Case #2.1 – Enron: Independence I. Technical Audit Guidance To maximize the knowledge acquired by students, this book has been designed to be read in conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing Standards that are referenced in this book are available for free at: http://pcaobus.org/Standards/Pages/default.aspx. In addition, the AU Sections that are referenced in this book are available for free at: http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisions of the Sarbanes-Oxley Act of 2002 is available for free at: http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarban es-Oxley+Act+of+2002.htm. II. Recommended Technical Knowledge The Sarbanes-Oxley Act of 2002 Section 201 Section 203 Section 206 Section 301 III. Classroom Hints This case provides students with the opportunity to understand what is meant by auditor independence and why it is important to the audit profession. In addition, the case provides students with an opportunity to understand how a lack of independence may impact the objectivity of auditors and potentially lead to biased professional judgments. To meet these objectives, this case illuminates a number of relevant issues about the business relationship that existed between Arthur Andersen and Enron in the years leading up to the Enron business failure. We believe it is essential for students to carefully read over the recommended technical knowledge, along with this case reading. The educational psychology literature suggests that the acquisition of technical/factual type knowledge increases dramatically when such knowledge can Full file at http://collegetestbank.eu/Solution-Manual-Auditing-and-Accounting-Cases-3rd-Edition-Thibodeau
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Case #2.1 – Enron: Independence
I. Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 201Section 203Section 206Section 301
III. Classroom Hints
This case provides students with the opportunity to understand what is meant by auditor
independence and why it is important to the audit profession. In addition, the case provides
students with an opportunity to understand how a lack of independence may impact the
objectivity of auditors and potentially lead to biased professional judgments. To meet these
objectives, this case illuminates a number of relevant issues about the business relationship that
existed between Arthur Andersen and Enron in the years leading up to the Enron business
failure.
We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
Full file at http://collegetestbank.eu/Solution-Manual-Auditing-and-Accounting-Cases-3rd-Edition-Thibodeau
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant post-Sarbanes technical audit knowledge, outlined above.
This case assignment will work best if is scheduled to coincide with the auditors'
professional responsibilities/conduct topic or the independence topic in the auditing course. We
do believe that it is helpful to introduce the notion of an auditor's responsibility to financial
statement users before discussing how a lack of independence can potentially bias an auditor's
professional judgments. Specifically, we suggest that instructors do everything possible to
illustrate the tension that auditors face when attempting to maintain an attitude of independence
during the financial statement audit. Students need to realize that the nature of the auditing
process sometimes makes it difficult to remember that your primary responsibility when
completing an audit is to financial statement users, not to client personnel.
The difficulty starts with the nature of the business relationship, in particular prior to the
Sarbanes-Oxley Act of 2002. The audit firm is hired and is paid by the audit client. Thus, the
audit client can also fire the audit firm. This is a nontrivial dynamic that can make it difficult to
maintain your independence and an attitude of professional skepticism throughout the audit.
Another aspect that adds to this tension is the reality that auditors need the client’s cooperation in
order to complete their work at the audit client. This reality forces the auditor to build a strong
rapport with client personnel. Such a rapport also just makes life more enjoyable for the auditor,
who is forced to work with client personnel on a daily basis. Each of these examples can add to
the tension that auditors face on a daily basis but they must always remember that their primary
responsibility is to the financial statement users. Thus, they must always maintain their
independence and their professional skepticism throughout the audit.
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1. What is auditor independence, and what is its significance to the audit profession?What is the difference between independence in appearance and independence infact?
The second general standard of generally accepted auditing standards (GAAS) is, “In all
matters relating to the assignment, an independence in mental attitude is to be maintained by the
auditor or auditors.” If the auditor is not independent, the financial statements are considered
unaudited for all practical purposes. In case where the SEC has found that a CPA firm was not
independent, it has required that the financial statements be re-audited by another firm. A lack of
independence can result in disciplinary action by regulators and/or professional organizations
and litigation by those who relied on the financial statements (e.g., clients and investors). The
profession, as a whole, depends on the value of independence in that the auditor’s opinion on the
financial statements loses its value if the auditor is not considered to be substantially independent
from the management of the firm.
Article IV of the AICPA’s Professional Code of Conduct requires that “a member in public
practice should be independent in fact and appearance when providing auditing and other
attestation services.” To be independent in fact, an auditor must have integrity, a character of
intellectual honesty and candor; and objectivity, a state of mind of judicial impartiality that
recognizes an obligation of fairness to management and owners of a client, creditors, prospective
owners or creditors, and other stakeholders. To be independent in appearance, the auditor must
not have any obligations or interests (in the client, its management, or its owners) that could
cause others to believe the auditor is biased with respect to the client, its management, or its
owners. Even if the auditor does not have any direct or indirect financial interest or obligation
with the client in fact, they must assure that no part of their behavior or actions appear to affect
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Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: “A
member in public practice should be independent in fact and appearance when providing
auditing and other attestation services.” Close relationships might affect independence in
appearance, even if independence in fact is maintained. Clearly there was cause for concern at
Enron. Causey was good friends with Andersen’s global engagement partner, David Duncan. In
fact, their families had even gone on vacations together. Andersen employees often attended
Enron-sponsored events and office parties. The nature of Causey and Duncan’s close
relationship violated the AICPA Code of Conduct’s requirements for independence in
appearance.
