Table of Contents

1.0 Background of Enron Corporation....................................................................................... 2

2.0 Fraudulent Financial Accounting of Enron Corporation ..................................................... 3
2.1 Mark-to-Market Accounting ............................................................................................ 3
2.2 Special Purpose Entities (SPEs) ....................................................................................... 4
3.0 Auditor and Their Failed Duties .......................................................................................... 5
3.1 Failure to Documenting Material Misstatement............................................................... 5
3.2 Failure to Evaluate on Internal Control ............................................................................ 6
3.3 Failure in Giving True and Fair Opinion ......................................................................... 7
3.4 Fail to Maintain High Level of Auditor’s Independence ................................................. 7
4.0 Lesson Learned From the Enron Scandal ............................................................................ 9
4.1 Auditors Must Maintain High Level of Independency .................................................... 9
4.2 Auditors must Adopt to Code of Ethics ........................................................................... 9
4.3 Audit Rotation ................................................................................................................ 11
4.4 Don’t Invest in Something Which Is Complicated ........................................................ 11
4.5 Fraud Never Pays ........................................................................................................... 11
5.0 Measures should be taken to prevent auditors from failing in performing their duty ....... 12
5.1 Safeguards ...................................................................................................................... 12
5.2 Audit Quality Control .................................................................................................... 12
5.3 Competency.................................................................................................................... 13
5.4 Code of Conduct............................................................................................................. 13
5.5 Professional skepticism .................................................................................................. 13
6.0 References .......................................................................................................................... 14

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1.0 Background of Enron Corporation
Enron Corporation was formed by a merger InterNorth Inc. and Houston Natural Gas
(HNG) in 1985 (Frontain, 2017). At the same time, Kenneth Lay has become the CEO and
the chairman of Enron. Enron Corporation is an energy, services and commodities company
with corporate in Houston, Texas. According to Michael Frontain (2017), Enron Corporation
has the 2nd largest pipeline system in the United States, about over 36,000 miles at the time.

Furthermore, Enron Corporation also known as an innovator and a corporation with

no fear. Enron not only is one of the largest integrated natural gas and electricity, it also
supply solar and wind renewable energy (Street, n.d.). Other than that, Enron also developed
some innovative trading products. Enron is named “America’s Most Innovative Company”
by Fortune in 1995, and it goes on to win this award for the following six years (Investopedia,
2017).

Jeffery Skilling joined Enron in 1990, and he was appointed to be the CEO of Enron
in 1997. He has change the accounting system from traditional accounting system to mark-to-
market system (Pavel & Encontro, 2012). In 1998, Andrew Fastow has promoted to become
the CFO of Enron Corporation. In 2000, Enron has earned total revenue $100 million,
Enron’s shares are increased dramatically and reach the peak of all time, $90.56 and it
became the 7th on the Fortune 500 company list (Street, n.d.). Moreover, Enron Corporation
has approximately over 21,000 employees.

According to Lucian & Cristina, 16th of August in 2001, Enron Corporation

announces and reports a $618 million of losses and $1.2 billion value write off, it lead to the
shares of Enron dives to $33.84. After the 6 days of announcement, 22nd of August, Securities
and Exchange Commission (SEC) is starting investigate Enron. On the 2nd of November,
Enron Corporation has admitted it has do a false account, it has overstated the profit around
$586 million since 1997. The auditor firm of Enron Corporation, Arthur Andersen, has
become one of the investigate target of SEC, when the Securities and Exchange Commission
(SEC) begin to expand the investigation. On the 2nd of December in 2001, Enron files for
Chapter 11 bankruptcy of the United States Bankruptcy Code, and its stocks was closed at
$0.26 (Pavel & Encontro, 2012).

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2.0 Fraudulent Financial Accounting of Enron Corporation
2.1 Mark-to-Market Accounting
Jeffery Skilling has joined Enron Corporation in 1990, and he was appointed to be the
Chief Executive Officer of Enron Corporation in 1997. Andrew Fastow, who has promoted to
become the Chief Financial Officer of Enron Corporation in 1998, and Skilling have change
the accounting system of Enron form the traditional accounting system to the mark-to-market
accounting system (Pavel & Encontro, 2012). Once a long-term contract was signed, the
mark-to-market method is required to predict the future costs and incomes or profit of the
contract. As it is a long-term contract, the costs of the contract are hard to estimate. However,
the method of mark-to-market is estimation the income and cost based on the present value of
future cash flow. In the other words, the amount of the assets will sell in the future market has
been recorded in the current financial statement (Yuhao, 2010). Other than that, it also means
that even though the money have not received by Enron, the predicted profit or income from
the contracts were recorded in the Enron’s financial statement. However, the Securities and
Exchange Commission (SEC) of United States has approved Enron Corporation to use the
method on 30th January in 1992.

