Instructor’s Manual, Chapter 2 22
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Business & Professional Ethics for Directors, Executives & Accountants, 5e,
Leonard J. Brooks and Paul Dunn
South-Western, Cengage Learning, Mason Ohio, 2010
Instructor’s Manual
Chapter 2 Enron Events Motivate Governance & Ethics Reform
Learning objectives ………………………………………………………2
Possible teaching approaches, using cases and readings…………………3
Answers to questions for discussion…………………………………….. 4
Case Notes………………………………………………………………. 7
Multiple Choice Questions………………………………………………23
PowerPoints are in a separate file at www.cengage.com/accounting/brooks
COMMENTARY ON CHAPTER 2:
GOVERNANCE, ACCOUNTING AND AUDITING, POST-ENRON
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Learning Objectives
Chapter 2 is designed to review the Enron, Arthur Andersen and WorldCom fiascoes to reveal:
· How fraudulent transaction were arranged and carried out,
· How flaws in the following permitted and facilitated these transactions:
· Focus of accountability,
· Governance perspective, understanding and mechanisms including the corporate culture involved,
· Motivation systems, including remuneration, stock option and bonus systems
· Understanding of roles, risks and mandates for:
· Directors and executives
· Professional accountants
· Lawyers
· Bankers who facilitated these transactions
· What the impacts have been and will be on these corporate and professional participants due to:
· Reactions by government and regulatory agencies
· The Sarbanes-Oxley Act of 2002
· Resulting SEC, NYSE and OSC securities and governance regulations
· The New Framework for Accountability and Governance
· Future developments that are likely
In addition, two other cases – involving Waste Management, Inc. and Sunbeam Corporation - are presented that further illustrate these patterns of flaws in Arthur Andersen’s approach and clients.
Important learning points to be developed include:
· An understanding of:
· what happened and what permitted it to happen
· appropriate roles to be played by directors, external and internal professional accountants, lawyers, executives, and so on
· appropriate mandates to be accepted by corporations (including banks) and professionals based upon stakeholder expectations
· the new expectations for accountability and governance to facilitate that accountability for both corporations and the accounting profession, including the changes required by the Sarbanes-Oxley Act and introduced by the SEC and how these will have a ripple affect around the world.
· how formal risk management programs might have raided the potential ethics problems that arose
· how Arthur Andersen’s demise changed the probability and cost impact of a “franchise risk” (one that threatens to end or curtail an operating mandate)
· likely future developments
· appropriate safeguards to avoid situations arising if the following assumptions turned out to be false.
· How and why the following assumptions turned out to be false:
· People can be trusted to act honestly without follow-up
· Dishonesty in some aspects of corporate activity will not affect basic overall integrity or accountability
· Incentive compensation schemes are good enough to cause employees to act in the best interests of shareholders (and therefore stakeholders) (i.e. agents will be free of moral hazards)
· The Board of Directors:
· would be told the truth by management, lawyers and professional accountants
· understood why policies and a system of governance/internal controls that ensured compliance was necessary
· understood what the system of governance/internal should be and how it should work, including the role of the internal auditor
· could rely upon the system of governance/internal controls without follow-up or review.
· Ethical concerns of whistleblowers would be reported and acted upon by management and/or brought to attention of the Board
· Making quarterly profits was all that mattered, and would lead to sustained success
Possible teaching approaches, using cases and readings
My approach to the material in this chapter is as follows:
· Students should read the chapter in advance, but unless they are senior accounting students they should be told not to slave over the accounting details.
· I start with a short overview discussion on governance to get the students to consider the role and responsibilities of directors and of executives, as well as of external auditors and lawyers
· Then I ask the students to assume they are Enron Board members and ask themselves what questions they should be asking as I present overheads that lead the students through the Enron, Arthur Andersen and WorldCom material including the bare bones of questionable acts such as those with SPEs.
· I continually challenge the students as to what they would ask, and why the Enron Board didn’t. For example:
· did they understand Enron’s business model and where the profits were coming from? It was from the wholesale division, and mostly from the Special Purpose Entities (SPEs)
· how many SPEs existed and why? It was in the thousands!!
