Sesriem ET een B SME i i = eer es 2 lle ¥ — % S ™~,. CONTEMPORARY _ AUDITING MICHAEL GC. KNAPP‘This isan electronic version of the print textbook. Due to lectronie rights restrictions, some third party content may be suppressed. Editorial review has deemed that any suppressed. content does not materially affect the overall learning experience, The publisher reserves the right {to remove cantent from this ttle any time if subsequent rights restrictions require it. For ‘valuable information on pricing, previous editions. changes to current eitions. and alternate formas, please visit some cengage.com/hiphered to search by ISBINE, author. te, oF key word for ‘materials in your areas of interest. nanan enSOUTH-WESTERN CENGAGE Learning Contemporary Auditing: Real Issues and Cases, Ninth Edition Michael. Knapp Vice FresidentofEditoral, Business: Jock. 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For your course and learning solotons, vai wwwncengage-com, Purchase any of aur products.at your local olieg prefered calise ctore www.eengagebraln.com. ‘ore or at ourBRIEF CONTENTS Prelace SECTION T Ww 12 13 1A 1s 16 WwW 1 Ww 110 Ww 12 stcrion 2 24 2.2 23 24 2.5 2.6 29 2.8 29 storion 3 1 32 33 3.4 a5 2.6 37 SECTION 4 aa 42 43 Comprehensive Cases Enron Corporation Lehman Brothers Hold Just for FEET. Ine Health Management, Ine. The Leslie Fay Companies NextCard, Ine Lincoln Savings and Loan Association Crazy Eddie, Ine. thid. Best Company, Inc. Gemstar TV Guide International, Ine New Century Financisl Corporation Madoff Securities s,Inc. Audits of High-Risk Accounts Jack Greenberg, Inc. Golden Bear Golf, Ine. Happiness Express, Inc. General Motors Company Lipper Holdings, LLC CBI Holding Company, Inc. Geo Securities, Inc. Regina Company, Ine. Internal Control Issues The Trolley Dodgers Howard Street Jewelers, Inc. United Way of America First Keystone Bank Goodner Brothers, Inc. Burancilo’s Ristorante Foamex Intemational Inc Ethical Responsibilities of Accountants Creve Couer Pizza, Inc. F&C International, Ine. Suzette Washington, Accounting Major reeseale Semiconductor, Ine. Wiley Jackson, Accounting Major Arvel Smart, Accounting Major David Quinn, Tax Accountant antBrotr Converts stonion & 1 5.2 5.3 5.4 5.5 5.6 SECTION 6 1 6.2 63 4 65 66 stcrion 7 7 22 23 74 78 7.6 stcrion & at 8.2 a3 3.4 a5 8.6 a7 3.8 a9 8.10 an 8.1z 8.13 a4 trciox Ethical Responsibilities of Independent Auditors Cardillo Travel Systems, Inc. American Intemational Group, Inc. The Notth Face, Ine, Waverly Holland, Audit Senior Phillips Petroleum Company American Fuel & Supply Company, Inc. Professional Rotes Leigh Ann Walker, Staff Accountant Bit! DeBurger, in-Charge Accountant Hamilton Wong, In-Charge Accountant Tommy O'Connell, Audit Senior Avis Love, Staff Accountant Chatles Tollison, Audit Manager Professional Issues Ligand Pharmaceuticals Sarah Russell, Staff Accountant Bud Carriker, Audit Senior Hopkins 0. Price Waterhouse Fred Stern & Company, ine, (Ulrantaes Corporation 2. Touche et al) First Securities Company of Chicago (Erast & Emst v. Hochlelder et al International Cases Livent, Ine. Parmalat Finangiagia, S.p.A. Kansayaku Registered Auditors, South Airica Ziran Yar Kaset Thal Sugar Company Republic of Somalia OAO Gazprom Societe Generale Institute of Chartered Accountants of India Republic of the Sudan Sharia Mohamed Sales Tae Kwang Vina EMladad, Internal Auditor Suanmary of Topies by Case Summary of Cases by Topic 293 301 305 313, 319 328 327 329 331 335 939 343 2aa7 351 953, 359 363 369 a7 295 391 393 407 421 per 413 455 459) 463 a7 493 505 SM 521 27 533 543CONTENTS Preface ai secrien 1 Comprehensive Gases i Case 14 Enron Corporation. 3 Arthur Edward Andersen established @ simple morto that he required his subsorclinates cane] elinis to invoke: “Think smaght, tlk snaight” For decades, that motto served Anthur Andersen Co. welt Linfortanatey, the fire's association witrone client, Enron Comparation, abruptly endecl Andersen's long ane proud history in the public accounting profession. Kev Topics: history al the public accounting profession in the United States, scope of professional services provided to audit clients, auditor independence, and retention, of audit workpapers. cas 1.2 Lehman Brothers Holdings Inc. 23 Wall Sireet was stunned in September 2008 witen is (conde investment barkiag (him filed for beutkruptey: Lehrnan's bankruptey exanainer charged that the company had en- gaged in tens of biilions of dollars of “accounting-motivated” wansactions 10 eahance tts oppavent finenncicd condticion. Kev Tonics; ‘accounting motivated" wansactions, materiality decisions by auditors, responsibility of auditors to investigate whistleblower allegations, auditors’ legal exposure, communications with audit committee, Case 1.3 Just for FEET, Inc. 9 In the Jall of 1999,just a few months after reporting a record profit for fiscal 1998, st for FEET collapsed and tiled for bankruptcy Subsequent investigations by fawo enforce: iene authorities reaealed a massive accounting feauct shat hac! grossly neisrepresented the company's reported operating results. Key features of the fraud were improper accounting for “vendor allowances and inlentional understatements of the compariy’s inwertory veitiation allowance, Key TOPICS: applying analytical procedures, identifying inherent risk and control risk factors, need for auditors to monitar key developments within the client's inclustry, assessing the health of a elient’s industry, and receivables confirmation precedures Case 1.4 Health Management, Inc. 5d The Private Securities Litigation Relorm Act (PSLRA) of 1995 amended the Securities Exchange Act of 1934. This new federal statute was projected to have a major émpact an aucitors’ Tegal iiabitity uncer the 1934 Act. The Fist major test of the PSLRA was triggered by a classeaction icwwsutt filed against BDO Seidman for its 1995 audit of Health Management, Inc, a New York-based pharmaceuticals distritstos, KEY TOMCS. inventory atudit procedures, auditor independence, content of audit work: papels, inherent risk factors, and auiditoys’ civil lability under the tederal securities laws. Case 1.8 The Leslie Fay Companies a Paul Potishan, the former chief financial officer of The Lestie Fay Companies, received annine-year prison sentence for fraudulently misrepresenting Lesiie Fay’s financialConrenrs statements in the early 1990s. Among the defendants in a large class-action lawsuit stemming from the fraud was the company’s audit frm, BDO Seidman. Key Topics: applying analytical procedures. need for auditors to assess the health ofa client's industry, identifying fraud risk factors, control environment issues, ane auditor independence. Case 1.6 NextCard, Inc. 83 In.January 2005, Thomas Trouger became she first partaer ofa mofor accounting firms (0 be sent to prison for violating the criminal provisions of the Sarbanes-Oxley Act of 2002. key Tonics; identifying fraud risk factors, nature and purpose of audit workpapers, Understanding a client's business model, critminal liability of auditors undes the Sarbanes-Oxley Act, and collegial responsibilities of auditors Case 1.7 Lincoln Savings and Loan Association 93 Charles Keating's use of creative accounting methods allewed him to manufacture huge paper profits for Lincoln. KEY TOPICS: substance-overform concept, detection of fraud, identification of key management assertions, collegial responsibilities of auditors, assessment of contre! risk, and auditor indepensience, Case 1.8 Crazy Eddie, Inc. 107 “Crazy Eddie” énitar oversaw @ profitable chain of consumer electronics stores on the East Coast during the 1970s anid 1980s. AMer new owners discovered that the com- pany’s financial data had been grossly misrepresented, Arar tled the country, leaving behind thousands of angry slockhokiers andl creditors Kev TOPICS: auditing inventory, inventary control activitles, mnanagement integrity, the use of analytical procedures, and the hiring of former auditors by audit clients. Case 1.9 2222 Best Company, Inc. uy Barry Minkow, the "boy wonder" of Wall Street, crated «1 $200,000,000 company that existed only on paper. KEY Topics: identification of key management assertions, limitations of audit evi- dence, importance of candid predecessor successor auditor communications, client confidentiality, and client imposed audit scope limitations. Case 1,10 Gemstar-TV Guide International, Inc. 131 In 2000, US. News and World Repart predicted that Henry Yuen, tre chief exectitive of Gemstar TV Guide International. would become the “Bill Gates of television” thanks to the innovative business model that he had developed for his company. When that business model proved to be a “bust,” Yuen used seveval accounting gimmicks i em- beflish his company’s reported operating results. lions commonly associated with ‘audit failures? revenue recognition, Key ToFICS: cond principle, quantitative and qualitative materiality assessments, and “legal"vs-“ethical” conduct.Comments New Century Financial Corporation 143 The collapse of New Century Financial Corporation in Aprid 2007 signaled the beginning of the subprime mortgage crisis in the United States, a crisis that world destabilize securities and evedit mareets around the globe. A federal bankreptcy exam iner has maintained that New Century's indeperctent audits were snacieqrae. KEY TOPICS: auditing loan loss reserves, Section 40M audit procedures, matetial inter nal control weaknesses, auditor independence, and auidit stafling issues, case 1. Case 1.12 Madatf Securities 161 As an adolescent, Bernie Macolf dreamed of becoming a “key player” on Wall Street, Madoff realized his dream by overseeing the world's largest and possibly longest run fang Ponoi scheme. Madoffs auditor pled guilty (a various criminal charges for his role in hat trove ke¥ ToPIGs: factors common to financial frauds, regulatory tole of Securities and Exchange Commission (SEC), nature and purpose of peer reviews, audil procedures for investments, and the importance of the independent audit function. stcTION2 Audits of High-Risk Accounts wi Case 2.1 Jack Greenberg, Inc. 173 A fedeval jiedge criticized Greenberg's independent auditors for failing fo realize the impact that pervasive intesnad control problems had on the reliability of the coonpany’s inventory accounting records. Case 2.2 Golden Bear Goll, Ine. 181 Jack Nicklaus, the "Golden Bear,” endured public embarrassment and lenge financial losses when hey subordinates misapplied the percentage-of-cormpletion accountng, metliod to: numerous golf course development projects. Case 2.3 Happiness Express, Inc. 189 To compensate for flagging sales of their Mighty Morphin Power Rangers toys, dts company’s executives booked millions of dollars of bogus sales. Deficiencies in the auctit procedures applted by Happiness Express’s qudtiors resulted in the bogus sales ane receivables going undetected Case 2.4 General Motors Company 197 fn early 2009, the SEC released the results ofa lenstiy iavestigation of Glas accounting nel financial reponing decisions over the previous decade. A major focus of that investiga tion anes G's questionable accounting for ts massive pension Fables and expenses. Case 2.8 Lipper Holdings, LLC 203 Lipper's auditors were criticlzed for falting to uncover a hhaudutent scliemne used by a portfolio manager fo materially tnflate the market values of mestments oxoried by three of the company’s largest hedge funds.Conrenrs Case 2.6 CBI Holding Company, In 2 This case focuses on auclit procectures applied to accounts payabie, including the search for unrecorded liabilities and the reconciliation of yearend vendor statements to recorded payables balances Cate 2.7 Geo Securities, Ine. 217 The SEC sanctioned GEO Securities’ audit engagement pariner for failing to apply proper audit procectiies (a a materiad foss contingency faced by the company Case 2.8 Belot Enterprises 221 Understating discretionary expense accruals is a common methoet used by self. interested conorate execiatives to exhiance their company’s fnanciad satennents. fr this case, Belot “juggled” the periad-ending balances of five majar expense acértials to achieve an earnings goa! established by the company’s new chief operating officer. Case 2.9 Regina Company 27 To reach forecasted sales and earnings targets, Regina evecutives used several accounting gimmicks that otodated the revenue recognition principle. stcrion3 Infernal Control Issues 235 Care 3, he Trolley Dodgers. 237 Control deficiencies in the Dodgers’ payroll transaction cycle allowed an accounting, manager #9 embezcle several hurxtied tousand dollars, Case 3.2 Howard Street Jewelers, Inc. 239 Given the susceptibility of cash to thett, retail companies typicatly establish rigorous internal controls for their cash processing functions. This case documents he high price af failing 40 implement such eonwrols. cas 3.3 United Way of America 2a Weak or aoneristeat internal conbols have resulted in this prominent charitable orga hhizatian.as weil as numerous ollie charities nations, being vfctimized by opportie nistic employees Case 3.4 First Keystone Bank 27 Thwee tellers of a Fist Keystone Banke branch embezzled more thar $100,060 from the branch's ATM. The disnict attomey who prosectited the tellers commented on the need for businesses to not onfy establish internal controls fo protect their assets but also on (the impontaace of ensuring that those controls are operational, Gase 3.5 Goodner Brothers, Inc. 251 An employee of this tne wholesaler found himself in serious financial trouble. To remedy this problem, the employee took advantage of his employer's weak iaternal«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.Comments stcrion6 Professional Roles 327 Care 6, Leigh Ann Walker, Staff Accountant 329 A stall accountant employed by a large accounting the is dismissed alter serious ques tions arise regarding hier integrity. cas 6.2 Bill DeBurger, In-Charge Accountant 331 To “sign off” ov “nat sign off” was the issue Bilf DeBurger wrestled with after he completed the cudit procedures for a client's most important account. An angry confrontation with: the audit engagenent partner made Bills decision even more aitficult tant Case 6.3 Hamilton Wong, In-Charge Accor 5 “Ealing tite.” Or underreporting. lire worked on cuudit enigagements, has serious implications for the quality of audit services and for the quality of auditors’ work environment. Harriton Wong came face-to-face with these issues when a colfeague insisted on understating the hours she worked on her assignments, Cate 6.4 Tommy O'Connell, Audit Senior 339) A new audit senior is quickly exposed to the challenging responsibilities of his profes- sional wore role when he is assigned to supervise a dificult andi engagemear. During the audit, the senior must deal with she posstbalay that a statf accountant t= not cam- pleting his assigned! audit procedures. Case 6.5 Avis Love, Staff Accountant 343. Auditors sometimes devetop elose iiendships with client personnel. Such friendships can prove problematic for auditors, as demonstated in this ease. Cas 6.6 Charles Tollison, Audit Manager 347 Audit rianagers occupy an important role on audit engagentents and are a critical link in the empioynrent hterarciy of public accounting firms. stction7 Professional Issues 351 Case 7.1 Ligand Pharmaceuticals 353 Ligand!’s auditor was the first Big Four fm sanctioned by the Public Company Accounting Oversight Board (PCAOB) Case 7.2 Sarah Russell, Staff Accountant 359 Sexual havassment is a sensitive sultjecr that arany companies ant professional tirens have been forced to contend with in recent years. This case recounts the experiences af a stat! accoustiant whio was harassed by ae audit partner.Conrenrs Case 7.3 Bud Carriker, Audit Senior 363 An executive of an audi client informs the audit partner thet he is not “conntortabie™ working with the senior assigned to the engagement. Why? Because the senior is a ‘umber ofa minority group. Wil the parmer assign «norte senios to the enspagenent? Cate 7.4 Hopkins v. Price Waterhouse 369 This case exploves the unique problems faced by women pursuing a career in public accounting. Case 7.8 Fred Stern & Company, Inc (WUltramares Corporation v. Touche et al) 37 This 1931 jogal case establishes she Limarnares Dactrine that decades Jater has a per. vasive influence on auditors’ civil liability under the common few Gase 7.6 First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al) 385, In this case, the Supreme Court defined the degree of auditor miseanchct that must be present betove a client can recover damages trom an auditor in a lawsuit fled uncer the Securities Exchange Act of 1934, sition Intemational Cases 391 Case 8.1 Livent, Inc, 393 Garth Drabinsky built Livent, Inc., inte a major