knew about Enron's problems nearly a year before the downfall. According to a February 6, 2001 internal firm e-mail, Andersen considered dropping Enron as a client due to the risky nature of its business practices and its \"aggressive\" structuring of transactions and related entities. The e-mail, which was written by an Andersen partner to David Duncan, partner in charge of the Enron audit, detailed the discussion at an Andersen meeting about the future of the Enron engagement. The Andersen Indictment Although the massive restatements of Enron's financial statements cast serious doubt on Andersen's professional conduct and audit opinions, ultimately it was the destruction of Enron-related documents in October and November 2001 and the March 2002 federal indictment of Andersen that led to the firm's rapid downward spiral. The criminal charge against Andersen related to the obstruction of justice for destroying documents after the federal investigation had begun into the Enron collapse. According to the indictment, Andersen allegedly eliminated potentially incriminating evidence by shredding massive amounts of Enron-related audit workpapers and documents. The government alleged that Andersen partners in Houston were directed by the firm's national office legal counsel in Chicago to shred the documents. The U.S. Justice Department contended that Andersen continued to shred Enron documents after it knew of the SEC investigation, but before a formal subpoena was received by Andersen. The shredding stopped on November 8th when Andersen received the SEC's subpoena for all Enron-related documents. Andersen denied that its corporate counsel recommended such a course of action and assigned the blame for the document destruction to a group of rogue employees in its Houston office seeking to save their own reputations. The evidence is unclear as to exactly who ordered the shredding of the Enron documents or even what documents were shredded. However, central to the Justice Department's indictment was an email forwarded from Nancy Temple, Andersen's corporate counsel in Chicago, to David Duncan, the Houston-based Enron engagement partner. The body of the email states, \"It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions.\"20 The Justice Department argued that Andersen's general counsel's email was a thinly veiled directive from Andersen headquarters to ensure that all Enron-related documents that should have previously been destroyed according to the firm's policy were destroyed. Andersen contended that the infamous Nancy Temple memo simply encouraged adherence to normal engagement documentation policy, including the explicit need to retain documents in certain situations and was never intended to obstruct the government's investigation. However, it is important to understand that once an individual or a firm has reason to believe that a federal investigation is forthcoming, it is considered \"obstruction of justice\" to destroy documents that might serve as evidence, even before an official subpoena is filed. In January 2002, Andersen fired Enron engagement partner David Duncan, for his role in the document shredding activities. Duncan later testified that he did not initially think that what he did was wrong and initially maintained his innocence in interviews with government prosecutors. He even signed a joint defense agreement with Andersen on March 20, 2002. Shortly thereafter, Duncan decided to plead guilty to obstruction of justice charges after \"a lot of soul searching about my intent and what was in my head at the time.\"21 In the obstruction of justice trial against Andersen, Duncan testified for the Federal prosecution, admitting that he ordered the destruction of documents because of the email he received from Andersen's counsel reminding him of the company's document retention policy. He also testified that he wanted to get rid of documents that could be used by prosecuting attorneys and SEC investigators.22 20 Temple, Nancy A. Email to Michael C. Odom, \"Document Retention Policy\" October 12, 2001. 21 Beltran, Luisa, Jennifer Rogers, and Brett Gering. \"Duncan: I Changed My Mind.\" cnnfn.com. May 15, 2002. See the following website: http://money.cnn.com/2002/05/15ews/companies/andersen/index.htm 22 Weil, Jonathan, Alexei Barrionuevo. \"Duncan Says Fears of Lawsuits Drove Shredding.\" The Wall Street Journal. New York. May 15, 2002. Although convicted of obstruction of justice, Andersen continued to pursue legal recourse by appealing the verdict to the Fifth U.S. Circuit Court of Appeals in New Orleans. The Fifth Court refused to overturn the verdict, so Andersen appealed to the U.S. Supreme Court. The firm claimed that the trial judge \"gave jurors poor guidelines for determining the company's wrongdoing in shredding documents related to Enron Corp.