ENRON: Aftermath'Lessons Learned

1
ENRON Aftermath.Lessons Learned

• AICPA
• Alan Anderson
• Senior Vice President

2
In a Way its Simple In a Way its Not.

• Tone at the Top
• Corporate Greed
• Individual Greed
• Market Euphoria
• Corporate Arrogance
• High Risk Deals

3
In the Beginning.

• 1985 Deregulation
• Houston Natural Gas and InterNorth merger
• Massive Debt coupled with loss of exclusive use
  of pipelines
• Gas Bank

4
Corporate Culture

• Best and the Brightest
• RICE Respect, Integrity, Communication,
  Excellence
• PRC Performance Review Committee
• Profits, Profits, Profits..
• Enron Capital and Trade Recources
• Enron Online (EOL)

5
Business Model

• Enron Finance Corp.
• Enron Capital and Trade Resources
• Enron Online (EOL)
• Became a model for the industry
• Competition Increased

6
Financial Reporting Model

• Mark to Market Accounting
• Swaps
• Related Party Transactions
• SPEs (Special Purpose Entities)
• Obscure Disclosures
• Others????

7
Potential Red Flags

• unduly aggressive earnings targets
• management bonus compensation based on those
  targets
• excessive interest by management in maintaining
  stock price or earnings trend through the use of
  unusually aggressive accounting practices
• Unduly aggressive financial targets and
  expectations for operating personnel
• .

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Potential Red Flags (continued)

• inability to generate sufficient cash flow from
  operations while reporting earnings and earnings
  growth
• assets, liabilities, revenues, or expenses based
  on significant estimates that involve unusually
  subjective judgments such asreliability of
  financial instruments and
• significant related-party transactions.

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Where were .

• Management
• Board of Directors and Audit Committee
• External Auditors
• Market Makers (Analysts)
• Regulators (SEC, AICPA, others)

-That is what everyone is asking
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SEC Initial Response Dec 11,2001

• A system of current disclosures, supplementing
  and updating quarterly and annual information
  with disclosure of material information on a
  real-time basis
• Public company disclosure of significant current
  trend and evaluative data, in addition to
  historical information
• Identification of most critical accounting
  principles by all public companies
• More timely and responsive accounting standard
  setting on the part of the private sector

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SEC Initial Response Dec 11,2001

• An environment of cooperation between the SEC and
  registrants that encourages public companies and
  their auditors to seek advice on disclosure
  issues in advance
• An effective and transparent system of
  self-regulation for the accounting profession,
  subject to SECs rigorous, but non-duplicative,
  oversight and
• More pro-active oversight by audit committees who
  understand financial accounting principles as
  well as how they are applied.

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Meaningful Reform will it

• 1. Help investors make informed investment
  decisions?
• 2. Enhance audit quality and the quality of
  financial reporting?
• 3.Help restore confidence in the capital markets,
  our nations financial
  reporting system, and the accounting profession?
• 4. Be good for Americas financial markets and
  economic growth?

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Wide Range of Proposed Reforms

• Federal State Legislative Proposals
• SEC Chairman President Bush Proposals
• AICPAs Main Views and Concerns
• Volckers Reform Proposals for Andersen
• Former POB Chair Bowshers Proposal
• Several States NY, Mn, Fla. Ca. and others

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Legislative Activity - U.S. Senate

• Highest level of activity in 25 years
• Senate Banking Committee in Lead
• Hearings on Enron debacle in March/April
• Many pending proposals being floated
• Legislation likely in April/May
• Many very important issues in play

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Legislative Activity - U.S. House

• Financial Services Committee in Lead
• Oxley/Baker Bill likely vehicle
• Prohibit IA/IT services consistent with original
  SEC Chairman Levitts proposal
• Dingell introduced his own bill
• New regulatory structure is almost assured
• Only question is how far it goes.