force on Broadway during the 1990s. A string of successful Broadway productions resulled in umerous Tay Awards for the Canadian company. Despite Livent’s theatrical success, its financial affairs weve in disarray. Drabinsky and severat of his op suboxcinates used abusive accounting prac: tices 10 conceat Livent’s dnaneial problems from their independent auditors. cas 8.2. Parmalat Finanziaria, S.p.A. 407, Parmaiat’s execuifves used a simple accounting ruse, @ “double-bitling scheme,” (0 produce billions of dollars of bogus receivables, sales, and profits for the compat The fraud unraveled in a matier of weeks after che company admitted that it would have difficulty paying off a smali bond issue that was coming due. Lawsuits filed ia this ease raised a fraubling legal issue that eould potentially shreaten the financial vt ability of major accounting firms, Gase 8.3 Kansayaku 421 Like the United Stetes, Japan has recently made significant changes in the regulatory infrastructure for its financia reporting system, Many of these changes have directly impacted Japan's accounting profession and independent audlit function. An account ing and autiting sconca involving a targe cosmetics and apparel company, Kanebo Limited, posed the first major challenge of that new regulatory IramseworkComments Case 8.4 Registered Auditors, South Africa 431 The South Atrican economy was rocked in secent years By @ Series of financial report ing scandals. To restore the credibility of the nation's capital markets, the Sowth African Pusliarnent passed a conmoversiaf new taw, the Auditing Profession Act (APA). The APA established a new auditing regulatory agency and a new professional creciential for independent auditors. The APA also mandated that independem auditors immedi- ately disclose 10 the new cudning agency any “reportable iaveguicrities” commited by arn audit chent case @uan Yan 443. The Big Four accounting fms view Chine as one of the most fucralive markets for accounting and auditing sewices worldwide. However, those fms face major chal- lenges it that market. Ainong these challenges are an increasing fitigation visk ant the dithicully of coping with the often heavy-handed tactics of China’s authoritarian central goverment. Cate Kaset Thai Sugar Company 455 This case focuses on the 1999 riueler of Michaed Wansiey. a pariner with Defoitte Touche Tomatsu. Wansley was supervising a deberestrrctusing engagement in arremote region of Thailand when he was gunned down by a professional assassin. Case 8.7 Republic of Somalia 459 PricewaterhouseCoopers (PwC) accepted « lacrative, unusital, andl very controversial engagement for the transitional government established for Somalia by the United Na- lions. The case questions require students 10 consider the significant 88s and thorny ethical issues that engagement poses for Puc. case 6.@ CAO Gazprom 4 Business Week referred (0 the huge Gazprom debacte as “Russia's Enron.” For the fst time in the history of the new Russian republic, a Big Four accounsing frrn was sued for allegedly issuing improper audit opinions on a Russian company’s financial statements. Case 8.9 Societe Generale 47 ‘This case addresses the surprising decision made by Societe Generale, France's second fengest bank, to backdaie a 6.4 biliion eure loss that resulted from unautrorized secant tues traces made by ore of its employees. Alfhough drat huge toss aeeurrec! in 2008, the bank inciucted the lass in its audited financial statements for 2007, To justify that decision, the bank's managesient invoked 4 controversial provision of fatemiationial Financial Reporting Standards (IFRS). Case 0 Institute of Chartered Accountants of India 493 The lnstitute of Chartered Accountants of india (ICA) is the federaF agency that aversees India’s accourating profession. in 2002, the ICAL commissioned a stucly of the alleged takeover of that profession by the major international accounting firms.Conrenrs The vesulting 90-page report changed that those fams had used a variety of illicit and 20en toga methods to “cofoni2e” India’s market for accounting, aubiting, and relaged services 10 the demiment of she nation’s domestic accounting (éns. Case 6.11 Republic of the Sudan 505 {In 2004, the SEC began requiring domestic and foreign registrants fo disclose any bust ness operations wiltre, or oifier relationships with, Siedara aad other countries identi- fiecl as state sponsors of terorism. Three years later, the SEC included a Web page on fis EDGAR website that fisted all such comparties. This SEC “biacktist” praved to be extremely controcersial aad triggered a contemtious debate aver the federad agency’s reguiaiory mandate and ils definition of “materintty.” cas 8.12 Shari'a 51 Islamic companies are prohibited from engaging in transactions that violate Shari'a, hat is, [shane religious low. To ensure that they have complied with Sana, fstaunic companies have their operations subjected to a Shari'a compliance auelit each year, Recently, Big Four firms have begun ollering Shari'a axel sewices, Case = Mohamed Salem El-Haclad, Internal Auditor 521 Accountants sometimes find themselves in situations in which Hey must report unethical or even ilegad conduct by otter members of their organization. This case examines the trials and tribulations of an interaal auditor who “blew tee whistle” on his immediate superior lor embezzfing large sums of cash from their employer, #he Washington, £.C., embassy of the United Arab Eiivates, Case 8.14 Fue Kwang Vine 527 “Enwionmental and tabor practices” qudiis ave ane of many nonmaditional services Hat major accounting Fins have begun offering in recent years to generate new revenue streams. Ernst & Young provided such an audit for Nike, which had been accused of operating foreign “sweatshops” to produce its (aotwear products. This case documents the unexpected challenges and prablems that accoumting firms may face when they provide services outside Meir iraihional areas of professional expesise Inclex 533 Summary of Topics by Case 543 Summary of Cases by Topic 555PREFACE ‘The past decade has arguably been the most turbulent and traumatic in the history af the accounting profession and the independent audit function, Shortly after the turn ofthe century, the Enron and WorldCom fiascoes focused the attention of the investing public, the press, Wall Street, and, eventually, Congress on our profession. ‘Those seandals resulted in the passage of the Sarbanes-Oxtey Act of 2002 (SOX) and. the creation of the Public Company Accounting Oversight Board (PCAOB). Next came the campaign to replace U.S. generally accepted accounting principles (GAAP) with International Financial Reporting Standards (IFRS). That campaign stalled when the subprime mortgage crisis in the United States cased global stack ‘markets ta imploxte and global credit markets o “tree” curing the fall of 2008. Many’ patties insisted that inadequate audits were a major factor that led to the onset of the most severe global economic downturn since the Great Depression. That economic downturn claimed many companies that had been stalwarts of the U.S. economy, ‘most notably Lehman Brothers. The huge investment banking firm filed for bank ruptey in September 2008 just a few months after having had its annual financial statements “blessed” by its audit firm, AAs Congress and regulatory authorities struggled to revive the U.S. economy, news ot the largest Ponzi scheme in world history grabbed the headlines in early 2009. Inves- tors worldwide were shocked to learn that Bernie Mactolf, an alleged “wizard of Wall Street” was a fraud, Law enforcement authorities determined that billions of dollars of client investinents supposedly being held by Madott's company, Madoff Securi did not exist. The business press was quick to report that for decades Madolf Securi- ties financial statements had been audited by a New York accounting firm and had received unqualified audit opinions each year from that firm. The auditing discipline absorbed another body blow in 2010 when @ courkappointed bankruptey examiner publicly singled out Lehman Brothers’ audit firm as one of the parties most respon- sible tor the Lehman Brothers debacle. As acadeinics, we have a responsibiliy to help shepliets| our profession theough these turbulent times, Auditing instructers, in particular, have an obligation to help restore the credibility of the independent audit function that has been adversely impacted by the events of the past decade. To accomplish this latter goat, one strategy we care use isto embrace the litany of velorms reeommended several years.ago by the Accounting Education Change Commission (ABCC), Among the AECC’s recommendations was that accounting educatars employ a broader array of instructional resources, partieue larly experiential resources, designed to stimulate active teaming by students. tn fact, the intent of my casebook is to provide auditing instructors with a source of such, ‘materials that can be used in both undergraduate and graduate auditing courses. ‘This casebook stresses the “people” aspect of independent audits, Il you review a sample of recent “audit failures,’ you will find that problem audits seldom result from«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.Presace First Keystone Bak, Buranello's Ristorante, and Foamex International are the tree new cases in the Intemal Controls [ssues section. The First Keystone case re: volves around a collusive fraud involving three employees of a small branch of a Pennsylvania-based bank The case questions require students to examine Internal contro] and audit issues linked 10 a device that plays an important rote in many, if not most, of their everyday lives. namety, the local ATM. In the Buranello’s case, the central focus is internal controfs for cash receipts. A frustrated manager of a popular restaurant organized a “sting” operation to snag red:handed a subordinate who he belioved was stealing from the business. Unfortunately, the sting went avery leaving the manager red-faced and his employer an the wrong end of a malicious presecu- tion lawsuit. Finally, Foames International became the first company in the post-SOX era to be sanctioned by the SEC for the sole reason that it had inadequate intemal controls Lehman Brothers Holdings is. 4 new comprehensive case in the ninth edition of my casebook, The principal source for this case is the massive 2,200-page report prepared by the bankruptcy examiner for this former iconic investment banking firm, Lehman played a leading and notorious role in the global economic crisis of 2008-2008. To enhance their company’s apparent financial condition, Lehman's, executives engaged in lens of billions 6! dollars of “accounting-motivaled® financing transactions referred to as Repo 105s, Lehman's controversial actions prompted a. debate within the profession regarding whether “intent matters” in accounting and financial reporting decisions. The final tivo new casesin this edition ate the Freescale Semiconductor and Phillips Petroleum Company cases. Freescale Semiconductor appears in Section 4, Ethical Responsibilities of Accountants, »hile Phillips Petroleum is included in Section 5, Ethical Responsibilities of Independent Auditors. The Freescale case provides an over. view ala series of xecent insider trading incidents involving partners or employees at the major international accounting firms, including the former vice chairman of ane of those firms. In the Phillips Petroleum case, the paitner in chaege of the company’s annual audit was found in contempt of court by a federal judge and jailed when he refused te compromise the confidentiality of his client’s accounting records. My casebook can be used in several different wavs, Professors cant use the casebook as a supplemental text foran undergraduate auditing course or as a primary text for a graduate-level seminar in auditing. The instiuctor’s manual contains a syllabus for a graduate auditing course organized around this text, This casebook can also be used in the capstone professional practice course incorporated in many {iv accounting programs. Customized versions of this casebook are suitable fora wide ranige of accounting courses.as explained later, Organization of Casebook Listed next are brief descriptions of the eight groups of cases included in this text, The casebook’s Table of Contents presents an annotated description of each case.Presace Comprehensive Cases Most of these cases deal with highly publicized problem audits performed by the major international accounting firms. Among the clients in- volved in these audits are Enron Corporation, ‘The Leslie Fay Companies, Lincoln Savings and Loan Association, Madoff Securities, and Z22Z Best Company. Each ot these eases addresses a Wwidle range of auditing, accounting, and ethical issues. Audits of High-Risk Accounts In contrast to the eases in the prior section, these cases highlight contentious accounting and auditing issues posed by'a single account or group of accounts. For example, the Jack Greenberg case focuses primarily on in- ventory audit procedures. The Happiness Express case raises audit issues relevant to accounts receivable, while the Golden Bear case examines a series of reventie recognition issues Intemal Control Issues In recent years, leading authorities in the public account- ing protession have emphasized the need for auditors to thoroughly understand their clients’ internal control policies and procedures. The cases in this section introduce students to contro! issues in a variety of contexts. For exainple, the Goodner Brothers case exainines control issues for a wholesaler, while the Howard Street Jewelers-case raises important control issues relevant te retail businesses. Ethical Responsibilities of Accountants Integrating ethics into an auditing course requizes much more than simply discussing the AICPX's Code of Professional Condtuce. This section presents specific scenarios in which accountants irave been forced to deal with perplexing ethical dilemmas, By requiring students to study actual situations in which important ethical issues have arisen, they will be better prepared to resolve similar situations in their own professional careers. Thiee of the cases in this seetion will “strike close to ome” for your students since they in- volve accounting majors, For example, in the Wiley Jackson case, a soon-la-graduale accouriting major must decide whether to disclose in a pre-employment dacument a minorin-passession charge that is pending against him, Another case in this section, F&C Intemational, profiles three corporate executives who had to decide whether to compromise their personal code of ethics in the face of a large-scale fraud master- minced by thelr compaay’s chieg executive Ethical Responsibilities of Independent Auditors The cases in this section highlight ethical dilemmas encountered by independent auditors. In the Cardillo ‘Travel Systems case, two audit partners face an ethical dilemma that most audit prac- titioners will experience at some point during thelr careers. The two partners are forced to decide whether to accep! implausible explanations fora suspicious client transaction given to them by client execuitives or, alternatively, whether to “compli- cate” the given engagement by insisting on fully investigating thee transaction, Professional Roles Cases in this section examine specific work roles in the accounting profession. These cases explore the responsibilities associated with, those roles and related challenges that professionals occupying thePresace encounter. The Tomy O'Connell case involves a young audlitor recently promoted to audit senior. Shorlty following his promotion, Tommy finds himself assigned to supervise a small but challenging audit. Tommy's sole subordinate on that engage- ment happens to be a young man whose integrity and work ethic have been ques- Lioned by seniors he has worked for previously. Two cases in this section spottight the staff accountant work rate, which many of your students will experience first hand following graduation, Professional fssues The dynamic nature of the public accounting profession con tinually impacts the work environment of public accountants and the natere of the services they provide, The cases in this section highlight important issues presently facing accounting firms. For example, the Hopkins v. Price Waterhouse case explores the unique problems that women face in pursuing careers in public accounting, While the Ligand Pharmaceuticals case addresses the reaponsibility accounting firms have to ensure that theiraudit partners ate qualitied to supervise audit engagements Finally, the Fred Stern and Fitst Securities cases examine the most important legal liabifity issues within the