LOVELYPROFESSIONALUNIVERSITY

DEPARTMENT OF MANAGEMENT

TERM PAPER
OF
FINANCIAL ACCOUNTING

TOPIC: “Study the financial scam of Arthur Andersen . Analyse the role of
accounting standards and the loopholes in such standard that leads to the
scope of such fraud”

SUBMITTED TO: SUBMITTED BY:

GARIMA MAM VIRENDRA OM

(LECTURER) ROLL NO: Q1010A29

REG NO.-7020070044
 INDEX
1. Introduction
2. History
3. Reputation
4. Andersen Consulting and Accenture
5. Enron scandal
6. Decline
7. Loopholes in the accounting standards:
8. REVENUE RECOGNITION
9. Mark-to-market Acounting
10. FINANCIAL STATEMENT OF ENRON
11. Special purpose entities
12. Financial audit
13. How the fraud was discovered
14. Causes of downfall
15. Conclusion
16. SUGGESTIONS
17. REFERENCES

Introduction
Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms
among PricewaterhouseCoopers, Deloitte Touché Tohmatsu, Ernst & Young and KPMG,
providing auditing, tax, and consulting services to large corporations. In 2002, the firm
voluntarily surrendered its licenses to practice as Certified Public Accountants in the United
States after being found guilty of criminal charges relating to the firm's handling of the auditing
of Enron, an energy corporation based in Texas which later failed. The other national accounting
and consulting firms bought most of the practices of Arthur Andersen. The verdict was
subsequently overturned by the Supreme Court of the United States. However, the damage to its
reputation has prevented it from returning as a viable business, though it still nominally exists.

One of the few revenue-generating assets that the Andersen firm still has is Q Center, a
conference and training facility outside of Chicago.

The former consultancy arm of the firm, now known as Accenture, which had split from the
accountancy side in 1987 and renamed themselves after splitting from Andersen Worldwide in
2000, continues to operate and has become one of the largest multinational corporations in the
world.

History

Founding

Andersen was orphaned at the age of 16 at which point he began working as a mailboy by day
and attended school at night, eventually being hired as the assistant to the controller of Allis-
Chalmers in Chicago. At 23 he became the youngest CPA in Illinois.

The firm of Arthur Andersen was founded in 1913 by Arthur Andersen and Clarence DeLany as
Andersen, DeLany& Co. The firm changed its name to Arthur Andersen & Co. in 1918. Arthur
Andersen's first client was the Joseph Schlitz Brewing Company of Milwaukee. In 1915, due to
his many contacts there, the Milwaukee office was opened as the firm's second office. In 1917,
after attending courses at night while working full time, he graduated from the Kellogg School at
Northwestern University with a bachelor's degree in business.

Andersen had an unwavering faith in education as the basis upon which the new profession of
accounting should be developed. He created the profession's first centralized training program
and believed in training during normal working hours. He was generous in his commitment to
aiding educational, civic and charitable organizations. In 1927, he was elected to the Board of
Trustees of Northwestern University and served as its president from 1930 to 1932. He was also
chairman of the board of certified public accountant examiners of Illinois.

Reputation

Andersen, who headed the firm until his death in 1947, was a zealous supporter of high standards
in the accounting industry. A stickler for honesty, he argued that accountants' responsibility was
to investors, not their clients' management. During the early years, it is reputed that Andersen
was approached by an executive from a local rail utility to sign off on accounts containing
flawed accounting, or else face the loss of a major client. Andersen refused in no uncertain
terms, replying that there was "not enough money in the city of Chicago" to make him do it.
Leonard Spacek, who succeeded Andersen at the founder's death, continued this emphasis on
honesty. For many years, Andersen's motto was "Think straight, talk straight."

Arthur Andersen audited major corporations in the US in the early 1960's, such as Louis Lesser
Enterprises, Inc..

Andersen also led the way in a number of areas of accounting standards. Being among the first to
identify a possible sub-prime bust, Andersen dissociated itself from a number of clients in the
1970s. Later, with the emergence of stock options as a form of compensation, Andersen was the
first of the major accountancy firms to propose to the FASB that stock options should be
included on expense reports, thus impacting on net profit just as cash compensation would.

By the 1980s, standards throughout the industry fell as accountancy firms struggled to balance
their commitment to audit independence against the desire to grow their burgeoning consultancy
practices. Having established a reputation for IT consultancy in the 1980s, Andersen was no
exception. The firm rapidly expanded its consultancy practice to the point where the bulk of its
revenues were derived from such engagements, while audit partners were continually encouraged
to seek out opportunities for consulting fees from existing audit clients. By the late-1990s,
Andersen had succeeded in tripling the per-share revenues of its partners.

