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Instructor’s Manual, Chapter 2 1______________________________________________________________________________

Business & Professional Ethics for Directors, Executives &

Accountants, 5e,

Leonard J. Brooks and Paul Dunn

South-Western, Cengage Learning, Mason Ohio, 2010

Instructor’s Manual

Chapter 2 Enron Events Motivate Governance & Ethics Reform

Learning objectives ………………………………………………………2Possible teaching approaches, using cases and readings…………………3Answers to questions for discussion…………………………………….. 4Case Notes………………………………………………………………. 7Multiple Choice Questions………………………………………………23

PowerPoints are in a separate file at www.cengage.com/accounting/brooks

Business & Professional Ethics for Directors, Executives & Accountants, 5e, L.J. Brooks & P. Dunn, Cengage Learning, 2010

http://www.cengage.com/accounting/brooks


COMMENTARY ON CHAPTER 2: GOVERNANCE, ACCOUNTING AND AUDITING, POST-ENRON_____________________________________________________________________________

Learning Objectives

Chapter 2 is designed to review the Enron, Arthur Andersen and WorldCom fiascoes to reveal:

How fraudulent transaction were arranged and carried out, How flaws in the following permitted and facilitated these transactions:

Focus of accountability, Governance perspective, understanding and mechanisms including the corporate

culture involved, Motivation systems, including remuneration, stock option and bonus systems Understanding of roles, risks and mandates for:

Directors and executives Professional accountants Lawyers Bankers who facilitated these transactions

What the impacts have been and will be on these corporate and professional participants due to: Reactions by government and regulatory agencies The Sarbanes-Oxley Act of 2002 Resulting SEC, NYSE and OSC securities and governance regulations

The New Framework for Accountability and Governance Future developments that are likely

In addition, two other cases – involving Waste Management, Inc. and Sunbeam Corporation - are presented that further illustrate these patterns of flaws in Arthur Andersen’s approach and clients.

Important learning points to be developed include:

An understanding of: what happened and what permitted it to happen appropriate roles to be played by directors, external and internal professional

accountants, lawyers, executives, and so on appropriate mandates to be accepted by corporations (including banks) and

professionals based upon stakeholder expectations the new expectations for accountability and governance to facilitate that

accountability for both corporations and the accounting profession, including the changes required by the Sarbanes-Oxley Act and introduced by the SEC and how these will have a ripple affect around the world.

how formal risk management programs might have raided the potential ethics problems that arose

how Arthur Andersen’s demise changed the probability and cost impact of a “franchise risk” (one that threatens to end or curtail an operating mandate)



likely future developments appropriate safeguards to avoid situations arising if the following assumptions

turned out to be false. How and why the following assumptions turned out to be false:

People can be trusted to act honestly without follow-up Dishonesty in some aspects of corporate activity will not affect basic overall

integrity or accountability Incentive compensation schemes are good enough to cause employees to act in

the best interests of shareholders (and therefore stakeholders) (i.e. agents will be free of moral hazards)

The Board of Directors: would be told the truth by management, lawyers and professional accountants understood why policies and a system of governance/internal controls that

ensured compliance was necessary understood what the system of governance/internal should be and how it

should work, including the role of the internal auditor could rely upon the system of governance/internal controls without follow-up

or review. Ethical concerns of whistleblowers would be reported and acted upon by

management and/or brought to attention of the Board Making quarterly profits was all that mattered, and would lead to sustained

success

Possible teaching approaches, using cases and readings

My approach to the material in this chapter is as follows:

Students should read the chapter in advance, but unless they are senior accounting students they should be told not to slave over the accounting details.

I start with a short overview discussion on governance to get the students to consider the role and responsibilities of directors and of executives, as well as of external auditors and lawyers

Then I ask the students to assume they are Enron Board members and ask themselves what questions they should be asking as I present overheads that lead the students through the Enron, Arthur Andersen and WorldCom material including the bare bones of questionable acts such as those with SPEs.

I continually challenge the students as to what they would ask, and why the Enron Board didn’t. For example:

did they understand Enron’s business model and where the profits were coming from? It was from the wholesale division, and mostly from the Special Purpose Entities (SPEs)

how many SPEs existed and why? It was in the thousands!! Why didn’t they know about the incredibly high stock option payments being made? Why didn’t more whistleblowers come forward, and why didn’t their concerns reach

the board? What could motivate the fraudulent behavior by Enron executives? Greed – see the



stock option payouts and SPE guarantees, both of which required Enron stock not to fall.

Was it OK for the banks to facilitate the Prepaid transactions when they knew the transactions had no economic substance?

Were Enron’s tax avoidance schemes OK? Will there be fallout for the advisors?

I then move on to discuss the Arthur Andersen case and its impact on the accounting profession.

I review the WorldCom case show how it galvanized action in the U.S. Congress and Senate leading to SOX.

Finally, I review the impacts of SOX on corporate accountability and governance, and well as on the accounting profession.

PowerPoints are available on my website.

Answers to Questions for Discussion

The following questions are posed at the end of the chapter.