public accounting profession. Intemational Cases The purpase of these eases is to provide yourstudents with aan introduction to impertant issues facing the global accounting profession and au- diting discipline. After studying these cases, students will discover that most of the technical, protessional, and ethical challenges facing U.S, practitioners are shared by auditors and accountants across the globe, Then again, some of these cases docu- ‘ment unique challenges that must be dealt with by auditors and accountants in cee- tain countries or regions of the world. For example, the Chinese ease (Zuan Yar’) demonstrates the problems that an authoritarian central government can present for independent auditors and accounting practitioners. Likewise, the Raset Thai Sugar Company case vividly demonstrates that atiditors and accountants may be forced to cope wit hostile and sometimes dangerous working conditions in developing coum: tries where their professional rales and responsibilities are not well understood or appreciated Gustomize Your Qwn Gasebook ‘To maximize your tlexibility in using these out-Western#Cengage Learning has included Contemporary Audtting: Real Issues and Cases in its customized publishing program, Make fl Yours, Adopters have the option of creating a customized version of this casebook ideally suited for their specific needs. at the University of Oklahoma, a customized selection of my cases is used to add an ethics component to the unclergraduate managerial account- ing course. In fact, since the cases in this text examine ethical issues acrossa wide swath of different contexts, adopters can develop a customized ethics casebook to supplement almost any accourting course. cases, ‘This casebook is ideally suited 1o be customized for the undergraduate auditing course, For example, auditing instructors who want to.add a strong international cam ponent to their courses can develop a customized edition of this text that includesPresace ae a series of the international eases, Likewise, to enhance the coverage of ethical is- sues in the undergraduate auditing course, instructors could choose a series of cases from this text that highlight important ethical issues. Following are several examples of customized versions of this casebook tat could be easily integrated inte the un- dergraduate auditing course, International Focus: Parmalat Finanziaria (82), Kansayakes (8.3), Registered Auditors, South Africa (84), Zuari Ya (8.5), OA Gazprom (8.8). Institute of Chartered Accountants of India (8.10). This custom casebook would provide your students with an in-depth understanding of the current state of the auditing discipline in several of the world’s most important countries Ethics Focus (Suzette Washington, Accounting Major (4.3), Wiley Jackson, Accounting Major (4.8), Arvel Smaet, Accounting Major (4.6), Leigh Ann Walker, Statf Accountant (61), Hamitton Wong, InsCharge Accountant (6.3). Avis Love, Staff Accountant (6.5). The frst three of these cases give your students an opportunity to discussand debate ethical issues directly pertinent te them as accounting majors. The final three cases expose stuclents to important ethical issues they may encounter shorily after graduation if hey choose to enter public acecunting Ethics Focus €#): Crave Cover Pizza, Ine. (4.1), F&C International, ine. (42), escale Semiconductor (1.4), David Quinn, Tax Accountant (1.7), American International Group 2), Waverly Holland, Audit Senior (4) This selection of ccases js suitable for auditing instructors who have a particular interest in covering wy of ethical topics relevant to the AICPA’s Cede of Professianal Conduct, several of which aye not directly or exclusively related to auditing, Applied Focus: Enron Corporation (1.1), NextCard,Ine. (1.6), ZZ2Z Best Compiany.inc. 1 9), Belot Enterprises @.8),American Fuel & Supply Company, Inc. (6.6), Livent, Inc.(81).This series of cases will provide students with a bbroad-brish introduction to the rea/ work of independent auditing, These cases raise a wide range of technical, professional,and ethical issues in a variety of client contexts Professional Roles Focus’ Leigh Ann Walker, Stalt Accountant (61), Bil DeBurger, In-Charge Accountant (62), Tommy O'Connell, Audit Senior (6.4), Avis Love, Staff Accountant (6.5), Charles Tollison, Audit Manager (6.6), Bud Carriker, Audit Senioe (7:3) This custom casebook would be usetul for aud Who choose to rely oma standard textbook to cover key technical topics in auditing-but who also want to expose their stu dents to the everyday ethical and professional challenges faced by individuals occupying various levels of the employment hierarchy within auditing firms, High-Risk Accourus Focus: Bach of the cases in Section 2, Audits of High-Risk Accounts. This series of cases will proxide your students with relatively intense homework assignments thal focus almost exclusively on the financial statement line ilems that pose the greatest challenges for auditors Of course, realize that you are free to choose any “mix” of my cases to include ina customized casebook for an undergraduate auditing course or another accountingPrerace course that you teach, For more information on how to design your customized case- book, please contact your Souths Western/Cen gage Learning sales representative ar visit the textbook website: wwrw.cengage com/custom /makeityours/knapp. Acknowledgements [ greally appreciate the insight and sugge: by the following reviewers of earlier editions of this text: Alex Ampadu, University at Buffalo; Barbara Apostolou, Louisiana State University; Sandra A. Augustine, Hilbert College; Jane Baird, Mankato State University; Jason Bergner, University of Kentucky; James Bierstaker, Villanova University; Ed Blocher, University of North Carolina; Susan Cain, Southern Oregon University: Kurt Chaloupecky, Missouri State University; Ray Clay, University of North Texas; Jeffrey Coben, Boston College; Mary Doucet, University of Georgia: Rafik Elias, California State University, Los Angeles; Ruth Engle, Lalayette Collage: Diana Franz, University of Toledo, Christynn Freed, University of Southem California: Carolyn Galantine, Pepperdine University; Soha. Ghallab. Brooklyn College; Russell Hardin, University of South Alabama: Michele C. Henney, University of Oregon; Laurence Johnson, Colorado State University: Donald McConnell, University of Texas at Arlington; Heidi Meier, Cleveland State University; Don Nichols, Texas Christian University; Marcia Niles, University of Idaho; Thomas Noland, University of South Alabama; Les Nunn, University of Southern Indiana; Robert J. Ramsay, Ph.D., CPA, University of Kentucky; John Rigsby. Mississippi State University: Mike Shapeero, Bloornsburg University of Pennsylvania; Edward F. Smith, Boston College; Dr. Gene Smith, Eastern New Mexico University; Rajendra Srivastava, University of Kansas; Richard Allen Tarpen, University of Alabama at Birmingham; T Sterling Wetzel, Oklahoma State University: and Jin Yardley, Virginia Polytechnic Unie versity, This project also benefitted greatly from the editorial assistance of my sister, Paula Kay Conatser, my wife, Carol Ann Knapp, and my sen, John Williatn Knapp. 1 would also like to thank Glen McLaughlin for his continuing generosity in funding the development of instructional materials that highlight important ethical issues. Finally, I would like to acknowledge the contributions af my students, who have pre- vided invaluable comments and suggestions on the content and use of these cases, ns provided Michael. Knapp McLaughlin Chair in Business Ethics, David Ross Boyd Professor, and Protessor of Accounting University of Oklahoma«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.CASE 1.1 Enron Corporation John and Mary Andersen immigrated to the United Stales from their native Nonway n TSS. The yours couple made thelr way to the small farming community of Plano, Hniols, some 40 miles sauthivest of downtown Chicago, Over the previous few de- ades, hundreds af Norwegian families had settled in Plano and surrounding com romithe couple's new tiametown: (n 1883, Arthur Edward Andersen was born. Fron fi inthe did his par oul me the drivi fer he was born, an accounting firm bearng Arthur the Andersens’ son had a fascina ents realize thal Anhurs interest in sii life, Less t n ane cent Hon with more than 1.060 partners and aperations in dozens of countries seatlered cross the al Think Straight, Talk Straight viseipline, honesty; and a strong work ethic were three key traits that Join and Mary 5 Tnstilled fy thels say. The Andetsens also constantly impressed upon him the Imporian sursiveto help himmachieve that goal, Orplaned by the fime he w Anilersen was farced (0 ake ime job as 4 mail clerk and attend might classes fo.work is way through high school After g from high schoo! Anders Hende versity of Illinois while working ssan Accountant for Allis Chalmers, Chica appany that man waclured tractersand other farming equipment in 1908, Andorsen accepte, ition with the Chi: fice of Pnce Warehouse Al the tine, Price Watethiouse, which was organized in Great Brilain dining the early tineteenth century, easily qualified asthe United States’ most prominent pub ounting finn ALage 2, Andersen became the young ayoung teenage PA In the state of Tilinols. A feweyears Andersen and a friend, Clarence Delany. established a partnership to provid ccounting, auditing, and related The two young accountants named their firm Andersen, Detany & ¢ sen renamed the Brm Artur Andersen & Con andep sthal de (he clase of the company’s fiscal year but rhon its § neial statements, one of tHe clients ships sank few formal rules forcempanies to follow al statements aud rule that required the company (¢ report material “subsequent event” occurring alter the close ofits fiscal year-such asthe lass of asset, Newsrtheless, Andersen insisted that his clien igelose the loss of the ship sen reasoned that third parties who Would use the company’s financial stalerments, among the any's banker, would want 10 b niorined of the los: jon, the client everizial!sectionone Couparmensivr Casts ‘Two decades after the steamship dilemina, Arthur Andersen faced a siilar situation With an audit client that was much larger, much more prominant, and much more prof ble for his firm. Arthur Andersen & Co. served as the independent auditor for the glant chemical company, du Pont. As the company’s audit neared completion one year, members of the audit engagement team and executives of du Pont quarreled over how to define the company’s operating income. Du Pont’s management insisted on a liberal definition of operating income that included income eared on certain investments Arthur Andersen was brought into arbitrate the dispute. When he sided with his sutror- dinates, du Pont's management learn dismissed the firm and hired anolher auditor. Throughout his professional caver, Arthur E. Andersen relied on a simple, tour word molto lo serve asa guiding principle in making important personal and profes- sional decisions: “Think straight, talk straight.” Andersen insisted that his partners and other personnel in his firm invoke that simple rule when dealing with clients, potential clients, bankers, regulatory authorities, and any other parties they inter- acted with while representing Arthur Andersen & Co. He also insisted that audit eli- ents “talk straight” in their financial statements, Former colleagues and associates often deseribed Andersen as opinionated, stubborn and, in some eases, “difficult But even his critics readily admitted that Andersen was point-blank honest. “Arthur Andersen wouldn't put up with anything that wasn't complete, 100% integrity. If any- body did anything atherwise, he'd fire them, And if clients wanted to do something he didn't agree with, he'd either try to change them or quit”! As a young professional attempting to grow his firm, Arthur Anclersen quickly recognized the importance of carving out a niche in the rapidly developing account- \g Services industry: Andersen realized that the nation’s buslling economy of the 1920s depended heavily on companies involved in the production and distribution of energy. As the economy grew, Andersen knew there would be a steadily inereas- ing need for electricity, ail and as, and other energy resources, So he focused his, practice development efforts on obtaining clients involved in the various energy in- dustries, Andersen was particularly successful in recruiting electric utilities as eli- ents. By the early 1950s, Arthur Andersen & Co. had a thriving practice in the upper Midwest and was.among the leading regional accounting firms in the nation. ‘The U.S. econemy’s preeipitaus dewntum during the Great Depression of the 1980s posed huge financial problems for many of Arthur Andersen & Co’s audit clients in the electric utilities industry, As the Depression wore on, Arthur Andersen personally worked with several of the nation’s largest metropolitan banks to help his clients ob- tain the financing they desperately needed to continue operating, The bankers anel other leading financiers who dealt with Arthur Andersen quickly learmied of his eam- mitment to honesty and proper. forthright accounting and financial reporting prac- tices, Andersen's reputation for honesty and integrity allowed lenders to use wilh, confidence financial data stamped with his approval. The end result was that many troubled firms received the financing they needed to survive the harrowing days of the 1990s. In turn, the respeet thal Arthur Andersen earned amang leading financial executives nationwide resulted in Arthur Andersen & Co. receiving a growing num- ber of referrals for potential clients located outside of the Midwest During the ater years of his career, Arthur Andersen became a spokesperson for his discipline. He authored numerous books and presented speeches throughout the nation regarding the need for rigorous accounting, auditing, and ethical standards for the emerging public accounting profession. Andersen continually urged his fellow 1. Frammoline and .Leeds, “Andersen's Reparation in Shree” es Tunes online, 0 Janvary 2002casei1 Eno Conronanion accauntants to adopt the public service ideal that had long served as the underlying premise of the moze mature professions such as law and medicine, He also lobbied or the adoption of a mandatory continuing professional education (CPB) require ment, Andersen realized that CPAs needed CPE to stay abreast of developments in the business world that had significant implications for accounting and financial re- porting practices, In fact, Anhur Andersen & Co. macle CPE mandatory forts emaploy- es long belote state boards of aecountancy adopted sueh a requirement. By the mid-I940s, Arthur Andersen & Co, had offices seaitered across the eastern oné-hali of the United States and employed more than 1,000 accountants. When Arthur Andersen died in 1947, many business leaders expected that the frm would disband without its founder, who had single-handedly managed its operations over the previous four decades, But, alter several months of internal turmoil and dissen- sion, the firn’s remaining partners chose Andersen's most tusted associate and pra- égé to replace him, Like his predecessorand close triend who had personally hired him in 1928, Leonard Spacek soon earned a reputation as a no-nonsense prafessional—an auditor's audi tor, He passionately believed that the primary role of independent auditors was to ensure that their clients reported fully and honestly regarding their financial affairs to the investing and lending public, Spacek continued Arthur Andersen's campaign to improve accounting and auditing practices in the Linited States during his fong ten ture as his firrn's chief executive. “Spacek openly criticized the profession for tolerating what le considered a sloppy patchwork of acecunting standards that left the investing public no way to compare the financial performance of different companies.” Such, ériticisin compelled the aecouinting profession to develop a more formal and rigorous rleemaking process. In the late 1950s, the profession created the Accounting Prine ciples Board (APB) to study contentious accounting issues and develop appropriate new standards. The APB was replaced in 1973 by the Financial Accounting Standards Board (FASB). Another legacy of Arthur Andersen that Leonard Spacek sustained was, requiring the firm's professianal employees to continue their education troughout their careers. During Spacek's tenure, Arthur Andarsen & Co. established the world’s largest private university, the Arthur Andersen & Co, Center for Professional Eduea- tion, located in St, Charles, Nlinois, not far irom Arthur Andersen's birthplace. Leonard Spacek’s strong