In laymans terms, how did they hide the poor health of the company from regulators and tbe public, why did the house of cards eventually collapse? And why couldn’t every company be doing the same or similar houdini tactics then and now?
In: Economics
Enron was a big and complicated company, with big and complicated financials. This allowed them to do various ‘tricks’ to make their numbers look better than they really were, because tracking the reality of all of their finances/deals/etc. would’ve been a full-time job, and regulators and investors have more than one company to worry about.
They used various tricks, but a big one was signing long term deals, and then ‘accelerating’ that long term revenue to their books immediately. So say they had signed an agreement to sell $10 million dollars worth of widgets to a company each year for the next 10 years. They’d count that as $100 million of revenue this year, in order to make their short term financials look better.
It fell apart because even though regulators/investors aren’t tracking 100% of their finances, they do occasionally take passing looks at them, so you need to have at least a little bit of reality to fudge, if you’re just making it all up from nothing that’s going to get noticed. But as Enron got deeper and deeper into its creative accounting, it got harder and harder to find numbers and deals that it could massage. Eventually enough cracks started showing that outside people started taking a closer look, and that was the beginning of the end.
Why couldn’t every company be doing the same thing? Well regulators and investors have learned some lessons from Enron (and other such scandals) so sometimes they’re more savvy about watching for similar issues. But the reality is that plenty of companies can and likely do fudge their numbers to various degrees. But at the end of the day it’s illegal, and if you get caught there can be some pretty rough consequences. Generally significantly worse consequences than the likely results of your company straight up failing and going bankrupt.
First of all they didn’t one hundred percent hide the flaws in their system, lots of people reviewed Enron’s financials and realized that the company was heading towards insolvency. The major stock analysts and credit rating agencies didn’t take those analysts seriously so Enron stock continued to be highly valued and their debt highly rated right up until the end.
As for how they Enron hid things, they used accounting tricks, many of which were actually perfectly legal at the time. One of the big things Enron did was they created separate legal entities called special purpose entities, and used those entities to hide debt. According to accounting rules at the time, separate legal entities did not have to be included in a company’s financial statements if that entity had at least 3% independent ownership i.e. Enron could own 97% of the entity but still leave it off their books. What Enron did that was determined later to be illegal was they had their own executives purchase 3% of the SPE. So the vice president of finance might own 3% of half a dozen of these entities and Enron considered that independent ownership so they left those entities off their books. And once they had entities that weren’t on their books they could do tricks like selling things to that entity for above market price and recognize that as Enron profits, even though they were selling things to themselves.
The last part of the picture that failed was their auditor, Arthur Anderson. Auditors are supposed to be independent outside accountants that review a company’s financials to verify that they are reasonably accurate. Arthur Anderson cut a lot of corners and didn’t do their full due diligence in reviewing Enron’s financials. This was in part due to the fact that Arthur Anderson wasn’t fully independent; many Arthur Anderson personnel went right from auditing Enron to getting a job at Enron, so they had an incentive to make Enron happy. However it should be pointed out that accounting regulations and oversight in the auditing world was very lax before the Enron scandal. Ultimately despite all of the shitty things Arthur Anderson did, the only definitely illegal thing they did was that a few managers ordered their office to shred documents during the SEC investigation.
Since Enron accounting rules have changed a lot and now there is an oversight board for auditors that helps ensure auditors don’t screw up like Arthur Anderson did.
This NYT article explains some of the stuff that was going on. The analyst referred to later gave evidence to Congress when it investigated the Enron scandal: https://www.nytimes.com/2002/10/15/business/analyst-dropped-enron-but-her-firm-loaded-up.html?unlocked_article_code=1.000.DQyG.dbfdHx_YSQJ7&smid=url-share
There is a movie called The Smartest Guys in the Room that highlight the history and collapse. Well worth the 2 hours
There were a couple of things going on with Enron. I’ll do my best to ELI5
**A Fundamentally Misleading Business Model**
Imagine that you decided to buy a racecar, and hire a driver to race it. It would cost you money to maintain the car and pay the driver, but if they won or placed in races, you would earn prize money that would cover your costs and make some cash. If you got tired of racing, you could sell the racecar and hopefully recover your costs, as long as your car won or placed often enough. There is a small risk that the car would crash, and you’d lose all your money. This is what we’d call a low-risk, low-return investment. You don’t make a ton of money, but you’re probably not going to lose all your money right away either.
Now compare that to just taking all your money and going to the betting window. If you bet a lot of money, and you win, you win a whole lot more money. But if you don’t win, you lose all the money you bet. Gambling is what we’d call a high-risk, high-return activity.
