Creative accounting doomed Enron

What does an auditor actually do?

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Ever wonder how a company can go from $13 billion to $100 billion in revenues in less than five years or how its stock price can go from $90 a share to $0 in 12 months? Simple answer: accounting fraud combined with a weak auditor.

At the time of its filing, Enron was the biggest corporate bankruptcy ever. But how did this happen?

Its important to understand how a company interacts with its auditor. Arthur Andersen was Enron’s auditor. Enron prepared financial statements based on management’s knowledge and Andersen would test the assumptions in the statements.

For example, if Enron said it was owed $10 million from customers, Andersen would pull a sample of those accounts receivable and send confirmation letters that said something like, “We are auditing the books and records of Enron and Enron claims you owe it $50,000. if this is accurate, please check the box. If its not accurate please explain below.”

A company’s auditor simply verifies what management is presenting.

When Enron went into its period of hyper growth, its financial statements became so complex they were described as impenetrable by financial analysts. During this time, Enron was led by Jeff Skilling, a brilliant executive who joined Enron after becoming the youngest partner in the history of McKinsey & Co., the world’s most prestigious consulting firm.

Skilling the exec

Skilling the inmate

Before Skilling left McKinsey to join Enron, he insisted on a key condition for taking the job: Enron must adopt mark-to-market accounting for the new energy-trading operation that Skilling was to manage.

Mark-to-market (MTM) accounting is a method of valuing assets and liabilities based on their current market value rather than their historical cost. When you check your stock portfolio, MTM accounting is being used — asset values are calculated in real time.

With its fleet of machinery and pipelines, Enron had never had any need for MTM, since MTM is a measure used primarily in the financial industry where stock and bond prices change every second AND such prices are visible and verifiable to players in the market.

 Imagine the discussion inside of Enron:

Bossman: Man, you guys stink. Why didn’t you hit the locker room before showing up in my office?

CoverallsGuy:  Sorry, Boss, but oil and gas are dirty businesses.

Bossman: Well, anyway, this new guy Skilling is coming on board, and he is a heavy hitter.

CoverallsGuy: Great, we need somebody to help figure out the best truck delivery routes and how to get better maintenance deals on our equipment. He know much about transporting sludge? I think it’s the next big opportunity for us.

Bossman: Listen here, you idiot. Skilling is not coming to Enron to hang out in the garage and talk about the trucks and holding tanks. He is bringing a new concept to Enron called Mark-to-Market accounting.

CoverallsGuy: Huh? My brother-in-law is an accountant, maybe he can help us.

Bossman: I have a better idea: Hey Siri, what is Mark-to-Market accounting?

Using this accounting treatment, Skilling and Enron started placing estimated values on all sorts of assets like oil pipelines that never were subject to such accounting. As Enron kept marking up and, in some cases making up, the value of these assets, its stock price kept rising, and Arthur Andersen kept playing along, never questioning or verifying much of anything.

As some say about championship wrestling on television, “it was all fake.”

There were no true increases in value in Enron’s assets, it was just accounting gone wrong. There were many real-time signals during Enron’s rise that most tended to ignore by using the thinking of, “Hey, if it ain’t broke, don’t fix it.” Well, plenty was broke and short sellers (investors that bet on a stock to go down) made a fortune as Enron’s stock price went all the way from $90 per share to $0.

In the end, Enron filed for bankruptcy, Skilling was sentenced to 20+ years in prison, and Arthur Andersen was in so many lawsuits it was liquidated.

While the Enron fraud was outrageous and received the headlines, the demise of Arthur Andersen was a hidden casualty. I worked with many professionals at Andersen through the years and it was the clear-cut top accounting firm in the industry. Even its peers at the time would have conceded such. A series of bad decisions and lack of oversight in managing its biggest client proved to be Andersen’s undoing.

Key Takeaways

  • The Enron story leads me to my new favorite saying when it comes analyzing failures where the company seems to be cruising with everybody making money along the way until, suddenly, it stops: Something was broken, but nobody dared to fix it.

  • Fraud is a difficult subject. If a person or company wants to commit fraud (which is an intentional deceit), even the best accounting firm in the world could not detect or stop it.

  • Anything that grows at several times the rate of its competitors must be doing something different from the competitors. Dig in and understand the secret sauce before investing in or going to work for such a business.

Things I think about

About 30% of college freshman never make it to the second semester.

This month’s reading recommendations

The Smartest Guys in the Room.
Journalists cover the Enron story end-to-end. The definitive account.

The Art of the Start 2.0
By Guy Kawasaki, original marketing evangelist at Apple

Thinking in Bets
Poker champ turned consultant teaches us how to evaluate risk.

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