\"23 The Supreme Court agreed with Andersen and on May 31, 2005, the Court overturned the lower court's decision. Sadly, the Supreme Court's decision had little effect on the future of Arthur Andersen. By 2005, Andersen employed only 200 people, most of whom were involved in fighting the remaining lawsuits against the firm and managing its few remaining assets. However, the ruling may have helped individual Arthur Andersen partners in civil suits named against them. The ruling also may have made it more difficult for the government to pursue future cases alleging obstruction of justice against individuals and companies. The End of Andersen In the early months of 2002, Andersen pursued the possibility of being acquired by one of the other four Big-5 accounting firms: PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte & Touche. The most seriously considered possibility was an acquisition of the entire collection of Andersen partnerships by Deloitte & Touche, but the talks fell through only hours before an official announcement of the acquisition was scheduled to take place. The biggest barrier to an acquisition of Andersen apparently centered around fears that an acquirer would assume Andersen's liabilities and responsibility for settling future Enron-related lawsuits. In the aftermath of Enron's collapse, Andersen began to unravel quickly, losing over 400 publicly traded clients by June 2002including many high-profile clients with which Andersen had enjoyed long relationships.24 The list of former clients includes Delta Air Lines, FedEx, Merck, SunTrust Banks, Abbott Laboratories, Freddie Mac, and Valero Energy Corp. In addition to losing clients, Andersen lost many of its global practice units to rival accounting and consulting firms, and agreed to sell a major portion of its consulting business to KPMG consulting for $284 million as well as most of its tax advisory practice to Deloitte & Touche. On March 26, 2002, Joseph Berardino, CEO of Andersen Worldwide, resigned as CEO, but remained with the firm. In an attempt to salvage the firm, Andersen hired former Federal Reserve chairman, Paul Volcker, to head an oversight board to make recommendations to rebuild Andersen. Mr. Volcker and the board recommended that Andersen split its consulting and auditing businesses and that Volcker and the seven-member board take over Andersen in order to realign firm management and to implement reforms. The success of the oversight board depended on Andersen's ability to stave off criminal charges and settle lawsuits related to its work on Enron. Because Andersen failed to persuade the justice department to withdraw its charges, Mr. Volcker suspended the board's efforts to rebuild the firm in April 2002. Andersen faced an uphill battle in its fight against the federal prosecutors' charges of a felony count for obstruction of justice, regardless of the trial's outcome. Never in the 215-year history of the U.S. financial system has a major financialservices firm survived a criminal indictment, and Andersen would not likely have been the first, even had the firm not actually been convicted of a single count of obstruction of justice on June 15, 2002. Andersen, along with many others, accused the justice department of a gross abuse of governmental power, and announced that it would appeal the conviction. However, the firm ceased to audit publicly held clients by August 31, 2002. On May 31, 2005, the U.S. Supreme Court unanimously reversed Andersen's convictions. The main reason given for the reversal was that the instructions given to the jury \"failed to convey properly the elements of 'corrupt persuasion'.\"25 23 Bravin, Jess. \"Justices Overturn Criminal Verdict in Andersen Case.\" The Wall Street Journal. New York. May 31, 2005. 24 Luke, Robert. \"Andersen Explores Office Shifts in Atlanta.\" The Atlanta Journal - Constitution, May 18, 2002. 25 Arthur Andersen LLP v. United States, 544 U.S. 696 (2005). 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] In your own words, summarize how Enron used SPEs to hide large amounts of company debt. [3] (a) What are the responsibilities of a company's board of directors? (b) Could the board of directors at Enron especially the audit committeehave 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? [4] Explain how \"rule-based\" accounting standards differ from \"principle-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 \"principle-based\" standards. Are there dangers in removing \"bright-line\" rules? What difficulties might be associated with such a change? [5] 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 is your view, and why? [6] 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 affect your career. What are the possible consequences when others question your integrity? What can you do to preserve your reputation throughout your career? [7] 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? [8] Why do audit partners struggle with making tough accounting decisions that may be contrary to their client's position on an 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? CASE 4.2 Comptronix Corporation Identifying Inherent Risk and Control Risk Factors MARK S. BEASLEY FRANK A. BUCKLESS STEVEN M. GLOVER DOUGLAS F. PRAWITT LEARNING OBJECTIVES After completing and discussing this case you should be able to [1] Understand how managers can fraudulently manipulate financial statements [2] Recognize key inherent risk factors that increase the potential for financial reporting fraud [3] Recognize key control risk factors that increase the potential for financial reporting fraud [4] Understand the importance of effective corporate governance for overseeing the actions of top executives [5] Identify auditor responsibilities for addressing the risk of management override of internal control INTRODUCTION All appeared well at Comptronix Corporation, a Guntersville, Alabama based