1. What were the common aspects that were necessary for the Enron and WorldCom debacles to occur?

In both cases, there was a dominant CEO who also controlled the Board of Directors. The Chair of the Board did not serve as an effective watchdog over the CEOs activities. In addition, senior financial officers were actively engaged in the manipulation of earnings and assets, and the siphoning off of funds for personal use, all to defraud the company. In each case, company policies and related internal controls of the company were suspended or over-ridden, and the Board was too trusting or too ignorant to ask the right questions. External auditors (Arthur Andersen in both cases) were willing to go along with manipulative entries and overstatements presumably to retain lucrative audit clients and consulting assignments. In so doing, they put aside the interests of the investing public and jeopardized pensions and employees’ interests. Finally, directors were apparently unaware of mounting problems because they were kept in the dark, and no whistle-blowers concerns were brought to them.

2. What actions by directors, executives and professional accountants could have prevented the Enron and WorldCom debacles?

Directors should have reviewed policies for conflicts of interest and followed up on compliance with them using reports from internal audit and other sources. As a normal practice, they should have reviewed payments to employees and directors for stock options and other items for reasonability. Also they should have taken steps to create and ensure an ethical corporate culture, complete with a protected whistle-blowing mechanism. Executives could have spoken directly to Board members, or to the media, or used the False Claims Act – see Singer article. Professional accountants could have done the same, plus reported to the Audit Committee of the board, or to Arthur Andersen in writing. Arthur Andersen, of course, should have been more vigilant on SPE transactions, and should have refused to allow manipulative transactions without



qualification of the audit opinion. They should have reported fully to the Audit Committee. In addition, they should have had more effective conflict of interest rules, and should not have permitted lure of revenue generation to overshadow their duty to the public interest.

3. Was the enactment of the Sarbanes-Oxley Act (SOX) necessary? Why or why not?I would say “yes” because the following patterns were too entrenched to be altered quickly without SOX, and the lack of credibility of and trust in the capital markets, and in turn in corporate accountability and governance, demanded a quick remedy:

Manipulation of financial reports to “smooth” earnings Enormous remuneration for top executives, particularly with stock options Lack of effective governance by Boards of Directors, due to:

Lack of understanding Failure to accept responsibility Lack of competence

Lack of effective legal penalties for executive and director malfeasance Rampant conflicts of interest in the public accounting profession Failure of public accounting profession to serve the public interest

The negative side could be argued – that the market should be allowed to self-correct, but the correction would be slow, and the players would be reluctant to give up their positions of advantage. In the end, self-regulation produced the debacle, so far-reaching, quick readjustments would be an unlikely possibility.

4. What are the three most important improvements in the governance structure that could result from the SOX?

It will take some time to know for sure, but the following are likely to be high on the list: Requiring directors on key committees (audit and nominating) to be

independent and competent Establishing direct criminal liability on the part of the CEO and CFO for

manipulations and/or failure to have appropriate control systems in place who must sign the quarterly financial reports asserting to both

Enhanced independence of external auditors Ensuring that the Audit Committee has unfettered access to auditors and their

discussions with management Ensuring that whistleblowers have a path to the Audit Committee

5. What were the common elements in Arthur Andersen’s approach that appeared to allow the disasters at Enron, WorldCom, Waste management, and Sunbeam?

Within Arthur Andersen, the audit partner responsible for each audit had the power to veto or ignore the recommendations of the quality control partner. Consequently, the ongoing pressure for more audit and consulting revenue (and take-home remuneration particularly for the audit partner) appears to have caused the audit partner in charge at each client cited to ignore warnings that could have prevented manipulations and the disasters. Pressure to retain and enhance revenue was also exerted by those managing the practice.



6. What is wrong with Enron’s banks financing transactions they knew were without economic substance?

With hindsight, Enron’s banks should have realized that they were becoming accessories to the crime of misleading investors. If there was no legitimate financial purpose, then they were facilitating something else. In the future, they will be more careful in assessing their mandates and why they are in some business deals. As articulated in the chapter, the banks have paid huge fines for aiding and abetting in the Enron fraud, and will be stiffening up their due diligence protocols in the future.

7. How should Boards of Directors change incentive remuneration schemes for executives to lessen the risk of motivating executives to risk manipulations to enrich themselves?

There should be less emphasis on short-term performance and on stock options where their value depends upon stock price rather than fundamental indicators of performance that are less susceptible to manipulation. Deferred payouts, concentration on cash payouts, remuneration schemes that have negative provisions for poor performance, and constant review and readjustment are all good ideas for a board to consider. Finally, the Compensation Committee of the Board should be independent of management so that decisions can be free of bias.

8. What lessons should be learned from reviewing the events described in this chapter? See the above list of learning points and false assumptions for Chapter 2.



ENRON DEBACLE – ENRON’S QUESTIONABLE TRANSACTIONS___________________________________________

What this case has to offer

The Enron Debacle is the icon for massive fraud allowed by failure of the company’s governance system and the conflicted interests of its executives, auditors and lawyers. It precipitated the loss of credibility and trust in financial markets and corporate governance and accountability that ultimately led to reform of corporate governance and accountability, and of the accounting profession, through the Sarbanes-Oxley Act of 2002. It is a case that all businesspeople and professional accountants should be familiar with and understand.

Teaching suggestions

I use the PowerPoint slides on my website for instructors. First, I set up the topic of governance; second, I use “Enron Affair” to review the important elements of the case; and finally I use “Enron Debrief” to debrief, and review the rest of the material in Chapter 2 and models used in the course.