Predictably, Andersen struggled to balance the need to maintain its faithfulness to accounting
standards with its clients' desire to maximize profits, particularly in the era of quarterly earnings
reports. Andersen has been alleged to have been involved in the fraudulent accounting and
auditing of Sunbeam Products, Waste Management, Inc., Asia Pulp & Paper, and the Baptist
Foundation of Arizona, WorldCom, as well as the infamous Enron case, among others.

Andersen Consulting and Accenture

The consulting wing of the firm became increasingly important during the 1970s and 1980s,
growing at a much faster rate than the more established accounting, auditing, and tax practice.
This disproportionate growth, and the consulting division partners' belief that they were not
garnering their fair share of firm profits, created increasing friction between the two divisions.

In 1989, Arthur Andersen and Andersen Consulting became separate units of Andersen
Worldwide SociétéCoopérative. Arthur Andersen increased its use of accounting services as a
springboard to sign up clients for Andersen Consulting's more lucrative business.

The two businesses spent most of the 1990s in a bitter dispute. Andersen Consulting saw a huge
surge in profits during the decade. However, the consultants continued to resent transfer
payments they were required to make to Arthur Andersen. In August 2000, at the conclusion of
International Chamber of Commerce arbitration of the dispute, the arbitrators granted Andersen
Consulting its independence from Arthur Andersen, but awarded the US$1.2 billion in past
payments (held in escrow pending the ruling) to Arthur Andersen, and declared that Andersen
Consulting could no longer use the Andersen name. As a result Andersen Consulting changed its
name to Accenture on New Year's Day 2001 and Arthur Andersen meanwhile now having the
right to the Andersen Consulting name rebranded itself as "Andersen".

Perhaps most telling about who won the decision was that four hours after the arbitrator made his
ruling, Arthur Andersen CEO Jim Wadia suddenly resigned. Industry analysts and business
school professors alike viewed the event as a complete victory for Andersen Consulting. Jim
Wadia would provide insight on his resignation years later at a Harvard Business school case
activity about the split. It turned out that the Arthur Andersen board passed a resolution saying
he had to resign if he didn't get at least an incremental US$4 billion (either through negotiation
or via the arbitrator decision) for the consulting practice to split off, hence his quick resignation
once the decision was announced.[citation needed]
Accounts vary on why the split occurred — executives on both sides of the split cite greed and
arrogance on the part of the other side, and executives on the Andersen Consulting side
maintained breach of contract when Arthur Andersen created a second consulting group, AABC
(Arthur Andersen Business Consulting) which began to compete directly with Andersen
Consulting in the marketplace. Many of the AABC firms were bought out by other consulting
companies in 2002, most notably, Deloitte (especially in Europe), Hitachi Consulting and KPMG
Consulting, which later changed its name to BearingPoint.

Enron scandal

Energy Company Enron was broken up after revelations of Andersen's performance as an

auditor. The Powers Committee (appointed by Enron's board to look into the firm's accounting in
October 2001) came to the following assessment: "The evidence available to us suggests that
Andersen did not fulfill its professional responsibilities in connection with its audits of Enron’s
financial statements, or its obligation to bring to the attention of Enron’s Board (or the Audit and
Compliance Committee) concerns about Enron’s internal contracts over the related-party
transactions".

On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents
related to its audit of Enron, resulting in the Enron scandal. Nancy Temple (Andersen Legal
Dept.) and David Duncan (Lead Partner for the Enron account) were cited as the responsible
managers in this scandal as they had given the order to shred relevant documents. Since the U.S.
Securities and Exchange Commission do not allow convicted felons to audit public companies,
the firm agreed to surrender its CPA licenses and its right to practice before the SEC on August
31, 2002 - effectively putting the firm out of business. It had already started winding down its
American operations after the indictment, and many of its accountants joined other firms. The
firm sold most of its American operations to KPMG, Deloitte &Touche, Ernst & Young and
Grant Thornton LLP. The damage to Andersen's reputation also destroyed the viability of the
firm's international practices. Most of them were taken over by the local firms of the other major
international accounting firms.

The Andersen indictment also put a spotlight on its faulty audits of other companies, most
notably Waste Management, Sunbeam, the Baptist Foundation of Arizona and WorldCom. The
subsequent bankruptcy of WorldCom, which quickly surpassed Enron as the biggest bankruptcy
in history, led to a domino effect of accounting and like corporate scandals that continue to
tarnish American business practices.