leadership and business skills transformed Arthur Andersen & Co. into a major international accounting firm, When Spacek retired in 1973, Arthur Andersen & Co. was arguably the most respected accounting firm not only in the United States, but worldwide as well. Three decades later, shortly after the dawn of the new millenaium, Arthur Andersen. & Co, employed more than 80,600 professionals, had practice offices in mare than 80 countries, and had annual rev- enues approaching S10 billion. However, in late 2001, the fiein, which by that time had adopted the one-word name “Andersen,” faced the most significant crisis in its history since the death ofits founder, Ironically, that crisis stemmed from Andersen's audits of an energy company a company founded in 1930 that, like many of Arthur Andersen’ clients, had struggled to survive the Depression. The World's Greatest Company Northern Natural Gas Company was founded in Omaha, Nebraska, in 1950. The princi- pal investorsin the new venture included a Texas-based company. Lone Star Gas Cor poration, During its first few years of existence, Northern wrestied with the problem 2 oisectionone Couparmensivr Casts of persuading consumers to use natural gas to heat their homes. Concern produced by several unfortunate and widely publicized hame “explosions” caused by natural gas leaks drove away many of Notthern’s potential customers. Bul. as the Depression wore on, the relatively cheap cost of natural gas convineed Incteasing numbers of cold-stricken and shallowspocketed consumers to became Norther customers. The availability ofa virtually unlimited source of cheap manual labor during the 1930s allowed Northern to develop an extensive pipeline network to deliver natural gasto the residential and industrial markets that it served in the Great Plains states As the company’s revenues and profits grew, Northem’s management launched a campaign to acquire dozens at its smaller competitors. This campaign was prompted, by management's goal of making Northern the largest natural gas supplier in the United States, In 1947. the company, which was stil relatively unknown ouside of its geographical market, reached a major milestone when its stack was listed on the New York Siock Exchange. That listing provided the company wilh greater access to the nation’s capital markets and the finanicing needed to continue its grawth-through- acquisition strategy over the following two decades. During the 1970s, Northern beeame a principal investor in the development of the ‘Ataskan pipeline. When completed, that pipeline allowed Northern to tap vast natu ral gas reserves it had acquired in Canada, In 1980, Northern changed its name to InterNorth, Inc. Over the next few years, company management extended the scape of the company’s operations by investing in ventures outside of the natural gas indus- ineluiding oil exploration, chemicals, coal mining, and fuel-ading operations, But the company’s principal focus remained the natural gas industry. In 1985, Inter Notth purchased Houston Natural Gas Company for $2.3 billion. That accuisition r= sulted in InterNarth controlling a 40,000«inile network of natural gas pipelines and, allowed it to achieve its long-sought goal of becoming the largest natural gas com pany’ in the United States, In 1986. InterNorth changed its name to Enron. Kenneth Lay, the former chairman of Houston Natural Gas, emerged as the top executive of the newly created firm thal chose Houston, Texas, as ils corporate headquarters. Lay quickly adopted the aggres- sive growth strategy that had long dominated the management policies of InterNorth, and its predecessor, Lay hired Jeffrey Skilling te serve as one of his top subordinates, During the 1990s, Skilling developed ane implemented a plan to transform Enron froma conventional natural gas supplier inlo an energy-trading company that served as an intermediary between producers of energy products, principally natural gas, and electricity, and end users of those commadilies. In early 2001, Skilling assumed Lay's position as Enron's chiet executive officer (CEO), although Lay retained the title of chairman of the board, In the management letter to shareholders included Enron's 2000 annual report, Lay and Skilling explained the metamorphosis thal Enron had undergone over the previous 15 years: Enron hrdiv resembles the company we were in the early lays. During our [Sieur history, wee have stretched ourselves beyond our own expectations, We have meta miorptosed fron en asset-based pipeline and power nesrenating company fa ar heting cmd logistics company whose biggest assets ene ts wellesiabiished business approach and its fanocative people, Enton’s 2000 annual report discussed the company’s fou principal lines of bust ness, Energy Wholesale Services ranked as the company’s largest revere produc: ‘That division's 60 percent increase in vansaction volume during 2000 was fueled by the rapid development of EntonOnline, a B2B Chusinessto-business) electronic mar- ketplace for the energy industries created in late 1999 by Enron, During fiscal 2000casei1 Eno Conronanion 2000 1999 19o8 19971906 Revener $100,789 $40.12 «$31,260 $0273 413,289, Net come: Operating Results 1,286 957 608 515, 193 Rens tmpacting Comparability __(eany (64) 5419) a1 Total 373 333 58 105 En Earnings Foe Share Operating Results Lar 118 90 a 3 Tens Impacting Comparitity (3) _(.08) a az Total 10 Eat Dividends Per Shares 30 50 48 46 a3 Total Assots: s55m3 3338) 20,350 2a.582 Cash from Operating etviies: ao 3228 1273 26 me Capital Expenctiures and Equity Investments 3316 3,085, 36h 2021.83 SE Price Ranges High goss 46.83 293388. tow 138 28.05 19051750 A7,31 Clate,Oscember 31 su 848 2853 (20.78.56 alone, EnronOnline processed more than $335 billiot of transactions, easily making Enran the largest e-commerce company in the world, Enron's three other principal ines of business included Enron Energy Services. the company's retail operating tunit; Enron Transportation Services, which was tesponsibie far the company’s pipe= line operations; and Enron Broadband Services, a new operating unit intended to be an intermediary between users and suppliers of broadband (Intemet access) ser- vices, Exhibit 1 presents the five-year financlal highlights table incitided kn Enron's 2000 annual report ‘The New Economy business model that Enron pioneered for the previously staid energy industries caused Kenneth Lay, Jeltrey Skilling, and their top subordinates to be recognized as skilltul entrepreneurs and to gain superstar status in the business world, Lay's position as the chiet executive of the nation’s seventh: largest firm gave him direct access to key political and governmental officials. In 2001, Lay served on the “transition teany” responsible for helping usher in the administration of Presidente elect George W. Bush. In June 2001, Skilling was singled out as “the No. 1 CEO in the entire courtry,” while Enron was hailed as “America’s most innovative company”! 2K The New York Tones (online ings Went Unhe ede” DB. Henriques, “Web of Deal February aun Enron Conrorarion £2000 Area Rivorr Fixanetst, Voontacirrs Tans, (Qn suLLioas excerT FOR PER SARE ANUS)«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.Seineren ExerRPrs roa SHurRRON Warknes! August 2001 Lever To Krwera Lay sectionone Couparmensivr Casts lear te Lay, Has Enran become a risky place to work? For those af us who did't get rich ever the last few years, can we afford to stay? Skilling’ abrupt departure will aise suspicions of accounting impropriatias and valuation fssues. Enion fas been very aggressive in its accounting—most notably the Raptor transactions and the Condor vehicle. 1We have recognized over $350 million of fair walua gains on stocks via our swaps with Raptor, much of that stock has declined significantly. . ., The value in the swaps won't be there for Raptor, so once again Enron will issue stock to offset these Losses, Raptor fs an LIM entity ure looks ta the laymen on tha street that we are hiding lozzes in a related company and will compensate that company with Enon stock in the future, {Lam incredibly nervous that we will implode in a wave of scandals, My 8 years oF Enron ‘work history will be worth nothing on miy resume, the business world will consider the past successes as nothing but an elaborate accounting hoax. Skilling fs resigning now for “personal reasons” but I think he wasnt having fun, looked down the road and knew this, stuff was unfisable and would rather abandon shiz now than rosign tn shame in 2 years. Is thore a way cur accounting gurus can unaind these deals now? I have thought and thought about how to do this, but keep bumping into one big problem—we hooked the Conder and Raptor deats in 1999 and 2000, we enjoyed 8 wonderfully high stock price, many executives, sold stock, we then tay and reverse or fx the deals in 2908 and f's abit lke robbing the bank in t year and trying to pay it back 2 years later... « 1 realize that we have had a lot of smart people lacking at this and a fot of accountants including AA & Co. have blessed the accounting treatment. None ofthis will protect Enron Lf these trasactions are aver disclosed in the bright ight of day ‘The overriding basic principle of account toa man on the street, would you influence his inves stock based on a thorough undesstanding of the facts? jn the “secounting treatment 14 decisions? Would he sell or buy the My concem is that the footnetes don't adequetely explain the transactions. If adequately coplained, the investor would know that the “Entities” deseribod in our related party footnote ae thinly capitalized, the equity holders have no kin in the game, and all the value in the entities comes from the underlying value of the derivatives (unfortunately inthis cate, 8 big loss) AND Enron stack and NYP. «« The related party footnote tries to explain these transactions. Don’t you think that several interested companies, ke Mey stock analysts, journalists, hedge fund managers, ety are busy trying ta discaver the reason Silling lef? Don’t you think their smartest paopla are pouring [sie} over that foatnate disclosure right naw? I can just hear the discussions —"It looks like they backed a $500 million gain fiom this related party campaay and I think, from all the undectpherable 1/2 pege on Enran’s contingent contributions to this related purty entity think the related party entity is capitalized with Enron stock.” . "No, no, no, you must have it all wrong, it can't be that, thats just too bad, too fraudulent, suraly AA & Co, woulda’t lot thent get away with that?”casei1 Eno Conronanion were used to finance the acquisition of at asset or fund a construction project or related activity. Regardless, the underlying motivation for creating an SPE was nearly always “debt avoidance.” That is, SPEs provided large companies with a jechanism to raise needed financing for various purposes without being required to report the debt in their balance sheets. Fortune magazine charged that corpo rate CFOs were using SPEs as sealpels “lo perform cosmetic surgery on their bat- ance sheets”! During the early 1990s, the Securities and Exchange Commission (SEC) and the FASB had wrestled with the contentious accounting and financial reporting issues posed by SPEs, Despite intense debate and discussions, the SE and the FASE provided little in the way of formal guidance for companies to follow accounting and reporting for SPEs ‘The most important guideline that the authoritative bodies implemented (or SPEs, the so-called 3 percent rule, proved to be extremely controversial. This rule allowed a company to omit an SPE's assets and liabilities {rom its consolidated financial statements a5 long as parties independent of the company provided a tnininzum of 3 percent of the SPE's capital. Almost immediately, the 3 percent threshold became both a technical minimum and a practical maximum, That is, large eompanies using the SPE structure artanged for external parties to provide exactly $ percent of an SPE's total capital. The remaining 97 percent of an SPE's capital was typically contris- uted by loans fram extemal lenders, loans arranged and generally collateralized by the company thal created the SPE. Many erities charged that the 3 percent rule undercutthe fundamental prineipte within the accounting profession that consolidated financial statements should be prepared for entities controlled by a Common ownership group. “There isa prestimplion that consoli- dated financial statements are more meaningful than separate statements and that they are usually necessary fora fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies" Busi- ness Week chided the SEC and FASB for effectively endorsing the 8 percent nale, Because of a goping loophole in accounting practice, companies cart create arcane legal structures, often called special prose enuities (SPS). Then, the parent can bankroll ep to 9F percene of te initial investment in an SPE without having to consol date... The comroversies exception that outsicers need invest only 3 percent ofan SPE's capita for it ta he iadependent and off the batance sheet came about through ‘unrbles by te Securities and Exchange Comision and the Financial Accounsing Standards Board. Throughout the 1990s, many companies took advantage of the minimal legal and accounting guidelines for SPEs to divert huge amounts of thelr labiltiesto off-balance sheet entities, Among the most aggressive and innovative users of the SPE structure was Enron, which ¢reated hundreds of SPEs. Unlike most companies, Enron did nat limit its SPE to financing activities. In many cases, Enron used SPEs for the sole pus- pose of downloading underperforming assets from its financial statements to the nancial statements af related but unconsolidated entities, For example, Enron would, arrange for a thied party to invest the minimum 3 percent capital required in an SPE and then sell assets fo that SPE. The SPE would finance the purchase of those assets by loans collateralized by Enron common stock. In some cases, undisclosed side 84K 1 "Oft Balance Sheu—AN of Conc.” Fort, 18 Febeusry 2092, 8 ecctating Research Bulla No, 51, “Conseltaed Finansial Staternents” (New York: AICPA. 12 11. D-Henny, Ff, Thnmons 8. Resenbush and M. Arnal ‘Who Blse Is Hig Debt?” Business Week PB danuary 2002, 8-97sectionone Couparmensivr Casts agreements made by Enron with an SPE'snominal owners insulated those individuals, from any losses on theie investments and, in fact, guaranteed them a wind all pratit Even more troubling, Enron often sold assets at grossly inflated prices to their SPES, allowing the company to mantelacture large “paper" gains on those transactions Enron made only nominal financial statement disclosures for its SPE twansactions and those disclosures were typically presented in confusing, if not cryptic, language ne aecounting professor observed that the inadequate disclosures that companies such as Enron provided for their SPE transactions meant that, “the nonprofessional [investor] has mo idea of the extent of the (given firn’s] real liabilities" The Wail Street Journal added to that sentiment when it suggested that Enron’s beiet anc ob» cure disclosures for ils offbalance sheet liabilities and related-party transactions were 86 complicated as to be practically indeeipherable.” Just a3 difficult to analyze for most investors was the integrity of the hefty prof its reported each successive period by Enron. As Sherron Watkins revealed in the letter she sent to Kenneth Lay in August 2001, many of Enron's SPE transactions re- salted in the company’s prafits being inflated by unrealized gains on increases in the market value of its own common stock. In the fall of 2001, Enron's board of directors, appointed a Special Investigative Committee chaired by William C. Powers, dean of the University of Texas Law School, to study the company’s large SPE transactions. In February 2002, that committee tssuec a lengthy report of its findings, a cocument commonly referred 10 a5 the Powers Report by the press. This report discussed al length the “Byzantine” nature of Enronis SPE transactions and the enormous and it~ proper gains thase transactions produced for the company, Accounting principies generally forbid a company from recognizing an increase fn theaakue of ts captal siock in its income Statement... The substance of fhe Raptors {SPE transactions] esfectvety alioaned neon fa repost gains on fs income siatement that were... fitributable to} Error stock, and contnacis to receive Bron stock, held by the Raptors." ‘The primary motivation for Enron's extensive use of SPESand the related accounting machinations was the company’s growing need for capital during the 1990s, As Kenneth Lay and Jelfrey Skilling transformed Enron