If you refer to the “Enron Affair” PowerPoints, you will see the order I have found to be very engaging and successful. I ask the audience to assume the role of a member of the Board of Directors, and then I challenge them throughout the case discussion with the following questions:

What is your role as a Board member? What questions should you ask? Why didn’t the Enron Board ask those questions?

Depending on the audience (non-accounting or accounting), I review less or more of the details of the fraudulent transactions. My PowerPoints provide a basic set. The key is to reveal enough that all audiences understand:

Basic governance structure and roles of the Board, executives, professional accountants and lawyers, as well company policy (particularly on conflicts of interest) and compliance systems.

What a Special Purpose Entity (SPE) is, the operation of the 3% rule for accounting for transactions, and how income, assets and liabilities could be manipulated using it.

How and by whom the basic frauds were committed.



The motivation for the frauds. Where the money went. What the impact of manipulation was on Enron’s financial reports, and the investing

public. How the governance system was short-circuited – see overheads. The role of an ethical or unethical corporate culture in preventing or abetting fraud. Why whistle-blowing is important. What Arthur Andersen contributed. What the banks contributed by facilitating the SPE transactions? How the Sarbanes-Oxley (SOX) Act arose. What changes SOX originated. How ethics risk management can help.

Discussion of ethical issues

The following questions are presented in the text for discussion of the significant issues raised in the Enron case:

1. Which segment of its operations got Enron into difficulties?Wholesale services was the segment where most of the manipulation went on. See Enron PowerPoint (PPT) 6 for a breakdown of the relative profitability (IBIT) of Enron’s divisions.

2. How were profits made in that segment of operations (i.e. what was the business model)?See PPTs 5 and 7 for a word version of activities – not how hard it is to understand. Transparency was not in the interest of Enron’s perpetrators.

3. Did Enron’s directors understand how profits were being made in this segment? Why not?Apparently they did not. They should have queried how almost 50% (See PPT 16 for the proportion of manipulated income) of Enron’s profits could have come from SPEs whose operations had no economic substance, or that asset sales and repurchase transactions between Enron and the SPEs were circular. You can’t make money off yourself. Also, there were apparently 1,000-3,000 SPEs created, and a good Director should wonder why so many were needed.

4. Enron’s directors realized that Enron’s conflict of interests policy would be violated by Fastow’s proposed SPE management and operating arrangements because they proposed alternative oversight measures. What was wrong with their alternatives?

The Board’s alternative controls were left to Fastow to institute, oversee and presumably report upon to the Board. He was the principal fraudster, and there was no internal audit follow-up (Arthur Andersen had taken the internal audit role as a subcontractor), nor did the Board demand feedback. No whistle-blower concerns reached the independent member of the Board. Like mushrooms, independent Board members were left in the dark.



5. Ken Lay was the Chair of the Board and the CEO for much of the time. How did this probably contribute to the lack of proper governance?

“Kenny Boy” did not serve as a useful foil or overseer of his own CEO actions, as a good independent Chair of the Board should. The inherent conflict of interests in being CEO and Chair has led to increasing separation of these functions as a measure of good governance, and some jurisdictions are requiring it. For example, Lay’s handling of the Sherron Watkins whistle-blowing letter showed either brilliance or evidence of incompetence on conflict of interest matters. He asked the lawyers who advised on creation of the SPEs if what they had done was all right.

6. What aspects of the Enron governance system failed to work properly, and why?See PPTs 2, 11, 12, 17 and 19 to focus the discussion. See also Fig. 2.4. of the text.

7. Why didn’t more whistleblowers come forward, and why didn’t some make a significant difference? How could whistleblowers have been encouraged?

See PPT 19. If you were contemplating coming forward, and you knew that Enron’s culture was unethical (see examples) and the bosses knew it, would you come forward – not likely because the risk was too high that you would be fired or not welcomed. There would have to be changes in the culture and systems to encourage whistle-blowers to come forward, such as measures to make the culture ethical (see text discussion, and a protected whistle-blower program. As a result of this apparent flaw, SOX/SEC has subsequently mandated that all SEC registrant companies have a whistle-blower system that reports to the Audit Committee.

8. What should the internal auditors have done that might have assisted the directors.They should have been alert for flaws in Enron’s conflict of interest policies, and any lack of compliance. When a policy was/is set aside by the Board, internal audit should have been advised or should have realized this by screening the relevant minutes. Also they should have been looking for any transactions with questionable economic substance. Their reports should go the Board of Directors as well as management.

9. What conflict of interests situations can you identify in: SPE activities Arthur Andersen’s activities executive activities.

The Enron Debacle shows conflicts of self-interest (personal gain of executives, employees, auditors, lawyers, bankers and directors) vs. shareholder (as many were misled and lost significantly) and other stakeholder interests (as the company objectives were not met and jobs etc, were lost. Each type of conflict has many examples.

An interesting additional discussion, is how each conflict of interest situation developed, and why the professionals and directors lost sight of their need for independence, and what the professional accountants and banker thought that their mandate really was.

10. How much time should a director of Enron have been spending on Enron matters each



month? How many large company boards should a director serve on?This depends on the complexity of the company’s operations, the competence and trust placed in its management and governance systems, and the competence and skills of the Board member. On a company of significant size, a Director may have to spend 4-5 days per month to discharge their duties properly. On this basis, allowing for personal business, a person who serves only as a director could only serve on 3-4 Boards.

