Chao Ren and Joseph Restuccia
Case 3.1 ??“ Enron
1.? ? Inherent risk is the risk that a class of transactions, account balances or disclosures is materially misstated without applying any related control. Paragraph 9 of PCAOB Auditing Standard NO.5 gives some instances where an auditor should pay attention to the effects on financial statements when planning the audit.
? ? ? ? In this case, Enron played an intermediary role between its gas suppliers and gas customers, allowing the contracts with gas suppliers to be traded. Enron applied this trading model to other markets using an ???asset-light??? strategy. In this model, Enron gave its producers cash up-front instead of payment over the life of the contract to diminish the risk brought by the long-term nature of the contracts. As for audit planning, this new payment method should be considered, thus raising Enron??™s inherent risk. Also, Enron devised complex and variable contracts and traded them. This action brought those contracts into the trading market, bringing many uncertainties and risks for the company.
? ? ? ? Last but not least, Enron used the ???asset-light??? strategy to achieve its expansion to other markets. This strategy reduced the fixed capital expenditure by divesting its assets related to the beginning and ending activities. How they evaluated and recorded the proceeds from those divested assets also increased Enron??™s inherent risk. Moreover, this strategy was applied to different markets and countries; the complexity of those markets also raised the inherent risk.
2.? ? The Planning section of AU Section 311 indicates that the nature, extent, and timing of planning vary with the size and complexity of the entity, experience with the entity, and knowledge of the entitys business. As in this case, Enron paid its producers cash up-front instead of payment over the life of the contract. Those transactions involved large amounts of cash and occurred frequently. This means there would be times where there were large amounts of cash on hand or processed, which gave employees the opportunity to misappropriate assets. So in the audit planning stage, the auditor should pay more attention to those cash up-front payments and gather evidence about those payments to ensure there is no error or fraud causing material misstatement.
? ? ? ? ? For the second factor, Enron devised the contracts to allow them to be traded. This action raises problems about valuation and calculation of those trading contracts. Since the method to devise the contracts is complex and variable, the auditor should ensure the calculations for the contract price are accurate and do not raise material misstatement. In addition, because the contracts are traded on the market, the auditor should also pay attention to how the contracts are priced or evaluated and recorded on Enron??™s statement.
? ? ? ? ? The ???asset-light??? strategy raises problems about the valuation and disposition of divested assets. Because of the boom of the energy industry, those assets have a great possibility of appreciating. If those assets are sold, the auditor should pay attention to whether Enron appropriately discloses the sales and related profits and whether the revenue would cause material misstatement, misleading the users of financial statement.
3.? The change in industry regulation and Enron??™s resulting strategy shift would impact the inherent risk assessment for the relevant assertions about revenue. The government??™s decision to deregulate the natural gas industry caused potential problems for Enron. It created conflicts of interest because the interests of the industry could be favored over the interests of the investors and the public. Because of this, auditors completing an inherent risk assessment may want to focus more attention when testing for completeness and valuation. Given the market completion and supply availability and cost, there would be an increase risk for material misstatement. Enron??™s resulting strategy shift was to charge companies to use its pipelines, as well as to become involved in natural gas trading and financing. The most relevant assertion for revenue after Enron??™s resulting strategy shift is valuation. Valuation is the most important because it checks whether different components of the financial statements have been included in the right proportion. This would include revenue.
4.? Revenue recognition fraud may occur under Enron??™s strategy in the late 1990s.? Enron earned profits by providing services such as risk management in addition to building and maintaining electric power plants, natural gas, pipelines and storage facilities. Service providers, when classified as agents, are able to report trading and brokerage fees as revenue, although not the full value of the transaction. Enron could elect to report the entire value of each of its trades as revenue. This action would inflate trading revenue.? An internal control function that can be very effective for preventing or detecting improper revenue recognition is an independent internal audit group. Internal audit teams routinely perform operational and compliance reviews which, if done properly, would identify materially unusual or unexpected relationships and investigate their cause