electronics company, until word hit the streets November 25, 1992 that there had been a fraud. When reports surfaced that three of the company's top executives had inflated company earnings for the past three years, the company's stock price plummeted 72% in one day, closing at $61/8 a share down from the previous day's closing at $22 a share.1 The Securities and Exchange Commission's (SEC) subsequent investigation determined that Comptronix's chief executive officer (CEO), chief operating officer (COO), and controller/treasurer all colluded to overstate assets and profits by recording fictitious transactions. The three executives overrode existing internal controls so that others at Comptronix would not discover the scheme. All this unraveled when the executives surprisingly confessed to the company's board that they had improperly valued assets, overstated sales, and understated expenses. The three were immediately suspended from their duties. Within days, class action lawsuits were filed against the company and the three executives. Immediately, the company's board of directors formed a special committee to investigate the alleged financial reporting fraud, an interim executive team stepped in to take charge, and Arthur Andersen, LLP was hired to conduct a detailed fraud investigation. Residents of the small Alabama town were stunned. How could a fraud occur so close to home? Were there any signs of trouble that were ignored? 1 \"Company's profit data were false,\" The New York Times, November 26, 1992, D:1. The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation. BACKGROUND Comptronix based its principal operations in Guntersville, a town of approximately 7,000 residents located about 35 miles southeast of Huntsville, Alabama. The company provided contract manufacturing services to original equipment manufacturers in the electronics industry. Its primary product was circuit boards for personal computers and medical equipment. Neighboring Huntsville's heavy presence in the electronics industry provided Comptronix a local base of customers for its circuit boards. In addition to the Alabama facility, the company also maintained manufacturing facilities in San Jose, California, and Colorado Springs, Colorado. In total, Comptronix employed about 1800 people at the three locations and was one of the largest employers in Guntersville. The company was formed in the early 1980s by individuals who met while working in the electronics industry in nearby Huntsville. Three of those founders became senior officers of the company. William J. Hebding became Comptronix's chairman and CEO, Allen L. Shifflett became Comptronix's president and COO, and J. Paul Medlin served as the controller and treasurer. Prior to creating Comptronix, all three men worked at SCI Systems, a booming electronics maker. Mr. Hebding joined SCI Systems in the mid-1970s to assist the chief financial officer (CFO). While in that role, he met Mr. Shifflett, the SCI Systems operations manager. Later, when Mr. Hebding become SCI Systems' CFO, he hired Mr. Medlin to assist him. Along with a few other individuals working at SCI Systems, these three men together formed Comptronix in late 1983 and early 1984.2 The local townspeople in Guntersville were excited to attract the startup company to the local area. The city enticed Comptronix by providing it with an empty knitting mill in town. As an additional incentive, a local bank offered Comptronix an attractive credit arrangement. Comptronix in turn appointed the local banker to its board of directors. Town business leaders were excited to have new employment opportunities and looked forward to a boost to the local economy. The early years were difficult, with Comptronix suffering losses through 1986. Local enthusiasm for the company attracted investments from venture capitalists. One of those investors included a partner in the Massey Burch Investment Group, a venture capital firm located in Nashville, Tennessee, just more than 100 miles to the north. The infusion of venture capital allowed Comptronix to generate strong sales and profit growth during 1987 and 1988. Based on this strong performance, senior management took the company's stock public in 1989, initially selling Comptronix stock at $5 a share in the over-the-counter markets.3 THE ACCOUNTING SCHEME4 According to the SEC's investigation, the fraud began soon after the company went public in 1989 and was directed by top company executives. Mr. Hebding as chairman and CEO, Mr. Shifflett as president and COO, and Mr. Medlin as controller and treasurer used their positions of power and influence to manipulate the financial statements issued from early 1989 through November 1992. They began their fraud scheme by first manipulating the quarterly statements filed with the SEC during 1989. They misstated those statements by inappropriately transferring certain costs from cost of goods sold into inventory accounts. This technique allowed them to overstate inventory and understate quarterly costs of goods sold, which in turn overstated gross margin and net income for the period. The three executives made monthly manual journal entries, with the largest adjustments occurring just at quarter's end. Some allege that the fraud was motivated by the loss of a key customer in 1989 to the three executives' former employer, SCI. The executives