September 2002

Enron Demonstrates Weaknesses in the Attestation Process

By Derk G. Rasmussen and Joseph L. Leauanae

In May, the SEC announced that it had begun investigating Enron’s recent disclosure that it overstated the value of its assets by up to $24 billion in the last year. The SEC is now focusing on how the company valued everything from trading activities to hard assets such as investments in power plants and fiber optic networks. Specifically, the SEC is seeking to determine how and when the downgraded assets were placed on the balance sheet, whether their value was artificially inflated, and which executives were involved in those decisions.

Throughout the period of the alleged financial statement manipulation, Andersen acted not only as Enron’s outside independent auditor but also as a consultant. This dual function is currently under intense scrutiny by Congress.

Lack of Objectivity

In attempting to retain large clients and the fees they generate, independent auditors can suffer impaired objectivity. The loose restrictions that govern firms providing audits and related consulting services can effectively grant companies leniency in the way they account for financial transactions.

Further weakening auditor objectivity is the fact that fees generated under the umbrella of consulting services often have the potential to be far greater than those generated by standard audit services. If CPAs act as both consultants and independent auditors, such relationships will lead to conflicts of interest and ethical dilemmas, and these are not always resolved on the side of caution.

Failure to Be Critical

Contemporary audit training emphasizes adherence to an audit program, which is generally no more than a checklist that must be “ticked and tied” to a company’s financial statements. Unfortunately, this type of training has supplanted more comprehensive techniques using analytical thinking and critical analysis. But without these skills, auditors cannot substantively determine that financial statements are not misstated or misleading.

An auditor is generally shipped to the front lines after minimal formal audit training. Most hands-on training takes place on-site, where the effectiveness of the auditor will depend on the effectiveness of the instructor. Without specific training in analytical thinking and critical analysis, an auditor cannot be completely effective.

In addition to training deficiencies, common mistakes of logic and laziness impair the execution of certain audit engagements even more. Beyond the quantitative aspects, many situations “just don’t feel right.” These are instances when auditors can apply analytical thinking and critical analysis to improve their ability to adequately observe, understand, and process misleading representations on the financial statements.

Put succinctly, effective training will allow auditors to answer the question, “Does this make economic sense?” Sometimes it is possible to have technical compliance with GAAP and still miss the mark, such as when an auditor verifies that a sales transaction is adequately collateralized but ignores the fair market value of the assets being acquired. These oversights of form over substance only weaken the effectiveness of an audit.

Failure to Recognize Limitations

Sometimes avoiding conflicts of interest and applying analytical thought and critical analysis are not enough. Many audit engagements involve complex issues that exceed an auditor’s expertise. Even though many large CPA firms have the capability, outside of the audit department, to address these issues, they are required to avoid even the appearance that conflicts of interest exist. Auditors must assess the limitations to their expertise, and if necessary, ask that complex issues exceeding their expertise be resolved by qualified professionals not associated with the audit firm. Such issues include conducting business valuations to appraise subsidiaries, and applying forensic accounting to reconstruct financial statements or identify fraud.

These were key issues in the Enron audit. The value of energy projects at various points in time was an important criterion in determining whether or not the financial statements were misstated or misleading. Had these projects been valued by a professional proficient in the appraisal of income-producing energy projects, these misstatements might have been avoided.

Finding Solutions

Fundamental changes in how audits and related consulting services are sold, maintained, managed, and performed are necessary to improve the quality of audited financial statements. Avoiding situations that might impair objectivity, recognizing the failure to critically analyze, and acknowledging limitations to expertise are primary factors that contributed to the deficiencies in the Enron audits. Until the audit profession is willing to address the weaknesses within current audit processes and focus resources on identifying and implementing solutions, debacles like Enron will continue to occur.