· Why didn’t they know about the incredibly high stock option payments being made?
· Why didn’t more whistleblowers come forward, and why didn’t their concerns reach the board?
· What could motivate the fraudulent behavior by Enron executives? Greed – see the stock option payouts and SPE guarantees, both of which required Enron stock not to fall.
· Was it OK for the banks to facilitate the Prepaid transactions when they knew the transactions had no economic substance?
· Were Enron’s tax avoidance schemes OK? Will there be fallout for the advisors?
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· I then move on to discuss the Arthur Andersen case and its impact on the accounting profession.
· I review the WorldCom case show how it galvanized action in the U.S. Congress and Senate leading to SOX.
· Finally, I review the impacts of SOX on corporate accountability and governance, and well as on the accounting profession.
· PowerPoints are available on my website.
Answers to Questions for Discussion
The following questions are posed at the end of the chapter.
1. What were the common aspects that were necessary for the Enron and WorldCom debacles to occur?
In both cases, there was a dominant CEO who also controlled the Board of Directors. The Chair of the Board did not serve as an effective watchdog over the CEOs activities. In addition, senior financial officers were actively engaged in the manipulation of earnings and assets, and the siphoning off of funds for personal use, all to defraud the company. In each case, company policies and related internal controls of the company were suspended or over-ridden, and the Board was too trusting or too ignorant to ask the right questions. External auditors (Arthur Andersen in both cases) were willing to go along with manipulative entries and overstatements presumably to retain lucrative audit clients and consulting assignments. In so doing, they put aside the interests of the investing public and jeopardized pensions and employees’ interests. Finally, directors were apparently unaware of mounting problems because they were kept in the dark, and no whistle-blowers concerns were brought to them.
2. What actions by directors, executives and professional accountants could have prevented the Enron and WorldCom debacles?
Directors should have reviewed policies for conflicts of interest and followed up on compliance with them using reports from internal audit and other sources. As a normal practice, they should have reviewed payments to employees and directors for stock options and other items for reasonability. Also they should have taken steps to create and ensure an ethical corporate culture, complete with a protected whistle-blowing mechanism. Executives could have spoken directly to Board members, or to the media, or used the False Claims Act – see Singer article. Professional accountants could have done the same, plus reported to the Audit Committee of the board, or to Arthur Andersen in writing. Arthur Andersen, of course, should have been more vigilant on SPE transactions, and should have refused to allow manipulative transactions without qualification of the audit opinion. They should have reported fully to the Audit Committee. In addition, they should have had more effective conflict of interest rules, and should not have permitted lure of revenue generation to overshadow their duty to the public interest.
3. Was the enactment of the Sarbanes-Oxley Act (SOX) necessary? Why or why not?
I would say “yes” because the following patterns were too entrenched to be altered quickly without SOX, and the lack of credibility of and trust in the capital markets, and in turn in corporate accountability and governance, demanded a quick remedy:
· Manipulation of financial reports to “smooth” earnings
· Enormous remuneration for top executives, particularly with stock options
· Lack of effective governance by Boards of Directors, due to:
· Lack of understanding
· Failure to accept responsibility
· Lack of competence
· Lack of effective legal penalties for executive and director malfeasance
· Rampant conflicts of interest in the public accounting profession
· Failure of public accounting profession to serve the public interest
The negative side could be argued – that the market should be allowed to self-correct, but the correction would be slow, and the players would be reluctant to give up their positions of advantage. In the end, self-regulation produced the debacle, so far-reaching, quick readjustments would be an unlikely possibility.
4. What are the three most important improvements in the governance structure that could result from the SOX?
It will take some time to know for sure, but the following are likely to be high on the list:
· Requiring directors on key committees (audit and nominating) to be independent and competent
· Establishing direct criminal liability on the part of the CEO and CFO for manipulations and/or failure to have appropriate control systems in place who must sign the quarterly financial reports asserting to both
· Enhanced independence of external auditors
· Ensuring that the Audit Committee has unfettered access to auditors and their discussions with management
· Ensuring that whistleblowers have a path to the Audit Committee
5. What were the common elements in Arthur Andersen’s approach that appeared to allow the disasters at Enron, WorldCom, Waste management, and Sunbeam?