11. How would you characterize Enron’s corporate culture? How did it contribute to the disaster?

Enron’s corporate culture was unethical (see PPTs 17 and onward). It was fraught with conflicts of interest, unethical and also illegal and acts, poor examples were set by directors and executives, and the directors, professional accountants and lawyers involved were self-interested instead of in the sustainable interest of shareholders and other stakeholders. If the process of allowing the satisfaction individual self-interest of the company’s directors, personnel and agents, they ignored their fiduciary duty to the shareholders and other stakeholders. The Board members who were independent of management and not conflicted, were in the dark. Measures to make a corporate ethical culture are discussed in the text and Chapter PPTs. This set introduces ethics risk management and other governance and accountability paradigm changes.

Subsequent Events

May 25, 2006. “Enron Verdict: Ken Lay Guilty on All Counts, Skilling on 19 Counts”, by Gina Sunseri and Sylvie Rottman, ABC News, download from http://abcnews.go.com/Business/LegalCenter/story?id=2003728&page=1

“Lay, 64, was convicted on all six counts against him, including conspiracy to commit securities and wire fraud. He faces a maximum of 45 years in prison. Lay also faces 120 years in prison in a separate case.

Lay posted a $5 million bond secured with family-owned properties at a hearing following the verdict. He was ordered to stay in the Southern District of Texas or Colorado.

"I firmly believe I'm innocent of the charges against me," Lay said following the hearing. "We believe that God in fact is in control and indeed he does work all things for good for those who love the lord."

Skilling, 52, was convicted on 19 counts of conspiracy and fraud. Combined with his conviction on one count of insider trading, he faces a maximum of 185 years in prison. Skilling was acquitted of nine other charges relating to insider trading.

"Obviously, I'm disappointed," Skilling told reporters outside the courthouse. "But that's the way the system works."

"I think we fought a good fight — some things work, some things don't," he said.”


http://abcnews.go.com/Business/LegalCenter/story?id=2003728&page=1


“In a separate, nonjury bank fraud trial related to Lay's personal banking, U.S. District Judge Sim Lake found the Enron founder guilty of bank fraud and making false statements to banks. Lake had withheld his verdict in the Lay bank fraud case until the Lay-Skilling jury announced its verdict. Lay faces up to 120 years in prison in that case.”

See also:

http://en.wikipedia.org/wiki/Enron_scandal

Film: Enron: The Smartest Guys in the Room (2005) available on DVD from Alliance Atlantis

Time Enron Scandal webpage at http://www.time.com/time/2002/enron/

Google search for Enron Scandal and related searches at the bottom of the page


http://www.time.com/time/2002/enron/

http://en.wikipedia.org/wiki/Enron_scandal


ARTHUR ANDERSEN’S TROUBLES___________________________________________


Arthur Andersen (AA) will forever be a key part of the Enron SOX chain that accelerated changes in the accountability and governance paradigm for corporations and the accounting profession. In fact, AA’s problems were systemic as their root was in the firm’s flawed governance system where the desire for profit was allowed to outweigh the firm’s fiduciary interests to client shareholders and the public interest. The case presents excellent opportunities to review conflict of interest issues, the need for inclusion of ethics in an organization’s strategy, operations and compliance processes, and for illustrating how the expectations of the public can dramatically affect an organization. AA’s disappearance dramatically illustrates how risk managers had been in the habit placed too low a value on loosing the ability to operate – known as “franchise risk”. Post-Enron and AA that valuation has changed upward considerably.


I use the AA PPTs (13-22) in the “Enron Affair” set to discuss the case. The key issues are:

What happened and who did it? The 3% SPE accounting rule and how it led to manipulation. How following the 3% rule precisely, and ignoring the overall principle that there

must be external validity (an independent outside buyer/seller) to allow the recording of profit, led to manipulation.

What the flaw was in AAA’s governance system that permitted the Enron, WorldCom, Waste Management and Sunbeam fiascoes?

Other matters raised in the questions below.


The following questions reveal the key points of the case:

1. What did Arthur Andersen contribute to the Enron disaster?AA failed to protect the interest of current and future shareholders, and stakeholders that relied

upon the financial reports and integrity of the company. AA failed to form a reliable part of the Enron governance system, thereby leaving the directors and other stakeholders at risk. See the list of AA’s apparent mistakes in the case.

2. What Arthur Andersen decisions were faulty?



See list of AA’s apparent mistakes in the text, as well as the section on AA’s internal control flaw.

3. What was the prime motivation behind the decisions of Arthur Andersen’s audit partners on the Enron, WorldCom, Waste Management, and Sunbeam audits – the public interest or …? Cite examples that reveal this motivation.

It was revenue generation and retention. They served their self-interest rather than the public interest by not acting upon the memos from their quality control personnel, and not challenging the manipulative practices and structures at Enron.

4. Why should an auditor make decisions in the public interest rather than in the interest of management or current shareholders?

