Case 6.1 Enron Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Enron Case Relevant Technical Knowledge PCAOB Ethics and Independence Rule 3520 “a registered public accounting firm and its associated persons must be independent of the firm's audit client throughout the audit and professional engagement period.”

Enron Case Relevant Technical Knowledge SARBOX Section 201 it shall be unlawful for a registered public accounting firm to provide any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible.

Enron Case Relevant Technical Knowledge SARBOX Section 203 the lead audit or coordinating partner and the reviewing partner must rotate off of the audit every 5 years SARBOX Section 206 requires a “one year cooling off period” before an audit firm employee accept a position as CEO, CFO, Controller, or Chief Accounting Officer of a former client

Enron Case Relevant Technical Knowledge SARBOX Section 301 requires that the “audit committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer.”

Enron Case Relevant Technical Knowledge Revenue Recognition Principle Revenue must be both earned and realized before it is recognized. That is, the product must have been delivered or the services must have been provided to the customer. In addition, the amount of the sale needs to be fixed and determinable. And, there must be a belief that the cash will be collected from the customer in a timely manner.

Enron Case Relevant Technical Knowledge PCAOB AS#12 – Paragraph #68 “the auditor should presume that there is a fraud risk involving improper revenue recognition and evaluate which types of revenue, revenue transactions, or assertions may give rise to such risks”

Enron Case Relevant Technical Knowledge PCAOB AS#15 – Paragraphs #4-8 describe the auditors’ responsibility regarding evidential matter. In general, the auditor must obtain evidence that is sufficient and appropriate given the facts and circumstances. The appropriateness of audit evidence refers to the quality of the evidence gathered for a financial statement assertion about a financial statement account balance and/or an economic transaction(s).

Enron Case Relevant Technical Knowledge PCAOB QC #20 - Paragraph #3 “A firm has a responsibility to ensure that its personnel comply with the professional standards applicable to its accounting and auditing practice. A system of quality control is broadly defined as a process to provide the firm with reasonable assurance that its personnel comply with applicable professional standards and the firm's standards of quality.”

Enron Case Relevant Technical Knowledge SARBOX Section 103 The PCAOB must require registered public accounting firms to “prepare, and maintain for a period of not less than 7 years, audit work papers, and other information related to any audit report, in sufficient detail to support the conclusions reached in such report.”

Enron Case Relevant Technical Knowledge SARBOX Section 203 the lead audit or coordinating partner and the reviewing partner must rotate off of the audit every 5 years PCAOB As of the Summer 2013, the PCAOB is contemplating the possibility of mandatory firm rotation, although it is not likely

Enron Case Relevant Technical Knowledge PCAOB AS #12 – Paragraph #7 “The auditor should obtain an understanding of the company and its environment to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement.”

Enron Case Relevant Technical Knowledge PCAOB AS #13 – Paragraph #6 The auditor should determine whether it is necessary to “make pervasive changes to the nature, timing, or extent of audit procedures to adequately address the assessed risks of material misstatement. Examples of such pervasive changes include modifying the audit strategy to: a) Increase the substantive testing of the valuation of numerous significant accounts at year end because of significantly deteriorating market conditions, and b) Obtain more persuasive audit evidence from substantive procedures due to the identification of pervasive weaknesses in the company's control environment.”

Enron Case Relevant Technical Knowledge PCAOB AS #5 Paragraph # 28 – “relevant assertions are those financial statement assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.” Paragraph #30 – “what could go wrong?”

Enron Case Relevant Technical Knowledge PCAOB AS #12 – Paragraph #52 “The discussion among the key engagement team members about the potential for material misstatement due to fraud should occur with an attitude that includes a questioning mind, and the key engagement team members should set aside any prior beliefs they might have that management is honest and has integrity.”

Enron Case Relevant Technical Knowledge PCAOB AS#12 – Paragraph #68 “the auditor should presume that there is a fraud risk involving improper revenue recognition and evaluate which types of revenue, revenue transactions, or assertions may give rise to such risks”

Enron Case Relevant Technical Knowledge PCAOB AS No. 5 – Paragraph #25 “because of its importance to effective internal control over financial reporting, the auditor must evaluate the control environment at the company.” The control environment is influenced heavily by a company’s management team and is therefore often referred to as “the tone at the top.”

Enron Case Relevant Technical Knowledge PCAOB AS No. 5 – Paragraph #21 “A top-down approach begins at the financial statement level and with the auditor's understanding of the overall risks to internal control over financial reporting. The auditor then focuses on entity-level controls and works down to significant accounts and disclosures and their relevant assertions.”

Enron Case Relevant Technical Knowledge SARBOX Section 301 requires that the “audit committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer.”

Enron Case Relevant Technical Knowledge SARBOX Section 302 the CEO and CFO of each issuer must now certify the “appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects, the operations and financial condition of the issuer.”

Enron Case Relevant Technical Knowledge PCAOB AS #15 – Paragraph 4 “The auditor must plan and perform audit procedures to obtain sufficient appropriate audit evidence to provide a reasonable basis for his or her opinion.” PCAOB AS #15 – Paragraph 6 “To be appropriate, audit evidence must be both relevant and reliable in providing support for the conclusions on which the auditor's opinion is based.”

Enron Case Relevant Technical Knowledge PCAOB AS #15 – Paragraph 5 “sufficiency is the measure of the quantity of audit evidence.” All things being equal, the greater the risk of material misstatement related to the financial statement assertion, the more audit evidence will be gathered by the auditor.

Enron Case Relevant Technical Knowledge SARBOX Section 401 explicitly requires that each set of financial statements (and related disclosures) that is required to be prepared in accordance with GAAP, “shall disclose all material off-balance sheet transactions" and "other relationships" with "unconsolidated entities" that may have a material current or future effect on the financial condition of the issuer.”

Enron Case Relevant Technical Knowledge PCAOB AS #5 Paragraph # 28 – “relevant assertions are those financial statement assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.” Paragraph #30 – “what could go wrong?”

Epilogue - Enron Cliff Baxter, Vice Chairman, committed suicide due to fraud Arthur Andersen indicted for obstruction of justice due to destroying evidence and barred from auditing public companies for five years Former CEO Jeffrey Skilling sentenced to 24 years in prison

Epilogue - Enron Founder Kenneth Lay dies from a heart attack before his sentencing Many top Enron executives were sentenced to multi-year prison terms. Eligible shareholders will receive $7.2 billion in settlements for their investment losses