Conspiracy of Fools: Audit Adjustments

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Enron had a history of trying to elicit favorable opinions on accounting issues from Arthur Andersen. The executives were aggressive in their reporting of income and expenses, always seeming to find a way to report things in the way that had the best effect on earnings.

As a part of Enron’s merger with Portland General, the company was acquiring a supply contract worth millions. Enron had a history of reporting income as soon as a contract was signed (which is a very aggressive and maybe incorrect accounting treatment), so naturally the executives wanted to book this contract as income immediately.

The Arthur Andersen partners were consulted on the issue. After much arguing and negotiation, the partners at the accounting firm, lead by David Duncan, determined that Enron should not recognize the income.

Rick Causey of Enron decided that the company wasn’t required to take Arthur Andersen’s advice.

From the book:

Andersen, still certain the accounting was in error, put the item on what is known as the adjustment sheet. Under the rules, if the numbers on the sheet were high enough, the company had to report them. But Duncan, having lost the accounting issue, argued that the amount was not material when viewed a particular way. That was an audit judgment – the area where Duncan had far more control. His argument won out; the dispute was kept hidden.

In the end, Andersen ruled that a single transaction almost doubling Enron’s annual profits – from $54 million to $105 million – would not strike investors as important.

Note: Items are determined to be material (or not) when compared to the company’s assets and/or revenue. While an additional $51 million in profits seems large, it may not seem so large when that number is compared to the company’s total revenue for the year.

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