An auditor is the agent of the shareholders, and is elected annually at the Annual general Meeting of Shareholders by the shareholders. As such, the auditor must make sure that audited annual financial statements comply with GAAP, and GAAP are designed to produce statements that do not favor the interests of current shareholders or executives and mislead future shareholders and other stakeholders such as governments, taxing authorities and the like. GAAP is therefore designed to produce statements that are in the public interest, and the auditor is the agent who should ensure GAAP is properly applied. An auditor who does not protect the public interest can face reputational and legal consequences because the expectations of the public have not been met.

5. Why didn’t the Arthur Andersen partners responsible for quality control stop the flawed decisions of the audit partners?

They tried via memos, but the firm’s governance structure had earlier determined that the audit partner in charge could over-ride them. Clearly, AA’s governing body made the wrong decision.

6. Should all of Arthur Andersen have suffered for the actions or inactions of under 100 people? Which of Arthur Andersen’s personnel should have been prosecuted?

I don’t think so, because it seems unfair to the many innocent partners, staff and audit client stakeholders that lost value because of the resulting discontinuity. I further do not believe that society was well-served by the loss of one of the Big 5, thus concentrating the choices for independent audit work in the future. On the other hand, the disappearance of AA sent a significant signal to the rest of the audit world. I would have preferred larger fine and imprisonment for AA’s decision makers who determined and carried out the policy of audit partner primacy, plus a very large fine and sanctions (no new SEC clients for 3 months) for the continuing firm. I would also consider carefully whether non-partner audit personnel had a responsibility for whistle-blowing, and would signal how this should be done in the future.

7. Under what circumstances should audit firms shred or destroy audit working papers?Given the developments in the AA Case, audit working papers should not be destroyed before

they could be of assistance and/or relevant in any legal, tax or other dispute. This means that the auditor should retain paper or digital versions for a very long time.



In some jurisdiction, the statute of limitations might come into play at the end of seven or ten years, but may not where fraud is concerned. An audit firm may chose not to follow the statutory limits because they might wish to be able to respond to protect themselves for a longer period. Public expectations that affect reputations are not bound by legal limits.

8. Answer the “Lingering Questions” in the case,See the answer to Question 6 above. I do not think that the Big 4 firms could be shrunk to the

Big 3 in the future because it would not be seen to be in the public interest. I think that other AA partners will be brought to trial, but not many. Perhaps only the head of the firm, the lawyer involved and the partners-in-charge of the firm and the region or function will be brought before the courts. Finally, I am sure that a similar tragedy will occur again – probably after the pain of ignoring the public interest abates again as is has from earlier scandals in earlier decades. Our memory fades as generations retire, and unless the education system plays a stronger role with students in the future, ethics lessons will be forgotten again.

Subsequent events

July 15, 2003. “Andersen Worldwide settles Enron Suits”, Jef Feeley, Financial Post, July 15, 2003, FP9.

“The network of foreign accounting firms once linked to Arthur Andersen LLP will pay US$40-million to resolves lawsuits stemming from Enron Corp.’s collapse…

Andersen Worldwide Société Cooperative is seeking to erase liability in suits filed by Enron investors and workers over the accounting firm’s role in helping Enron hide more thanUS$1-billion in losses… The accord doesn’t cover Arthur Andersen LLP, Enron’s auditor for more than a decade… Andersen Worldwide also agreed to pay US$20-miooion to Enron’s bankruptcy creditors.

The settlement is a small fraction of the US$29-billion that shareholders and former workers say they lost in Enron’s meltdown.”

May 31, 2005.

In the case of Arthur Andersen, LLP v. United States, 544 U.S. 696 (2005), the Supreme Court of the United States unanimously reversed AA’s conviction due to serious flaws in the jury instructions.

As of 2008, there were over 100 civil lawsuits pending against AA.

See also

Time Enron Scandal webpage at http://www.time.com/time/2002/enron/ http://en.wikipedia.org/wiki/Arthur_Andersen


http://en.wikipedia.org/wiki/Arthur_Andersen

http://www.time.com/time/2002/enron/

http://www.law.cornell.edu/supct/html/04-368.ZS.html


WORLDCOM: THE FINAL CATALYST___________________________________________


When WorldCom announced massive overstatements of profit in June 2002, it completely shattered the trust in corporate accountability and governance that President Bush and others had been trying to rebuild. Sarbanes and Oxley combined their separate efforts in the U.S. Congress and Senate, and the Sarbanes-Oxley Act emerged in late July 2002, thus triggering a change in corporate accountability and governance, and well as the accounting profession. The WorldCom case involves simple manipulations, but once again offers lessons about the need for an ethical corporate culture, whistle-blower protection, over-dominant CEO, no independent Chair of the Board, and incompetence of Directors. The prosecution and dissolution of AA was so far along by June/July 2002, that their role in not finding the problems earlier was overshadowed by the emergence of SOX.


I review the events after Enron and up to SOX, and I indicate how it galvanized the development of SOX. I then deal with the questions listed below.


The following questions wee presented for discussion of the significant issues raised in the case:

1. Describe the mechanisms that WorldCom’s management used to transfer profit from other time periods to inflate the current period.

Details are in the case, but the major mechanisms use included: Capitalization of current costs to move them to future periods Reduction of current costs by drawing down reserves

2. Why did Arthur Andersen go along with each of these mechanisms?AA may not have known about the manipulations, or at least some of them. Cynthia Cooper,

Vice-president for Internal Audit was apparently the first to identify the irregularities. According to the SEC quotations in the case, WorldCom went to some lengths to conceal the manipulations from AA. However, this raises the question of how effective AA’s audit work was because the manipulations were significant. Moreover, if AA knew of some of the manipulations, then is it another case of AA wishing not to confront management and preferring to protect future fee revenue.