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Proposals of SEC Chairman Pitt

• New body dominated by public members
• New disciplinary mechanism
• SEC handles law violations itself
• Regulatory Body pursues ethical and/or competence
  standards cases complaints
• Quicker disciplinary proceedings
• Body publicizes results and imposes fines

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Reengineer Peer Review Approach

• Replace triennial firm-on-firm peer review
• More frequent monitoring of audit quality
• Use permanent Quality Control staff
• Body composed of knowledgeable people
  unaffiliated with any accounting firms
• Staff deployed and overseen by new publicly
  dominated body and its staff
• Limited to Auditors of Public Companies

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Other Components of Pitt Proposals

• Will ban IT and internal audit services
• But says if Congressional proposals to restrict
  more services go thru, we will have far worse
  quality audits than we have today
• Aggressive enforcement- CEOs Auditors
• Improvements on financial disclosures
• Timely reporting of events, stock sales, etc.

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President Bushs Key Proposals

• Tougher oversight of auditors
• CEOs sign off on full honest disclosures
• Take away bonuses stock gains for executives
  when reporting is inaccurate
• Wants SEC to set scope limits vs.Congress
• Audit committees decide on non-audit work
• Rejects tort reform, expensing stock options

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FASB to be more responsive

• Board size being reduced, speed increased
• Fast track project to deal with SPEs
• Also dealing with guarantees of debt and
  determining fair value on forward contracts
• Move toward more focus on principles
• Accounting details for IASB, not IFAC
• But clear support for working with IASB

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AICPA Input and Views

• Testifying in Congressional hearings
• Providing constructive input
• Zero tolerance for violation of rules or laws
• Urging all to be wary of simplistic solutions
  which can lead to unintended consequences
• Working to limit cascade effect

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New Public Regulatory Organization

• Radical change from last 25 years
• Move from Public Oversight to Public
  Participation
• New robust private sector regulatory body
• Independent of the accounting profession
• Structured with SEC oversight to handle
• Professional discipline and quality review
• Eventually auditor independence issues

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Roles of the New Regulatory Body

• Perform quality reviews of audit firms
• Enforce compliance with professional stds
• Discipline for violations of prof stds
• Establish rules deemed necessary for such reviews
  and enforcement
• Later influence new independence standards and
  other standards (eg. audit standards)

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Important Process Issues

• Regulatory Body serves as disciplinary and
  quality review board, not standards setter
• Ability to move quickly, keep information
  confidential, and take remedial actions
• Able to compel production of documents and
  protect documents reviewed from discovery or
  admissibility in civil litigation

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Non-Audit Services

• Some are necessary part of modern audit
• OMalley Panel - some improve quality
• Audit quality dependent on auditor quality
• AICPA urges caution, impacts
• Audit Quality
• Future Staff
• New restrictions should not impede audit quality
  or the quality of financial reporting

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Restrictions - Non-audit services

• Agree to restrict IT and Internal Audit
• Oppose ban on all non-audit services
• Many unintended consequences
• Onerous to smaller companies - costly
• Ripple effect to non public companies
• Overrides informed and reasoned decision-making
  by audit committees

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Risk of Creating Audit Only Firms

• Threat is the risk to audit quality
• Skills/expertise outpaced by changes in business
  practices and financial transactions
• Less knowledge of client businesses
• Will lead to loss of necessary expertise
• Eventually, scale and other factors will lead to
  audit quality deterioration

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Corporate Governance

• Public reporting of audit committee charter
• Audit committees should hire/fire auditors
• And evaluate relationships and services of the
  audit firm for conflicts
• Harmful to cast a dark cloud over all services
  outside the statutory audit
• Rely on knowledgeable members to decide

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Mandated Auditor Rotation

• Audit firm rotation has been proposed
• Most believe the costs outweigh the benefits
• Does not pass public interest test
• Would create significant proposal frenzy
• Rotation of team members seems adequate
• Loss of knowledge of company hurts a lot

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Tort reform ideas

• Reasoned law critical to integrity of markets
• 1995 law enacted to deal with abuses
• Liabilities are still an enormous deterrent
• Securities class actions cases are on the rise
• Average settlements are also way up
• Profession opposes reform of current law
• Concerns about liability are global

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Employment Restrictions

• There are many safeguards required today
• Some legislators propose more restrictions
• Like one or two year cooling-off period
• Many sound easy, but are hard to effect
• They can severely limit eligible audit firms
• Putting limits on individual careers and client
  recruiting efforts are hard to legislate

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Financial Reporting Reforms

• Improved disclosures plain English
• More timely reporting to investors
• Client reporting on their internal controls
• Auditor assurance on internal controls
• Increased resources for the SEC to oversee
  financial reporting disclosures

