The Role of Accounting in Enron’s Downfall
We’ve written about Enron a number of times on our blog. There are several reasons for this. For one, the fall of Enron was one of the most disastrous scandals in the history of corporate America. When the dust settled, thousands and thousands of employees had lost their jobs, pensions, and, in some cases, their professional reputations. The bankruptcy of Enron was among the largest corporate bankruptcy in U.S. history. Another interesting aspect of the Enron scandal was its pervasiveness. The Enron scandal involved corruption at multiple levels, both inside and outside the company. Enron’s law firm was guilty of unethical behavior, as was Arthur Andersen, Enron’s accounting firm. Virtually any player who had a chance to gain something ultimately participated in the downfall. Among other things, the story of Enron shows that unchecked greed can corrupt even those who may otherwise be very level-headed and virtuous.
In this post, we will talk about the role that accounting played in Enron’s decline and fall. There were many factors which contributed to Enron’s ruin, but accounting played a very substantial role. One of Enron’s pivotal development’s was its adoption of mark-to-market accounting. We will discuss this type of accounting, as well as other shady accounting practices which led to Enron’s demise.
Enron’s Misuse of Mark-to-Market Accounting
Different companies use different accounting methods to keep track of their assets, liabilities and overall financial condition. Sometimes, a company prefers a particular method because of its industry. Mark-to-market accounting is an accounting method which tries to portray the value of an asset or liability based on its current market price. This means that mark-to-market takes market fluctuations into consideration. The goal of mark-to-market is to portray the financial condition of a given company with the greatest accuracy. Often, the book value of an asset differs from its actual market value, and so mark-to-market tries to correct this imbalance. Problems arise when the market for a given asset is difficult to define or relatively undeveloped. Problems can also arise during unusual economic conditions, such as a societal wide financial crisis.
Enron’s executives petitioned for and received approval from the SEC to use mark-to-market. Enron misused mark-to-market by deliberately misrepresenting the value of certain assets. For instance, Enron would list the value of a business deal at the time of its signing based on projected future profits. And in some cases, Enron continued to list the value of the deal even after the deal collapsed and failed to yield any profits. This led to Enron reporting a highly inaccurate financial picture of itself to the outside world. In many cases, this was done intentionally by Enron executives to manipulate the company’s stock price.
Use of Phony Companies to Hide Debts and Losses
Along with misuse of mark-to-market, Enron also used phony companies to stash away debts and losses in order to avoid placing them on its own balance sheet. The company’s CFO, Andrew Fastow, became notorious as the principal architect of this strategy. This allowed Enron to lose money and still see its stock price rise on the market. Enron referred to these phony companies as “special purpose entities.” Related party transactions involving special purpose entities are common in the corporate world, but Enron took these transactions to a new level. Enron’s main purpose behind these transactions was solely to hide debts and losses. This deceptive and unethical behavior came to the foreground when Enron’s executives faced prosecution following the company’s collapse.
The Eventual Collapse and Fall
Enron’s steady profits began to draw suspicion from financial journalists and experts in the investment community. Reporters began to wonder how the company managed to consistently meet or exceed growth expectations. When Enron executives were unable to provide satisfactory answers regarding the company’s finances and overall performance, Enron’s downward spiral commenced. Ultimately, Enron’s deceptive practices were brought to light and its stock price began to decline. The true financial picture of the company emerged, and it was far less bright than it had been portrayed to be. Enron’s stock price plummeted in record time. Enron’s top executives sold off more than $1 billion in stock prior to the price decline. Arthur Andersen shred tons and tons of documents as Enron was unraveling. These documents presumably would have provided evidence for Arthur Andersen’s collusion in Enron’s unethical activities.
Enron’s downfall brings a great many issues to the forefront. Among other things, Enron proves that even those who are seemingly at the top of the corporate world are not above highly unethical behavior. Professionals – lawyers, accountants, etc. – can be led astray when there is the prospect of great monetary gain. This is why it’s so important for people who are seeking to hire a professional to exercise caution. No matter what his or her credentials may be, you should investigate a prospective hire to determine his or her character.
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Focus keywords: accounting, mark, market, enron
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