For instance, Enron Corporation was signed a 20 years contract to introduce a new
online video game with Blockbuster Video. However, the analysts are questioned the demand
of the market and the technical viability, Enron was predicted the profit of the contract is
more than $110 million. Blockbuster Video has pulled out of the agreement, when the
network is failed to work. Even though the contract is resulted in a loss, Enron still continued
to recognize the future incomes or profits in the financial statement. This is due to Enron
Corporation is using the method of mark-to-market to pump up the stock price of Enron to
cover the losses of the contract and attracting the potential investors and customers (Lemus,
2014).

It will bring a negative effect, if the company use the mark-to-market accounting
system by the incorrect ways. As the Enron Corporation was used the method in the incorrect
way, the financial statement of Enron has been corrupted and Enron is too optimistic in its
prediction of the future profits and incomes (Pavel & Encontro, 2012). Company need cash to
run the business, however, the incomes and profits of Enron mostly come from paper
revenues. Hence, in the middle of 2001, Enron was not enough to run the business and facing
the cash problems.

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2.2 Special Purpose Entities (SPEs)
Special Purpose Entities (SPEs) also known as Special Purpose Vehicles (SPVs) and
it is a subsidiary company. It is created to fulfil temporary or special objectives and it is a
legal entity. Companies will use SPEs to separate the financial risk from the parents company.
Usually, companies will transfer their assets to SPEs to let the entity handle the assets by risk
management or funding. Other than that, some companies are willing to minimize the risk of
a project by creating a SPE to finance and operate the project. If the company wanted the SPE
to be legal, there are some requirements that the company need to fulfil, an independent third
party owner should invest at least three percent of the capitalization and the independent third
party must handle or control the SPE instead of control by the parent company (Yuhao, 2010).

However, Enron has misused the off-balance-sheet financing also known as special
purpose entities (SPEs). Enron Corporation had created at least 3,000 SPEs. According to an
article in New Yorker, every SPE requires 1,000 pages of paperwork. If we want to
understand all the Enron’s SPEs, we need to analysis 3,000,000 pages of paperwork (Rimkus,
2016). Enron Corporation used SPE to hide its losses, debts and fake revenues in order to
maintain the stock price. Moreover, Enron also used SPE to prevent the bank want it to pay
back the money and prevent lower the investment grade. As a result, it will lead to the
balance sheet of Enron understated its liabilities and the profits and equity will be overstated.
In the late of 2001, some SPEs were started collapse such as ChewCo, JEDI, LJM1 and
LJM2; and it lead to the stock price of Enron drop significantly, when there are some news
about the hiding debt of Enron come to surface. After the investigation of the Securities and
Exchange Commission (SEC), the Enron employees are not independent as they are
controlling the SPEs, like the SPE, ChewCo is running by the Michael Kopper, he is an
accountant working for Andrew Fastow.

For the SPE of ChewCo, every SPE requires a limited or general partner, therefore,
Andrew Fastow simply created another SPE to act as the limited partners, Small River and
Big River. The Barclays lent $11.5 million to each of Small River and Big River and they
used the money invest back into the ChewCo. Furthermore, Barclays also lent $240 million to
ChewCo and another SPE of Fastow, JEDI also lent $132 million to ChewCo. Besides,
Michael Kopper is controlled the ChewCo, however, he only invest $125k into the ChewCo,
it is the only real equity in the deal and it is only 0.03% of the capitalization. Normally, the
debt for ChewCo should transferred the whole transaction into the balance sheet of Enron.
However, Enron hid it from the balance sheet by fraudulent accounting (Rimkus, 2016).