Within Arthur Andersen, the audit partner responsible for each audit had the power to veto or ignore the recommendations of the quality control partner. Consequently, the ongoing pressure for more audit and consulting revenue (and take-home remuneration particularly for the audit partner) appears to have caused the audit partner in charge at each client cited to ignore warnings that could have prevented manipulations and the disasters. Pressure to retain and enhance revenue was also exerted by those managing the practice.
6. What is wrong with Enron’s banks financing transactions they knew were without economic substance?
With hindsight, Enron’s banks should have realized that they were becoming accessories to the crime of misleading investors. If there was no legitimate financial purpose, then they were facilitating something else. In the future, they will be more careful in assessing their mandates and why they are in some business deals. As articulated in the chapter, the banks have paid huge fines for aiding and abetting in the Enron fraud, and will be stiffening up their due diligence protocols in the future.
7. How should Boards of Directors change incentive remuneration schemes for executives to lessen the risk of motivating executives to risk manipulations to enrich themselves?
There should be less emphasis on short-term performance and on stock options where their value depends upon stock price rather than fundamental indicators of performance that are less susceptible to manipulation. Deferred payouts, concentration on cash payouts, remuneration schemes that have negative provisions for poor performance, and constant review and readjustment are all good ideas for a board to consider. Finally, the Compensation Committee of the Board should be independent of management so that decisions can be free of bias.
8. What lessons should be learned from reviewing the events described in this chapter?
See the above list of learning points and false assumptions for Chapter 2.
ENRON DEBACLE – ENRON’S QUESTIONABLE TRANSACTIONS
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What this case has to offer
The Enron Debacle is the icon for massive fraud allowed by failure of the company’s governance system and the conflicted interests of its executives, auditors and lawyers. It precipitated the loss of credibility and trust in financial markets and corporate governance and accountability that ultimately led to reform of corporate governance and accountability, and of the accounting profession, through the Sarbanes-Oxley Act of 2002. It is a case that all businesspeople and professional accountants should be familiar with and understand.
Teaching suggestions
I use the PowerPoint slides on my website for instructors. First, I set up the topic of governance; second, I use “Enron Affair” to review the important elements of the case; and finally I use “Enron Debrief” to debrief, and review the rest of the material in Chapter 2 and models used in the course.
If you refer to the “Enron Affair” PowerPoints, you will see the order I have found to be very engaging and successful. I ask the audience to assume the role of a member of the Board of Directors, and then I challenge them throughout the case discussion with the following questions:
· What is your role as a Board member?
· What questions should you ask?
· Why didn’t the Enron Board ask those questions?
Depending on the audience (non-accounting or accounting), I review less or more of the details of the fraudulent transactions. My PowerPoints provide a basic set. The key is to reveal enough that all audiences understand:
· Basic governance structure and roles of the Board, executives, professional accountants and lawyers, as well company policy (particularly on conflicts of interest) and compliance systems.
· What a Special Purpose Entity (SPE) is, the operation of the 3% rule for accounting for transactions, and how income, assets and liabilities could be manipulated using it.
· How and by whom the basic frauds were committed.
· The motivation for the frauds.
· Where the money went.
· What the impact of manipulation was on Enron’s financial reports, and the investing public.
· How the governance system was short-circuited – see overheads.
· The role of an ethical or unethical corporate culture in preventing or abetting fraud.
· Why whistle-blowing is important.
· What Arthur Andersen contributed.
· What the banks contributed by facilitating the SPE transactions?
· How the Sarbanes-Oxley (SOX) Act arose.
· What changes SOX originated.
· How ethics risk management can help.
Discussion of ethical issues
The following questions are presented in the text for discussion of the significant issues raised in the Enron case:
1. Which segment of its operations got Enron into difficulties?
Wholesale services was the segment where most of the manipulation went on. See Enron PowerPoint (PPT) 6 for a breakdown of the relative profitability (IBIT) of Enron’s divisions.
2. How were profits made in that segment of operations (i.e. what was the business model)?
See PPTs 5 and 7 for a word version of activities – not how hard it is to understand. Transparency was not in the interest of Enron’s perpetrators.