On May 31, 2005, in the case Arthur Andersen LLP v. United States, the Supreme Court of the
United States unanimously reversed Andersen's conviction due to what it saw as serious flaws in
the jury instructions. In the court's view, the instructions were far too vague to allow a jury to
find obstruction of justice had really occurred. The court found that the instructions were worded
in such a way that Andersen could have been convicted without any proof that the firm knew it
had broken the law or that there had been a link to any official proceeding that prohibited the
destruction of documents. The opinion, written by Chief Justice William Rehnquist, was also
highly skeptical of the government's concept of "corrupt persuasion"—persuading someone to
engage in an act with an improper purpose even without knowing an act is unlawful...

Decline
Since the ruling vacated Andersen's felony conviction, it theoretically left Andersen free to
resume operations. However, the damage to the Andersen name was so severe that as of
2010[update], it has not returned as a viable business even on a limited scale. There are over 100
civil suits pending against the firm related to its audits of Enron and other companies. In
addition, its reputation was so badly tarnished that no company wanted Andersen's name on an
audit. Even before voluntarily surrendering its right to practice before the SEC, it had many of its
state licenses revoked. A new verb, "Enroned" was coined by John M. Cunningham, the former
Arthur Andersen Director in the Seattle Office, to describe the demise of Arthur Andersen.

From a high of 28,000 employees in the US and 85,000 worldwide, the firm is now down to
around 200 based primarily in Chicago. Most of their attention is on handling the lawsuits and
presiding over the orderly dissolution of the company.
As of 2010[update], Arthur Andersen LLP has not been formally dissolved nor has it declared
bankruptcy. Ownership of the partnership has been ceded to four limited liability corporations
named Omega Management I through IV.

Loopholes in the accounting standards:

Enron's nontransparent financial statements did not clearly depict its operations and finances
with shareholders and analysts. In addition, its complex business model and unethical practices
required that the company use accounting limitations to misrepresent earnings and modify the
balance sheet to portray a favorable depiction of its performance. According to McLean and
Elkid in their book The Smartest Guys in the Room, "The Enron scandal grew out of a steady
accumulation of habits and values and actions that began years before and finally spiraled out of
control." In an article by James Bodurtha, Jr., he argues that from 1997 until its demise, "the
primary motivations for Enron's accounting and financial transactions seem to have been to keep
reported income and reported cash flow up, asset values inflated, and liabilities off the books."

The combination of these issues later led to the bankruptcy of the company, and the majority of
them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling,
Andrew Fastow, and other executives. Lay served as the chairman of the company in its last few
years, and approved of the actions of Skilling and Fastow although he did not always inquire
about the details. Skilling, constantly focused on meeting Wall Street expectations, pushed for
the use of mark-to-market accounting and pressured Enron executives to find new ways to hide
its debt. Fastow and other executives "...created off-balance-sheet vehicles, complex financing
structures, and deals so bewildering that few people can understand them even now."

REVENUE RECOGNITION

Enron and other energy suppliers earned profits by providing services such as wholesale trading
and risk management in addition to building and maintaining electric power plants, natural gas
pipelines, storage, and processing facilities. When taking on the risk of buying and selling
products, merchants are allowed to report the selling price as revenues and the products' costs as
cost of goods sold. In contrast, an "agent" provides a service to the customer, but does not take
on the same risks as merchants for buying and selling. Service providers, when classified as
agents, are able to report trading and brokerage fees as revenue, although not for the full value of
the transaction.

Although trading firms such as Goldman Sachs and Merrill Lynch used the conventional "agent
model" for reporting revenue (where only the trading or brokerage fee would be reported as
revenue), Enron instead elected to report the entire value of each of its trades as revenue. This
"merchant model" approach was considered much more aggressive in the acounting
interpretation than the agent model. Enron's method of reporting inflated trading revenue was
later adopted by other companies in the energy trading industry in an attempt to stay competitive
with the company's large increase in revenue. Other energy companies such as Duke Energy,
Reliant Energy, and Dynegy joined Enron in the top 50 of the Fortune 500 mainly due to their
adoption of the same trading revenue accounting approach as Enron.

Between 1996 to 2000, Enron's revenues increased by more than 750%, rising from $13.3 billion
in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year was unprecedented
in any industry, including the energy industry which typically considered growth of 2-3% per
year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in
revenues, which placed the company at the sixth position on the Fortune Global 500.

Mark-to-market Acounting

In Enron's natural gas business, the accounting had been fairly straightforward: in each time
period, the company listed actual costs of supplying the gas and actual revenues received from
selling it. However, when Skilling joined the company, he demanded that the trading business
adopts mark-to-market accounting, citing that it would reflect "... true economic value." Enron
became the first non-financial company to use the method to account for its complex long-term
contracts. Mark-to-market accounting requires that once a long-term contract was signed, income
was estimated as the present value of net future cash flows. Often, the viability of these contracts
and their related costs were difficult to judge. Due to the large discrepancies of attempting to
match profits and cash, investors were typically given false or misleading reports. While using
the method, income from projects could be recorded, which increased financial earnings.
However, in future years, the profits could not be included, so new and additional income had to
 be included from more projects to develop additional growth to appease investors. As one Enron
competitor pointed out, "If you accelerate your income, then you have to keep doing more and
more deals to show the same or rising income." Despite potential pitfalls, the U.S. Securities and
Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural
gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas
in the company to help it meet Wall Street projections.