from: fainly standatel natural gas supplier into a New Econamy intermediary forthe energy industries the company hada constant need, for additional capital to nance that transformation. Like most new business endeavors, Enron's Internet-based operations did not proclce positive eash Movs tnmediately. To convince lenders to continue pumping cash into Enroa, the company’s management tenuis ealized that thelr fim would have lo maintain a high credit rating, whieh, in turn, 1e- quired the company to release impressive financial statements each succeeding period, Arclated factor that motivated Enron's executives to window dress their company’s financial statements was the need ta sustain Enron’s stock price at a high level. Many’ of the SPE loan agreements negotiated by Enron included so-called price “riggers” Ihe market price of Enton’s stock dropped below a designated level (rigger), Enron was required to provide additional stock to collateralize the given loan, to make significart cash paymentsto the SPE, or fo restructure prior transactions with the SPE. 2, Mo 1, J. Enushwillerand R, Smith, “Murky Wotese A Primer on the Engon Partnerships” Phe Will Steet Journal (online) 21 Janwary M4, W.C. Powers, B.S Toubh, and. §. Wh shut "Report af lavesigation bythe Specta! Investigativecasei1 Eno Conronanion Ina worst-case scenario, Enron might be forced to dissolve an SPE and merge its as- sets and liabilities into the company’s consolidated financial statements, What made Enron's slock price so importardl was the lact hat some of the company's rest important deots uit the partnerships (SPEs] run by Mf. Fastew—deat that hd allewed Eeron to keep handvedls of millioes of collars of potential losses off tts books —were thaanced, in effect, wi Envon stock, Those transactions could fall apart ithe stewk price ell too har AsEnron’s stock price drifted lower throughout 2001, the complex labyrinth af le gal and accounting gimmicks underlying the company’s finances became a shaky house of cards. Making matters worse were large losses suttered by many of Enron's, SPEs on the assets they had purchased froin Enron, Enron executives were forced to pour additional resources into many of those SPES to keep them solvent. Contrit- uting to the financial problems of Enron's major SPEs was alleged sell-dealing by Enton officials involved in operating those SPEs, Andrew Fastow realized $30 million in profits on his investments ins Enron SPs that he oversaw at the same tite he was serving as the company"s CFO. Several of his friends also reaped windfall profits on investments in those same SPES. Some of these individuals “earned” a profit of as, much as $1 million on an initial investment of $5,800. Even more startling was the fact thal Fastow’s friends realized these gains it as litle as 6 days, By October 2001, the falling price of Enron's stock. the weight of the losses suffered by the company’s large SPEs, anid concems being raised by Andersen atiditors forced company executives to act, Enron's management assuined contra! and ownership of several of the company’s troubled SPEs and incorporated their dismal financial statement data into Enron's consolidated financial statements, This decision led to the large loss reported by Enron in the fall of 2001 and the related restatement of the company’s earnings for the previous five years. On December 2, 2001, the trans- formed New Age company filed its bankrupley petition in New Age fashion—via the Internet. Only six months earlier. Jetfrey Skilling had been buoyant when comment- ing on Enron's first quarter results for 2601. "So in conclusion, first-quarter results were great, We are very aptimnistic about our new businesses and are confident that ourrecord of growth is sustainable for many years to come.”! As law enforcement authorities, Congressional investigative committees, and busi- -ss journalists rifled through the mass of Enron documents that became publicly avail able during early 2002, the abusive accounting anel financial reporting practices that had been used by the company surfaced. Enron's creative use of SPE became the pri- mary target of critics; however, the company also mace extensive use of otheraccount- ing gimmicks, Forexample, Enron had abused the marito-market accounting method, for ts long term contracts involving various energy commodities, primarily natural gas anid electricity. Given the nature of their business, energystrading firms regulary enter into longterm contracts to deliver energy commodities. Some of Enzon's commodity contracts extended over petiods of more than 20 years and involved massive quantities ofthe given commodity, When Enron finalized these deals, company officials otten ‘made tenuous assumptions that inflated the profits booked an the contracts. Energy trcters sats! Book al Pie projected profits rom a supply contract inthe quarter in which the deat ie made, even ifehe contact spans mony yous. That mecns compos niles can éattate profits by using unrealistic price forecasts, ax Enron has been accused of doing. Ifa company contracted to bey nafurat gas Umough 2010 for S3 per thousand 15, Elehunwald and Heusiques, Web of Data” 1, tisectionone Couparmensivr Casts cube feet, an energyeteading desk could aggressioely axsenne if wuld b pty gees in each year al a cost of just $2, fora ST prot maagin.? able to sup: ‘The avalanche of startling revelations regarding Enron's aggressive business, a¢- counting, and financial reporting decisions reposted by the business press curing the early weeks of 2002 created a firestorm of angerand criticism directed at Enron's key executives, principally Kenneth Lay, Jeltrey Skilling, and Andrew Fastow. A common theme of the allegations leveled at the three executives was that they had created a. corporate culture that festered, if not encouraged, rule breaking” Fortune magazine observed that, “I nothieg else, Lay allowed a culture of nile breaking to Nourish” while Sherron Watkins testified that Enron's corporate culture was “arrogant” and “intimidating” and discouraged employees [rem reporting and investigating ethieal lapses and questionable business dealings." Finally, a top executive of Dynegy, company that briefly considered merging with Enron duving late 2001, reported that “the lack of internal controls [within Enton] vas mindboggling.* Both Kenneth Lay and Andrew Fastow invoked their Fifth Amendment rights against seltincrimination when asked to testity before Congress in early 2002. Jetfrey Skilling did not, While being peppered by Congressional investigntors regarding Enron's ques- Honable accounting and financial reporting decisions, Skilling replied calmly and re- peatedly: “Iam not an accountant” A well-accepted premise in the financial reporting domain is that corporate executives and theiraceountantsare ultimately responsible for Ue integrity of their company’s financial statements. Nevertheless, frustration steruming fromthe lack of answers provided by Enron insiders to Key accounting and financial reportingcrelated questions eventually caused Congressional investigators, the business press, and the public o focus theirattention, their questions, and theirscotn on Bxtran’s independent audit firm, Andersen, These parties insisted that Andersen representatives, explain why their audits of Enron had failed ta result in more transparent, i not reli- able, financial statements for tke company. More pointedly, those critics demanded that Andeisen explain how it was able to issue unqualified zurdit opinions on Eneon’s finan- cial statements throughout its 15syear tenure asthe company’s independent audit firm Say It Ain't So Joe Joseph Berardino became Andersen's chiet executive shortly betore the firm was swamped by the storm of criticism surrounding the collapse of its second-largest el- ent, Enron Corporation, Rerardino launched his business career with Andersen in 1972 immediately after graduating trom college and just few months before Leonard Spacek ended his long and illustriaus career with the firm, Throughout its histary, the Andersen firm had a policy of speaking with one voice, the voice of its chief ex- ecutive. So, the unpleasant task of responding to the angry and often self-righteous ssations hrled at Andersen following Enron's demise fell to Berardino, although, hhe had net been a party to the key decisions made during the Enron audits. A coinmon question ditected at Berarditio was whether his firt hadl been aware of the allegations Sherran Watkins made during August 2001 and, if so, how had Andersen responded to those allegations. Watkins testified before Congress that shortly atler she communicated her concerns regarding Enron's questionable ac- counting and financial reporting decisions to Kenneth Lay, she had met with a Coy... Pores, a 1. Foust. "Enrore How Good an Energy Trader” Business Week, Ul Febroat 18. B McLean, “Monster ies<® Founune 4 February 2002, 15, Hamburger, Watkins Tells of Arrogant Culture 20. N.fanjoroe, 0.Barbora, and.s, Warren, “At Ennor, Lavish Excoss Of Carne bufore Success,«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.casei) xno Conronarion nf ms \ Page Sz In virtually all ofthe [SPE] transactions Enron's accounting treatment was detocrvned with the extensive pasticipation and stecturing advice fem Andersen, which eS reported ta the Coard. REPORT REGARDING Awoensen's Page 17: Various disclosures [regarding Enen’s SPE transactions] ware approved by one er fever ‘more of Enron's outside [Andersen] auditors and its inside and outside counsel. Howevey, Ev ACCOUNTING these disclosures were obtuse, did not communicate the essence ofthe transactions AND FINANCIAL completely or cesrly, and flied to coney the substance of what was gaing on between Ferrokrne Enron and the partnerships, Dretsons oe Exons SPE. age 24; The avidence available to us suggests that Andarsen did rt fulfill ts professional TRANSweTIONs responsibilities in cormection with its audite of Ervan’s financial statemants, or its obligation to bring to the attention of Enron's Board (or the Audit and Compliance Commiteee) eoncemns ‘bout Enron's intemal conttots over the related-party (SFE] transactions. Page 24: Andersen participated in te structuring and accounting treatment of the Raptor transactions, and charged over SI million for its services, yet ft apparently failed to provide the objective accounting judgment that chould have provented there transactions fram: going forward. Page 25: According to recent public disclosures, Andersen also faited to bring to the attention of Enrow/s Audit and Conipliance Committee serious ceservations Andersen partners voiced intemally about the related-party transactions, Page 25: The Board appears to have reasonably relled upon the professional judament of Andersen concerning Enron's financial statements and the adequeey of controts for the relatod-party transactions, Gur raview indicates that Andersen failed to mact ite responsibilities in both respects. Page 200: Accountants from Andersen were lovely involved in structuring the Raptocs [SPE tuansactions).. . . Enron’ records sow that Andersen billed Enron approximately 335,000 J connection with its work on the creation of the Raptors fn the fist several months of 2000. Page 107: Causey [Enron's chiof accounting officer) infoamed the Finance Committae that Andersen “had spent considerable time analyzing the Talon structure and the gowemance structure of LIM2 and was comfortable with the proposed [SPE] transaction.” Page 126: At the time [September 2001], Enron accounting personnel and Andersen Ccontluded (using cuslitative analysis) that the error [fn a prior SPE transaction] was not ‘material and a restatement was not necessary, Page 129: Proper financial accounting dos not permit this result [auestionsble accounting treatment for certain of Enron's SPE transactions]. To reach it, the accountants at Enron and Anderzen—incluting the local engagement team snd, zpnarently, Andersen's nationa| office experts in Chicago—had to surmount numerous obstacles pravented by pertinent accounting rules. Page 12¢: It is particulaity surprising that the accountants at Andersen, who should have brought a measure of objectivity and perspective to these banssctions, did mvt do 33. Based on the recollections of those involved nthe transactions and a large cotlection of documentary evidence, there is no question that Andersen arcauntante were in a posi to understand all the critical features of the Raptors and offer advice en the appropriate ‘accounting treatment. Andersen’s total bill for Raptor-related work came ta approximately 51.3 milion. Indeed, there is abundant evidence thot Andersen fn fact offered Enon advice (continued)/ renin 3— Siussrey EActRI IS Faow THE Panes REPORT REGARDING ANDERSEN'S ISVOLVEMENT I Key Accounris Axo Financnat Reronrint Dircstons pot Enkon's SP4 TRANSACTIONS sectionone Couparmensivr Casts at every step, fom inception through restructuring and ultimataly to terminating the Raptors. Enron followed that advice, age 202; Whila we have nat had the benefit oF Andasson's position on a number of these {issues the evidence we have seen suggests Andersen aceountants di not function as an sffecive check on the dircloswe approach taken by the company, Andersen was copied on sats ofthe financial statement footnotes and the proxy statements, anc we were told that ‘t routinely provided comments on the related-party transaction diclosues in eesponie. Me also understand tht the Andersen auitors closest to Eran Global Finance were volved in drafting of atleast some ofthe dselonures. An internal Andersen ems rom Febeuanye 2001 release in enanection with recent Congressiant hearings suggests that Andersert may havo had concorns about the disclosures of the rlated-party transactions inthe financial statement footnotes. Andersen di rot express such concerns to the Board. Gn the contrary, ‘Kndercen's engagement parkne tld the Audit ard Compliance Commtine just a week after the intemal email that, with respect to related-paty Lensactions, “[rJequited disclosure {ha been] reviawed for adequacy! and that Andersen would sue an unqualified ait opinion on the financial statements.” ‘ove: WL Powers, 5, Trew, and HS Wink “Report of Snsestigation by the Spact Investigative Committ ofthe Baa of Directors of Enron Corporati.” 1 Fodruary 2002. Among the parties most critical of Andersen's extensive involvement in Enran’s ac- counting and financial reporting decisions for SPE transactions was former SEC Chief Accountant Lynn Turner, During his tenure with the SEC In the 1990s, Turner had participated in the federal agency's investigation of Andersen's audits of Waste Man- agement Inc. That investigation culminated in sanctions against several Andersen auditors and in a $1.4 billion restatement of Waste Management's financial statements, the largest accounting restatement in U.S. history at that time, Andersen eventually aid a reported $75 million in settlements to resolve various civil lawsuits linked to those audits and a $7 million fine to settle charges filed against the firm by the In an interview with The New York Times, Turner suggested that the charges ot shoddy audit work that had plagued Andersen in connection with its audits of Waste Management, Sunbeam, Enron, and other high-profile public clients was well- deserved ‘Tuner compared Andersen's problems with those experienced several years ear- lier by Coopers & Lybrand. a firin or which he had been an audit pariner. Accort= ing to Turner, a series of “blown audits” was the source of Coopers’ problems, “We gol bludgeoned 10 death in the press. People did not even want to see us at their doorsteps, It was brutal, but we deserved it. We hiad gotten into this mentality in the firm of making business judgment calls" Clearly, the role of independent auditors does not include "making business iudginents” or their clients. Instead, auditors have: a responsibility 10 provide an objective point of view regarding the proper account- ing and financial reporling decisions for those judgments, Easily the source of the most embarrassinent far Berardino and his Andersen col- leagues wasthe widely publicized effort of the firm's Houston office to shred a large quantity of documents pertaining to various Enron audits. In early January 2002. Andersen officials informed federal investigators that persannel in the Houston of- fice had “destroved a significant but undetermined nuinber of documents relating 28. & Nort, "Brom Sua BY November The New York Pines toutingcasti1 Enon Conrorarion to the company [Enron] and Its finances."