2. Refer to Section 201 of SARBOX. Identify the services provided by ArthurAndersen that are no longer allowed to be performed. Do you believe that Section201 was needed? Why or why not?
Section 201 says that it shall be unlawful for a registered public accounting firm to provide
any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping
or other services related to the accounting records or financial statements of the audit client; (2)
financial information systems design and implementation; (3) appraisal or valuation services,
audit services.” Andersen had been providing internal audit services to Enron for eight years.
The non-audit services that Andersen provided were encouraged by the structure of partner
compensation.
Importantly, the bill allows an accounting firm to “engage in any non-audit service,
including tax services,” that is not listed above, only if the activity is pre-approved by the audit
committee of the issuer. The audit committee is required to disclose to investors in its periodic
filings its decision to pre-approve non-audit services.
Most observers now agree that Section 201 was needed. The rise of non-audit services
has been a common trend in the public accounting profession. In 1993, 31% of the fees in the
industry came from consulting. By 1999, that number had jumped to 51%. In fact, the AICPA
released a publication in 1999 titled “Make Audits Pay: Leveraging the Audit Into Consulting
Services.” The book advised the auditor to think of himself as a “business advisor.” It did note
that conflicts could arise from performing the role of business advisor (which was a client
advocate) and the auditor (which had to be independent). It advised erring on the side of looking
out for the public interest. Other striking examples include KPMG, which billed Motorola $3.9
million for auditing and $62.3 million for other services; Ernst & Young, which billed Sprint
Corp. $2.5 million for auditing and $63.8 million for other services; and
PricewaterhouseCoopers, which billed AT&T $7.9 million for auditing and $48.4 million for
other services.
3. Refer to Sections 203 and 206 of SARBOX. How would these sections of the lawhave impacted the Enron audit? Do you believe that these sections were needed?Why or why not?
Section 203 says that “the lead audit or coordinating partner and the reviewing partner must
rotate off of the audit every 5 years.” Section 206 says that the CEO, Controller, CFO, Chief
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Accounting Officer or person in an equivalent position cannot have been employed by the
company’s audit firm during the 1-year period ("the cooling off period) preceding the audit.
Section 203 could have impacted the Enron audit. David Duncan, lead partner for the Enron
engagement, had formed a close personal relationship with Enron’s Chief Accounting Officer,
Richard Causey. “…and their families had even gone on vacations together.” The nature of this
close relationship put Duncan in a position that he might not be able to challenge management. A
key point to raise in this response is that David Duncan would not have been the lead audit
partner after 5 years of service because of the establishment of Section 203. It is important to
point out that the relationship that develops among professionals is interrupted by regulation to
help insure independence.
Section 206 requires a “one year cooling off period” for former Andersen employees to
accept a position as CEO, CFO, Controller, or Chief Accounting Officer. “Causey was
responsible for recruiting many Andersen alumni to work at Enron. Over the years, Enron hired
at least 86 Andersen accountants. Several were in senior executive positions.” Section 206 of
SOX would have prevented some of these hirings before the cooling off period had expired.
Since both of these laws help to ensure independence in appearance and in fact, most
students are likely to agree that they were needed. Both Section 203 and Section 206 would have
impacted the Enron engagement.
4. Refer to Section 301 of SARBOX. Do you believe that Section 301 was important tomaintaining independence between the auditor and the client? Why or why not?
Section 301 of SARBOX requires that the “audit committee of an issuer shall be directly
responsible for the appointment, compensation, and oversight of the work of any registered
public accounting firm employed by that issuer.” As a result, the relationship between the audit
firm and the CFO and/or Controller at an audit client has changed dramatically. In the past, it
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To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 203Section 206
III. Teaching Hints
This case provides students with the opportunity to understand what is meant by an audit
firm exercising due professional care in completing the audit and the consequences associated
with a failure to do so. In addition, the case provides a mechanism to illustrate auditor
independence and why it is important to the audit profession. More specifically, the case
provides students with an opportunity to understand how a lack of independence may impact the
objectivity of auditors and potentially lead to biased professional judgments. Finally, the case
provides a context to discuss what is meant by an adjusting journal entry proposed by an auditor.
To meet these objectives, this case illuminates a number of relevant issues about the business
relationship that existed between Arthur Andersen and Waste Management, the quality control
review process at Arthur Andersen and Waste Management’s refusal to record adjusting journal
entries proposed by Arthur Andersen.
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To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
PCAOB Auditing Standard No. 5
Paragraph # 14Paragraphs #A8 (in Appendix A)
III. Classroom Hints
This case provides students with an opportunity to understand that an auditor’s
professional responsibility includes exercising due professional care and maintaining an attitude
of professional skepticism on every audit engagement. The case also provides a mechanism to
show how a perceived lack of independence might impact an auditor carrying out his/her
professional duties. In addition, the case provides a context to introduce the difference between
substantive analytical review and substantive test of details as a means to gather evidential
matter. Finally, the case allows for the introduction of what is meant by a “top-side” adjusting
journal entry and why such an entry poses special risk to an auditor. In fact, since this may be
the first time students have been exposed to a “top-side” entry, we recommend that instructors
spend time discussing this topic in class. This can be accomplished when reviewing the answer
to question #4.