For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to
introduce on-demand entertainment to various U.S. cities by year-end. After several pilot
projects, Enron recognized estimated profits of more than $110 million from the deal, even
though analysts questioned the technical viability and market demand of the service. When the
network failed to work, Blockbuster pulled out of the contract. Enron continued to recognize
future profits, even though the deal resulted in a loss.

FINANCIAL STATEMENT OF ENRON

Balance Sheet of
--------------- in Rs. Cr. ------------
ENRON

Dec '95 Dec '96 Dec '97 Dec '98 Dec '99
 9 mths 12 mths 12 mths 12 mths 12 mths

Sources Of Funds

Total Share Capital 184.72 187.48 187.83 187.88 187.94

Equity Share Capital 184.72 187.48 187.83 187.88 187.94

Share Application Money 0.82 0.28 0.10 0.00 0.08

Preference Share Capital 0.00 0.00 0.00 0.00 0.00

Reserves 1,951.21 2,955.16 3,964.78 4,739.85 5,828.20

Revaluation Reserves 0.00 0.00 0.00 0.00 0.00

Net worth 2,136.75 3,142.92 4,152.71 4,927.73 6,016.22

Secured Loans 950.12 720.96 266.03 450.00 550.00

Unsecured Loans 121.30 50.20 40.38 32.03 16.92

Total Debt 1,071.42 771.16 306.41 482.03 566.92

Total Liabilities 3,208.17 3,914.08 4,459.12 5,409.76 6,583.14

Dec '05 Dec '06 Dec '07 Dec '08 Dec '09

9 mths 12 mths 12 mths 12 mths 12 mths

Application Of Funds

Gross Block 4,628.64 4,816.25 5,464.07 5,835.67 6,826.27

Less: Aksum. Depreciation 1,722.29 1,893.76 2,149.35 2,365.97 2,667.98
Net Block 2,906.35 2,922.49 3,314.72 3,469.70 4,158.29
Capital Work in Progress 290.95 558.42 649.19 1,602.86 2,156.21
Investments 333.80 543.09 844.81 679.08 1,475.64
Inventories 600.95 624.13 730.86 793.27 778.98
Sundry Debtors 199.17 213.96 289.29 310.17 203.70
Cash and Bank Balance 100.60 152.98 78.87 87.57 95.64
Total Current Assets 900.72 991.07 1,099.02 1,191.01 1,078.32
Loans and Advances 533.54 569.21 544.31 779.76 714.55
Fixed Deposits 2.19 467.19 664.61 896.67 650.74
 Total CA, Loans & Advances 1,436.45 2,027.47 2,307.94 2,867.44 2,443.61
Differed Credit 0.00 0.00 0.00 0.00 0.00
Current Liabilities 1,449.02 1,596.50 1,991.27 2,245.39 2,558.73
Provisions 316.77 541.83 666.27 963.93 1,091.88
Total CL & Provisions 1,765.79 2,138.33 2,657.54 3,209.32 3,650.61
Net Current Assets -329.34 -110.86 -349.60 -341.88 -1,207.00
Miscellaneous Expenses 6.41 0.94 0.00 0.00 0.00
Total Assets 3,208.17 3,914.08 4,459.12 5,409.76 6,583.14

Contingent Liabilities 282.42 341.56 890.62 1,734.21 840.52

Book Value (Rs) 115.76 167.81 221.33 262.56 320.45

Profit& Loss account of

------------------- in Rs. Cr. -------------------
ENRON
Dec '95 Dec '96 Dec '97 Dec '98 Dec '99

9 mths 12 mths 12 mths 12 mths 12 mths

Income
Sales Turnover 3,723.51 6,467.84 7,865.11 8,300.18 8,803.17
Excise Duty 539.71 736.09 970.32 1,070.21 781.58
Net Sales 3,183.80 5,731.75 6,894.79 7,229.97 8,021.59
Other Income 300.84 247.87 369.35 252.84 137.40
Stock Adjustments 45.26 -29.25 6.93 0.33 28.74
Total Income 3,529.90 5,950.37 7,271.07 7,483.14 8,187.73
Expenditure
Raw Materials 1,078.84 1,513.55 1,843.65 1,180.48 1,233.42
Power & Fuel Cost 299.52 430.98 517.56 1,598.96 1,539.65
Employee Cost 184.84 318.02 352.73 413.04 367.71
Other Manufacturing Expenses 157.65 262.45 344.17 362.90 421.69
Selling and Admin Expenses 838.12 1,298.32 1,547.30 1,620.65 1,658.79
Miscellaneous Expenses 84.88 189.08 354.51 270.99 262.72
Preoperative Exp Capitalized 0.00 0.00 0.00 0.00 0.00
Total Expenses 2,643.85 4,012.40 4,959.92 5,447.02 5,483.98
 Dec '05 Dec '06 Dec '07 Dec '08 Dec '09