3. How should WorldCom’s Board of Directors have prevented the manipulations that management used?



An ethical corporate culture should have been developed that would have encouraged the personnel who were ordered to manipulate to whistle-blow. If scrutiny and analysis by internal and external auditors were known to have been tighter, then perhaps the manipulation attempts would not have been attempted. Moreover, if WorldCom had not been so dominated by Bernard Ebbers (i.e. if an independent Chair of the Board and appropriate whistle-blowing mechanisms had been in place) then he might not have tried to manipulate, and/or other might have reported the attempt. Ebbers might not have attempted the manipulation if the Board had not allowed him to borrow $408 million and spend it in ways that required rising WorldCom stock prices and/or cash.

4. Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to make his manipulations work. Why did WorldCom’s accountants go along?

Because they thought they could get away with it for a while, and that when profits returned that “adjustments” would be restored. They might have thought that everyone was manipulating and that smoothed earning were ‘good”. They did not see their duty as protecting the shareholders’ interests or the public interest.

5. Why would a Board of Directors approve giving its Chair and CEO loans of over $408 million?

The Board did not recognize the risk that Ebbers would misuse the funds borrowed. To some extent the Board was at fault for allowing a loan arrangement for Ebbers where he could draw down amounts on his own without reporting mechanism to the Board and for subsequent approval as amounts rose beyond reasonable levels, and they did not check on the specific use of the money and the vale of that usage as collateral.. They trusted Ebbers who had built the company up from its early roots. They did allow him to borrow money for the purpose of buying the largest ranch in Canada, which was also unusual.

6. How can a Board ensure that whistleblowers will come forward to tell them about questionable activities?

A protected whistle-blower mechanism is vital, and it’s use must be encouraged by top management. Even then, there is no guaranty. In the end, an ethical corporate culture is essential to the promotion of whistle blowing and ethical behavior in general. This topic is discussed further in Chapter 3.



WASTE MANAGEMENT, INC.___________________________________________


The Sunbeam and Waste Management cases were early, high profile evidence of Arthur Andersen’s flawed decision making process, and approach to dealing with clients and “working out” of audit adjustments rather than forcing large negative changes to financial statements or qualifying their audit report. Both cases proved to damage AA’s reputation, and were instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out” response when AA failed a third time with Enron to rectify the same audit and decision making deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to give opinions on SEC registrant clients rather than apply a monetary sanction that could readily be paid and require another undertaking that could be ignored by AA.


I ask a student in the class be asked to recap the main issues of the case, and then ask his/her colleagues to add their comments. I make sure that the class understands the manipulation methods revealed in the case, and the motivation for them. I would then discuss the questions listed at the end of the case and answered below


1. Why didn’t Arthur Andersen stand up to WMI management?Arthur Andersen didn’t stand up to the management of Waste Management, Inc. (WMI) because the firm wanted not to aggravate the management (Buntrock et al) an raise the risk of losing a lucrative audit and consulting client. The penalty for not demanding immediate corrections or an audit opinion qualification was quite low at the time relative to the revenue being generated, and the risk that WMI would not make a profit must have seemed low. A long-term work out of errors (slow correction over future years) may have seemed to be reasonable solution at the time. Of course, the overall financial picture changed, and AA was caught.

2. What aspects of their risk management model did the Arthur Andersen partners incorrectly consider?

AA’s partners failed to accurately consider the cumulative damage to AA’s reputation, particularly with the SEC. As mentioned in the opening comment on this case, the SEC ultimately became fed up and AA lost its franchise to operate. Ultimately AA did not correctly compute its franchise risk and the cumulative change therein.



3. To whom should Arthur Andersen have complained if WMI management was acting improperly?

To the WMI Audit Committee and Board, particularly to the independent directors

4. Did the WMI Board and Audit Committee do their jobs?I would say that the WMI Board and Audit Committee did not do their jobs as fiduciaries of the public interest, and particularly they did not protect the interests of some shareholders who acquired shares under false pretenses as well as others like banks and governments.

5. Were the fines levied high enough?With hindsight, I would say that the fines were not high enough to change AA’s behavior or signal other executives that this kind of manipulation should stop.

6. Should you use the same “dog” to discover the “bones” in an accounting scandal?Using an agent that has made mistakes, does not guaranty the mistakes will be rectified or that the “dog” will offer the best service available. The statement is ridiculous. AA was probably retained so that they would not embarrass management or perhaps the major shareholder, Mr. Buntrock.



SUNBEAM CORPORATION AND CHAINSAW AL___________________________________________


The Sunbeam and Waste Management cases were early, high profile evidence of Arthur Andersen’s flawed decision making process, and approach to dealing with clients and “working out” of audit adjustments rather than forcing large negative changes to financial statements or qualifying their audit report. Both cases proved to damage AA’s reputation, and were instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out” response when AA failed a third time with Enron to rectify the same audit and decision making deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to give opinions on SEC registrant clients rather than apply a monetary sanction that could readily be paid and require another undertaking that could be ignored by AA.