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1. What is auditor independence, and what is its significance to the audit profession?Based on the case information, do you believe that Andersen violated the secondgeneral standard? Why or why not?
According to the second general standard of Generally Accepted Auditing Standards, “In all
matters relating to the assignment, independence in mental attitude is to be maintained by the
auditor or auditors.” If the auditor is not independent, the financial statements are considered
unaudited for all practical purposes. In case where the SEC has found that a CPA firm was not
independent, it has required that the financial statements be re-audited by another firm. A lack of
independence can result in disciplinary action by regulators and/or professional organizations
and litigation by those who relied on the financial statements (e.g., clients and investors). The
profession, as a whole, depends on the value of independence in that the auditor’s opinion on the
financial statements loses its value if the auditor is not considered to be substantially independent
from the management of the firm.
Unfortunately, the facts of the case reveal several issues that suggest that Andersen’s
independence may have been compromised. For example, WorldCom was one of Andersen’s
biggest audit clients. In terms of the total amount of fees charged to clients, WorldCom was one
of Andersen’s top 20 engagements in 2000, and the largest client of its Jackson, Mississippi,
office. From 1999 through 2001, WorldCom paid Andersen $7.8 million in fees to audit the
financial statements of WorldCom, Inc.; $6.6 million for other audits required by law in other
countries; and about $50 million for consulting, litigation support, and tax services.
At Andersen, the compensation of partners depended on their ability to cross-sell other
services to its audit clients. The fees charged to WorldCom for non-audit services were highly
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significant. The size of the fees would likely have made it hard for Andersen auditors to
challenge WorldCom’s management team on difficult accounting issues.
In addition, the substantial amount of non-audit work completed by Andersen provided
incentives to work as an advocate on behalf of WorldCom. For example, in a presentation to the
Audit Committee on May 20, 1999, Andersen stated that it viewed its relationship with
WorldCom as a “long-term partnership,” in which Andersen would help WorldCom improve its
business operations and grow in the future. In its Year 2000 Audit Proposal, Andersen told the
Audit Committee that it considered itself “a committed member of [WorldCom’s] team” and that
WorldCom was “a flagship client and a ‘Crown jewel’” of its firm.1
Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: “A
member in public practice should be independent in fact and appearance when providing
auditing and other attestation services.” Close relationships might affect independence in
appearance, even if independence in fact is maintained. Clearly there was cause for concern at
WorldCom.
2. Refer to the responsibilities principle of Generally Accepted Auditing Standards(GAAS). Given the reluctance of WorldCom’s management team to communicatewith Andersen, do you believe that Andersen exercised due care and professionalskepticism in completing the audit? Why or why not?
The reluctance of WorldCom’s management team to communicate with Andersen was a
major issue and reveals a lack of professional skepticism and/or due professional being exercised
by Andersen. Indeed, there are a number of specific observations that indicated a lack of
professional skepticism and/or due professional being exercised by Andersen. The observations
include:
A failure to demand supporting evidence for certain recorded transactions;
1 Board of Directors’ Special Investigative Committee Report, June 9, 2003, 225.
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Top management tried to intimidate and often silenced its division managers and
employees in order to prevent them from revealing information to Andersen. This
was evidenced by several requests for information and interviews by Andersen
being denied by WorldCom;
The failure of WorldCom to disclose the maximum risk classification to the Audit
Committee at WorldCom;
Top management prevented the auditors from gaining access to the computerized
General Ledger;
Finallly, The failure to adequately respond to the maximum risk classification by not
requiring adequate evidence for “top-side” journal entries and a reliance on substantive analytical
review instead of tests of details to gather evidence was an inadequate audit response.
3. In terms of audit effectiveness and efficiency, briefly explain the difference betweensubstantive analytical procedures and substantive test of details. Do you believe itwas appropriate for Andersen to rely primarily on substantive analyticalprocedures? Why or why not?
A substantive test is used to gather evidence that substantiates whether an account balance
and/or an economic transaction was recorded in accordance with generally accepted accounting
principles (GAAP). There are two primary ways of conducting substantive tests: 1) substantive
analytical review and 2) test of details.
When applying substantive analytical reviews to gather evidence, the auditor must develop
an independent expectation of what he/she thinks the account balance should be. Once this is
developed, the expectation is compared to the recorded amount. Analytical procedures are used
to study the relationships between accounts within client information to identify possible
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material misstatements. Any significant differences must be investigated and corroborated with
evidence. In order to be effective, the procedure must be conducted with exacting precision and
high degree of rigor.
When applying substantive test of details, the auditor must seek to understand the account
balance and/or economic transaction to ensure, based on valid and reliable evidence, that the
amount was recorded in accordance with GAAP.
In general, a substantive analytical review is more efficient, while the test of details is more
effective. However, there are a number of situations where the substantive analytical procedures
can be equally effective. Thus, many auditors rely substantially on substantive analytical
reviews.