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3.0 Auditor and Their Failed Duties
Arthur Anderson which was once considered as a major player of “Big Five”, five
largest audit and accountancy firms in the world. Arthur Anderson was established by Arthur
Edward Anderson in the year of 1913 and began their career as an accounting which
providing auditing, consulting and tax services to others companies (Edelman & Nicholson,
2011). During their successful career, the firms engaged by Enron in the year 1986 as one of
their client, where Arthur Anderson will provided the services such as internal auditing,
external auditing and consulting services to Enron.

3.1 Failure to Documenting Material Misstatement

This happens when Enron mishandle and utilize “special purpose entities” (SPEs) and
exploited the off-balance-sheet financing vehicles, whereby Enron created tons of SPEs in
order to hide the debt liable by Enron and manipulated the revenues and earnings of the
parent company (Rimkus, 2016). This can be seen in the case of where Enron used one of
their “special purpose entities”, namely Joint Energy Development Investment (JEDI) and
Chewco Investment, to borrowed large amount of money in order to settle off the balance of
their overvalued contracts (Li, 2010). In other words, Enron used the SPEs to convert the
assets burdened with debt obligation and loans into revenue. Furthermore, the large amount
of burdened debt from the purchase of debt and assets by the SPEs was not reported in the
Enron’s financial report (Li, 2010). As the results, the shareholders was misled as false figure
stating in the financial report where the debt are low, while the revenue was increased.

This happens when Enron mishandle and utilize "special purpose entities” (SPEs) and
exploited the off-balance-sheet financing vehicles, whereby Enron made huge amounts of
SPEs in order to shroud the debt liable by Enron and controlled the earnings and revenue of
the parent company (Rimkus, 2016). This can be found on account of where Enron utilized
one of their SPEs specifically Joint Energy Development Investment (JEDI) and Chewco
Investment, to borrowed vast amount of cash in order to settle off their overvalued contracts
balance (Li, 2010). In other words, Enron utilized the SPEs to change over the assets
burdened with loans and debt obligation into income. Moreover, the vast burdened debt
amount from the debt and assets purchase by the SPEs was not revealed in the financial
report of Enron (Li, 2010). As the outcomes, the shareholders was deceived as false figure
expressing in the financial report where the debt are less, while the income was expanded.

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 However, it was claimed that Arthur Anderson was alleged to have known the
problem occurs in the company but did not force Enron to reveal them. The auditors that in
charge in auditing Enron failed to disclose this fraud in the audit papers, although they
acknowledge the transaction between Enron and JEDI (Edelman & Nicholson, 2011). Thus,
the auditors had failed their duties in disclosure of any material misstatement which results in
the occurrence of fraud.

Nonetheless, it was asserted that Arthur Anderson was affirmed to have known the issue
happens in the company yet did not compel Enron to disclose them. The auditors who were
responsible in auditing Enron neglected to reveal this deception in the audit papers, though
they recognize the transaction amongst Enron and JEDI (Edelman and Nicholson, 2011).
Therefore, the auditors had fizzled their obligations in any material misstatement disclosure
which results in fraud occurrence.

3.2 Failure to Evaluate on Internal Control

Internal Control can be defined as the act or action of the management regarding the
significance of control within the organization in order to achieve the objective and target of
the company (The Institute of Internal Auditors, 2011). The auditors are required to evaluate
the effectiveness of the company’s internal control in order to prevent the occurrence of
fraudulent activities which will effect on the true and fair view of the financial statement of
the entity. In the case of Enron, risk for these entities was assumed by Enron and not the outside
party, yet were not completely independent. The auditors acknowledge the fraudulent activities
between Enron with their related parties. Based on Arthur Andersen’s risk assessment, these
activities were risky; however, audit procedures did not reflect consideration of this internal control
risk, whereby the auditors had conducted a faulty risk assessment on the company’s internal
control during the audit (Edelman & Nicholson, 2011). As the results, the risk assessment on
the internal control that conducted by the audit does not truly reflect the current financial risk
associated with the company’s internal control, and thus results in the continuing of the
fraudulent activities.