I would suggest that a student in the class be asked to recap the case, and then ask his/her colleagues to add their comments. I would want to ask whether the class thought that Chainsaw Al’s overbearing style represented a common or uncommon stereotype. This discussion usually reveals that his dominating approach is not common, but by no means unique. It is a common thread through most of the AA cases discussed in Chapter 2. I would then discuss the questions listed at the end of the case and answered below.


1. Explain how Chainsaw Al used “cookie jar” reserves to inflate Sunbeam’s profit?In principle, “cookie jar” reserves are created when an opportunity presents (i.e. to overstate costs of reorganization) itself to overstate expenses in one reporting period and carry forward the credit as a “reserve” to be used to understate future expenses. This shifts profit forward to the future period when management decides extra profit is needed (i.e. the cookies are needed).

2. Can “bill and hold” practices ever be considered sales that should be recorded in the period in which the goods are initially “held”?

Not unless there is an explicit (written) agreement that the goods are being held at the request of the customer who accepts the risks of storage at the seller’s premises without condition. This means that the seller cannot take the goods back for a credit. Also, the buyer should pay for the goods.

3. Why didn’t Sunbeam’s Board of Directors catch on to the manipulations?



The Board was not informed until one of the internal auditors, Deidra DenDanto, resigned because no one would listen on April 3, 1998, and sent a letter to the Board. A stock analyst, Andrew Shore, had raised the alarm earlier but the Board was apparently not on guard. The unethical culture that Chainsaw Al and his associate, Russell Kersh, had created made sure that earlier concerns did not reach the Board. A culture of loyalty and silence was created by a system of stock options to 250 of the company’s top 300 executives.

4. How should a Board make sure that it gets the information it needs to monitor management actions and accounting policies?

The Board should have introduced a whistle-blowing mechanism with reports to it at an earlier date, and should have been aware of the culture that was being created within the company as well as the style of management being practiced. They should make the opportunity to make contact with and get to know executives so these executives will contact them if need be, and to assess their competency when projects are being evaluated. Surveys of personnel attitudes can also be taken by outside services.

5. If you are a professional accountant who reports an ethical problem to your superior who does nothing, what more should you do?

I would continue to report ‘up the line’ until I got reasonable answer, or to the ombudsman or ethics officer, or finally to the Audit Committee, or the Chair of the Board.

6. What problems can you identify with Arthur Andersen’s work as auditor of Sunbeam?The problems that could reflect poor audit work by AA might include: Failure to verify reasonability of reserves such as by estimates of restructuring

charges after the restructuring, and the ultimate use of the “cookie jar” credits thus created,

Failure to detect channel stuffing through normal cutoff tests, reviews of inventory amounts, unusual sales and discount practices

Failure to review large or unusual inventory and sales transactions, and large changes in reserves

Poor cutoff tests that did not detect the extension of a reporting period. See also the section on AA’s Role

7. How should a Board assess the performance of their company’s auditors?A Board can assess the performance of the company’s auditors by: Questioning them on their audit approach, findings and discussions with management Assessing them on their knowledge of the company and its industry by posing

questions about alternatives likely to be under consideration Assuring that auditors understand that they are to report specific problems to the

Board and are independent of management influence Discuss the external auditors’ performance with management and separately with the

head of internal audit. Compare the auditor’s performance with that of other auditors that board members

have encountered



Periodically ask for bids from other firms and the incumbent auditors

8. While it is attractive to have a CEO that is a strong person with a high profile, how should a board manage or keep track of such a person without demotivating them?

CEOs must be expected to report regularly to the Board on standard matters and for any significant matters, particularly those requiring policy advice. The Board has a right to be kept up to date, to consult other executives, make policy recommendations and operate their portion of the governance system. Boards should not be a rubber stamp. They should set or approve strategy and policy, provide advice, evaluate performance and ensure compliance with policy and the law. If a Board member believes that s/he is not getting enough information, s/he should raise the matter and should consider resignation if the matter is not resolved. The Board also should have the right to meet without management present. See further discussions in Chapters 2 and 3.

9. Can a Board effectively monitor a CEO who is also the Chair of the Board?Not unless there is a “Lead Director” who acts as a quasi-chair and runs that portion of every Board meeting wherein the CEO and Chair is invited to leave the room for open discussion by the rest of the Board, or when matters pertaining to the CEO and Chair are being discussed.



Multiple Choice Questions_______________________

1) Most observers agree that Enron’s problems were caused by:

a. Management’s failure to exercise adequate oversightb. Failure of the audit committee to exercise adequate oversightc. Auditor’s lack of independenced. Deficiencies in audit procedurese. Failure of the board of directors to exercise adequate oversight

ANSWER: e

2) Under the U.S. accounting rules, the following conditions were required to consider special purpose entities (SPEs) to be independent parties:

a. Independent investment of less than 3% of the SPE’s equity and independent control of the SPE

b. Independent investment of at least 3% of the SPE’s equity and independent control of the SPE

c. Substantive investment of at least 3% of the SPE’s equity and independent control of the SPEd. Independent investment of at least 3% of the SPE’s assets at risk and independent control of

the SPEe. Substantive investment of less than 3% of the SPE’s assets at risk and independent control of

the SPE

ANSWER: d

3) The Board of Directors’ paramount duty is:

a. To determine management’s compensationb. To safeguard the interest of the company’s stakeholdersc. To safeguard the company’s assetsd. To formulate the company’s strategye. To safeguard the interest of the company’s shareholders