®” That large-scale effort began in Sep- tember 2001 and apparently continued into November atter the SEC revealed it was conducting a formal investigation of Enron's financial affaits. The report of the shredding effort Immediately caused many crities to suggest that Andersen's Hous- ton office was attempting to prevent law enforcement authorities from obtaining potentially incriminating evidence regarding Andersen's role in Enron's demise. Senator Josep Lieberman, chairman of the U.S, Senate Gavernmental Attairs Committee that would be investigating the Enron debacle, warned that the eftort lo dispase of the Enron-telated doctiments might be particularly problemati¢ for Andersen, Jt fhe docement-stredding} came at a time when people inside, including the execu- tives of Aufur aradersen ond Enron, keen tal Enron was é rea! trouble ane slat the oof was abaut te collapse on Hen, and tere wes about Jo be a comporate scandal [This] raises very serious cprestions about whether obsenuction of ustice occured hhere. The folks at ArtherAncersen could be on the other end of an fndictment before this fs over. This Baron episcde may en uhts company's history" ne barrage of criticism directed at Andersen cantinued unabated during the early months of 2002. rnically, some of that criticism was directed at Andersen by Enron's top management. On January 17, 2002, Kenneth Lay issued a press release reporting that his company had decided to discharge Andersen as its independent ausit firm! _As announced of Oct. 31. the Enron Board of Directors eonvened a Special Conumitee {o-fook into accaueting and oiler issues veleting do certain transactions, Watle we had been wilting to give Andersen the boned ofthe donb met the completion of that investigation, we can't adfard to wait any fonger ir fight of recent events, including the reported destruction of documents by Andersen personnel aa dhe eisciplinary actéons against several of Andersen's partners in is Houston office,” ‘Throughout the public relations nightmare that besieged Andersen following Enron’s bankruptcy filing. a primary tactic employed by Joseph Berardino was to in- sist repeatedly thal poor business decisions, not errors on the part of Andersen, were responsible for Enron's downfall and the massive losses that ensued for investors, creditors, and other parties. “At the end of the day. we do not eause companies to fail Such statements failed to generate sympathy lar Andersen, Even the ed torin- hie! of Accounting Today, one of the accounting prolession's leading publications, was unmoved by Berarelino’s continual assertions that his fim was not responsible (or the Enron fiasco, “If you accept the audit and collect the fee, then be prepared to accept the blame. Otherwise you're not part of the solution but rather part of the problem. K.Elchenwald ond FN) Conligep, 1 Janwary 2002 30, & A. Cppel, sAvcotwon Saye Latnper Latte Stall Dest Fie! Ta Rw: Work Ties (oni rs, “Enon Autor A nls Desitoyed Dacutnents* The New Yok Thnes roaischalrmt ofthe bout atid CEO on Js tec” hax requested hi to sep owes M2. ohe eh Lay resigned assectionone Couparmensivr Casts Ridicule and Retrospection ‘As 20011 came toa close, The New York Tiines reported that the year had easily been the worst ever for Andersen, “the accounting firm that once deserved the title of the conscience af the industry.” The following year would prove to be an even darker time for the firm, During the early months of 2002, Andersen faced scathing eriti- cism trom Congressional investigators, enotmous classaction lawswits filed by angry Enron stockholders and creditors, and a federal criminal indiciment stemming from the shredding of Enron-related documents. In late Slarch 2002, Joseph Berardino unexpectedly resigned as Andersen's CEQ after failing to negotiate a merger of Andersen with one of the other Big Five firms During the foltowing tew weeks, dozens of Andersen clients dropped the firma as their independent auditor out of concern that the firm might not survive if it was found guilty of the pending criminal indictment. The staggering loss at clients forced, ‘Andersen to lay off more than 25 percent of its workforce in mid-April. Shortly af- ler that layoff was announced, US. Justice Department officials revealed that David Duncan, the former Enron audit engagement partner, had! pleaded guilly to obstruc- lion of justice and agreed to testify against his former firm. Duncan's plea proved to be the death knell for Andersen. In June 2002, a federal jury found the firm guilty at abstruction of justice. That conviction forced the firm to terminate ils relationship with Its remaining public clients, effectively ending Andersen's long and proud his- tory within the U.S. accounting profession. Three years later. the U.S. Sapreme Court unanimously overturned the felony conviction handed down against Andersen. In an opinion written by Chief Justice William Rehnquist. the High court ruled that federal prosecutors di not prove that Andersen had intended to interfere wilh federal investigation when the firm shred- ded the Enron audit workpapers. The Supreme Court's decision was little comsola- tion to the more than 20,000 Andersen partners and employees who had lost their jobs when the accounting firtn was forced out of business by the felony conviction Numerous Enron officials faced criminal indictments for their roles in the Enron fraud, among them Andrew Fasiow, Jeffrey Skilling. and Kenneth Lay. Fastow pleaded guilly to conspiracy to commét securities fraud as well as to other charges. The former CFO received a 10-year prison term, which was reduced to six years alter he testified against Skilling and Lay. Fastow was also required to forieit nearly $25 million of pee- sonal assets thal he had accuanulated curing his tenure at Enron. Largely as a result of Fastow’s testimony against them, Skilling and Lay were convicted on multiple counts of fraud and conspiracy in May 2008. In September 2006, Skilling was sentenced to 24 years in prison. Kenneth Lay, who was to be sentenced al the same time, died of a massive heart attack in July 2006, Three months later, a federal judge overturned Lay's conviction since Lay was no longer able te pursue his appeal af that conviction, ‘The loll taken on the public aecouinting profession by the Enron debacle was nol limited to. Andersen, its partners, or its employees. An unending flood ot jokes and, ridicule directed at Andersen tainted and embarrassed practically every accountant in the nation, ineluding both accountants in publie practice and those working in the private sector. The Enron nightmare also prompted widespread soubsearching within the profession and a public outcry to strengthen the independent audit func- tion and improve accounting and financial reporting practices. Legistative and regue latory authorities quickly respanded to the public's demand forreforms ‘The FASB imposed stricteraccounting and financial reporting guidelines on SPEsas a direct result of the Enron case. Those new rules require most companies to include 38. Nonils, “From Sunbearn 19 Enron,casei1 Eno Conronanion the financial data for SPE in their consolidated financial statements. In 2002, Con- gross passed the Sarbanes-Oxloy Act to strengthen financial reparting far public eam- panies, principally by improving the rigor and quality of independent audits. Among other requireinents, the Sarbanes-Oxley Act limits the types of consulting services, that independent aucitors can pravide to their clients and tequites public companies to prepare annual reports on the quality of their internal controls. The most sweeping change in the profession resulting from the Enron flasea was the creation at a new federal agency, the Public Company Accounting Oversight Board, to oversee the rule: making process for the independent audit Lunction Among the prominent individuals who commented on the challengesand problems facing the accounting profession was former SEC Chairman Richard Breeden when he testified belore Congress in ealy 2002. Chairman Breeden observed that there \was a simple solution to the quagmire facing the profession. He called on accoun- tants and auditors to adopta simple rule of thumb when analyzing, recording, and re- Porting on business transactions, regardiess of whether those transactions involved. “New Economy" or “Ole Economy” business ventures. “When you're all stone, the result had better fairly reflect what you see in reality” In retrospect, Commissioner Breeden’s recommendation seems to be a restate: ment of the “Think straight, talk straight” motia of Arthur E. Andersen. Andersen ane his colleagues insisted that their audit clients adhere to a high standard of integrity when preparing their financial statements. An interview with foseph Berardino by The New York Times in December 2001 suggests that Mr. Berarcina and his contem- poraries may have had a different attitude when it came to dealing with cantanker- us clients such as Enon "In am interview yesterday, Mr Berardina said Andersen had no power to force a company to discinse that it had hidden risks and lasses in speciakpurpose entities. ‘A client says: “There is no requirement to disclose this, You can't hold me to a higher standard Berardino is certainly correct in his assertion. An audit firm cannot force a client toadhere to a higher standard. In fact, even Arthur Edward Andersen did not have that power. But Mr. Andersen did have the resolve to tell such clients to immediately begin searching for another audit frm, Questions 1, The Enron debacle created what one public official reported was.a “crisis of confidence” on the part of the public fn the accounting profession. List the patties who you believe were most responsible for that crisis. Briefly justity each of your choices, 2. List three types of consulting services that audit firms are now prohibited from providing to clionts that are public companies. For each item, indicate the specific threats, any, that the provision of the given service could pose foran audit firm's independence. 3. For purposes of this question, assume thal the excerpts from the Powers Report shown in Exhibit 3 provide accurate descriptions of Andersen's involvement in Enron's accounting and financial reporting decisions, Given this assumption, do you believe that Andersen's involvement in those decisions violated any professional auditing standards? If so, ist hose standards and briefly explain your rationale. R.Sellonk “Force Februay 2000, 5, Norns, “The Desire Numbers at Enron.’ The News Yor Tires (online), M December 20 Chinen Unge Con gress to Free FASE Accounting Wed (colin),«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.sectionone Couparmensivr Casts Another revelation in the bankruptey report that stunned the public was the faet that Lehman’s audit firm had been aware of the billion-dollar transactions the company had used to window-dress its financial statements. According to the bankmpicy examiner, the Big Four aucit firm had discussed those lransactions on many occasions with company afficials but had not insisted or, apparentiy, even suggested that the company disclose them in their financial statements oF the ac- comipanying notes, ‘The bankruptey examiner also maintained that the audit firm had not properly formed Lehman's management and audil committee of an internal whistleblow- ers allegations that management was intentionally misrepresenting the company’s financial statements, Because of alleged professional malpractice, Lehman's audit firm was among the parties the bankruptey examiner suggested could be held civilly liable for the enormous losses suflered by the company’s stockholders and. creditors, The Cotton Kings Political unrest and poor economic conditions in their homeland prompted six mil- lion Germans to immigrate to the United States during the nineteenth century Those nmigrants included three brothers from Bavaria, the beautifsl mountainous region ol southeastern Germany. In 1844, 23-yearald Henry Lehman arrived in Montgomery, Alabama, a small city with fewer than §,000 inhabitants in south central Alabama. Over the next few years, Henry’s two brothers, Emanuel and Mayer, joined him in Montgomery ‘The three brothers establistied a small retail store that stocked a wide range of merchandise including groceries, clothing, and hardware, Among the brothers! prineipal customers were cotton farmers from nearby rural areas who often paid for the merehandise they purchased with cotton bales. The brothers soon realized that there were more profits to be made in buying and selling cotton than operating a relail slore, 50 they became cotton merchants By 1860, “King Cotton’ ruled the South, The southern states accounted for three- fourths of the cotton produced worldwide. Cotton was alsa the nation's largest ex- ort, accounting for 6 percent of the U.S.’ tatal annual exports. In 1858, the huge demand for cotton in New England's booming textiles industry had convinced the Lehman brothers to establish an office in lower Manhattan. just a few blocks from the Wall Street financial district, But the outbreak of the Civil War in 1861 forced the Lehmans, who supported the Confederacy, to close that office. The economic embargo imposed by President Lincoln an the South during the Civil Warmeant that cotton merchants such as the Lehinan brothers lost their biggest market. Because the Lehmans realized that the demand for cotton would spike dra- matically following the war, they bought large quantities of ectton produced during the War years and stored it in wellhiddien warehouses scattered across the South, ‘The postwar prafits the brothers realized {rom selling that cotton helped them rees- tablish their firm as oné of the South’s largest cotton merchants following the war. By 1870, the Lehman brothers hag reopened their New York City office; a short time later, hey made that office the headquarters of their business In the latter decades of the nineteenth century, the Lehman brothers gradually ex- banded their business to include the trading of other commodities, such as coftee, sugar, wheat, and petroteum products. ‘The three brothers also decided to purchase a seal on the New York Stock Exchange. They realized that there was a need for financial intermediaries to fisnnel private investment capital to the large companies that were fueling the nation’s rapid economic growth. Because of the nature of theircastia Lamm Broviers Hotoines, Ise. business, the three brothers were well acquainted with the banking and credit indus- tries and believed they could use that experience to easily segue into the emerging and very lucrative investment banking industry. By the early years of the twentieth centuiy, the Lehman firm, which by then was being managed by the second generation of the Lehman family, had cut its tiesto the cotton industry and focused sattertion almost exclusively on investment banking, During that time frame, the fiem served as the underwnter forseveral companies that would become stalwarts of the U.S, economy. These companies included BF, Goodrich, Campbell Soup, FW. Woohvoith, RH. Macy & Co, and Sears, Roebuck & Co. Investment banks facilitate the flow of investment capital in a free market economy by effectively "pricing risk Thatis, investment bankers help buyers and sellers de- termine the appropriate relationship between the risk posed by given securities and the price at which those securities shauld be initially sold. This pricing process helps ensure that searce investment capital is allocated in an efficient manner lo corpora tions, other business organizations, and governmental agencies that need external fundsto finance their operations. Investment banking firms face a wide range of business risks. For example, invest- ‘ment banks sometimes absorb large losses on new client securities that they acquire during the underwriting pracess and ate unable to sell lo third parties, The most important factor contributing to the risk profile of investment banks is the degree of financial leverage they utilize. Similarto commerctal banks, investment banks rely heavily on debt capital rather than invested eapital. This high degree of financial leverage typically results in significant profits accruing to the firms’ stockholders in a slrong économie environment when the investment banking industry praspers On the other hand, during economic downturns, investment banks often incur large losses that wipe oul much of their stockholders’ equity, hroughout ils hislory, Lehman Brothers experienced the highs and laws of the volatile business cycle common to the investment banking industry. The inteasity of that cycle was magnified by a new line of investment products thal Lebman and its competitors made popularon Wall Street during the 1990s. Playing with Fire Lehman Brothers and the other large investment banks became major players in the financial derivatives markets that emerged in the final