Since WorldCom was considered a maximum risk client, Andersen should have relied on
more than just substantive analytical procedures. When a client is categorized as maximum risk
this requires the audit team to gather more evidence than is normally necessary. Andersen
should have accumulated more factual evidence such as test of details and not relied on
relationships of data; especially since the client was maximum risk and the numbers in the data
could have been skewed and manipulated. If WorldCom was rated at a lower level of risk, the
use of substantive analytical procedures may have been sufficient. It is the increased risk which
really made tests of details necessary on this audit engagement.
4. Consult Paragraphs 14 and A8 (in Appendix A) of PCAOB Auditing Standard No.5. Provide an example of both a preventive control and a detective control thatcould address the risk that a fraudulent top-side adjusting journal entry could bemade by a member of management.
Paragraph #14 of Auditing Standard #5 focused on the importance of auditors utilizing the
results of their fraud risk assessments as part of the audit. Specifically, according to the
paragraph, “the auditor should evaluate whether the company's controls sufficiently address
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To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 103Section 203
III. Classroom Hints
This case provides students with an opportunity to understand what is meant by quality
control in the financial statement audit process and to understand why a quality control
mechanism is an important internal control procedure for an audit firm. Further, the case
provides a terrific example for students to see what can actually happen when quality control
breaks down at an audit firm. In the case of Arthur Andersen, the breakdown in quality control
ultimately led to the demise of the firm. To meet these objectives, this case illuminates the role
of the professional standards group (PSG) at Arthur Andersen and the dialogue that occurred for
several technical issues between Andersen’s PSG and the lead partner on the Enron engagement,
David Duncan.
We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
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make and then to demonstrate how a lack of independence can impact the final professional
judgment.
IV. Assignment Questions & Suggested Answers
1. Explain why an accounting and auditing research function (like Andersen’s PSG) isimportant in the operations of a CPA firm. What role does the function play incompleting the audit?
In order to mitigate their risk of an audit failure, CPA firms must implement their own
system of internal controls to ensure that professional standards (and their own standards) of
audit quality are being met. Stated simply, a firm must have assurance that the work being
completed by its audit professionals is being completed in accordance with professional
standards set forth by the firm.
The accounting and auditing research function (like Andersen’s PSG) is an instrumental part
of a firm’s quality assurance process. Typically, the group is comprised of a CPA firm’s leading
technical experts on accounting, auditing and industry-specific professional standards. Thus, if
an engagement partner (like Andersen’s David Duncan) encounters a difficult technical issue,
he/she has the necessary technical support that may be necessary to reach the correct conclusion
in the field.
2. Consult Section 103 of SARBOX. Do you believe that the engagement leader of anaudit (like David Duncan on the Enron audit) should have the authority to overrulethe opinions and recommendations of the accounting and auditing research function(like the PSG)? Why or why not?
According to Section 103 of SOX, the “PCAOB shall: 1) register public accounting firms; 2)
establish, or adopt, by rule, “auditing, quality control, ethics, independence, and other standards
relating to the preparation of audit reports for issuers; 3) conduct inspections of accounting firms;
4) conduct investigations and disciplinary proceedings, and impose appropriate sanctions; 5)
perform such other duties or functions as necessary or appropriate; 6) enforce compliance with
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3. After Carl Bass was removed from the Enron account, he indicated to his boss thathe did not believe Enron should have known about internal discussions regardingaccounting and auditing issues. Do you agree with Bass’s position? Why or whynot?
In general, it is hard not to agree with Carl Bass’s position that Enron should not have known
about the internal discussions regarding accounting and auditing treatments. There are a number
of different points that can be made to support this view. They include:
The firm has an obligation to maintain independence and objectivity per therequirements of Rule 102 of the AICPA Code of Conduct. In order to maintainindependence and objectivity, the firm should have a policy that prevents this type ofcommunication with the client about the treatment of complex accounting or auditingtransactions. Collaboration with the client on these types of issues is comparable toasking “their opinion,” which of course would be a violation of independencestandards.
It is absolutely not acceptable to allow the client to know about any internaldiscussions related to a complex accounting and/or auditing issue. The firm’sposition needs to be unified to the client in all cases. If employees of Enron knewabout such conversations, they may be able to understand the “thinking” behindcertain audit procedures and perhaps take actions to circumvent other auditprocedures that might be considered by the audit firm. Additionally, sharing thisinternal information violates independence in appearance.
4. Consult Section 203 of SARBOX. Do you believe that this provision of the law goesfar enough? That is, do you believe the audit firm itself (and not just the partner)should have to rotate off an audit engagement every five years? Why or why not?
According to Section 203, “the lead audit or coordinating partner and the reviewing partner
must rotate off of the audit every 5 years.” Again, it is hard not to agree that some type of
auditor rotation should be required. However, there may be differences in opinion on whether
this provision goes far enough. Some thoughts raised by students may include:
The current provision is sufficient to maintain independence. There is no need to rotatethe entire firm from the audit. Doing so would be too costly to both CPA firms and auditclients. If the entire audit firm was required to rotate off, the tradeoff is that the new CPAfirm would not have the benefit of the experience and knowledge gained by the staff on
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prior audits. Previous knowledge proves beneficial for analytical procedures and duringsubstantive testing. As a result, the overall cost of performing the audit would increase.
