Enron: Accounting expertise to the rescue

Steve Salterio Ph.D. CA Associate Professor of Assurance School of Accountancy

with the assistance of the following students: Jill Considine Alan Jin Amy Kane Matt Martorello

The Story Line

What was Enron? Why did Enron come to prominence? What happened at Enron? What were the accounting warning signs? What does accounting research say about why they were ignored? What are the organizational impediments to leveraging expertise?

Brief History of Enron

1985 - Houston Natural Gas merges with

InterNorth, a natural gas company based in Omaha, Neb., to form an interstate and intrastate gas pipeline company with 37,000 miles of pipe.

1986 - Kenneth Lay is appointed 1989 - Over the years, the company becomes
the largest natural gas merchant in North America and the United Kingdom

chairman and chief executive officer.

Brief History of Enron

Aug. 2000 - Shares hit an all-time high of

$90.56

Dec. 2000 Enron announces Jeffrey

Skilling (President) will take over as CEO.

Aug. 14, 2001 - Skilling resigns; the

company attributed his departure to personal reasons.

Brief History of Enron

Aug. 22, 2001 Sherron Watkins, a vice president, writes to CEO Lay, warning him that the company might "implode in a wave of accounting scandals."

Brief History of Enron

Oct. 12, 2001 David Duncan, Andersens audit

partner in charge of Enron, says Andersen's lawyers had suddenly began emphasizing Andersen's policy allowing destruction of unneeded documents.

Duncan organizes a two-week document destruction effort to discard many records.

Oct. 16, 2001 - Enron reports its first quarterly loss

in over four years after taking charges of $1 billion on poorly performing businesses.

Where did the billion go? The Raptors partnerships

Enron gave a related party called Raptor 3.7 million shares of Enron common stock Enron received $1.2 billion in notes receivables

IOUs from a company Enron owned

Enron called this income! Andersens Duncan accepts this accounting in 2000 and 2001 over the objections of Andersens technical accounting partners

Cash

3% Cash

Asset

Guarantee

Cash

Asset < 3% Cash Guarantee

Transactions

Source: WSJ, 1/21/02

Then what happened?

12-2-01 Enron files Ch. 11 bankruptcy 01-09-02 -- Justice Department opens a criminal investigation 01-10-02 Andersen admits Houston office shredded documents 01-17-02 Enron fires Andersen 01-25-02 -- Enron Vice Chairman commits suicide 02-02 David Duncan, Andersen auditor in charge of Enron audit, is charged with obstruction of justice

Then what happened?

03-02 Andersen firm is charged with obstruction of justice 04-02 David Duncan plea bargains for a reduced sentence in return for implicating the entire Andersen firm in the obstruction of justice charge 06-02 Andersen is found guilty of obstruction of justice and ends the 89 year practice of auditing.

Dispelling Accounting Myths

1. Auditors create financial statements. WRONG 2. There is a comprehensive accounting rule book you just have to look up the right answer. WRONG 3. There is no judgment in accounting. WRONG 4. The auditor is a independent third party. IT DEPENDS HOW YOU LOOK AT IT

How do auditors deal with difficult accounting issues?

By definition, you cant look up a rule Consult

others on the audit team others in your office others auditing in the same industry in other offices

All this consultation is mediated by computer data bases, electronic mail and expert systems that collect data just in case Finally consult national office technical gurus

Accounting research: Based on Naturalistic Decision Making Theory

Situation assessment stage Searching data bases for prior similar cases where the facts are roughly the same to current case

External data bases Firm specific data bases

Can be considered an information search task Two units:

Central Research Unit (Salterio 1994, 1996) Accounting Consultation Unit (Salterio and Denham 1997)

Accounting Expertise Measures: CRUs

Examine managers who interface with computer system to advise audit partners about appropriate accounting policies. Effectiveness measures (Table 2, Salterio 1996) over six month tour of duty managers

Increase number of on point findings from 4.26 per case to 7.63 per case (66% increase) Review time (e.g. quality control) decreases 0.93 to 0.68 (33% decrease) Number of reviewer enquiries decreases

Accounting Expertise Measures: CRUs

Efficiency measures (Table 3)