9 mths 12 mths 12 mths 12 mths 12 mths

Operating Profit 585.21 1,690.10 1,941.80 1,783.28 2,566.35

PBDIT 886.05 1,937.97 2,311.15 2,036.12 2,703.75
Interest 66.19 75.19 73.87 39.96 84.30
PBDT 819.86 1,862.78 2,237.28 1,996.16 2,619.45
Depreciation 164.64 254.61 305.43 294.18 342.09
Other Written Off 6.46 6.24 1.55 0.00 0.00
Profit Before Tax 648.76 1,601.93 1,930.30 1,701.98 2,277.36
Extra-ordinary items 46.93 14.55 -0.16 35.39 21.54
PBT (Post Extra-ord Items) 695.69 1,616.48 1,930.14 1,737.37 2,298.90
Tax 140.17 369.10 491.70 524.60 688.93
Reported Net Profit 544.18 1,231.84 1,438.59 1,212.79 1,606.73
Total Value Addition 1,565.01 2,498.85 3,116.27 4,266.54 4,250.56
Preference Dividend 0.00 0.00 0.00 0.00 0.00
Equity Dividend 147.61 280.92 375.02 375.33 431.76
Corporate Dividend Tax 20.70 39.40 63.74 63.79 73.38
Per share data (annualised)
Shares in issue (lakhs) 1,845.08 1,872.78 1,876.24 1,876.82 1,877.40
Earnings Per Share (Rs) 29.49 65.78 76.67 64.62 85.58
Equity Dividend (%) 80.00 150.00 200.00 200.00 230.00
Book Value (Rs) 115.76 167.81 221.33 262.56 320.45

Cash Flow of ENRON ------------------- in Rs. Cr. -------------------

Dec '95 Dec '96 Dec '97 Dec '98 Dec '99

9 mths 12 mths 12 mths 12 mths 12 mths

Net Profit Before Tax 405.46 1449.82 1717.18 1687.74 2294.39

Net Cash From Operating Activities 643.84 1421.68 2004.90 1708.33 2397.94
Net Cash (used in)/from
-181.23 -482.70 -824.30 -1170.44 -2181.22
Investing Activities
Net Cash (used in)/from Financing
-419.04 -423.42 -1057.29 -297.13 -454.58
Activities
Net (decrease)/increase In Cash and
43.57 515.56 123.31 240.76 -237.86
Cash Equivalents
Opening Cash & Cash Equivalents 59.22 104.61 620.17 743.48 984.24
Closing Cash & Cash Equivalents 102.79 620.17 743.48 984.24 746.38

