Case 3.

1 Enron Understanding the Clients Business and Industry

Kalpna Gaule
Sweta Shah
AC 741 HB1
I. Factors leading to increased Inherent Risk
1. Industry specific factor: Deregulation of the Natural Gas sector, which allowed for the market
forces to determine the price and allowed for open access to the pipelines. It reduces barriers to
entry and increases competition which depresses the prices, margins and returns in the longer
term for all the market participants. Probability of depressed returns could have been the primary
motivation for Enron to assort to enter the Energy derivatives trading.
2. Company specific factors:
1.1. Shift from core business strategy Enron entered in the trading and financing of complex
Energy derivative products .These complex derivative trading hold Counterparty risk and the
fair valuation of these products lead to volatility in income statement and balance sheet items
and were primarily traded over the counter. OTC market is not regulated, and a lack of a
clearing party exposes the participants to a higher risk. Enron also adopted an Asset light
strategy could prevent Enron from supplying the contracted amount. The natural hedge
available to Enron of owning the pipelines and charging a price for distribution that was
proportional to the spot price gas it might purchase was reduced when Enron adopted the
asset light strategy.
1.2. Geographical Expansion and Diversification into unrelated businesses Geographical
expansion not only exposed Enron to country risk but also to foreign currency risk. As a
result of expansion and diversification, Enron would have to understand and keep track of the
foreign policies and industry specific regulations. The unrelated nature of the businesses does
not allow leveraging skills or expertise of across businesses.
II. Impact of the Factors on Audit planning:
Enron had a complex business model, which required an Auditor to evaluate the inherent risk
associated with the Commodity, Trading and Broadband industry and managements policies to
reduce that risk. We identified following key impacts as a result of the business risks on the planning
of audit.
1. Extensive preliminary tests to assess the Risk of Material Misstatement: Test of controls has to be
extensive to evaluate the overall control environment, documentation of risk appetite and
measures to reduce the risk and accounting estimates. Management and personnel interviews need
to be conducted to evaluate their expertise in the area of operation. Preliminary analytical
procedure like Free Cash Flow analysis and evaluation of return ratios such as ROIC/ROE could
determine the need of debt financing - a repercussion of which is maintaining the debt covenants
or resorting to off balance sheet financing. These steps will help in identifying significant account
balances, which run the risk of material misstatement.
2. Establish a lower level of Materiality and tolerable misstatement: Planning materiality and
Tolerable misstatement to be applied to assertions made about the Revenue, Asset including Cash
and derivatives, Liabilities such as Debt and Contingent liability accounts have to be a
substantially lower value. This will require much more detailed test of Since Net Income before
tax for Enron could be a fluctuating number, the average of Net Income before tax for past three
years may be used as a benchmark.

3. Interim Audits: Fair valuation of derivative contracts and exposure to foreign currency risk will
require a detailed interim audit to evaluate the management estimates and assertions about
unrealized holding gains and losses and gains and losses to due to hedging.
4. Consider Multilocations Geographical expansion require identifying and focusing on the
locations, which possess higher level of Country risk and restrictive trade policies.
5. Team requirements and structure: Dedicated teams for a particular line of business headed by a
specialist in the areas a. Valuation of Contingencies and OTC Energy Derivatives and hedges, b.
asset impairments for pipelines and broadband network due to decline in demand c. Energy
contract terms and evaluation of buyers creditworthiness.
6. Government regulation and Environmental laws: Auditor must create a scenario analysis to
determine Direct and Material effect of the change in government regulation and indirect but
material impact of environmental contingencies
III. Revenue Assertions
Due to the deregulation, Enron anticipated of decline in margins and returns led to engaging in a
much more rewarding but equally risky energy derivative trading business. Firms use energy
derivative trading primarily as a hedging strategy, however Enron engaged in basis trading it did
not use the trading as a safeguard , but for speculation and for arbitrage opportunity . This aggressive
growth strategy was followed by aggressive accounting policy.
The most relevant assertions about revenue Existence and Valuation are difficult to be evaluated
given the change in the business model. Accounting principles for a normal purchases and normal
sales exception energy contract entered in Enron original business are much more conservative and
objective as compared to the fair value accounting principles for Financial Contract entered in
Enrons new business model (FASB Accounting Rules and Implications for Natural Gas Purchase
Agreement). Costs for the Normal purchases and normal sales exception energy contract are
expensed as incurred and sales are booked when sales occur.
On the other hand, the estimated market value of the financial contract and associated obligations are
recognized when the contracts are signed and increases (decreases) in the estimated market value of
the contract are added (subtracted) on the income statement. The recognition is inherently risky due
to subjectivity of management estimates and timing of recognition (Valuation) and uncertainty of real
future cash flows (Existence). The Compensation linked to EPS, meeting debt covenants and earnings
forecasts could have been some of the incentives to overstate (understate) the gains (losses) from the
contracts.
IV. Internal Control Procedure to deter Revenue Recognition fraud
The transactions, which Enron engaged in, lacked economic substance providing an opportunity for
misstatements. The uncertainties around real cash flows forced Enron to resort to debt financing for
expanding to new businesses. Debt covenants required maintaining certain ratios, which provided an
incentive to use aggressive accounting policies and overstate revenues and gains
We believe that since the control environment has pervasive impact on strategies, operations and
accounting policies, the internal control procedure has to set the right tone at the top
Establishing a Risk Review Committee:

1.1. Comprising of members of Audit Committee, Internal Auditors and Board of Directors who
have certain expertise to evaluate the risks of new business strategies and corresponding
plans to mitigate the risks.
1.2. The committee should scrutinize and vote on Aggressive expansion strategy and aggressive
accounting policies of the Management.
1.3. Management must ensure proper documentation of method and assumptions used in
determining risk appetite of the firm and estimating the fair value and the estimates and make
these documents available to the committee from time to time.
2. Internal Audit function should be strengthened so that the accounting policies are complied with
in handling complex accounting situation such as derivatives, hedges
3. HR policies to hire and train for Competency and Expertise For operating and managing
diversified and complex businesses.