Neither of these are better than the other, they’re just different, and people have different levels of risk that they’re comfortable with, and different amounts of return they are looking to earn when investing.
The problem with Enron is that they claimed to be in the energy utility business (which traditionally was a very low-risk, low-return industry) but were claiming lots and lots of income, suggesting that they had somehow found a way to have a very low-risk, very high-return investment. The reality (which they tried to obscure) is that they were mostly engaged in energy commodities trading, which is basically a form of gambling: high returns, but a high risk of loss.
**Regulatory Capture**
If you go in to one of those oil-change places with a coupon, the company might actually be losing money if you just get the most basic oil change and nothing else. But when you go in to do that, they’ll offer to change your car’s cabin air filter, flush your radiator, change your battery, install new windshield wipers, maybe even offer to sell you new tires. All of those other services are quite profitable, so the oil change places are really using the oil change service as a way to try and sell you other, more valuable services.
When a company has stock that’s publicly traded, they are required to hire an outside auditing firm to review and testify to the accuracy, completeness, and truthfulness of your financial statements. At the time of Enron, most auditing firms also offered a lot of other services like financial consulting, and those other services were actually bigger business and more lucrative than financial audits. Businesses like Enron knew this, and so if the (low dollar, low value) financial audits weren’t going well, Enron could offer to hire a different firm to do their financial audit… along with all their other consulting business.
(As a quick aside: good criminals break the law in clever ways, but really brilliant criminals do things that only become illegal after it gets discovered. After Enron and some other scandals, a bunch of laws got passed making a lot of things illegal that used to be legal, including auditing firms also offering non-auditing consultation business)
**Sketchy Accounting Practices**
Others have covered this pretty well, but just to add a few notes.
One problematic part of the accounting at Enron involved making financial statements about things *as if* they had been done, when they hadn’t. More ELI5 time!
Imagine you buy a Charizard card for $10 at the start of the month. At the end of the month, you go to the hobby store and see that they’re buying that same card for $50. You don’t sell the card, but you do write down that it’s now worth $50. When someone asks you if you made any money this month, you say “Yeah, I made $40 investing in Pokemon cards!”
While it’s true that the value of the asset you have increased by $40, you don’t actually have $40 in cash. You’d need to sell the card to actually get real money, and you didn’t do that. But (and again, this is one of those thing that wasn’t as restricted before as it was after) Enron was allowed to “mark to market” the value of their assets, and claim that as income, even though they never sold those assets.
They did something similar with debts they owed, and options available for borrowing. They owed money, but the banks they worked with had agreed that if asked they would give loans up to a specific amount. Enron didn’t list the debts they owed on their financial statements, and instead put a note that while they owed money, they also had unused lines of credit and loans equal to the amount they owed, so they could pay off those debts if they needed to… but they never took out those loans, so on paper, the business looked like it owed a lot less money than it did.
It should be noted here that Enron did have a very successful business model, which involved a very wide horizontal monopoly in the energy production and delivery industries. They were able to work around price fluctuations that other companies had to suffer through.
They got in trouble anyway. They were investing so heavily in so many markets that competitors were getting past them, and they tried hiding the losses.
Kenny wants to open a lemonaid stand. He’ll need lemons, water, sugar, and a table. Kenny borrows money from his mom to buy those things and promises to pay her half of the profits. He gets set up and for a while is running a successful lemonade stand.
Then Kenny has a problem. The price of lemons keeps going up and down. He realizes he can make a bet that lemons will go up in price so if they do, the winnings from the bet offset the increased costs of the lemons. If the price fall, he loses the bet but that’s offset by being able to buy cheaper lemons. These bets are successful and Kenny focuses more and more on that. Soon the business is basically just gambling on the price of lemons. Kenny doesn’t tell his mom about the gambling and spends the money he was supposed to split with his mom on toys.
Kenny is so busy gambling on lemon prices he hires a friend to run the lemonade stand. He convinces the friend to get paid in ownership of the company like his mom and share in the profits (that Kenny has been keeping for himself).
Then Kenny’s bets stop winning. The lemonade stand can’t afford lemons anymore. Mom asks for her money back, but it’s gone. The friend asks for his money, but it’s gone too.
There’s a good 2 part podcast just released about this. https://pca.st/podcast/6ae9be80-deb0-0135-e956-00437879387e
It’s the newest 2 episodes: The Enron Scandal
Hope the link is allowed. I listened to part 1 last night and found a lot of detail in there I never knew before.
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