Key Financial Ratios of

------------------- in Rs. Cr. -------------------
ENRON

Dec '95 Dec '96 Dec '97 Dec '98 Dec '99

Investment Valuation Ratios

Face Value 10.00 10.00 10.00 10.00 10.00
Dividend Per Share 8.00 15.00 20.00 20.00 23.00
Operating Profit Per Share (Rs) 31.44 89.30 103.47 95.02 136.52
Net Operating Profit Per Share (Rs) 172.56 306.06 367.48 385.22 427.27
Free Reserves Per Share (Rs) 91.75 144.12 206.60 247.26 304.59
Bonus in Equity Capital 49.78 49.05 48.95 48.94 48.92
Profitability Ratios
Operating Profit Margin (%) 18.21 29.17 28.15 24.66 31.95
Profit Before Interest And Tax Margin
12.86 24.35 23.24 20.01 27.22
(%)
Gross Profit Margin (%) 17.32 28.97 23.72 20.59 27.68
Cash Profit Margin (%) 21.95 25.53 21.57 19.22 23.61
Adjusted Cash Margin (%) 12.97 22.63 21.57 19.22 23.61
Net Profit Margin (%) 16.85 21.16 20.44 16.29 19.69
Adjusted Net Profit Margin (%) 7.68 18.15 20.44 16.29 19.69
Return On Capital Employed (%) 14.16 38.35 39.84 31.43 35.80
Return On Net Worth (%) 25.47 39.19 34.64 24.61 26.70
Adjusted Return on Net Worth (%) 11.64 33.64 29.16 23.05 26.32
Return on Assets Excluding
10.94 20.35 221.33 262.56 320.45
Revaluations
Return on Assets Including
10.94 20.35 221.33 262.56 320.45
Revaluations
Return on Long Term Funds (%) 15.36 40.10 39.98 31.43 35.80
Liquidity And Solvency Ratios
Current Ratio 0.58 0.77 0.86 0.89 0.67
Quick Ratio 0.42 0.61 0.55 0.61 0.42
Debt Equity Ratio 0.50 0.25 0.07 0.10 0.09
Long Term Debt Equity Ratio 0.39 0.20 0.07 0.10 0.09
Debt Coverage Ratios
Interest Cover 6.87 19.97 24.05 42.56 27.96
Total Debt to Owners Fund 0.50 0.25 0.07 0.10 0.09
Financial Charges Coverage Ratio 9.45 23.43 28.21 49.92 32.02
Financial Charges Coverage Ratio Post
11.81 20.85 24.63 38.71 24.12
Tax
Management Efficiency Ratios
Inventory Turnover Ratio 5.37 9.33 24.85 27.51 25.22
Debtors Turnover Ratio 16.34 27.75 27.40 24.12 31.22
Investments Turnover Ratio 12.29 22.40 24.85 27.51 25.22
Fixed Assets Turnover Ratio 1.05 1.72 1.26 1.25 1.19
Total Assets Turnover Ratio 0.99 1.46 1.55 1.35 1.23
Asset Turnover Ratio 0.69 1.19 1.26 1.25 1.19

Average Raw Material Holding 19.85 22.19 21.34 33.05 37.17

Average Finished Goods Held 9.14 7.07 7.17 6.45 7.01
Number of Days In Working Capital -27.93 -6.96 -18.25 -17.02 -54.17
Profit & Loss Account Ratios
Material Cost Composition 33.88 26.40 26.73 16.32 15.37
Imported Composition of Raw Materials
1.36 3.00 6.49 9.83 15.72
Consumed
Selling Distribution Cost Composition 22.80 20.02 18.55 19.05 17.37
Expenses as Composition of Total
1.93 1.20 1.29 0.99 0.69
Sales
Cash Flow Indicator Ratios
Dividend Payout Ratio Net Profit 30.92 26.00 30.49 36.20 31.43
Dividend Payout Ratio Cash Profit 23.53 21.45 25.13 29.13 25.92
Earning Retention Ratio 32.15 69.70 63.78 61.35 68.11
Cash Earning Retention Ratio 59.85 75.70 71.10 69.30 73.78
Adjusted Cash Flow Times 2.56 0.59 0.20 0.34 0.29

Special purpose entities

Enron used special purpose entities—limited partnerships or companies created to fulfill a

temporary or specific purpose—to fund or manage risks associated with specific assets. The
company elected to disclose minimal details on its use of special purpose entities. These shell
firms were created by a sponsor, but funded by independent equity investors and debt financing.
For financial reporting purposes, a series of rules dictates whether a special purpose entity is a
separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose
entities to hide its debt.

The special purpose entities were used for more than just circumventing accounting conventions.
As a result of one violation, Enron's balance sheet understated its liabilities and overstated its
equity, and its earnings were overstated. Enron disclosed to its shareholders that it had hedged
downside risk in its own illiquid investments using special purpose entities. However, the
investors were oblivious to the fact that the special purpose entities were actually using the
company's own stock and financial guarantees to finance these hedges. This setup prevented
Enron from being protected from the downside risk. Notable examples of special purpose entities
that Enron employed were JEDI, Chew co, White wing, and LJM.

Financial audit

Enron's auditor firm, Arthur Andersen, was accused of applying reckless standards in their audits
because of a conflict of interest over the significant consulting fees generated by Enron. In 2000,
Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount
accounted for roughly 27% of the audit fees of public clients for Arthur Andersen's Houston
office). The auditors' methods were questioned as either being completed solely to receive its
annual fees or for their lack of expertise in properly reviewing Enron's revenue recognition,
special entities, derivatives, and other accounting practices.

Enron hired numerous Certified Public Accountants (CPA) as well as accountants who had
worked on developing accounting rules with the Financial Accounting Standards Board (FASB).
The accountants looked for new ways to save the company money, including capitalizing on
loopholes found in Generally Accepted Accounting Principles (GAAP), the accounting industry's
standards. One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to
our advantage. All the rules create all these opportunities. We got to where we did because we
exploited that weakness."
Andersen's auditors were pressured by Enron's management to defer recognizing the charges
from the special purpose entities as their credit risks became clear. Since the entities would never
return a profit, accounting guidelines required that Enron should take a write-off, where the value
of the entity was removed from the balance sheet at a loss. To pressure Andersen into meeting
Enron's earnings expectations, Enron would occasionally allow accounting firms Ernst & Young
or PricewaterhouseCoopers to complete accounting tasks to create the illusion of hiring a new
firm to replace Andersen. Although Andersen was equipped with internal controls to protect
against conflicted incentives of local partners, they failed to prevent conflict of interest. In one
case, Andersen's Houston office, which performed the Enron audit, was able to overrule any
critical reviews of Enron's accounting decisions by Andersen's Chicago partner. In addition,
when news of SEC investigations of Enron were made public, Andersen attempted to cover up
any negligence in its audit by shredding several tons of supporting documents and deleting
nearly 30,000 e-mails and computer files.

