We are approaching the tenth anniversary of the collapse of Enron. Have the lessons been learnt? Enron was the US energy giant that failed only 12 months after its share price rated it seventh largest corporation in America. A handful of tenacious journalists penetrated the miasma of filed data and revealed that the bulk of its reported earnings were unmatched by cash. The share price collapsed and bank support for its energy trades dried up. In late 2001 it filed for bankruptcy.
I once reported on an audit firm whose client’s business was the production of pre-fabricated, collapsible squash courts. It sold these to municipal sports centres in Europe, and secured guarantees for its invoices under the government’s export drive. It then discounted them under a revolving credit facility with its bank, new invoices being matched and offset against earlier ones. When the facility limit was reached the bank obligingly raised it – until it exceeded £5 million. At that point the owner and his family fled the country, not to be seen again.
The only collapsible item was the company itself
There never were any squash courts. The only collapsible item was the company itself, and the only fabrication was the documentation needed to support the outrageous scam. The bank and auditors were too busy matching invoices to notice that there was no cash coming in. A trifling, unsophisticated foretaste, perhaps, of the Enron syndrome: the ability of accounts to generate cashless earnings.
Exploiting accounting foibles
The camouflage at the core of Enron’s machinations was obviously far more intricate. Two devices enabled it to produce accounts that appeared to support borrowing levels. First was the “mark-to-market” accounting aberration. If Enron contracted with the state of Oregon to supply several million kilowatt hours of electricity in five years time in return for $100 million, it was able to enter, as earnings on day one, the market’s anticipation of what that contract would yield on delivery – say $15 million, reflecting the market’s own embedded assumptions on electricity price fluctuations over that period.
The other device was Enron’s creation of thousands of special-purpose entities (SPEs) to keep liabilities off its balance sheet. The company would sell parcels of gas or oil leases to an SPE partnership with other investors. The leases would serve as collateral for loans that the SPE would make available to Enron. Complex paperwork ensured that Enron did not “control” the SPE, so the liability did not appear in its accounts, although many SPEs were managed by unidentified “senior officers” of the company itself. Banks and co-investors were always reassured by Enron’s guarantee to make up shortfalls on SPE asset sales with its own shares.
Burying the truth
When the tangled web of exotic transactions was unraveled two startling facts emerged: (i) there were questionable practices galore, but no proven illegalities; and (ii) the best source for discovering what was really going on was Enron’s own published filings.
The journalists who analysed these could see, for example, that in Q2 of 2000 $747 million of Enron’s reported earnings were unrealized; margins were plummeting; cash flows had all but dried up; its rate of return on capital was less than it paid on external borrowings; and, in four of its last five years, it paid no taxes. The US tax code didn’t recognize mark-to-market accounting: companies were assessed on realized income only. All this was discernible from the company’s own published disclosures.
Enron illustrates the hazards of information overload. The only valid criticism of its published disclosures is that there was too much. The ultimate violation was not that the accounts lied. Rather, they buried the truth in an impenetrable data-jungle. There could, instead, have been a simple statement of the percentage of reported earnings realized in cash.
As accounting standards relentlessly pile on the pages, driving intelligibility into extinction, this is the real lesson of Enron. And we know from accounting travesties exposed in the banking crisis that it has still not been learnt.