This paper analyzes the role Arthur Andersen & Co. played in Enron's accounting fraud, focusing on the firm's failure to adequately disclose related party transactions and special purpose entities (SPEs) used to hide billions in off-balance-sheet debt. The paper describes how partnerships such as Chewco Investments, JEDI, and LJM Cayman inflated Enron's earnings by over $500 million while masking deteriorating asset quality. It then evaluates the logical flaws in Arthur Andersen's audit approach, offers a proposed checklist for external auditors handling special projects, and recommends legislative and regulatory reforms — including SEC oversight of the accounting profession — to prevent similar corporate fraud in the future.
Related party transactions are transactions conducted between closely related parties or individuals. Although not inherently wrong in isolation, they can be particularly harmful when abused. The problem with Enron's disclosure was that it was not clear enough — investors, analysts, and creditors could not properly ascertain the extent of the related party transactions taking place. This was compounded by the fact that the company deliberately concealed them. As a result, Enron was able to hide billions of dollars in off-balance-sheet debt from investors, creating large and unknown exposures.
Arthur Andersen looked the other way rather than informing investors about these exposures. The firm classified many of the entities holding excessive debt as special purpose entities (SPEs), and with Arthur Andersen's assistance, Enron avoided consolidating the results of these SPEs onto its financial statements.
Related party transaction partnerships connected to Andrew Fastow were largely ignored, as the company was able to fool its auditors. After Enron's eventual collapse, however, nearly 3,000 partnerships were discovered. Many of these were hidden and employed a variety of schemes to enrich senior executives at the expense of shareholders. In addition, these joint ventures created phantom profits that were used to meet Wall Street earnings expectations. By meeting those expectations, the company's share price was artificially inflated, which in turn encouraged still further use of the joint ventures.
The joint ventures reported on by Arthur Andersen involved three separate entities — each distinct, but all three serving to mislead investors through fraudulent accounting. The three primary entities were Chewco Investments, JEDI, and LJM Cayman. Together, these three partnerships inflated Enron's earnings by over $500 million. A significant portion of those inflated profits resulted from Enron's failure to consolidate these partnerships onto its balance sheet.
Under Andrew Fastow's leadership, the complexity of these partnerships grew exponentially. The company parked troubled assets into the partnerships and SPEs to keep their deteriorating value off its financial statements. As investors grew worried about the declining quality of these assets, Enron sought to assuage their concerns and compensate partnership investors for downside risk by promising to issue additional shares of its own stock.
This appeared to be a win-win situation at the time, as Enron's stock was rising rapidly. Retail and institutional investors alike bid the share price higher and higher, which reassured investors in the SPEs. As the value of the assets in these partnerships fell, however, Enron incurred larger and larger obligations to issue its own stock in the future. This caused the company to substantially increase its reliance on related party transactions, which helped mask internal problems by inflating reported profits. Those inflated profits, in turn, appeased Wall Street skeptics and kept the stock price afloat — allowing Enron to continue transferring bad assets into SPEs and keeping those transactions off its balance sheet.
The key component of the entire scheme was the related party transactions between company partnerships and SPEs. Without them, the broader plan would have failed. These transactions included material and significant sales. For example, in December 1999, LJM Cayman paid $30 million for a 75% equity stake in an Enron power project in Poland, after which Enron booked $16 million in investment gains. A similar transaction occurred in September 1999 involving a power project in Brazil, where Enron booked a gain of $65 million in revenue. Because these transactions were conducted with related parties, they did not represent legitimate sources of recurring revenue. They were nonetheless used to prop up Enron's stock price and reassure investors who had placed money into the partnerships' risky assets.
The firm's logic was flawed for a number of reasons. First, Arthur Andersen did not analyze the transactions thoroughly — auditors simply skimmed over them in an effort to complete the audit without conducting the necessary due diligence. The firm also failed to properly inform management about the extent of off-balance-sheet debt. Second, the accounting firm characterized many of these transactions as economic hedges. In reality, the transactions were designed to circumvent accounting rules and regulations. Through the SPEs, Enron never actually hedged its risk of loss; in fact, a significant portion of that risk remained with the company.
The three primary joint ventures also involved significant related party transactions that directly influenced reported financial performance. For example, Enron shifted expenses related to LJM Cayman by providing administrative assistance and office space to its owners. JEDI, meanwhile, recorded revenues allocated to Chewco that consisted entirely of appreciation in the value of Enron's stock. The related party transactions even involved Enron itself directly: in June 2000, the company sold fiber optic cable to LJM Cayman for $100 million and added the after-tax amount to earnings. That same year, Enron recognized $20 million in income for maintenance and marketing of those same products to LJM Cayman.
None of these transactions were indicative of the company's underlying financial performance. Arthur Andersen, however, made the incorrect assumption that these revenues and earnings were legitimate — when, in reality, they were not.
The following checklist is proposed for special projects performed by external auditors to limit errors and reduce risk:
"Andersen's audit shortcuts and misclassified hedges"
"Five-point checklist to reduce auditor error and risk"
"Disclosure reform, auditor independence, and SEC oversight"
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