Revelations concerning Andersen's overall performance led to the break-up of the firm, and to
the following assessment by the Powers Committee (appointed by Enron's board to look into the
firm's accounting in October 2001): "The evidence available to us suggests that Andersen did not
fulfill its professional responsibilities in connection with its audits of Enron's financial
statements, or its obligation to bring to the attention of Enron's Board (or the Audit and
Compliance Committee) concerns about Enron's internal contracts over the related-party
transactions".

Enron made a habit of booking costs of cancelled projects as assets, with the rationale that
no official letter had stated that the project was cancelled. This method was known as "the
snowball", and although it was initially dictated that snowballs stay under $90 million, it was
later extended to $200 million.

In 1998, when analysts were given a tour of the Enron Energy Services office, they were
impressed with how the employees were working so vigorously. In reality, Skilling had moved
other employees to the office from other departments (instructing them to pretend to work hard)
to create the appearance that the division was bigger than it was. This ruse was used several
times to fool analysts about the progress of different areas of Enron to help improve the stock
price.
How the fraud was discovered

The accounting misstatements were discovered starting when on “November 8t Of 2001 Enron
told investors they were restating earnings for the past 4 and ¾ years” (Albrecht). Declaring
bankruptcy shortly after restating its earnings was also a clue. The “smoking gun” that was not
in the accounting books was when Sharron Watkins, Vice president at the time, wrote a memo to
chairman Kenneth Lay about the fraud that was occurring.

The governmental organizations involved in the Enron investigation are the Second IRS. The
SEC investigated the fraud, issued fines, and filed criminal and civil charges against the
companies involved and the Department of Justice (Enron Task Force) prosecuted the accused
firms. The IRS’s role is unclear because of the investigative reports involving the scandal not
being available due to Enron’s rights as private taxpayer, according to Business Week.

Causes of downfall
Nontransparent financial statements did not clearly depict its operations and finances with
shareholders and analysts. In addition, its complex business model and unethical practices
required that the company use accounting limitations to misrepresent earnings and modify the
balance sheet to portray a favorable depiction of its performance.” The Enron scandal grew out
of a steady accumulation of habits and values and actions that began years before and finally
spiraled out of control. In an article by James Bodurtha, Jr., he argues that from 1997 until its
demise, "the primary motivations for Enron's accounting and financial transactions seem to have
been to keep reported income and reported cash flow up, asset values inflated, and liabilities off
the books."

Whistle blower an employee of the Enron responsible for the downfall.

Conclusion

Joseph Bernardino began to defend his company by directing attention away from Arthur
Andersen specifically and on to more fundamental problems among the Big Five accounting
firms. Old rules for recording transactions no longer applied; auditors faced unprecedented
volumes of information to process, leading to unintentional errors; the regulatory structure failed
to adequately check auditors’ work and in the new environment of close auditor/ client relations,
Andersen headquarters could not micromanage each partner’s branch.

Bernardino’s defense both succeeded and failed. On one hand, the American public and
Congress both agreed on a need for major reform of the accounting industry and the regulatory
oversight system. By the summer of 2002, Congress had passed bills for corporate reform that
would change the rules governing consulting services performed by auditors, increase executive
culpability for financial misconduct, and redefine the ways in which businesses recorded their
assets and liabilities.

Although Americans viewed Enron as an example of a need to change accounting practices,

AsBerardino had argued, Berardino’s efforts to share culpability with the entire industry did not
save his company. In the months from the November 29th, 2001, announcement of the

SEC subpoena, to the June 15th, 2002, jury conviction on a felony charge of obstruction
ofjustice, the accounting firm made weekly front-page news for misconduct. The American
public remained fixated on the implosion of both Enron and Andersen and the corporate
wrongdoing associated with the collapse.

Many people attempted to save Arthur Andersen. The accounting firm entered 2002 as alarm of a
global network with a presence in cities across America and 86,000 employees. Byte spring, it
was searching for merger partners and shedding its workforce in layoffs or through transfers to
other companies willing to accept both former Andersen clients and former Andersen employees.
It is not clear how Bernardino could have best handled the Enron crisis. What is clear, however,
is that, as one Wall Street Journal headline phrased it:

SUGGESTIONS:
Accounting irregularities are cited directly in the cases which is the main cause of Enron
financial scam.