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Inner Control can be characterized as the management act in regards to the criticalness of control
inside the organization in order to accomplish the goal and focus of the organization (The Institute of
Internal Auditors, 2011). The auditors are requisite to assess the company’s internal control
effectiveness to keep the event of deceitful activities which will impact on the financial statements’
true and fair of the entity. On account of Enron, Enron has expected risks for these entities and not
the outside group, yet were not totally independent. The auditors recognize the deceitful activities
between Enron with their linked parties. In view of Arthur Andersen's risk assessment, these actions
were risky; but, audit procedures does not reflect internal control risk considerations, whereby the
auditors had led a flawed risk assessment on the internal control of the company during the audit.
(Edelman and Nicholson, 2011). As the outcomes, the internal control risk assessment that directed
by the audit does not really mirror the current financial risk related with the organization's internal
control, and consequently brings about the proceeding of the fraudulent activities.

3.3 Failure in Giving True and Fair Opinion

Auditor plays a vital part in giving their opinion’s true and fair view which based on
the financial statements of clients (Matis & Bota, 2008). It can be observe that the auditors
from Arthur Anderson recognize the fraudulent doings led by top management of Enron for
instance, not revealing the exact debt level amount in their financial statement. Nevertheless,
the auditors did not reveal the deceitful activities, in which they kept quiet of these extortion
while giving their opinion in auditor report.

3.4 Fail to Maintain High Level of Auditor’s Independence

Auditor independence can be characterized as the independence of auditors from the
financial interest when acting audit work with different parties (Abdullah, 2004). In view of
the Enron cases, other than giving auditing services, Arthur Anderson additionally gave non-
audit services, for example, consulting services to the company. Non-auditing services are
one of the risk to audit independence as the association with their client could influence the
auditor view as the auditors are needed to provide unbiased, professional and honest opinion
on the financial statement (Abdullah, 2004).

Besides, Enron paid a big amount of money adding up to $52 million to Arthur Anderson for
the external audit, internal audit and consulting service delivered (Stinson, n.d.). $27 million
are ascribed to consulting services out of the $52 million of charges, thusly it might have a
higher shots that Arthur Anderson turned out to be less skeptical and overlook the fraudulent
doings as they dread to lose their consulting business. As the consequences, the auditors that

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are fee dependent can effects by decreasing their capacity to give true and fair view. The
indication of absence of independence was clear.

In this circumstance, the inquiry is how could such noteworthy error was not identified. On
the reasonable surface, it is essentially because of the expansive fee generated from Enron
and the intimacy between the two bodies. Andersen may effortlessly neglect on the client's
compliance with pertinent policies and necessities. Besides, Andersen has been auditing
Enron for a long term and get comfortable with the organization's accounting practices and
strategies. Andersen's independence has been compromised by his profitable role in the
organization and the close individual relationship created with Enron. Andersen signed the
financial statements of Enron yet they acknowledged that there were severe complications
with it.

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In this circumstance, the inquiry is the manner by which could such noteworthy blunder was
not identified. On the reasonable surface, it is essentially because of the expansive bit of
charge created from Enron and the closeness between the two gatherings. Andersen may
effortlessly neglect on the customer's consistence with pertinent approaches and necessities.
Besides, Andersen has been evaluating Enron for a long term and get comfortable with the
organization's bookkeeping practices and strategies. Andersen's lucrative part in the
organization and the nearby individual relationship created with Enron all through their long
residency traded off Andersen's freedom Andersen knew there were not kidding issues with
Enron's money related explanations however they marked it off at any rate.

4.0 Lesson Learned From the Enron Scandal

4.1 Auditors Must Maintain High Level of Independency

Auditors firms should be independent from any other company, especially from the
company of their own client. Auditors are required to be independent so that the honest and
professional opinion given by the auditors are not influenced by the relationship between the
auditors and the other parties (Abdullah, 2004). The impairment of auditor independence will
threaten the entire community. The auditors should not provide other non-audit services to
the client as this could create a self-interest conflict and affect the transparency of the opinion
given by the auditors in the auditor’s report. Based on the Enron cases, we can see that Arthur
Anderson had provided non-audit services where they provided both external and internal
audit and consulting services to Enron and results in the occurrence of fraud. Furthermore,
auditors should not be fee dependent with their client as it will affect the willingness of
auditors to challenge any possible misstatements as they might be fear of losing income. For
example in the case of Enron, more than half of the amount of $52 million are came from
consulting services, as the results, Arthur Anderson might fear to lose their client and
therefore the fraudulent activities were silenced kept.