The current provision is not enough. Instead, Section 203 of SOX should require that theaudit firm should rotate off the engagement every five years. The fact is that the longer afirm is involved with a client, the greater the chance that the firm’s objectivity willbecome compromised as evidenced by the relationship between Andersen and Enron.
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To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 204Section 301
PCAOB Auditing Standard No. 5
Paragraph #69
III. Classroom Hints
This case provides students with the opportunity to understand what is meant by an audit
firm exercising due professional care in completing the audit and the consequences associated
with a failure to do so. It is important to emphasize to students that the consequences attach to
both the firm and the individual auditor. In addition, the case provides a context to discuss what
is meant by an adjusting journal entry proposed by an auditor and the issues associated with an
auditor’s decision about whether to require that such entries be recorded. Finally, the case
provides an opportunity for instructors to discuss the role of the audit committee in helping to
prevent these types of situations. To meet these objectives, this case illuminates a number of
Full file at http://collegetestbank.eu/Solution-Manual-Auditing-and-Accounting-Cases-3rd-Edition-Thibodeau
To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Sarbanes-Oxley Act of 2002
Section 201Section 203Section 206
III. Classroom Hints
This case provides students with the opportunity to understand what is meant by auditor
independence and why it is important to the audit profession. In addition, the case provides
students with an opportunity to understand how a lack of independence may impact the
objectivity of auditors and potentially lead to biased professional judgments. To meet these
objectives, this case illuminates a number of relevant issues about the relationship that existed
between Arthur Andersen, the Fund of Funds (FOF), and King Resources Corporation (KRC).
In particular, the case focuses on the issues that can arise when the same audit firm conducts the
audit of two different organizations that share an important business relationship.
We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
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Overall, the case questions are designed to demonstrate how important it is for auditors to
maintain an independent and objective attitude at all times. By making sure that the firm is
independent and objective, this helps to unsure that auditors will always make audit judgments
without any bias whatsoever. Indeed, we believe that it is helpful to remind students that they
have a professional responsibility to maintain an attitude of skepticism throughout the audit
process. One of the primary goals of the Sarbanes-Oxley Act of 2002 was to take steps to
improve the independence and objectivity of the audit process (e.g., Section 201).
IV. Assignment Questions & Suggested Answers
1. What is auditor independence, and what is its significance to the audit profession?What is the difference between independence in appearance and independence infact? Based on the case information, do you believe that Arthur Andersen violatedany principles of auditor independence? Why or why not?
The second general standard of generally accepted auditing standards (GAAS) provides that,
“In all matters relating to the assignment, an independence in mental attitude is to be maintained
by the auditor or auditors.” If the auditor is not independent, the financial statements are
considered unaudited for all practical purposes. In cases where the SEC has found that a CPA
firm was not independent, in the meaning provided by the second general standard, it has
required that the financial statements be re-audited by another CPA firm. A lack of
independence can result in disciplinary action by regulators and/or professional organizations
and litigation by those who relied on the financial statements (e.g., clients and investors). The
profession, as a whole, depends on the value of independence in that the auditor’s opinion on the
financial statements loses its value if the auditor is not considered to be substantially independent
from the management of the firm.
Article IV of the AICPA’s Professional Code of Conduct requires that “a member in public
practice should be independent in fact and appearance when providing auditing and other
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attestation services.” To be independent in fact, an auditor must have integrity, a character of
intellectual honesty and candor; and objectivity, a state of mind of judicial impartiality that
recognizes an obligation of fairness to current and prospective management and owners of a
client, creditors and other stakeholders. To be independent in appearance, the auditor must not
have any obligations or interests in the client, its management, or its owners, that could cause
others to believe the auditor is biased with respect to the client, its management, or its owners. It
is important that even if an auditor maintains independence in fact, that independence in
appearance is also maintained. Without being independent in appearance, the value that the audit
function has to the public is weakened or lost. Given the facts and circumstances of the case,
there are some concerns.
2. Consider that both KRC and FOF, including its NRFA, were audited by ArthurAndersen. In addition, Arthur Andersen audited King’s personal accounts. Do youbelieve these relationships impaired the independence of Arthur Andersen? Why orwhy not?
While it may be possible for the Arthur Andersen auditors to remain objective and unbiased
(unless the auditor was auditing his/her own work), the interrelationships among the entities
would make it very difficult to do so. Indeed, while the AICPA Code of Professional Conduct
does not specifically preclude auditors from performing audit services for clients that are
interrelated, it is absolutely essential that auditors perform all of their duties in an objective,
unbiased manner.
In this case, the public may perceive the interdependency of KRC and FOF (since essentially
NRFA’s financial statements rely upon information generated from KRC) as a violation of
independence in appearance. This is particularly true since the partner and manager assigned to
the KRC audit also had the same responsibilities on the NRFA audit. The bottom line is that
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students need to consider whether the interrelationship would possibly impair the professional
judgments of the partner and/or manager.
3. Would your answer change if different partners were assigned to both the KRCaudit and the NRFA audit? Assume that both audit teams were completelydifferent. Why or why not would your answer be different?
