Accounting Horror Stories
Nearly 20-Years Later, the Ghost of Enron Still Looms Large
With Jack-o’-lanterns in place and faux-cobwebs sprinkled liberally around the office, FloQast is feeling particularly spooky these days. To really get into the Halloween spirit, we decided to tell a few scary stories, but with a twist — they’re all true. In today’s episode of Accounting Horror Stories, we explore the horror story that played a major role in the Sarbanes-Oxley Act coming to life.
The 1990s was a wild decade (maybe not when compared to previous decades, but bonkers nonetheless). While the World Wide Web certainly provided a multitude of new ways to break the law, billion-dollar corporations didn’t need the interweb to commit fraud.
In today’s tale, we take a look at a company virtually synonymous with fraud. Enron inspired a book (“The Smartest Guys in the Room”), several documentaries and podcasts, a short-lived Broadway musical, and, of course, wide-sweeping new financial regulations. The scandal was so big that even a young John Siegel was aware (only because Enron Field, home to the Houston Astros, abruptly dropped the name prior to the start of the 2002 Major League Baseball Season).
As with all good frauds, Enron took several years to get going. But once it did, hoo boy, did it get going. So, how did it all go down and how did it stay hidden for so long? What have we learned and what CAN we learn from the rise and fall of a company like this? Let’s take a look.
The Origins of Enron
In 1985, America was introduced to the 8-bit Nintendo, Michael Jordan was named Rookie of the Year, and Marty McFly went “Back to the Future.” (A chilling metaphor of what was about to happen? OK, probably not but think about it for a while.) It was also the year Houston Natural Gas Company merged with InterNorth Inc., forming Enron.
Houston Natural Gas Company CEO Kenneth Lay became CEO of the new corporation and started shifting the focus from piping gas to supplying and trading all kinds of energy. The deregulated markets of the 1980s were a crazy place; just imagine the Wild West, if everyone was wearing Spandex and illicit drugs were widely available. With Lay at its helm, Enron put on its black hat, loaded up six-shooters, and charged right into the land of ethics with guns blazing.
In 1990, Lay created Enron Finance Corporation, putting McKinsey & Company consultant Jeffrey Skilling in the CEO role, while Lay remained chairman of the board. Throughout the 1990s, Enron would be involved in all sorts of trading and investing activities and much of their “success” hinged on the way Skilling leveraged Mark-to-Market accounting.
The Fraud
The SEC approved the Market-to-Market accounting method for Enron in 1992. It allowed them to forego the historical cost and value their assets at current market value. It’s a valid and helpful practice for many companies and a manipulative weapon in the hands of fraudsters like Lay and Skilling.
In this case, Mark-to-Market was used to book speculative future earnings as current revenue and profits, even if those earnings would never materialize. It was one of the first in a series of deceptions Enron used. They created a house of cards from their paper profits and appeared incredibly successful when there was actual very little real business going on.
Let’s look at a quick example of how this actually happened. In 2000, Netflix didn’t exist. Back then, people headed to Blockbuster to rent VHS tapes and recently released DVDs. But what if they could stream movies over the internet straight into their homes? Enron thought that sounded lucrative, so they worked out a deal with Blockbuster, who would orchestrate the movie distribution rights while Enron handled the internet bandwidth to make it possible.
Sadly, it never came together. Blockbuster struggled to get rights to enough movies and Enron’s technology couldn’t support quality streaming of movies over the 2000-era internet. The joint project fell apart. But Enron still got something out of the deal. They booked over $100 million in revenue they had projected over the next 20 years (yep, they claimed income in 2000 that they still wouldn’t have earned to this day!) Their MTM accounting made this look pretty good on their income statement even though nothing really happened.
So, what do you do when you book future earnings that never happen? In theory, you mark them back down to reflect the new market value. In practice, CFO Andy Fastow had a “better” idea. Fastow was promoted to CFO in 1998 and quickly developed a plan to hide debts and failing assets. Enter Special Purpose Vehicles.
No, we’re not talking about the 1991 Ford Explorer I drove in high school. SPVs — also called Special Purpose Entities — are another accounting tool that has a legitimate purpose. But in this case, it wasn’t meant to be. Fastow created subsidiary companies, financed with Enron stock, which was skyrocketing at the time and riding the Dot-com bubble. When one of Enron’s investments went south, they would simply transfer it to one of their subsidiaries, sweeping the debt and losses under the rug and keeping it off their own financial statements. Although this was a clever bit of financial skullduggery, it came back to bite Enron later on. But let’s not get ahead of ourselves.
The Whistleblower
After more than a decade of quietly defrauding people, the collapse of Enron happened surprisingly quietly (or maybe unsurprisingly.) Eventually, as all good/bad acts of fraud do, a few people watching from afar called bull.
Sherron Watkins, an accountant and a VP at Enron at the time, was one of those people. She would later be protected as a whistleblower when testifying before Congress. She warned Lay that the company couldn’t sustain what it was doing with the SPVs. While working under Fastow at the time and reviewing the subsidiaries where Enron hid its dirty laundry, she sent a memo to Lay, telling him she was worried that the company would “…implode in a wave of accounting scandals.” So, what exactly was getting ready to implode?
Enron’s SPVs were capitalized with Enron stock. Since they were basically closets for Enron to hide their skeletons in, they didn’t have any way to repay their debts except with Enron stock. Enron had guaranteed these companies, and when the stock prices fell, those guarantees came into effect.
The Downfall
There’s no dramatic moment in the Enron story where our hero rides in and saves the day.
By October 2001, Enron posted its first losses and closed down one of its SPVs to avoid paying out dividends. They also made a last-minute change of pension plan administrators, which had the convenient side-effect of preventing employees from selling shares for 30 days.
The SEC got curious and announced an investigation into Enron and its SPVs. Enron’s response was not at all suspicious — they fired Fastow the same day and restated their earnings for the past four years, to the tune of around $600 million. It wouldn’t be long before one of America’s largest corporations was filing for bankruptcy.
Enron’s external auditors, Arthur Anderson, were also involved in some questionable business. If the name is familiar it’s because they were one of the Big 5 accounting firms and would end up being involved in far more than their fair share of scandals. Arthur Anderson was found guilty of obstructing justice by shredding Enron audit documents to hide them from the SEC investigators (Note: The conviction was later overturned by the Supreme Court for procedural reasons.)
The Impact
- $74 Billion dollars lost by stockholders in the last 4 years of Enron
- 4,500 jobs lost at bankruptcy
- Over $1 billion worth of employee retirement funds disappeared
- Jeffrey Skilling served 11 years in prison
- Andy Fastow served Five years in prison
- Ken Lay was convicted but died of a heart attack prior to sentencing
- Sarbanes-Oxley Act passed soon after*
*It’s been observed that the provisions in SOX very closely reflect the fraud committed by Enron.