Time employed by managers to

Search computer data bases on line decreased by 2.5 minutes Total time to perform research reduced by .7 hour More complex search using more Boolean operators per search Total number of precedents increase 12.5 Average number of precedents increase 3.3

Search strategy of managers

Number of potential precedents examined

CRU Research conclusions

Salterio (1996) shows that in searching for precedents used by local offices there is a significant expertise effect for those located in the Central Research Unit for six months Think about the amount of expertise gained through years of national office residency that partners in the Accounting Consultation Unit gain

Accounting Consultation Units

Salterio (1994, 1996) done in US Salterio and Denham (1997) done in Canada but strong analogy can be made to US setting (and most of the research was repeated in US environment) Was not allowed to study Andersen, the only member of the then Big 6 firms to refuse to participate

Organization Memory Theory

OM is composed of the individual memories of firm members plus the firms standard operating procedures (SOPs), organizational structure and organizational culture as well as any internal and /or external archives (data bases) SOPs are embedded both in human routines as well as computer systems

OM Theory: Discovering organizations

2 Canadian firms (and all US firms studied) are classified as discovering organizations:

Ability to scan the environment

Resources both people and data high

Customer focus

Audit office client is focus hence understanding business reason for issue is key
Informal and formal searches made utilizing all resources available

Search processes employed

Goal to come up with best answer that complies with GAAP

OM Theory: Discovering organizations

Firm wide peer review looks for:

Consultations that should have been made even if not mandatory by firm policy. Consistency across clients was gold standard

Emphasis on early consultation

Standard operating policies

An objection by the ACU partner to the accounting desired by the local office partner (and called for by the client management) must be reported on and judged by the senior managers of the audit firm. Almost never was an ACU position overruled. Remember, the only Big 6 firm I was unable to get assess to was Andersen (see 3rd page (674) of Salterio and Denham (1997)).

Andersens Professional Standards Group

Until roughly 1990 Andersen had followed similar practices to other Big 6 firms

A very strong and powerful national office technical group If anything, they were the most conservative auditors of all of the Big 6 In early 1990s Andersen changed its policy to help local office partners obtain new business

Indeed it was a selling point at Andersen

Andersens Professional Standards Group Objects to Enron

1999 Carl Bass repeatedly objects to early Enron accounting for the various partners (i.e. the Raptors)

his objections continued in 2000

His continual objections caused Duncan (at the behest of Enron) to ask Andersens national office to remove Bass. National office accepted his request and transferred Bass.

Andersens SOP Limits Professional Standards Group

Unlike the other firms, the local office partner (i.e. Duncan) could overrule the technical partner (i.e. Bass) by reference to the practice director in his own office. Overruling does not have to be referred to Andersens CEO and executives as in other audit firms. Business Week highlighted this practice difference in its coverage of Enron in early 2002

If Andersen had followed others SOPs?

Senior Andersen managers would have been in the decision making loop in 1999. Rarely do senior audit firm managers overrule technical partners in other firms. Enrons initial rogue accounting could have been stopped in 1999!!!! Lack of expertise was not the reason Andersen failed in its audit responsibility!!!!

Could Andersen have prevented Enrons implosion?

Maybe not, but the accounting might not have been used to prolong the life of Enron. Enron might have had difficulty surviving if the correct accounting had been done in 1999. Early discovery could have prevented many of the transactions that were entered into in 2000 and 2001 that caused the vast majority of the losses.

Academic research to the rescue???

Well maybe not, . . . . . But, what if I had been able to get into Andersen in 1996-97? Would they have listened to the finding that they were an outlier among their peers? Some interesting evidence:

In Canada, one of the conditioned learning firms moved to the discovery mode after my research was made public. The mixed firm has also moved strongly to a discovery mode.

Leveraging expertise

Andersen had:

state of the art computer technology, computer systems and people to operate and develop the technology cutting edge technology which it applied to both manage the individual audit and to manage the firm as a whole. some of the best minds in accounting industry were located in their Professional Standards Group and were supported with state of the art technological and systems resources

Leveraging expertise

but the firms organizational memory was set up in such a fashion that the experts and their support systems were used to support marketing the firm instead of ensuring the highest quality accounting experts, expert systems and technology without assess to managerial power to prevail can result in the same decisions that would be made in the absence of such expertise.