decade of the twentieth century, Investopedia (wwwinvestopedia.com) defines a financial “derivative” as follows, A security wise price ts dependent upon or derived from exe oF more uaderiving ‘assets, The derivative selfs merely contraet betuiean two oF more parties. ls wale is determined by fictrations fn the urdderbing asset. The most comenon usicierbyng assets include stocks, bonds, commodities, currencies, énderest rates and market in dlenes. Most clevivotives are characterized by Fgh leverae, Many types of financial derivatives have existed far decades, including the most ienerie, namely, put and call options on common stocks. In the mic 198s, however, a new genre of exotic financial derivatives became increasingly prevalent. These new derivatives inchided collateralized debt obligations, credit default swaps, and in- terest rate swaps, among many others, Institutional investors accounted for the bulk: of the trading volume in these new securities because they were poorly understood. and thus shunned by most individual investors The new breed of derivatives produced large and profitable revenue streams for the investment banking industry. On the downside, the risks posed by these new securities were often difficult to assess. which, in turn, made those risks difficult, ifsectionone Couparmensivr Casts not impossible, to manage. Some economists and Wall Street experts suggested that the risks posed by many of these derivatives were, in fact, dispraportionately high Compared to the rates of return they gemerated. Further enhancing the risk profile of these Investments was the fact that they were subject to only minirial regulatory oversight In-a 2009 retrospective overview of the securities markets, Presidemt Obama observed that over the priar two deeades those markets had been eharacterized by “wild risk-taking” The president added that many of the new securities that became popular during that time frame were so complex and multifaceted thal the “old regte- latory schemes” developed for the securities markets in the 1930s did not provide adequate oversight for thier Lehman flourished financially as the derivatives markets mushroomed in st and prominence during the 1990s and beyond. The firm was particularly active in the market for residential morigage-backed securities (RMBS). By the turn of the century, government agencies, brakerage firms, and investment banks were pro- ducing a huge volume of RMBS each year. This ‘securitization process involved purchasing residential mortgages from the banks, mortgage companies and ether entities that originated them, bundling or “pooling” these mortgages together, and then selling ownership interests (Securities) in these pools. The purchasers of RMS were actwally purchasing a claim an the cash flaws generated by the mort- gages that “hacked” those secwrities, By 2004, Lehman produced more RMBS an- ually than any other entity.? ‘The high yields on RMBS created a surging demand for these new hybrid securi- ties. In tum, the inereasing demand for RMBS caused mortgage originators to be- come increasingly aggressive in extending loans to individuals who in years past had not been able to qualify for a home mozigage because of an insufficient in- come, a paor eredit history, or other Issues, These mostly first-time home buyers were referred to as “subprime” borrowers. Mortgage originators were not concerned by the sizable default risk posed by subprime borrowers since they intended to sell their loans “downstream” and thereby transfer that risk to the purchasers of RMBS, ‘The critical factor that influenced the riskiness of RMBS was the underlying health af the housing market in the United States, Steadily rising housing prices curing the decade from 1995 through 2005 made the default risk on residential mnartgages tnini mal, Wall Street analysts warned, however, that a downturn In housing prices woul trigger a rise in mortgage defaults that would be problematic for parties having sig nificant investments i RMBS. On the other hand, a sudden and sharp dowatarn in housing prices could prove to be catastrophic for those investors. Sadly, the latter doomsday scenario took place. Housing prices peaked in the Uniled States in 2006, By late 2007, housing prices had begun to tumble, declining in many residential markets by 20 percent ox more by mid:2008, In some of the residential markets that had seen the sharpest increases over the previous several years, such as Las Vegas and south Florida, housing prices plunged by 50 percent 2. 8 Labaton, “Obama Sought a Range of Vows on Pinance Rules” The New York Tees (online), Tere $005, 8, Lehman paschased afarge mrtion of tne tesideevial mentgages that it ecu tzecd fromm New Century Finan clal Corporation, one of the nation’s major sub nmanies, Case LIT docu New Century's biel and surbulecastia Lamm Broviers Hotoines, Ise. Falling housing prices caused a growing number of U.S. homeowners to be “upside down,” meaning that the market values of their homes were lower than the unpaid balances of their mortgages. By early 2008, an estimated 9 million Aimericams had a galive equity in their homes, which caused a rapid rise in inorgage defaults and foreclosures. It was only a matter of time before the sharp decline in housing prices undercut the market for RMBS. Government agencies, lrge institutional investors, and investment banks having an ownership interest in RMBS suddenly found the value of those securities spiral- ig dawnward when it became obvious that housing prices would continue thetr freetall, n some cases, the markets tor mortgage-backed securities simply “froze.” meaning that the securities could not be sold at any price, Lehman was among those entities that held a large inventory’ of mortgage-backed securities when the houstid market crumbled. At the end of 2007, the company owned nearly $90 billion of those “oxic” assets. By comparison, Lehman's total stockholders! equily at the time was, only $22.5 billion. Prior to the collapse of the housing market, Lehman's high-risk business model has produced a stving of record-breaking years. Exhibit I presents a financial high- lights table for Lehman for the five-year period 2003 through 2007, which is a com: densed version of a similar table included in the company's 2007 annual report Notice that during that time period the company reported record revenues anc net income each successive year, Lehman's string of impressive reported operating re- sults continued sn early 2008, When the company posted stronger than expected results for the first quarter of 2008, the price of its cammon stock soared by nearly 50 percent in one day. Lehman's top executives profited enormousiy tram the consistently strong reported Financial performance of their company, Richard Fuld served as Lehman's chief ¢x- ecutive officer (CEO) from 1984 through 2008, Over that time, Fuld earned nearly $500 million in compensation. In addition to monetary rewards, Lehman's executives were lavished with praise and accolades. Just as Lehman's financial empire was begining to buckle in 2008, Barron's included Fuld in its list af the top 30 CEOs nationwide and tagged him with the title of “Mr. Wall Street” 2007 20062005 «2006 _ 2003 Revenues siz $176 Sue $118 | Sar Net Incomes Ae AM 26 ww Total Assots eo1t BORE MNT 387.2 BIA Total Stockholder” Favity 25 18.2 18B 4s 132 Earnings per Share 72000 OR 5433.85 Dividends per Share so 4840 2 za Year-end Stock Price 6263767 G00.) BAL Return an Equity 208% 24% 2 17% 18.2% Leverage Ratio 207 2 Bh 289 BRT. Niet Leverage Ratio Bio 5G “In billions. of dollars except for per share amounts. xu Lainean Bromine Finawct Hicauicars, ‘2oe-2007‘20 sectionone Couparmensivr Casts Despite the glowing operating results reported for fiscal 2007 andl the first quarter of 2008, Lehman's management recognized that the eompany faced daunting ehal- lenges. “Lebinan wos publicly presenting a rosy oullook about its future while it was privalely serainbling for a solution to its deepening problems." Complicating matters, for Lehman's management was the fact that financial analysts and other parties closely monitoring the investment banking industry had begun raising serious ques- ons regarding the company’s financial health, Those questions stemmed primarily from two issues facing Lehman, one of which was the mayhem taking place within the hausing markel. The second and more important issue facing the large invest- ment banking firm was the fact that it was “wildly overlevernged”® ‘This issue was critical because by this Lime there was a general consensus on Wall Street that an Investment bank's degree ol financial leverage was the most important metric to use in evaluating its financial health. Lehman's financial highlights table in Exhibit ! presents two measures of financial leverage. ‘The company’s conventional leverage ratio was computed by dividing total assets by total stockholders’ equily. At fiscal yearend 2007, this ratio was $0.7 for Lehman, meaning that the company had only $1 of stockholders’ equity for every $2070 of assets thot it held. In the company’s 2007 annual report, Lehmanis manage ment suggested that the “net leverage ratio” was a much beller measure of the cam- pany’s financial leverage than the conventional leverage ratio. [n computing the net leverage ratio, the company excluded from total assets a large volume of “low-risk” assets. Notice that Lehman's 2007 net leverage ratio was nearly flty percent lower than its conventional leverage ratio. ‘The importance being ascribed to Lehman's leverage ratios, in particular, ils net leverage ratio, by financial analysts in late 2007 prompted Dick Fuld to arder a company-wide “deleveraging strategy.” In an intercompany communication during this time frame, one of Fuld’s subordinates noted that “reducing leverage is necessary to... win back the canticence of the market, lenders, and inves- tors."* Another of Fuld’s subordinates subsequently testified that beginning in late 2007 “Lehman set balance sheet targets with an eve to reaching [reducing] certain leverage ratios that rating agencies used to measure and gauge Lehman's pertormanee” Lehinan’s management chose an unconventional method to reduce the company's net leverage ratio. This improvised tactic involved engaging in a large volume of “accounting-motivated” transactions, known internally as Repo 105 trans- actions, near the end of each quarterly reporting period. Because the Repo 105. twansactions were not disclosed in Lehman's SEC filings, third-party financial state- ment users were unaware that the company’s net leverage ratio was being inten tionally “seulpted” by management. “Lehman never disclosed thal its net leverage ratio—whieh Lehman publicly touted as evidence of its discfpline and financial health—depended upon the Repo 105 practice.” sed With Lost Chances! The New: York 1. L Stony and B White, ‘The Road to Lehman’s Failure Ws Ul Times (ontine), 6 Gevober 2008, 5. D.Leonond, How Lelunan Brothers Got ite RealEstate Fs? The New Work Temes online) 9 May 200, cued quotes, less tctcsted were tae ot 1, Debtors, "Repotol Anton R Walukas, Exaeniner” US. ‘strict ot New York, Chapter W Case Mo, 85.135 5, Thisand all subse olen so Inve: Lebman Brothers Hollies fa rupwy Court«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.castia Lamm Broviers Hotoines, Ise. analysts tracking Lelman’s stock, for example, the company's chief financial of- ficer (CFO} stressed the fact that the company’s financial leverage was being re- duced: however, she “said nothing about the firm's use of Repo 105 transactions.” AL the same time, the CFO totd those analysts that her company was committed to providing them ‘a great amount of transparency” regarding the company’s bal- ance sheet ‘The bankruptcy examiner maintained that even ifthe accounting treatment ap- plied to the Repo 105s technically complied with SFAS No, [40, that accounting treatment vidlaled Generally Accepted Accounting Principles (GAAP) by causing Lehman's financial staternemts to be misteading To support his position, the bank ruptey examiner referred to a ruling handed down by a federal district court ina cage involving an aecounting matter, "GAAP itself recognizas that technical complt- ance with particular GAAP rules may lead to misleading financial statements, and. imposes an overall requirement that the statements taken as a whole accurately re- flect the financial status of the company According to the bankruptcy examiner, there had been no underlying business purpose for the Repo 105s. Instead, the sale purpose of the transactions had been to make Lehman's “balance sheet appear stronger than it actually was.” fn sum, the transactions had been ‘accounting motivated" The bankruptcy examiner referred to a prior SEC release to define that term “Accounting-moticated stractured transactions” are “transactions that are stractured in anatlempt to achieve repartorg resieis thet are not consisten4d wit tre econtamtics at the Iransaction, and thereby impair the hanspareney of financial reports.” [Aempts) In portray the texisactions: ferenity frona their sulstarice de not operate tse inter ests of nbestors, and may be in violation of the secures laws ‘The bankruptcy examiner uncovered numerous instances of intercompany com- munications that suggested the Repo 105s had been accountiog-diven. In responding toan inquiry regarding why Lehman was engaging in a large volume of Repo 105s at the end of each quarter, one company executive had told another, “It’s basically window-dressing. We are calling repas Inte sales based on legal teehniealities Another company executive testified that “It was universally accepted throwghout the entive institution [éompany] that Repo 105 was used for balance sheet reliet al quarter end.” 4 lowerevel Letman emplayee had referred to Repo 105s as.an “ac- counting gimmick” and a "zy way of managing the balance sheet Finally, a high- ranking accounting officer admitted to the bankruptey exantiner that “there was no substance to these transactions” and that their only “purpose ar motive was reduc: tion [of assets] in the balance sheet” Further validating the bankruptcy examiner's argurnent that the Repo 105s had been purely accounting-driven was the fact that they had been more expensive than Lehman's normal rapo transactions, That is, the company could have secured the short-term financing provided by the several hundred billions of dollars of its Repo 105s at a lower cost by using conventional repo agreements, “Lehman could have obtained the same financing at a lower cast by engaging in ordinary repo transac- tions with substantially the same counterpatties using the same assets involved in the Repo 105 transactions” When considering the issue af whether the accounting treatment applied to the Repo 105s riadé Lehitian’s financial statements materially misleading, the bank tuptey examiner effectively invoked the definition of that construct found in Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Injornation”sectionone Couparmensivr Casts The magnitude ofan omission or misstatenrent of aecounting iiorrncton the, i Hight of fe surrounding circumstances, makes if probable that the fudaruent of a reasoite able pesson relying on te inforination would have been changed oy ihaenced by the omission or misstatement ‘The bankruptcy examiner surveyed a wide range of “reasonable” parties that had relied on Lehman's financial statements. Neatly all of these parties insisted that they would have wanted fo know that the company was using the Repo 105 transactions to distort its balance sheet and key Gnancial ratios. “Lehman's directors, the rating agencies, and government regulatoss—all of whom were unaware of Lehman's use of Repo 105 transactions —have advised the examiner that Lehman's Repo 105 us, age was material or significant information that they would lave wanted to know” In fact, in 2008, the controller of Lehman’s European operations had e-mailed a Lehman colleague in the United States and warned him that the Repo 103s “are understating what we have at risk by a material amount especially around quarter ends” The bankruptey exariner relied on such statements in arriving at his decision that “tier of fact,” that is, a court, would likely find that the Repo 105s had resulted, in Lehman's financial statements being materially misleading. To bolster this conclusion, the bankruptcy examiner referred to a discussion of materiality inckeded in the 2007 workpapers of Lehman's independent audit firm, Emst & Young. “Indeed, audit walk-through papers prepared by Lehman's outside auditor, Est & Young, regarding the process for reopening or adjusting a closed balance sheet stated: ‘Materially is usually defined as any iter individually, or in