Case 3.1 Enron: Understanding the Client’s Business and Industry Price, Ria; Walters, Jessica
1. Inherent risk, a component of the audit risk model, refers to the susceptibility of the accounts to material misstatement, without regard to the systems internal controls. Inherent risk is a function of the nature of the client’s business, the major types of transactions, and the effectiveness and integrity of its managers and accountants. A clear understanding of the audit client’s business model is essential in assessing inherent risk. Paragraph 9 of PCAOB Auditing Standard No. 5 entails the planning of the audit of internal control over financial reporting. The paragraph states that the auditor should properly plan the audit of internal control over financial reporting and properly supervise the engagement team members and lists factors that could impact the auditor’s procedures. Upon evaluation of the case, our understanding of inherent risk and Paragraph 9 of PCAOB Auditing Standard No. 5, we found the following factors that would result in elevated inherent risk:
● Enron’s industry was significantly impacted following the government’s decision to deregulate the once highly regulated natural gas industry. As part of the deregulation process, the government required that pipeline companies provide open access to other companies wanting to transport natural gas. Enron adapted to this change by charging other firms for the right to use their pipelines. Additionally, Enron entered into long term contracts with their clients to transport gas, in some instances contracting with other companies to use their pipelines, in order to fulfill their contractual agreements. By doing so, Enron assumed additional risk related to gas transportation. The long term
contracts Enron entered into held the risk of prices rising to high enough levels that would cause the contract to be unprofitable. The significant change in the industry, assumption of additional risks including risky long term contracts would elevate inherent risk at Enron.
● Following the government's deregulation of the natural gas industry, Enron became involved in natural gas trading and financing. Enron served as an intermediary between producers contracting to sell their gas from Enron and customers who contracted to purchase gas from Enron. Additionally, Enron expanded their operations beyond natural gas, expanding into electricity and commodities markets. To do so, Enron pursued an assetlight strategy in order to have lesser fixed capital expenditures. Both events resulted in more complex transactions, affecting the relative complexity of the company’s operations, thereby elevating inherent risk.
● Although it is not mentioned in the case, Enron’s utilization of markto market accounting would lead to an elevated inherent risk. Marktomarket accounting was most commonly used in the trading of securities to determine the actual value of a security at the moment. Under marktomarket accounting, whenever companies have outstanding energyrelated or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period (source:
). This new method would cause us to immediately elevate inherent risk, since it affects the complexity of operations and its operating characteristics.
According to paragraph 11 of PCAOB Accounting Standard No. 5, the risk that a company's internal control over financial reporting will fail to prevent or detect misstatement caused by fraud usually is higher than the risk of failure to prevent or detect error. The auditor should focus more of his or her attention on the areas of ...
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