The answer might be different. As stated previously, the relationships do not explicitly
violate independence in fact (unless the auditor was auditing his/her own work). However, there
is still a question as to whether independence in appearance has been violated. The fact that
there would now be completely different audit teams does help to mitigate the possible
independence in appearance concern. However, the dependency of NRFA’s financial statements
on the information presented by KRC still poses a potential issue of concern. It is certainly
possible that the investing public would still believe that this interdependency might impair
Arthur Andersen’s ability to be objective and unbiased in performing its duties. The bottom line,
again, is that students must consider whether the interdependency would impair the professional
judgments of the auditors.
4. Refer to Sections 201, 203, and 206 of SARBOX. Based on your understanding ofthe FOF audit, do you believe these sections were needed? Why or why not? Bespecific.
Section 201 says that “it shall be unlawful for a registered public accounting firm to provide
any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping
or other services related to the accounting records or financial statements of the audit client; (2)
financial information systems design and implementation; (3) appraisal or valuation services,
Case #2.7– Bernard L. Madoff Investment and Securities: A Focus onAuditors’ Legal Liability and Due Care
I. Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
The Securities Act of 1933
Section 24
The Securities Exchange Act of 1934
Section 32
III. Classroom Hints
This case provides students with the opportunity to understand what is meant by an audit
firm exercising due care in completing the audit and the consequences associated with a failure
to do so. It is important to emphasize to students that such the consequences attach to both the
firm and to the individual auditors involved. To meet these objectives, this case illuminates a
number of relevant issues that have surfaced about the audits of Bernie Madoff’s company,
Bernard L. Madoff Investment and Securities (BLMIS) by the accounting firm Friehling &
Horowitz.
We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
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acquisition of technical/factual type knowledge increases dramatically when such knowledge can
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant technical knowledge about the Securities Act of 1933 and Section 32 of the
Securities Exchange Act of 1934, outlined above. In our opinion, this case assignment will work
best if is scheduled to coincide with the auditors’ legal liability and/or auditors' professional
responsibilities topic in the auditing course. Alternatively, the case can be used in connection
with a discussion of quality control at an audit firm.
We recommend that instructors begin the case discussion with an overview of what is
meant be a “Ponzi” scheme. In our experience, students are likely to have heard this term, but
are not likely to fully understand what is meant by the term. A Ponzi scheme is any fraudulent
investment plan that pays its returns to an investor from either that investor’s own funds or those
paid by other investors in the future. Next, we believe that instructors should take the time to
reinforce the Responsibilities principle under Generally Accepted Auditing Standards. This can
be accomplished quite effectively while going over question number one and two. We also
recommend that instructors spend time explaining the nature of an auditor’s legal liability under
both common law and statutory law. Thus, we believe that this case can be an effective tool to
help students understand the differences between common law and statutory law which can often
be difficult for students. We believe that this discussion can be accomplished quite effectively
while going over question number three and four.
IV. Assignment Questions & Suggested Answers
1. Refer to the Fundamental Prinicples governing an audit. Under the ResponsibilitiesPrinciple, auditors are required to exercise due care and maintain professionalskepticism throughout the audit. Based on the case information, do you believe that theauditors from Friehling & Horowitz exercised due care and maintained professionalskepticism throughout the audit? Why or why not?
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Based on the case information, due care was not exercised during the audit of BLMIS.
According the Responsibilities Principle, auditors are responsible for “maintaining professional
skepticism and exercising professional judgment throughout the planning and performance of the
audit. This was clearly not exhibited by the auditors at Friehling & Horowitz on the BLMIS
audit.
Friehling & Horowitz did not conduct any independent confirmations of BLMIS’s assets,
liabilities, sales and other revenues during the audit. Thus the existence and validity of these line
items was never tested. In addition, the auditors did not test to determine whether any internal
controls were in place at BLMIS to prevent fraud. Finally, Friehling & Horowitz neglected to
send independent confirmations for BLMIS’s bank statements. The bottom line is that that the
auditors did not gather and then objectively evaluate enough evidence to render an opinion,
based on the case information. So, they did not fulfill the Responsibilities Principle under
GAAS.
2. Consider the charges brought against the BLMIS auditor, Friehling regarding hisfailure to complete certain audit steps. If you were auditing BLMIS, what type ofevidence would you like to review to determine whether BLMIS had truly purchased,sold and maintained proper custody of investment securities?
According to paragraph #21 of AU Section 326, “To be competent, evidence, regardless of
its form, must be both valid and relevant.” Indeed, “the validity of evidential matter is so
dependent on the circumstances under which it is obtained that generalizations about the
reliability of various kinds of evidence are subject to important exceptions.” So, the competence
of audit evidence refers to the quality of the evidence gathered for a financial statement assertion
about a financial statement account balance and/or an economic transaction(s). And, as indicated
in the standard, there are two aspects to evidence quality that are most important: relevance and
reliability. The relevance of audit evidence specifically relates to whether the evidence gathered
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actually relates to the financial statement assertion being tested. That is, will the evidence allow
the auditor to reach conclusions related to that financial statement assertion?