the aggregate, that moves nel leverage by 0.1 or more (typically $1.8 billion). Repo 105 moved net leverage not by tenths, but by whole points” As shown in Exhibit 1, Lehman's reported net leverage ratio as of the end of fiscal 2007 was 161. According fo the bankruptcy examiner, the actual ratio would have been 178 Hf the company had accounted for the Repo 105s as financing transactions During his investigation, the bankruptcy examiner spent considerable tinne res viewing the Ernst & Young (E&Y) audit workpapers. The prominent accounting firm ultimately became a major focus ofthat investigation and the targel of scathing eritcisin by the bankruptey examiner. Auditors on the Firing Line ERY served as Lehman's independent audit firm from 1994 through 2008, For the 2007 audit, the final audit of the company prior to its collapse, Lekman paid E&Y ap- proximately $28.5 million. That figure included the tee for the 2007 audit, fees for tax services provided fo the company, and miscellaneous fees. William Schlich served as the engagement audit partner for the 2007 audit of Lehman. [n July 2008, Schiich, a longtiine E&Y partner, was named the head of E&Y’s “Global Banking & Capital Markets” practice, the firm's largest individual industry practice. Lehman's bankruptcy examiner interviewed Schlich extensively during his in- vestigation. Schlich told the bankruptcy examiner that E&Y had been aware of the Repo 105 transactions and was also aware that Lehman had not disctosed the trans- actions in financial statements fled with the SEC. Schlich also revealed that Lebman officials had consulted with ERY while they were developing the company’s Repo 105 accounting policy, althaugh he reparted that his firm had not been directly involved, in that process and had not formally approved the accounting policy Martin Kelly, Lehman's former Financial Controller, tastitied that he discussed the Repo 105 transactions with Schilich in late 2007, Kelly told the bankruptcy examiner that he had a certain degree of “discomfort” with the Repo 105s, ostensibly becausecastia Lamm Broviers Hotoines, Ise. Lehman had been unable to obtain a legal opinion trom a US. lave firm that sup- ported the company’s deciston to record those transactions as sales of securities. Kelly recalled that he had discussed Lehman's inability to obtain stich a legal opin jon with the E&Y auditors Surprisingly, Schiich told the examiner that he did not know whether anyone on the E&Y engagement team had actually reviewed the legal apinion on the Repo 105, transactions issued by Linklaters, the British law firm. Sehlich suggested that the re- sponsibility for reviewing that letter would have rested with his firm's British affiliate, ERY United Kingdom, which had audited the accounting records of LBIE, the British arm of Lehman Brothers that had executed the Repo 105 transactions. Throughout his investigation and in his report, the bankruptcy examiner repeat- edly characterized the Repo 105s as ‘accounting motivated” transactions without an. underlying business purpose that had been intended to embellish Lehman's financial statements and its net leverage ratio. While being interviewed by the examiner, how- ever, Schlich staunchly defended the accounting treatment that had been applied to those transactions, The E&Y partner insisted that the “oft-balance sheet treatment” at the Repo 108s was purely a “eonseqttence of the accounting rules’ rather than the underlying “motive for the tronsoctions.” When the examinerasked Schlich whether technical adherence” to SFAS No, 140 or any other specific accounting rule could have resulted in Lehman's financial statements being misstated, “Schlich retrained, from comment." On two occasions, the examiner “offered Emst.& Young the oppor unity” to explain or identity the “business purpose of Lehman's Repo 105 transac- tions” On each occasion, the E&Y representative (apparently Schlich) “dectined that invitation? ‘The bankruptcy examiner subsequently criticized EXY for not addressing the possibility that Lelimanis “Repo 105 transactions were accounting-motivated transac- tions thal lacked a business purpose.” According to the exatniner, E&Y should have recognized, or at least considered the possibility, that the Repa 105s were simply intended to improve Lebman's apparent fnaneial condition, in particular, its net le- verage ratio, The examiner stated thal there was “no question that Emst & Young fad a full understanding of the net leverage ratio’ and that the auditors understood the importance af that ratio to third-party financial statement users, ‘The bankruptcy examiner focused considerable attention on the materiality of the Repo 105 transactions while he was interviewing Schilich. At one point, the examiner asked Schlich what volume of Repo 105 transactions would have been considered material” by E&Y, “Schlich replied that Ernst & Young did not havea hard and fast rule defining materiality in the balance sheet context, and that, with respect to bal- ance sheet issues, ‘materiality’ depends upon the facts and circumstances.” In bis report, the bankruptey examiner juxtaposed this slatement of Sehlich with the fact that ERY's 2007 Lehman workpapers had identified the following precise materiality threshold for the company’s net leverage ratio: “Materialty is usually defined as any item individuaily, or in the aggregate, that moves net leverage by 0.1 or mora (typi- cally $1.8 billion)” ‘When questioned further regarding the materiality of the Repo 105s, Sehlich told the bankruptcy examiner thal E&Y’s audil plan had nol required the Lehman engagetnent teamn to “review the volume or tiining of Repo 105 transactions." Con- sequently, “as part of its yearend 2007 audit, E&Y did not ask Lehman about any directional trends, such as whether its Repo 105 activity was increasing during fiscal year 2007" The bankruptey exatniner reparted that Schlich was unable to “confirma or deny that Lehman's use of Repo 105 transactions was increasing in late 2007 and, into mid-2008.°sectionone Couparmensivr Casts A final majorissue raised with William Schlich by the bankruptcy examinerwas B&Y"s response to the whistleblower letter sent to. company management in May 2008 by a se- rior member of Lehman's accounting staff. Letman’s management had asked E&Y to be involved in investigating the allegations in that letter! Among other allegations, the whistleblower suggested that Lehman’s assets and liabilities were routinely misstated, by “tens of billions of dotiars’ in the company’s periodic balance sheets. "Ta remind his superiors of thelr responsibiliies related to finaneial reporting, the whistleblower had included in his letter the following excerpt from Lehman's Cade of Ethics. All employees... must endeavor to entsure that énformation ti documents that Tehran Broltiers hes teat or subinis te the SEC, ox othenvise discloses to te public fs presented sn a fal, fark, accurote, timely and understandable manner. Adchiionety cach tndividaa? involved in the preparaiton of tee Firm's hnancial statements musi pre- pare thaxe statentents ia accorcance w#tt Generally Accepted Accounting Principles, ‘consistenth: applied, and any other applicable accounting standards and ales $0 shat the financial statements present fairy. all material respects, the fnaricial position, esitts of operations and cersh fous ofthe Fim Approximately four weeks passed before E&Y interviewed the author of the whistleblower letter. Schlich and Hillary Hansen, another ERY partner, conducted that interview, Hansen's handwritten notes compiled during the interview indicated that the whistleblower alleged that Lehman had used tens of billions of dollars of Repo 106 transactions to strengthen its quarter-ending balance sheets. According to the examiner, E&Y never interviewed the whistleblower a second time and never “fol- lowed up” on bis allegation regarding Lehinan’s improper use of Repo 105s. The day after interviewing the whistleblower, E&Y auditors met with Lehman's audit committee but, according to the bankruptey examiner, did not inform the eant- mitice members of the whistleblower’s Repo 105 allegation. Three weeks later, E&Y auditors met once more with Lehman’s audit committee and again reportedly failed to mention that allegation, The bankruptcy examiner subsequently reviewed ER's work papers for the 2007 audit and the 2008 quarterly reviews and “found! no refer- ence lo any communication with the audit committee about Repo 105.” During his interview with the bankruptcy examiner, Schlich indicated that he did not recall the whistleblower mentioning the Repo 105 transactions when he and Hansen mel with him, When informed that Hansen's handwritten notes of that meeting indicated that the whistleblower had referred to those transactions, Schlich. did not dispute the authenticity” of those notes [In summarizing his investigation of E&'s ole as Lehman's auditor, the bankruptcy ex- aminer reported that there was “sufficient evidence to support at least three colorable Claims that coud be asserted against Ernst & Young relating to Lehman's Repo 105 activie tiesand reporting"The first colorable claim involved E&Y’ alleged failure to “conduct an adequate inquiry” into the whistleblower’ allegations and failing “to properly inform man- agement and the adit committee” of those allegations. Second, the bankruptcy exam ior charged that E&Y had failed to “take proper action” to investigate wikether Lehman's Financial staterients forthe frst two quarters of 2008 were iterally misleading due to the company’s failure to disclose its Repo 105 transactions, The Final colorable claitn involved: 12, Atte reading the whlalsblomer keto Schiele conihde oto col as ‘pretty ty” and that tl Take usa signifies it amount of time to ged throu ‘The whistieblewer wa aamissed pproims lyre meinth after sending his ltterto Lehman's tp anagement, He-was seportediy dismissed as a resulted a comporatewvide “downsizing” campaign. la ‘Co |s.a claim strong enough ta fave a reasonable chance of being vali he fect andthe facts can be proven in court” hitp/Atopcstaw-corrl eu), rable claln" isa kyal earn. A slain thot able clam isgentally a phcastia Lamm Broviers Hotoines, Ise. ESY'sallleged failure to “take proper action" to investigate whether Lehinan's financial statements for fiscal 2007 were matortally misleading due to the Repo 108s, “The allegations that the bankruptcy examiner filed against E&Y spawned wide spread discussion and debate within the accounting prolession, One accounting pro- fessor defended the accounting treatment that Lehman applied to its Repo 105s and, by implication, E&Y’s tacit approval of that treatment, In responding to the question of whether Lehman was entitled to account for those Iransactions as sales of securi- ties, the professor responded, “Absolutely, Bven if fntended to influence (or deceit- fully change) the numbers reported? Yes, intent doestt matter It [Lehman] found a rule it could utilize to its advantage and followed i." The professor went on to explain that the given “rule” was a bad one that should be amended, ‘Three other aceounting prolessors expressed a very different point of view. These professors noted that “a fundamental financial reporting objective that overrides the application of any specific rute is that the accounting of a transaction should not obluscate its economic substance.” The professors then noted that “parties with meaningful roles in the financial reposting process" shouldn't be involved in apply- ing "accounting rules with the intent to obuseate the eeonamie substance" of given transactions. Finally, the prolessars made the following observation regarding the professional responsiblities of the accountants and auditors involved in the Lehman debacle External auditors, intemal auditors, crtd managernent aceauntants all have profes, sfonal stanclards thet ane aspirationel ie nature, and, regardless of whetdier Letine’s ‘auditors and acconntants niet th ruinimiuen standards thet might shield then bom legal liability anit formal professional sanciton, it seerns clear that they fell shout of the higher standards fo which all management aceountaris and exaditors should aspire." OGUE The revelations and allegations included in the repait issued by Lehman's bankrupley & aminer evoked an immediate response trom the SEC. In March 2010, an SEC spokesperson reported that the federal ageney had been un- aware that Wall Street firms were using Repo 105-type transactions lo enhance their appar ent financial condition, The SEC revealed that it was contacting twenty major financial institu- tions to determine if they had used similar tac- tics to “manage” their balance sheets. To date. the SEC has not commented on the results of that survey or identified the specific firms that were contacted. Lehman's bankruptcy report served as an ‘open invitation” to file civil lawsuits against E&Y. And that is exactly what happened ‘Throughout 2010, numerous lawsuits that named ERY asa delendant or co-defendant were filed on behalt of parties that sultered losses due to Lehman's collapse, Among these lawsuits, the ‘one with arguably the highest protile was a civil fraud lawsuit fled agininst E&Y in late De~ cember 2010 by Andrew Cuomo, New York's 15, ‘The bankrupt examiner noted that ERY “may have wali defense! tthe colors ble ini that Be as ered guinst the Farm. The examiner discussed some cf these defenecs including the tact iat mony a dling standards donee impose “bright lie niles bul iostead provide enly“yoneral guidance” to autor 1s. D. Aibrecht, “Repo 105 Explained with Nubers ana Detsil> 26 Api 2010, nip ress coma 20} Ova 17, 8K, Dutta. Caplan, and R, Lawson, Rone Risk Management” Stategte Finance, August 2000, 2% 1 se te, it 20. Taxa Soetely ol Colifed Public Accountants, “Accounting Web—April 2.20102 hitp#hworwcteepa.ons«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.«a You have either reached a page thatis unavailable for viewing or reached your viewing limit for this book.sectionone Couparmensivr Casts The Repo 105 transactions reduced Lehman's net leverage ratio from IP 8 to 161 at the end of fiscal 2007. Do you believe that was a “material difference”? Why or why not? In general, what responsibilty do auditors have to investigate whistleblower allegations that relate to the material accuracy of an audit elient’s financial statements? ERY isa defendant in Lehman-telated lawsuits fled in both state and federal courts, Identify the factors that influence E&Y’s legal exposure between lawsuits filed in state courts versus those filed in federal causts.CASE 1.3 Just For FEET, Inc. Lifeis so fragile Hie to rarn trrever HS Disvice year-old Thomas Shine founded a small sparting goods compar lid eventually become known as Loge Athletic. Shine’s company 07, th manufactured and marketed a wide range of shirts, hits, jackets, and other gy patel items that boldly displayed the loges of the Denver Broncos. Detroit Red jigs, Sian Diego Padres, and dozens of ather professional sports ears. [n 200) Shine sold Loge to Reebok and became that company’s senior vice president ol ns and entertainment marketing, In thal positien, Shine wined and dined major sparta stars with the intent Gf persuading them to sign exclusive endersement his Jong carser, Thomas Shine became ane of the most well:kno Dun vnand Shrines prominence ancl credibility a criminal indictment fled againat him by partment of Justice, The Justice hie had signed a false audit eonfiermation sent to hiny in early 1989 by one of Logo's la mners. The confirmation indicated that Lago oyred that ous! resi }, Although Shine knew that no such debt existed, he audit firm, D customer As at n federal prison anda fine oj tip to $280.00 onifiemation and rehired it to the customer's ind ndent aessuted to doso by au executive of the ouche, alter be Lot his guilty Out of South Africa Af approximately the samme time that ‘Thomas Shine was launciaing his business ca: i fhe retail industry in the United States, Harold Ratte was doing the sar Sout Africa. Ruttenberg. native al Johannesburg pale forhis colege education by working nights and weekeuds cleric in an upscale men’s clothing stor After gradation, lie began importi iisfeans from the United States and selling them from his car, ins eventual goa! being to accumulate sufficient capiial to open retallistore. Ruttenbem quichly accomplished that goal. In fact, by the tine he was 3, ned acmail chai af men'sapparel sores Mounting palitical and economic troubles in his home country during the ea nnd smici49703 eventually convinced Ruttenberg to move his family to the Linted States, South Africa's strict emigration laws iorced Ruttenberg to leave practically I of bis net worth behind. When he areived in Calitorgia in 1