How accounting fraud bankrupt Enron

WLP Group

Enron was an American multinational in the energy industry. Enron was eventually shuttered in December 2001. It’s fall was a huge milestone and set the stage for the Sarbanes–Oxley Act of 2002 and was a huge stock to American investors and the public since it had been long hailed as one of the largest multinationals in the USA (Fortune had ranked Enron as the most innovative company in the USA for 6 consecutive years). The Enron Scandal is also a story told by many in Singapore and there’s a lot to learn for investors and the public about accounting fraud and the importance of integrity in business.

The story of how accounting fraud led to the bankruptcy and closure of Enron is a long story. Investopedia covers it well and there are a ton of videos on Youtube too.

But we’ll focus on two key points in this post:

  1. Enron’s change to the MTM accounting method
  2. Enron’s use of SPVs and SPEs to hide its debt and bad assets from investors, and to borrow money
  3. Arthur Andersen’s role in shredding documents to cover up Enron’s accounting fraudulent acts

Enron’s change to the MTM accounting method

One of the biggest questions that people have about Enron is this – “How did Enron manage to hide being in a mountain of debt for so long?”. One way that Enron did this was through changing from the traditional historic cost accounting method to the MTM accounting method.

The MTM accounting method refers to how a company tracks the value of its assets. Majority of investment firms use the MTM accounting method since share prices swing up and down on a daily, weekly and monthly basis. But this isn’t usually the case for retail companies like Toys R Us where the value of toys generally stays the same (or depreciates) over time.

Enron was an energy company and since the price of energy materials like gas changes over time, they were able to use that as an excuse to switch over to the MTM accounting method. Many say that this was the start of Enron’s fraudulent practices.

Because Enron now had the freedom to state the “estimate value” of its assets and liabilities, they were able to artificially inflate the value of their assets and artificially deflate the value of their liabilities. This meant that they were able to fool and lie to investors about their losses and make up increasing equity and assets that weren’t actually there.

For example, imagine that Toys R Us switched to a MTM accounting method. Say that they buy a pack of toy cars for $1 per unit. They sell them for $4 per unit in their stores. With the traditional historic cost method, Toys R Us have to state that each toy car is valued at $1 on their balance sheet. With the MTM accounting method, Toys R Us can make up any number they wish, such as $10 per unit, despite each toy car selling for $4 per unit in stores.

This is how Enron created money out of thin air.

Enron’s use of SPVs and SPEs to hide its debt and bad assets from investors, and to borrow money

First, let’s explain these abbreviations. SPV stands for Special Purpose Vehicles and SPE stands for Special Purpose Entity.

Simply put, SPVs and SPEs were legal corporate entities that Enron could start and capitalise. Instead of cash, Enron capitalised SPVs and SPEs with Enron stock. This isn’t usually recommended since the value of shares rise and fall on a daily basis. And since Enron’s SPVs and SPEs were borrowing and taking out huge loans, this meant that they could be asked to provide more collateral with a short time basis.

This is similar to an individual borrowing money and putting his Bitcoin as collateral. He buys a huge number of META shares. But days later, the price of Bitcoin crashes and he gets a margin call – he has to come up with more Bitcoin or cash as collateral. Otherwise, he will be forced to sell his META shares at a loss.

This is obviously bad practice. But Enron was able to hide this by creating SPVs and SPEs. Remember, they’re essentially separate corporate entities (although they’re owned by Enron). So Enron didn’t need to disclose them under their own financial statements since they were technically a liability of Enron’s SPVs and SPEs (which weren’t Enron itself).

Enron did mention their SPVs and SPEs but a lot of people didn’t understand SPVs and SPEs. Also, they underplayed and didn’t disclose what they were doing and it’s extremely difficult to dig up information that companies try to hide. This is something that only became known after the SEC launched an investigation into Enron and when banks asked for repayments on loans that Enron couldn’t pay.

Arthur Andersen’s role in shredding documents to cover up Enron’s accounting fraudulent acts

Finally, let’s talk about Arthur Andersen. Arthur Andersen was one of the largest accounting and audit firms back in 2000. It was widely accepted as one of the top five accounting and audit firms and had a reputation for being honest and trustworthy. Arthur Andersen is now known as a fraudulent accounting and audit firm that was also responsible for accounting fraud done for Enron and Worldcom. A huge fall from fame. 

They misused this trust and the Arthur Andersen stamp of approval helped Enron to hide its fraudulent activities from investors and the SEC for as long as they did.

Arthur Andersen signed off on corporate reports for years and in June 2002, they were found guilty for shredding documents to hide Enron’s accounting fraud from the SEC and investigators. (This charge was later overturned on appeal but Arthur Andersen’s reputation was ruined and the company closed down.)

What can we learn from the Enron Scandal?

This story of Enron serves as a reminder to everyone that in business, trust is everything. Lying and committing fraud may work for a few years. But after a while, everything comes to light. And the lies and sneaking around comes with a cost.

And I’m not referring to just the legal consequences. (I think everyone in Singapore is familiar with the strict laws and sentencing.) Kenneth Lay, who was Enron’s first CEO, died of a heart attack after he was convicted of fraud and conspiracy, and bank fraud.