4.2 Auditors must Adopt to Code of Ethics

Integrity can be known as a characteristics of individual that are consistently
considered, compassionate, transparent, honest and ethical (Jan, 2015). Auditors need to be

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integrity by being honest, completeness and accurate in perform the auditing process in order
to gain public trust in the financial statement based on their professional judgment.

Objectivity can be knows as a characteristics behavioural which concerning the

unbiased mental attitude of auditors (James & Marianne, 2014). Auditors must possess
unbiased attitude and avoid any conflict of interest in order to provide assurance to all of the
stakeholders by constantly following the correct audit procedure.

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4.3 Audit Rotation
An audit rotation is one of the ways to prevent auditors in failing their duties and
improve the audit quality (Brody & Moscove, 1998). By constantly rotating the audit partner
could prevent bound relationship between the auditor and the client which could affect the
auditor judgment. Moreover, audit rotation could also reduce the threat to auditor
independence so that auditors are less likely to produce any prejudice or bias opinion in the
auditor report and thus increase the stakeholder confidence (Dopuch, King, & Schwartz,
2001). For example, a company should changes their auditors every five years in order to
prevent the familiarity threat.

4.4 Don’t Invest in Something Which Is Complicated

Enron heavy involvement in business activities which include operated gas pipelines,
water and electricity plants, broadband assets and also financial markets trading, which made
Enron had a very complicated business model that investors are confuse when trying to
understand it (McCullum, 2017). Furthermore, Enron’s financial statements were also
difficult to understand as there are the financing structures are complex which involving
hundreds of special purpose entities and off-balance-sheet vehicles. Therefore, it will put
investors in a risky situation in which blindly investing might results in loss of money as the
investors does not have sufficient information and knowledge towards that particular
investments.

4.5 Fraud Never Pays

It can be seen that Enron had committed fraudulent activities by violates the special
purpose entities to hide their debts obligations from their financial statements. As the results,
many of the management and executive who involvement in these fraudulent activities are
ended up serving their time in jail and paying huge amount of fines. Situation are the same in
Arthur Anderson, where the auditors intend to kept silence for the fraudulent activities
conducted by Enron and thus results in imprisonment and suspension of the audit license.

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5.0 Measures should be taken to prevent auditors from failing in
performing their duty

5.1 Safeguards
A safeguards is a guidance or an action which attempts to solve the ethical threats
from occurring (William & Arthur, 2002). Ethical threats such as self-interest, self-review,
advocacy, familiarities and intimidation, could affect the auditor independence. In order to
safeguards the independence, the auditors will have to provide various ways in order to
safeguards in response to threat. For example, the auditors will have to ensure that the
members does not participate in the activities held by the auditees as it could strengthen the
relationship between the auditors and auditees.

5.2 Audit Quality Control

The audit quality control can be recognized as the policies and procedure that used to
ensure that the firms to provide with reasonable assurance that personal comply with the
professional standard and regulation requirement (International Federation of Accountants,
2010). The firms must be responsibility to ensure the auditors must be objectivity and
independently in collecting and verifying the audit evidence, evaluate and reports their audit
findings (Stanislav & Walter, 2000). For example, the firms need to ensure that their auditors
act according to the audit objectivity such as the consistency process and results of audit, the
application of appropriate methodology, materiality of evidence, use of systematic audit
approach and free from bias. A good quality control could reduce the occurrence of
fraudulent activities that exist in the operation and thus improve the stakeholder’s
confidential towards the financial statements from the opinion given by the auditors that are
free from bias.

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5.3 Competency
Competency can be viewed as the capabilities of human to perform certain tasks in an
organization through the tools or system to perform certain function in order to ensure the
continuous operation of the organization (Nor Aishah, Zakiah, Shahida, & Zurina, 2015). The
firms must ensure that employees are well-educated and trained properly through training and
education so that the employees are understand the job objective and criteria, thus reduce the
error and mistake made. Auditor must be competence in order to maintain the professional of
the audit quality which enhance the confident from stakeholders.

5.4 Code of Conduct

A strict code of conduct must be implemented in the firms or an organization in order
to guide the employees in the workplaces. The firms maintain a strong internal control in the
organization whereby each employees are liable for the legal and ethical compliance
principles so that enhance the ethical behaviour of employees towards the organization and
client.