ANSWER: e

4) The independence of the Enron Board of Directors was compromised by:

a. Family ties between the company and certain board membersb. Employment ties between the company and certain board membersc. Financial ties between the company and certain board membersd. Fiduciary ties between the company and certain board memberse. All of the above

ANSWER: c



5) The following three broad duties stem from the fiduciary status of corporate directors:

a. Obedience, loyalty, and confidentialityb. Obedience, loyalty, and due carec. Loyalty, due care, and confidentialityd. Obedience, loyalty, and good faithe. Loyalty, confidentiality, and good faith

ANSWER: b

6) In order to ensure an investment-grade credit rating, Enron began to emphasize the following three actions:

a. Reducing accruals, increasing cash flow, and lowering debtb. Smoothing accruals, increasing cash flow, and lowering debtc. Increasing cash flow, lowering debt, and smoothing earningsd. Increasing cash flow, lowering earnings and decreasing option expensee. Increasing cash flow, lowering debt, and decreasing option expense

ANSWER: c

7) Which of the following was not a committee in Enron’s Board?

a. Risk Management Committeeb. Executive Committeec. Finance Committeed. Audit and Compliance Committeee. Nominating Committee

ANSWER: a

8) Enron referred to this transactions as “monetizing” or “syndicating” its assets:

a. Buy more assets using syndicated loansb. Sell assets to third parties and record cash income as earningsc. Hedge the company’s assetsd. Lend money to third parties to buy assetse. Recording profits on energy derivatives trading

ANSWER: b

9) Enron created the following SPE(s) to hide off-balance sheet liabilities, recognize revenues early , and recognize profits on own shares:

a. LJMb. LJM1/Rhythmsc. LJM2/Raptorsd. Chewco/JEDI



e. LJM3

ANSWER: d

10) Which of the following was not a flaw found in LJM1 arrangements?

a. Profits were improperly recorded on treasury shares used or sheltered by non-existing hedgesb. Enron was hiding employee stock option expense c. Enron was hedging itselfd. Enron had to advance treasury shares to buy them back at preferential ratese. Enron officers and their helpers benefited

ANSWER: b

11) At the time of Enron’s collapse, the prevailing treatment for employee stock option expense was:

a. Record stock options only when and if exercised, at exercise priceb. Record all stock options when issued, at exercise pricec. Record all stock options at market priced. Record stock options only when exercised at market pricee. Record not exercised options at market price

ANSWER: a

12) Which of the following was not a conflict of interest that Arthur Andersen’s personnel encountered?

a. Auditing their own work as SPE consultantsb. Losing a very large clientc. A partner reviewed another partner’s workd. Internal debates about Enron’s questionable accounting treatments were not discussed with

the audit committeee. Audit staff leaving the firm to work for Enron

ANSWER: c

13) Which of the following was not among Arthur Andersen’s shortcomings in conducting Enron’s audit?

a. Lack of competenceb. Failure of quality control standardsc. Misunderstanding of auditor’s fiduciary roled. Inconclusive testing of controle. Insufficient information provided by Enron’s staff

ANSWER: d

14) Which of the following was not a strategy used by Enron to avoid taxes?

a. Deduction of losses twice



b. Shifting depreciable assets to non-depreciable assetsc. Tax deductions for repayment of debt principald. Duplication of single economic losse. Generation of fees for serving as an accommodation party for another taxpayer

ANSWER: b

15) In general terms, WorldCom overstated its reported net income by:

a. Generating false expensesb. Booking false revenuec. Capitalizing line costsd. Amortizing line costs quicker than allowed under GAAPe. Recognizing future period’s revenue

ANSWER: c

16) This type of manipulation is known as “cookie jar” accounting:

a. Manipulation of profits through reserves or provisionsb. Incorrect classification of long term debt as equityc. Incorrect classification of regular expenses as extraordinary itemsd. Manipulation of profits through booking revenue in early periodse. Manipulation of reserve for uncollectible amounts

ANSWER: a

17) After SOX, which of the following is not a prohibited non-audit service for external auditors?

a. Appraisal or valuation servicesb. Bookkeeping and other servicesc. Legal servicesd. Tax servicese. Internal audit outsourcing

ANSWER: d

18) Which of the following is not a requirement imposed by the SOX Corporate Governance Framework?

a. The audit committee must be comprised solely by independent directorsb. The audit committee is responsible for appointing the company’s external auditorc. The audit committee must establish procedures to allow employees to submit anonymous

complaintsd. The audit committee must approve non audit services to be provided by the auditorse. The audit committee must be comprised solely by financial experts



ANSWER: e

19) SOX increased the time requirement and legal risk for company directors. These requirements will likely:

a. Increase the number of directors in the boardb. Reduce the number of directors in the audit committeec. Increase audit feesd. Reduce the number of boards that each director sits on e. All of the above

ANSWER: d

20) These companies are more likely to voluntarily adopt improved governance measures:

a. Larger companiesb. Less profitable companiesc. Foreign companiesd. Smaller companiese. Private companies

ANSWER: a


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