The reliability of the evidence specifically relates to whether the evidence gathered can truly
be relied upon as providing a true indication about the financial statement assertion being tested.
There are a number of factors that should influence an auditor’s conclusions about reliability, the
most important of which is the source (e.g., is it from a third party?) of the audit evidence.
According to paragraph #22 of AU Section 326, “The amount and kinds of evidential
matter required to support an informed opinion are matters for the auditor to determine in the
exercise of his or her professional judgment after a careful study of the circumstances in the
particular case.” So, the sufficiency of audit evidence refers directly to the quantity of the audit
evidence gathered about a financial statement assertion. All things being equal, the greater the
risk of material misstatement related to the financial statement assertion, the more audit evidence
will be gathered by the auditor.
Of course, auditors need to gather evidence that explicitly relates to the relevant assertion
being tested. Thus, the answer to this question may vary depending on the specific assertion
being tested in the circumstances. When auditing the purchase of securities, an auditor would
likely seek to vouch a sample of the purchases to external supporting documentation. When
auditing the custody of securities, an auditor would likely seek to confirm directly with the
financial institution that was serving as the custodian for the securities.
3. Consider an auditor’s common law liability to third parties. Please describe thedifference between the three levels of failure to exercise professional care, ordinarynegligence, gross negligence and fraud. Based on the case information, please commenton the possible level of failure that was seemingly exhibited by Friehling & Horowitz.Are there any mitigating factors to help defend the actions of the auditing firm?
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Ordinary negligence can be defined as “an unintentional breach of duty owed to another
party” due to the lack of reasonable care. Gross negligence can be defined as a “breach of duty
owed to another party” due to the lack of even minimal care. Finally, fraud can be defined as
wholly misrepresenting the facts that an auditor knows is a false misrepresentation. So, with
fraud, there is intent to deceive.
The BLMIS auditor, Friehling & Horowitz, failed to conduct, examine, and test certain
aspects of BLMIS’s financials which ultimately resulted in the continuation of BLMIS’s fraud.
At the present level of understanding, there is not enough information to know whether this is an
example of gross negligence or fraud. Stated simply, at the present time, we cannot be
absolutely sure that deception was intentional here, but fraud is clearly possible, depending on
the final facts and circumstances that come to light.
4. Consider Section 24 of the Securuties Act of 1933 and Section 32 of the SecuritiesExchange Act of 1934. Do you believe an auditing firm should be held criminallyresponsible for a fraud committed by its client’s management team? Next, based on thecase information, do you believe that the BLMIS auditor, Friehling, should be facingcriminal charges? Why or why not?
According to Section 24 of the Securities Act of 1933, there can be criminal penalties
imposed on an auditor. In order for an auditor to be subject to criminal penalties, there must be a
willful violation by the auditors. That is, they must have “willfully” caused material misstated
financial statements to be filed. As a result, this is very difficult to prove.
According to Section 32 of the Securities Exchange Act of 1934, there can be criminal
penalties imposed on the auditor. In order for the auditor to be subject to criminal penalties, the
critical test is whether the auditor “willfully and knowingly” knew about the misstatement in the
financial statements.
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To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
PCAOB Auditing Standard No. 3
Paragraph 2Paragraphs 4-6Paragraphs 14-15
The Sarbanes-Oxley Act of 2002
Section 103
III. Classroom Hints
This case provides students with an opportunity to understand what is meant by audit
documentation in the financial statement audit process and to understand why the retention of
audit documentation is an important quality control mechanism for an audit firm. Further, the
case provides a terrific example for students to see what can actually happen when a quality
control mechanism breaks down at an audit firm. In the case of Arthur Andersen, the breakdown
in quality control ultimately led to the demise of the firm. To meet these objectives, this case
illuminates the circumstances surrounding the shredding of evidence related to the Enron audit
that occurred in the fall of 2001 by auditors at Arthur Andersen.
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We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant post-Sarbanes technical audit knowledge, outlined above.
This case assignment will work best if is scheduled to coincide with a discussion of audit
documentation and/or an auditor firm’s quality control process. We believe that it is critical to
stress the importance of maintaining adequate audit documentation at an audit firm. This will
naturally lead to a discussion of the quality control process at audit firms.
Of course, in January 2002, Arthur Andersen fired Duncan for his lead role in the
shredding of documents. After Duncan pled guilty to the crime of obstruction of justice, the US
Justice Department filed a criminal indictment against Arthur Andersen in March 2002. The
entire firm was indicted because of the several offices that had worked on the Enron account and
that had been involved with shredding documents.1 The indictment signaled the beginning of the
end for Enron’s auditor Arthur Andersen LLP, one of the five largest international public
accounting firms.
In May 2002, Andersen was convicted on one charge of obstruction of justice in
connection with the shredding of documents related to the Enron audit. And although this
conviction was overturned in May 2005 by the United States Supreme Court, Andersen’s
decision to destroy evidence cast suspicion on whether Andersen was trying to cover up any guilt
related to a failure to perform its professional responsibilities.
1 Susan E. Squires, Cynthia J. Smith, Lorna McDougal, William R. Yeack, Inside Arthur Andersen (Upper SaddleRiver, NJ: Prentice Hall, 2003), p. 127-128.
