Since the public downfall of Enron in 2001, there have been many think pieces written about what went wrong. Many potential causes have been identified. Whether it was the toxic “profit above all” culture, the lack of oversight for the off-books financial entities with which Enron did business, or the management’s lies about the financial health of the company. While all these factors contributed to the demise of Enron, we’ll focus on one key cause: the conflict of interest of Arthur Andersen, who served as Enron’s auditor and consultant.
Other resources you might find helpful:
Let’s take a step back and review this historic scandal before we dissect the role that unethical auditing practices played in the story and how companies can avoid the fate of Enron through more frequent, thorough, and transparent audits.
The Rise and Fall of Enron
Enron was founded in 1985 and was a trader of energy derivative contracts, acting as an intermediary between natural-gas producers and their customers. For a fee, Enron negotiated contracts, and the natural-gas producers were able to mitigate the risk of energy price fluctuations by fixing the selling price of their products. They soon dominated the market for natural-gas contracts, and the company’s profits soared. Eventually, they began financing the company through investments in increasingly complex instruments and traded derivative contracts for a wide variety of commodities—including electricity, coal, paper, and steel—and even for the weather.
With the economy slowing down and the competition level increasing in the energy-trading business, Enron company executives began to rely on unethical accounting practices to hide their shrinking profits, including a technique known as “mark-to-market accounting.” Using mark-to-market accounting, Enron would write unrealized future gains from trading contracts into current income statements, thus giving the illusion of higher current profits. Then the worst-performing sectors of the organization were transferred to so-called special purpose entities (SPEs), which are essentially limited partnerships created with outside parties. Enron used SPEs as dump sites for its most toxic assets. Hiding those assets in SPEs meant that they were kept off Enron’s books, making the company’s losses look less severe than they really were. The final egregious mistake: Arthur Andersen served as both Enron’s auditor and consultant during this time. This is an obvious conflict of interest, allowing for the perpetuation of the grift to go unreported.
In mid-2001, several outside business analysts began to sound the alarm about Enron’s publicly released financial statements. Shareholders were in shock when Enron announced in October that it was going to post a $638 million loss for the third quarter and take a $1.2 billion reduction in shareholder equity. After the Securities and Exchange Commission (SEC) investigated and uncovered the details of the accounting frauds, Enron went into a free fall. On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection. Many of the company’s executives were indicted on charges and later sentenced to prison.
In 2002, Arthur Andersen was convicted of obstruction of justice for shredding documents related to its audits of Enron. The impact of the scandal, combined with the findings of criminal complicity, ultimately destroyed the firm. Because the SEC will not accept audits from convicted felons, Arthur Andersen agreed to surrender its CPA licenses and its right to practice before the SEC—effectively putting the firm out of business.
The Aftermath: New Financial Reporting Regulations
The Enron scandal resulted in the passing of new regulations designed to increase the accuracy of financial reporting for publicly traded companies. The most significant of those was the Sarbanes-Oxley Act (2002), which imposed harsh penalties for destroying, altering, or fabricating financial records. The act also prohibited auditing firms from doing any concurrent consulting business for clients they were auditing. Much has changed since 2002, and thankfully many auditors have vastly improved technology and enhanced automation tools that they leverage to avoid any risks.
Auditors working with automated AP systems now have data analysis for continuous monitoring and review of all transactions. This increases their coverage to perform detailed testing and documentation review transactions.
Accounts Payable Invoice Automation (APIA) providers can allow internal auditors to save time and expenses in the execution of their annual audit responsibilities by providing them access to detailed invoice processing data. This access provides the auditors information relative to their stated process and lets them know how well the organization in question is complying with the process. APIA also contains an audit trail for all transactions available at the click of a mouse, eliminating the internal auditor’s need to request stacks of paper documents and copies to review.
APIA reduces expenses for the company in three ways:
- It reduces to near zero the amount of time required by businesses to produce records and documents related to audit requests.
- It greatly increases the efficiency with which internal auditors can analyze and review data.
- It significantly reduces the amount of time the auditor needs to spend on-site to complete their fieldwork and findings.