were successful in manipulating quarterly financial statements partially because their quarterly filings were unaudited. However, as fiscal year 1989 came to a close, the executives grew wary that the company's external auditors might discover the fraud when auditing the December 31, 1989, year-end financial statements. To hide the manipulations from their auditors, they devised a plan to cover up the inappropriate transfer of costs. They decided to remove the transferred costs from the inventory account just before year-end, because they feared the auditors would closely examine the inventory account as of December 31, 1989, as part of their year-end testing. Thus, they transferred the costs back to cost of goods sold. However, for each transfer back to cost of goods sold, the fraud team booked a fictitious sale of products and a related fictitious accounts receivable. That, in turn, overstated revenues and receivables. 2 \"Comptronix fall from grace: Clues were there, Alabama locals saw lavish spending, feud,\" The Atlanta Journal and Constitution, December 5, 1992, D:1. 3 See footnote 2. 4 Accounting and Auditing Enforcement Release No. 543, Commerce Clearing House, Inc., Chicago. The net effect of these activities was that interim financial statements included understated cost of goods sold and overstated inventories, while the annual financial statements contained overstated sales and receivables. Once they had tasted success in their manipulations of year-end sales and receivables, they later began recording fictitious quarterly sales in a similar fashion. To convince the auditors that the fictitious sales and receivables were legitimate, the three company executives recorded cash payments to Comptronix from the bogus customer accounts. In order to do this, they developed a relatively complex fraud scheme. First, they recorded fictitious purchases of equipment on account. That, in turn, overstated equipment and accounts payable. Then, Hebding, the chairman and CEO, and Medlin, the controller and treasurer, cut checks to the bogus accounts payable vendors associated with the fake purchases of equipment. But they did not mail the checks. Rather, they deposited them in Comptronix's disbursement checking account and recorded the phony payments as debits against the bogus accounts payable and credits against the bogus receivables. This accounting scheme allowed the company to eliminate the bogus payables and receivables, while still retaining the fictitious sales and equipment on the income statement and balance sheet, respectively. This scheme continued over four years, stretching from the beginning of 1989 to November 1992, when the three executives confessed to their manipulations. The SEC investigation noted that the Form 10-K filings for the years ended December 31, 1989, 1990, and 1991 were materially misstated as follows: image The executives' fraud scheme helped the company avoid reporting net losses in each of the three years, with the amount of the fraud increasing in each of the three years affected.5 The fraud scheme also inflated the balance sheet by overstating property, plant, and equipment and stockholders' equity. By the end of 1991, property, plant, and equipment was overstated by over 90%, with stockholders' equity overstated by 111%. 5 Information about fiscal year 1992 was not reported because the fraud was disclosed before that fiscal year ended. THE COMPANY'S INTERNAL CONTROLS6 The three executives were able to perpetrate the fraud by bypassing the existing accounting system. They avoided making the standard entries in the sales and purchases journals as required by the existing internal control, and recorded the fictitious entries manually. Other employees were excluded from the manipulations to minimize the likelihood of the fraud being discovered. According to the SEC's summary of the investigation, Comptronix employees normally created a fairly extensive paper trail for equipment purchases, including purchase orders and receiving reports. However, none of these documents were created for the bogus purchases. Approval for cash disbursements was typically granted once the related purchase order, receiving report, and vendor invoice had been matched. Unfortunately, Mr. Shifflett or Mr. Medlin could approve payments based solely on an invoice. As a result, the fraud team was able to bypass internal controls over cash disbursements. They simply showed a fictitious vendor invoice to an accounts payable clerk, who in turn prepared a check for the amount indicated on the invoice. Internal controls were also insufficient to detect the manipulation of sales and accounts receivable. Typically, a shipping department clerk would enter the customer order number and the quantity to be shipped to the customer into the computerized accounting system. The accounting system then automatically produced a shipping document and a sales invoice. The merchandise was shipped to the customer, along with the invoice and shipping document. Once again, Mr. Medlin, as controller and treasurer, had the ability to access the shipping department system. This allowed him to enter bogus sales into the accounting system. He then made sure to destroy all shipping documents and sales invoices generated by the accounting system to keep them from being mailed to the related customers. The subsequent posting