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1. Consult Paragraph 2 of PCAOB Auditing Standard No. 3. Define auditdocumentation. Why is it important for an auditor to retain audit documentationfor a specific period of time?
According to Paragraph #2 of PCAOB Auditing Standard No. 3 audit documentation is
“the written record of the basis for the auditor's conclusions that provides the support for the
auditor's representations, whether those representations are contained in the auditor's report or
otherwise.” Audit documentation aids in the, “planning, performance, and supervision of the
engagement.” As a result audit documentation can be used as the basis in reviewing the quality
of the work because it is a written documentation that can be used as evidence for the audit
conclusion. Audit documentation can be a, “record of the planning and performance of the work,
the procedures performed, evidence obtained, and conclusions reached by the auditor. Audit
documentation is also known as work papers or working papers.” It is important for an auditor
to retain documentation for a specific period of time because it represents the written evidence
that the auditor has completed his/her work in accordance with generally accepted auditing
standards.
2. Refer to Section 103 of SARBOX. Do you believe that this provision of the law goesfar enough; that is, do you believe that the law is adequate related to auditdocumentation requirements? Why or why not?
According to Section 103 of SOX, the “PCAOB shall: 1) register public accounting firms; 2)
establish, or adopt, by rule, “auditing, quality control, ethics, independence, and other standards
relating to the preparation of audit reports for issuers; 3) conduct inspections of accounting firms;
4) conduct investigations and disciplinary proceedings, and impose appropriate sanctions; 5)
perform such other duties or functions as necessary or appropriate; 6) enforce compliance with
the Act, the rules of the Board, professional standards, and the securities laws relating to the
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preparation and issuance of audit reports and the obligations and liabilities of accountants with
respect thereto; 7) set the budget and manage the operations of the Board and the staff of the
Board.” In addition, the Board must require registered public accounting firms to “prepare, and
maintain for a period of not less than 7 years, audit work papers, and other information related to
any audit report, in sufficient detail to support the conclusions reached in such report.” There are
a number of allowable answers to the second part of the question. The absolute key is for a
student to try and justify his or her position.
3. Consult Paragraphs 4-6 of PCAOB Auditing Standard No. 3. In your own words,describe what is expected to be documented in the audit workpapers for eachrelevant financial statement assertion.
There are a number of allowable answers to this question as each student will be answering
the question in his/her own words. The absolute key is that the student’s responses reflect an
understanding of the relevant paragraphs from the standard. Please consider the following.
According to Paragraph #4 of Auditing Standard No. 3, “the auditor must prepare audit
documentation in connection with each engagement conducted pursuant to the standards of the
PCAOB. Audit documentation should be prepared in sufficient detail to provide a clear
understanding of its purpose, source, and the conclusions reached. Also, the documentation
should be appropriately organized to provide a clear link to the significant findings or issues.
Examples of audit documentation include memoranda, confirmations, correspondence,
schedules, audit programs, and letters of representation. Audit documentation may be in the form
of paper, electronic files, or other media.”
According to Paragraph #6 of Auditing Standard No. 3, the “auditor must document the
procedures performed, evidence obtained, and conclusions reached with respect to relevant
financial statement assertions. Audit documentation must clearly demonstrate that the work was
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in fact performed. This documentation requirement applies to the work of all those who
participate in the engagement as well as to the work of specialists the auditor uses as evidential
matter in evaluating relevant financial statement assertions. Audit documentation must contain
sufficient information to enable an experienced auditor, having no previous connection with the
engagement: a) To understand the nature, timing, extent, and results of the procedures
performed, evidence obtained, and conclusions reached; and b) To determine who performed the
work and the date such work was completed as well as the person who reviewed the work and
the date of such review.”
4. Consult Paragraphs 14-15 PCAOB Auditing Standard No. 3. Do you believe thatthe shredding of documents acquired during the audit process still occurs? Why orwhy not?
According to Paragraph 14 of PCAOB Auditing Standard No. 3, “The auditor must retain
audit documentation for seven years from the date the auditor grants permission to use the
auditor's report in connection with the issuance of the company's financial statements (report
release date), unless a longer period of time is required by law.”
According to paragraph 15 of PCAOB Auditing Standard No. 3, “Prior to the report release
date, the auditor must have completed all necessary auditing procedures and obtained sufficient
evidence to support the representations in the auditor's report. A complete and final set of audit
documentation should be assembled for retention as of a date not more than 45 days after the
report release date (documentation completion date).”
Yes, as long as the documentation is not needed to support the auditor’s conclusion on a
particular audit, the shredding of documentation still likely occurs. However, if the evidence is
necessary to support an auditor’s conclusion, the shredding of audit documentation should not
occur.
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5. Consider the actions of Andersen lawyer Nancy temple and practice directorMichael Odom. Do you believe that their actions were appropriate under thecircumstances? Why or why not?
Clearly, there are a number of allowable answers to this question. The absolute key is for a
student to try and justify his or her position. However, it must be made clear to students that as
soon as the SEC announced its decision to investigate the Enron matter, it was entirely
unacceptable for any employee at Andersen to shred any documentation related to the Enron
audit.
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