5.5 Professional skepticism

Professional skepticism can be known as an attitude which include a questioning mind,
being alert to the situation which might indicate possible misstatement, and critical
assessment of audit evidence (The Institute of Chartered Accountants in England and Wales,
2012). The auditors must have the mindset of professional skepticism, in which auditors have
the responsibilities to identify and spot any transaction that are potential fraud.

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6.0 References
Abdullah, D. F. (2004). The Enron-Anderson Regulatory Review To Strengthen Auditor
Independence. 30-44.
Brody, R. G., & Moscove, S. A. (1998). Mandatory auditor rotation. National Public
Accountant, 32-36.
Dopuch, N., King, R. R., & Schwartz, R. (2001). An experimental investigation of retention
and rotation requirements. Journal of Accounting Research, 93-117.
Edelman, D., & Nicholson, A. (2011). Arthur Anderson Auditors and Enron: What happened
to their Texas CPA licenses? Journal of Finance and Accountancy Vol. 8.
Frontain, M. (30 October, 2017). Enron Corporation. Retrieved from Texas State Historical
Association: https://tshaonline.org/handbook/online/articles/doe08
International Federation of Accountants. (2010). Retrieved from International Standard on
Auditing 220 Quality Control for an Audit of Financial Statements:
http://www.ifac.org/system/files/downloads/a010-2010-iaasb-handbook-isa-220.pdf
Investopedia. (23 October, 2017). Enron Scandal: The Fall of a Wall Street Darling.
Retrieved from Investopedia: http://www.investopedia.com/updates/enron-scandal-
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James, D. A., & Marianne, O. (2014). Objectivity and Independence: The Dual Roles of
External Auditors. Journal of Forensic & Investigative Accounting Vol. 6, Issue 2,
200-224.
Jan, W. D. (2015). The role of integrity in individual and effective corporate leadership .
Journal of Academic and Business Ethics .
Lemus, E. (2014). The Financial Collapse of the Enron Corporation and Its Impact in the
United States Capital Market. Global Journal of Management and Business Research:
Accounting and Auditing, Volume 14, Issue 4, Version 1.0, 41-42.
Li, Y. (2010). The Case Analysis of the Scandal of Enron. International Journal of Business
and Management Vol. 5, No. 10, 37-41.
Lucian, C., & Cristina, D. (n.d.). Enron Corporation – History & Analyzing the Fraud:
Timeline and Financial Highlights. Fraud Case Analysis: Enron Corporation, 195.
Matis, D., & Bota. (2008). Study Regarding The Quality of The True and Fair View Supplied
By The Financial Statements From Financial Auditor's Point of View. 1298-1309.
McCullum, N. (2017, July 22). 5 Actionable Lessons from the Enron Scandal. Retrieved from
https://www.suredividend.com/actionable-lessons-enron-scandal/
Montange Porfolio. (1 February, 2008). Financial Statement Fraud in Enron, WorldCom
Scandals, Fraud Motivation Triangle And The SOX Act 2002. Retrieved from A
Medium Corporation: https://medium.com/@MontangeUpdate/financial-statement-
fraud-in-enron-worldcom-scandals-fraud-motivation-triangle-and-the-sox-act-
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Nor Aishah, M. A., Zakiah, M. M., Shahida, S., & Zurina, S. (2015). Competency of Shariah
Auditors in Malaysia: Issues and Challenges. Journal of Islamic Finance, Vol. 4 No. 1,
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Stanislav, K., & Walter, W. (2000). Quality Assurance and Effectiveness of Audit Systems.
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Stinson, T. (n.d.). Arthur Andersen and Enron: Positive Influence on the Accounting Industry.
Retrieved from https://www.mckendree.edu/academics/scholars/issue4/stinson.htm
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The Institute of Chartered Accountants in England and Wales. (2012, January 30). Retrieved
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The Institute of Internal Auditors. (2011, April). Auditing The Control Environment.
Retrieved from
https://www.iia.org.uk/media/97410/Auditing%20the%20control%20environment.pdf
William, T. A., & Arthur, S. (2002). Threats and Safeguards in the Determination of Auditor
Independence. 519-543.
Yuhao, L. (2010). The Causes of Enron’s bankruptcy. The Case Analysis of the Scandal of
Enron , 37-39.

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