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
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.
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