I am reading a case study for a marketing law class, but the finance/accounting/legality aspect is difficult for me to understand
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Leadership of a company care about the price of that company’s stock, because they’re paid in it and because it’s a measure of their job performance.
The stock price, in turn, depends on the financials of the company (among other things). All else equal, companies that are deep in debt tend to have lower stock prices than companies that are not.
This creates an obvious incentive for leadership to pretend the company’s financials are in a better state than they are. That is, it creates an incentive for them to commit *accounting fraud*. And the Enron scandal is one example of this. Enron’s leadership used a number of accounting tricks to make it look, on paper, like Enron’s financials were a lot better than they actually were. This inflated the price of Enron stock.
This is *supposed* to be prevented by [rules about how accounting is done](https://en.wikipedia.org/wiki/Generally_Accepted_Accounting_Principles_(United_States)), and by *audits* done by third-party accountants where they go through the company’s finances. But Enron leadership exploited loopholes in those rules, and their auditor – one of the “Big Five” accounting firms at the time called Arthur Anderson – didn’t want to expose them because Enron’s fees represented a substantial chunk of *their* income.
But you can’t hide these things forever, and when it came out, Enron’s stock price tanked, effectively draining billions from the people who’d invested in the company. Enron went out of business, and Arthur Anderson’s reputation was so damaged by the scandal (and by resulting legal action) that they mostly did too. The scandal also resulted in the passing of the [Sarbanes-Oxley act](https://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act), which strengthened the rules around accounting for publicly-traded companies.
Enron was an energy company. A lot of things went wrong with the company in complicated ways, but the main thing that destroyed them was their innovative approach to accounting.
They used something called “Mark-to-market” accounting which was legitimately used in financial organizations.
They used this to assign value and profits to things that didn’t actually had any value or made any profits.
Once people started actually looking at the books it became clear that there was a lot less money there than they claimed.
In general Enron pioneered the idea of treating energy more like financial instruments. This hist upon limits when people actually want to do things like use the energy to heat their homes and turn on the lights. A lot of things you can do with financial instruments you can’t do with megawatts and barrels of oil.
The idea that the whole point of the energy infrastructure was to maximize profits instead of providing light and heat to people, lead to blackouts when there was no real shortage and people just wanted to drive prices up. Line workers having their pensions stolen and generally business decision being made without any regard to human suffering that would be caused made the company hugely unpopular to a lot of people, but as long as they still made profits on paper the guys in charge were in the clear.
Only when it turned out that they had written anticipated earnings in their books as actual future profits that would never come into existence and that the whole thing was a house of cards did they crash.
They tried a lo of ridiculous things Weather derivative hat were basically gambling on weather it would rain. (different from buying insurance in case your big event gets rained out)
Crazy stuff that could only fly because of the dotcom boom and all the changes that came with it.
the mark-to-market thing to invent profits that weren’t real was what brought them down though.
Basically, Enron used mark to market accounting to over inflate their profits. This is the process of counting projected future revenues from projects in today’s revenue. This by itself is not unreasonable if done correctly. Let’s say you sign a simple service contract with a client for $5 million, but it starts several months from now. You know exactly how much that contract is worth, so you can book those future profits.
However, Enron badly abused this system. They were booking future profits from projects that did not have a known value and were very difficult, if not impossible, to forecast. On top of that, they were hyper inflating those projections. They weren’t just estimating $20 million on a $19 million project… they were booking $80 million on a $5 million project.
Eventually, the lies caught up with them. You can only pull this scheme for so long before people start to notice that the actual cash coming into the business is nowhere close to what has been reported.
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