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Modernizing Business Reporting

• Unreported intangibles and discussion of risk
• Off balance sheet activity
• Non-financial performance indicators
• Forward-looking information
• Enterprise opportunity and risk
• More Timely reporting (movement toward continuous
  disclosure)

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Broader Perspective Needs

• Broader bandwidth of info for investors, a
  recommendation long advocated by AICPA
• New distribution channels that recognize the
  ubiquity of the Internet communication
• Increased financial reporting frequency, and
  ultimately online, real-time reporting

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Volcker Proposals for Andersen

• Volcker wants Andersen rehabilitated and serving
  as the gold standard for auditing
• Really wants to reform a resisting industry
• This creates concerns for AICPA Big 4
• Split of audit and consulting businesses
• Separate partnerships no profit-sharing
• Much broader restrictions of services

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Other Controversial Volcker Ideas

• Proposed new restrictions on services
• Aggressive tax planning services
• Presumably includes creating tax shelters
• Legal services and some advocacy roles
• Tax accounting services for executives
• Also favors cooling off period for partners
  joining clients, and 5 year partner rotation

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POB Reverses Long-standing Views

• Public Oversight Board quits/terminates
• POB Chairman testified March 19
• Highly critical of profession
• Propose unrealistic measures
• Far in excess of Pitt and Bush Proposals
• Favors big legislative solutions

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A Very Political Process

• Congress is more involved than ever before
• Issues are red hot and elections coming up
• High risk of harsh legislative solutions
• Profession working with legislators
• Trade-offs in SEC vs. legislative solutions
• Very hard to forecast the end results

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Recap of Key Issues in Play

• Scope of service/independence restrictions
• Considering perception versus reality
• Audit committee judgment or bright lines
• Audit firm or partner rotation proposals
• Firm rotation mandates create concerns
• Appropriate limits on rotation of people

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Other Key Issues in Play

• Revolving door/ hiring audit firm people
• Peer review/ new quality assurance
• New regulatory structure for profession
• New disciplinary structure protections
• Auditor/audit committee relationship
• Corporate governance reforms

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Other Key Issues in Play

• Accounting standards
• Process timeliness improvements
• Depth and coverage of standards
• Auditing standards
• Responsibility for fraud detection
• Fraud reporting reqts and standards

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Other Reform Issues in Play

• Who pays for audits
• SEC/FASB/Regulatory Body funding
• Tort reform
• Deductibility of stock options
• Tax shelter changes
• Pension and 401-K reforms

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Remember There will always be Strains on the
System of Checks and Balances

• Management
• Boards of Directors and its Committees
• Independent Auditors
• Security Analysists
• Regulators (SEC, FASB and others)

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Foundation for the Future

• Must work to protect the public interest under
  the current reporting models
• Must work to develop approaches and programs to
  respond to marketplace demands for assurance
  under New Economic models

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Convergence

• Blurring of Boundaries between
• Auditing of Financial Statements
• Assurance
• Attestation on Financial and non-financial items
• Need for on-line real time assurance

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What it takes to get Real Time Assurance.

• Reliable systems
• a common method of disseminating information on
  the internet
• reporting on subsets of financial data as well
  as non financial data, industry specific rather
  than one size fits all, common global approach
• corporate accountability including management
  integrity, solid enterprise risk management
• Understandable disclosures including the ability
  to drill down into expanded discussion if the
  user desires to do so

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AICPA Initiatives

• Reliable Systems
• Method of Disseminating Information
• Financial Data and Non Financial Data

• Trust Family (Systrust)
• XBRL
• VMRC
• Performance View

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AICPA Initiatives

• Corporate Accountability
• Understandable disclosures

• Trust Family (Webtrust)COSO ERM ProjectASB
  Fraud StandardEnvironmental ReportingAudit
  Committee Rules
• FASB ProjectsVMRCSEC Plain English Plan

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Recap

• Uncertainty where Enron debacle will end
• Profession needs to play leadership role
• Avoid overreaction simplistic solutions
• Consider unintended consequences
• Focus on the public interest in all we do

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In Summary

• We must work to build a foundation for the future
  to continue to protect the public
• We must be responsive to marketplace changes as
  our audit model will continue to decline in
  relevance
• We should work together Globally whenever
  possible