Audit Assignment one (thu, 2011 Winter Semester)

Audit Assignment 1

1. What were the business risks that Enron faced, and how did those risks increase the likelihood of material misstatements in Enron's financial statements?

One fundamental business risk that the company faces is market or economic risk, especially as an energy company that provides both physical delivery and commodities trading. The speculative nature of Enron exposed the company to much additional risk, which created pressure to adopt aggressive financial reporting practice. For example, Enron acted as a broker of speculative energy futures and was a market maker in financial hedges.

In addition, many of Enron's a transactions (including its SPEs) depended heavily on a high and bullish stock price. The company had guaranteed its obligations with stock and had contractually agreed that those obligations would become immediately due and payable if the stock price fell below certain levels. Such an aggressive and increasingly complex business model could present additional pressure for accounting manipulation.

The corporation also faced significant foreign exchange risk, since it operated in many different countries in the world but most of its subsidiaries' functional currency is in US dollars. This presents substantial exchange rate fluctuations during group consolidation of accounts.

Assessment of client business risk also includes management controls that may mitigate business risk, such as effective risk assessment practices and corporate governance. The internal environment at Enron is also subject to risk from the aggressive risk appetite of its senior management/ executives (pg 75). From an audit perspective, after evaluating client business risk, the auditor can then assess the risk of material misstatement in the financial statements, and apply the audit risk model to determine the appropriate extent of audit evidence.

The site's success "depended… more importantly on the trust the company developed with its customers and partners who expected Enron to follow through" also shows that the company is subject to significant reputation risk, due to the nature of its business. As such, there are high stakes (i.e. liquidity crunch) that may incentivize Enron's management to turn to creative accounting adjustments, which was exactly what happened in the third quarter of 2001 when Enron's stock price faced serious threats of sharp decline.

2. a) What are the responsibilities of a company's board of directors?

The board of directors are responsible for ensuring that the management of the firm/ company is acting in the best interest of the owners (principal-agent theory), who are the shareholders. Each individual duty is subject to directors' duties, which include: Acting bona