Enron Booked Profits on Deals That Had Not Happened Yet
The collapse in 2001 destroyed a company, took down one of the largest accounting firms with it, and produced the securities law that governs public companies today.
The Accounting at the Centre
Enron transformed itself from a pipeline operator into a trading business. With regulatory approval, it applied mark to market accounting to long term energy contracts.
Under that method, when the company signed a contract spanning many years, it estimated the total profit expected across the entire life of the deal and recognized the present value of that profit immediately.
For contracts traded in liquid markets with observable prices, this is defensible. For bespoke twenty year energy agreements with no market price, the value was a model output based on assumptions Enron chose. The company was, in effect, booking today the profit it hoped to earn over two decades.
Once a company recognizes twenty years of expected profit today, next quarter requires a new deal, and a larger one. The accounting created a permanent obligation to keep expanding.
The Entities
The second mechanism was the special purpose entity. Enron created separate entities, some run by its own executives, and transferred assets and debt to them.
Accounting rules at the time permitted a company to keep such an entity off its consolidated balance sheet if outside investors held a small percentage of the equity. Meeting that threshold allowed Enron to move debt off its own books while retaining economic exposure.
Several of these entities were capitalized partly with Enron's own stock. That created a fatal dependency. If the share price fell, the entities lost the collateral supporting their obligations, and those obligations came back to Enron precisely when it was least able to absorb them.
Why the Auditor Failed
Arthur Andersen served as both auditor and paid consultant to Enron, earning substantial fees from both. That relationship compromised the independence auditing depends on.
The firm was ultimately convicted on obstruction charges relating to document destruction, and although the conviction was later overturned by the Supreme Court, the firm had already collapsed. An accounting firm's asset is its reputation, and the indictment destroyed it faster than the legal process could resolve.
It Was Disclosed
The uncomfortable detail is that much of this appeared in the filings. The related party transactions were described in the footnotes. The accounting policies were stated.
The disclosure was dense and written to be technically complete rather than clear, and almost nobody read it carefully. Analysts largely relied on management presentations and the reported earnings figures. The information was available to anyone willing to read a hundred pages of footnotes, and essentially no one did.
What It Produced
The collapse led directly to the Sarbanes Oxley Act in 2002, which required executives to personally certify financial statements, mandated internal control assessments, restricted auditors from providing certain consulting services to audit clients, and created an oversight board for the accounting profession.
Consolidation rules were also tightened so that control, rather than a percentage threshold, determines whether an entity must appear on the balance sheet.
The Bottom Line
Enron recognized decades of hoped for profit immediately and parked its debt in entities backed by its own shares. Both were disclosed in footnotes nobody read, which is why reading them is now the job.