ENRON: Aftermath…….Lessons Learned

1. ENRON: Aftermath…….Lessons Learned AICPA Alan Anderson Senior Vice President

2. In a Way it’s Simple… In a Way it’s 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 • SPE’s (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; .

8. 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 as…reliability of financial instruments; and • significant related-party transactions.

9. Where were ………. • Management • Board of Directors and Audit Committee • External Auditors • Market Makers (Analysts) • Regulators (SEC, AICPA, others) -That is what everyone is asking

10. 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;

11. 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 SEC’s 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.

12. 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 nation’s financial reporting system, and the accounting profession? • 4. Be good for America’s financial markets and economic growth?

13. Wide Range of Proposed Reforms • Federal & State Legislative Proposals • SEC Chairman & President Bush Proposals • AICPA’s Main Views and Concerns • Volcker’s Reform Proposals for Andersen • Former POB Chair Bowsher’s Proposal • Several States: NY, Mn, Fla. Ca. and others

14. 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

15. Legislative Activity - U.S. House • Financial Services Committee in Lead • Oxley/Baker Bill likely vehicle • Prohibit IA/IT services consistent with original SEC Chairman Levitt’s proposal • Dingell introduced his own bill • New regulatory structure is almost assured • Only question is how far it goes…….

16. 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

17. 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

18. 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.

19. President Bush’s 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

20. 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

21. 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

22. 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

23. 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)

24. 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

25. Non-Audit Services • Some are necessary part of modern audit • O’Malley 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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)

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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)

44. 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

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

46. 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

47. Reliable Systems Method of Disseminating Information Financial Data and Non Financial Data Trust Family (Systrust) XBRL VMRC Performance View AICPA Initiatives

48. Corporate Accountability Understandable disclosures Trust Family (Webtrust)COSO ERM ProjectASB Fraud StandardEnvironmental ReportingAudit Committee Rules FASB ProjectsVMRCSEC “Plain English” Plan AICPA Initiatives

49. 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

50. 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