Auditing

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CHAPTER
AUDIT PLANNING AND ANALYTICAL PROCEDURES
THE FALL OF ENRON: DID ANYONE UNDERSTAND THEIR BUSINESS?

8
LEARNING OBJECTIVES
After studying this chapter, you should be able to
8-1 Discuss why adequate audit planning is essential. Make client acceptance decisions and perform initial audit planning. Gain an understanding of the client’s business and industry. Assess client business risk. Perform preliminary analytical procedures. State the purposes of analytical procedures and the timing of each purpose. Select the most appropriate analytical procedure from among the five major types. Compute common financial ratios. 8-2 8-3

The bankruptcy of Enron Corporation, at one time the nation’s largest energy wholesaling company, represents the biggest corporate collapse in American history. Despite being listed as No. 7 on the Fortune 500 list with a market capitalization of $75 billion before its collapse, the meltdown of Enron was rapid. The fall began in October 2001 when Enron officials reported a shocking $618 million quarterly loss related to allegedly mysterious and hidden related party partnerships with company insiders. Then, in early November 2001, company officials were forced to admit that they had falsely claimed almost $600 million in earnings dating back to 1997, requiring the restatement of four years of audited financial statements. By the end of 2001, the company was in bankruptcy. Enron was created in 1985 out of a merger of two gas pipelines, and was a pioneer in trading natural gas and electricity in the newly deregulated utilities markets. In its earlier years, Enron made its money from hard assets like pipelines. However, by the end of the 1990s, 80% of Enron’s earnings came from a more vague business known as “wholesale energy operations and services.” Enron had built new markets, such as trading of weather securities. In early 2001, speculation about Enron’s business dealings began to surface. One highly regarded investment banker publicly stated that no one could explain how Enron actually made money. In the wake of the collapse, many wonder how these issues could go undetected for so long. Many point to the incredibly complicated business structure at Enron and Enron’s related vague and confusing financial statements. “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity,” noted John Dingell, U.S. Congressman from Michigan. Others even allege that the men running the company never even understood their business concept because it was too complicated. Apparently, the complexity and uncertainty surrounding Enron’s business and financial statements fooled their auditors, too. Enron’s auditor faced a flurry of attacks, class action lawsuits, and a criminal indictment that ultimately led to the firm’s demise. In December 2001 congressional testimony, the audit firm’s CEO admitted that the firm’s professional judgment “turned out to be wrong” and that they mistakenly let Enron keep the related entities separate when they should have been consolidated. Several lessons will likely come out of the Enron disaster. One to be underscored for auditors is the paramount importance of understanding the company’s business and industry to identify significant business risks that increase the risk of material misstatements in the financial statements. Without that understanding, it will be almost impossible to identify the next Enron. Source: Adapted from Bethany McLean, “Why Enron Went Bust,” Fortune (December 24, 2001), pp. 58–68.

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s the chapter story illustrates, Enron’s complex and confusing business structure helped disguise material misstatements in Enron financial statements for several years. Gaining an understanding of the client’s business and industry is one of the most important steps in audit planning. This chapter explains audit planning in detail, including...
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