So according to me this thing you can do to avoid these types of financial scam these
are…….
Examine your ethical climate and put safeguards in place.
Consider conducting a formal assessment of your corporate culture from the perspective of
attitudes, perceptions, values, and standards of conduct, pressures to commit misconduct,
communications, risks and vulnerabilities. Pay particular attention to your corporate values and
how well they have been internalized by your Board, senior leadership, employees at all levels
and key stakeholders.

Build a robust ethics infrastructure that is self-sustaining.

Writing a code of conduct, supporting it at top levels and communicating it to employees are just
a start. Corporations should have a committee of independent non-executive directors on its
Board of Directors who are responsibility for ensuring that systems are in place in the
corporation to assure employee compliance with the Code of Ethics. Measures they recommend
should include staff training, evaluations of compliance systems, appropriate funding and
staffing of the corporate ethics office, and effective protections to employees who "blow the
whistle" on perceived actions contrary to the spirit and/or letter of the Code. Many corporations
establish independent "hot lines" or "help lines" where employees can seek guidance when they
are faced with an ethical when they encounter unethical conduct in the workplace. Annual
training on the code is becoming common place.

Publicly commit to being an ethical organization.

Go public. No, not an IPO (Initial Public Offering) an EPO: an Ethical Public Offering.
Corporations that are open about their ethical standards and conduct seem to be more trustworthy
than those who stay silent. Some issue an annual report of their ethics accomplishments and the
challenges they faced. Other corporations openly post their vision, values and codes of conduct
on their web sites for public viewing. Every member of the Board of Directors of a publicly
listed corporation should be required to sign the Code of Ethics and pledge that she or he will
never support a Board motion to suspend the Code. All outside law firms and auditing firms that
consult to publicly listed corporations should be required to sign statements noting that they
understand and accept the corporation's Code of Ethics.

Separate auditing from consulting functions.

Allowing Arthur Andersen to both audit and consult with Enron created at least an appearance of
a conflict of interest. Subsequently, hiring Arthur Andersen employees as Enron employees who
then managed the affairs of their former colleagues made this a real ethical conflict of interest.
The independence and integrity of financial auditing organizations are fundamental to the
 stability and growth of American business and free markets throughout the world. Auditing and
consulting functions must be kept separate.

Talk with employees at all levels often!

Failure to communicate causes far more pain than smashing your thumb with a hammer. The
sore thumb will heal poor communication can be fatal these informal conversations give
employees two sets of data. There is the spoken information that is exchanged and the inferred
data that employees glean from the more subtle communications that accompany a manager's
words. Employees basically want to know two things. They want to know what is expected or
required for them to survive and to be successful (tasks and ethics). They also want to know
"how they are doing" at this point in time (tasks and ethics).Communicate the following: Goals,
Roles, Expectations and Priorities.

Build ethical conduct into corporate systems.

Define your position as an ethical business. Provide employees and customers with a written
pledge. These are our values. This is how we define what is right, fair and good. We promise that
all employees (at every level) of this organization will treat each other and customers
accordingly. Train your employees on their ethical responsibilities. Teach people how to
translate the pledge into specific actions that support the pledge and build trust. Provide support
and guidance to employees. Take time to share what you have learned about how the pledge
applies in particular cases within the organization. Measure your success. Implement simple
systems to measure the effectiveness of this ethics initiative. Determine if employees are living
the pledge and measure the differences it makes to your employees, your customers and your
bottom line. Reward those employees who choose to live the promises and remove those who
don't.

Establish an Ethics Committee to constantly keep the organization focused on the seven
main provisions of the Federal Sentencing Guidelines

1. Guidelines to the appropriate personnel program.

2. Assume responsibilities for overall compliance.

3. Assure due care in assigning discretionary responsibility

4. Communicate the organization's standards and procedures

5. Monitor and audit compliance.

6. Serve as primary agent for enforcement and discipline.

7. Take the steps necessary to ensure that offenses are not repeated.
Choose to live your corporate values.

No compliance manual, regardless of its thoroughness, can cover every contingency. And, if one
could be written that did cover all possibilities, it would occupy so much space and be so
cumbersome to use that its covers would never be opened. By equipping employees with
corporate-supported values and empowering them to make decisions based on those values, you
will free them to take action even when specific guidance isn't readily available.

Keep the lines of communications open.

If you ask about what is going right, what is going wrong and what makes employees
uncomfortable in their jobs, you can usually identify pitfalls before you step into them.
Communicate openly and honestly.

References

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