of bogus payments on the customers' accounts was posted personally by Mr. Medlin to the cash receipts journal and the accounts receivable subsidiary ledger. The fraud scheme was obviously directed from the top ranks of the organization. Like most companies, the senior executives at Comptronix directed company operations on a day-to-day basis, with only periodic oversight from the company's board of directors. The March 1992 proxy statement to shareholders noted that the Comptronix board of directors consisted of seven individuals, including Mr. Hebding who served as board chairman. Of those seven individuals serving on the board, two individuals, Mr. Hebding, chairman and CEO and Mr. Shifflett, president and COO, represented management on the board. Thus, 28.6% of the board consisted of inside directors. The remaining five directors were not employed by Comptronix. However, two of those five directors had close affiliations with management. One served as the company's outside general legal counsel and the other served as vice president of manufacturing for a significant customer of Comptronix. Directors with these kinds of close affiliations with company management are frequently referred to as \"gray\" directors due to their perceived lack of objectivity. The three remaining \"outside\" directors had no apparent affiliations with company management. One of the remaining outside directors was a partner in the venture capital firm that owned 574,978 shares (5.3%) of Comptronix's common stock. That director was previously a partner in a Nashville law firm and was currently serving on two other corporate boards. A second outside director was the vice chairman and CEO of the local bank originally loaning money to the company. He also served as chairman of the board of another local bank in a nearby town. The third outside director was president of an international components supplier based in Taiwan. All of the board members had served on the Comptronix board since 1984, except for the venture capital partner who joined the board in 1988 and the president of the key customer who joined the board in 1990. Each director received an annual retainer of $3,000 plus a fee of $750 for each meeting attended. The company also granted each director an option to purchase 5,000 shares of common stock at an exercise price that equaled the market price of the stock on the date that the option was granted. 6 See footnote 4. The board met four times during 1991. The board had an audit committee that was charged with recommending outside auditors, reviewing the scope of the audit engagement, consulting with the external auditors, reviewing the results of the audit examination, and acting as a liaison between the board and the internal auditors. The audit committee was also charged with reviewing various company policies, including those related to accounting and internal control matters. Two outside directors and one gray director made up the three-member audit committee. One of those members was an attorney, and the other two served as president and CEO of the companies where they were employed. There was no indication of whether any of these individuals had accounting or financial reporting backgrounds. The audit committee met twice during 1991. MANAGEMENT BACKGROUND The March 1992 proxy statement provided the following background information about the three executives committing the fraud: Mr. Hedding, Mr. Shifflett, and Mr. Medlin. William J. Hebding served as the Comptronix Chairman and CEO. He was responsible for sales and marketing, finance, and general management of the company. He also served as a director from 1984 until 1992 when the fraud was disclosed. He was the single largest shareholder of Comptronix common stock by beneficially owning 6.7% (720,438 shares) of Comptronix common stock as of March 2, 1992. Before joining Comptronix, Mr. Hebding worked for SCI Systems Inc. from 1974 until October 1983. He held the title of treasurer and CFO at SCI from December 1976 to October 1983. In October 1983, Mr. Hebding left SCI to form Comptronix. He graduated from the University of North Alabama with a degree in accounting and was a certified public accountant. Mr. Hebding's 1991 cash compensation totaled $187,996. Allen L. Shifflett served as Comptronix's president and COO, and was responsible for manufacturing, engineering, and programs operations. He also served as a director from 1984 until 1992 when the fraud unfolded. He owned 4% (433,496 shares) of Comptronix common stock as of March 2, 1992. Like Mr. Hebding, he joined the company after previously being employed at SCI as a plant manager and manufacturing manager from October 1981 until April 1984 when he left to help form Comptronix. Mr. Shifflett obtained his B.S. degree in industrial engineering from Virginia Polytechnic Institute. Mr. Shifflett's 1991 cash compensation totaled $162,996. Paul Medlin served as Comptronix's controller and treasurer. He also previously worked at SCI, as Mr. Hebding's assistant after graduating from the University of Alabama. Mr. Medlin did not serve on the Comptronix board. The 1992 proxy noted that the board of directors approved a company loan to him for $79,250 on November 1, 1989, to provide funds for him to repurchase certain shares of common stock. The loan, which was repaid on May 7, 1991, bore interest at an a