What was Enron? The scandal that changed accounting

Enron was an American energy and trading company, based in Houston, that was one of the largest businesses in the United States until it collapsed in 2001 in one of history's biggest accounting frauds. Its executives used partnerships, some run by its own finance chief, to hide billions of dollars of debt and make profits look larger. When the truth came out, its shares went from about $90 to under $1, it went bankrupt, and its auditor, Arthur Andersen, fell with it.

In short

• Enron's business was real; its accounts weren't. Off-balance-sheet partnerships kept debt off its books and turned losses into reported gains.
• It went from Fortune 500 star to bankruptcy in about a year, wiping out shareholders and many employees' retirement savings.
• The scandal brought the Sarbanes-Oxley Act of 2002, which made executives personally sign off on their accounts and put auditors under a new regulator.

How did Enron become so big?

It began in 1985, when Kenneth Lay merged Houston Natural Gas with InterNorth, a pipeline company from Omaha; the combined company took the name Enron a year later. At first it ran natural gas pipelines. Then, as US energy markets were deregulated, it turned itself into a trader, buying and selling gas and electricity contracts, and later trading almost anything, from broadband capacity to weather risk.

Investors loved it. Enron reported revenue of $100.7 billion in 2000, and its shares peaked at $90.75 in August that year. The SEC's later complaint notes it rose to seventh place on the Fortune 500. Fortune's surveys named it America's most innovative large company year after year. Jeffrey Skilling, the executive behind the trading strategy, became chief executive in February 2001.

Part of the shine came from an accounting method called mark-to-market. When Enron signed a long-term contract, it booked the whole estimated profit at once, even if the cash would come over many years. Those estimates were Enron's own guesses, and if they turned out wrong, the profit already reported didn't go away by itself. That pushed the company to keep signing new deals to keep reported profits growing.

How did it hide its debt?

Through special purpose entities, or SPEs: separate companies set up for a single deal. Under the accounting rules of the time, as the SEC's complaint against Enron's former finance chief, Andrew Fastow, explains, a company did not have to put an SPE's debts on its own balance sheet if independent outside investors had put in at least 3% of the SPE's assets, and that money was genuinely at risk. Enron used hundreds of such entities. Some were legitimate. Many were not, because the "outside" investor was secretly backed by Enron or was Fastow himself.

A simplified example shows why it mattered. The numbers are invented; the mechanism is the one the SEC described.

1. The starting point. A company owns a power plant on its books at $900 million and has $6 billion of debt against $4 billion of shareholders' equity.
2. The SPE. It sets up an SPE that borrows $970 million from a bank and gets $30 million, 3% of $1 billion, from an investor described as independent.
3. The sale. The SPE buys the plant for $1 billion. The company books a $100 million gain on the sale, and the bank loan sits on the SPE's books, not the company's.
4. The catch. In a side deal, the company promises the investor its money back, plus a return. The investor's 3% is no longer at risk, so the rules say the SPE belongs on the company's books.
5. What honest accounts would show. Put the SPE back, and the $100 million gain disappears, because a company can't make a profit selling something to itself, and the company's debt rises by $970 million.

Enron's real numbers were of that kind. When it finally consolidated one partnership, Chewco, the SEC complaint records, Enron's reported net income fell by $45 million for 1997, $107 million for 1998, $153 million for 1999 and $91 million for 2000, and its debt rose by between $561 million and $711 million in each of those years. Fastow also earned millions personally from running partnerships such as LJM, named after his wife and two sons, that did business with Enron.

How did Enron collapse?

Fast, once outsiders began to look.

Date	What happened
1985	Houston Natural Gas merges with InterNorth; the company is renamed Enron in 1986
Late 1997	Fastow and colleagues begin the partnership deals, starting with Chewco, that the SEC later called fraud
June 1999	Enron waives its conflict-of-interest rules so that Fastow can run the LJM partnership
August 2000	Enron shares peak at $90.75
14 August 2001	Skilling resigns after six months as chief executive; days later an Enron executive, Sherron Watkins, warns Lay in writing about the accounting
16 October 2001	Enron announces a large third-quarter loss and a $1.2 billion cut to shareholders' equity
November 2001	Enron restates its accounts for 1997 to 2000; on 28 November its planned rescue by Dynegy collapses
2 December 2001	Enron files for bankruptcy with $63.4 billion of assets, then the largest in US history
15 June 2002	A jury convicts Arthur Andersen of obstructing justice
30 July 2002	The Sarbanes-Oxley Act becomes law
31 May 2005	The Supreme Court overturns Andersen's conviction
25 May 2006	A jury convicts Lay and Skilling of fraud and conspiracy; Lay dies on 5 July, before sentencing

People who had trusted the numbers paid. About 4,000 employees lost their jobs at the bankruptcy. Many had their 401(k) retirement savings largely in Enron shares, which became nearly worthless. Fastow pleaded guilty in 2004 and served a prison sentence; Skilling was sentenced to 24 years, later reduced by a decade. Lay's conviction was set aside because he died before he could appeal.

Why did Arthur Andersen's fall matter?

Because auditors are the people investors rely on to check a company's numbers. Andersen, one of the five biggest accounting firms in the world, had signed off on Enron's accounts and earned large fees from it for consulting as well as auditing. As Enron's troubles became public, Andersen staff destroyed Enron documents under the firm's document policy. It was convicted of obstruction in June 2002, and the conviction ended its business auditing public companies.

In 2005 the Supreme Court overturned that conviction, ruling unanimously that the jury instructions had not required proof that Andersen knew it was acting wrongly. By then the firm had lost its clients and most of its staff. A firm of tens of thousands of people disappeared over one client, and the Big Five accounting firms became the Big Four.

What did Enron change?

The main answer was the Sarbanes-Oxley Act, signed on 30 July 2002 after the WorldCom fraud added urgency. Its best-known parts:

• A regulator for auditors. Section 101 created the Public Company Accounting Oversight Board to inspect and discipline audit firms, ending self-regulation.
• Limits on auditors. Section 201 bars an audit firm from selling many other services, such as bookkeeping and many kinds of consulting, to the companies it audits.
• Personal responsibility. Under section 302, chief executives and finance chiefs must certify each report, and section 906 makes knowingly certifying a false one a crime.
• Internal controls. Section 404 requires companies to assess their own controls over financial reporting, and their auditors to check that assessment.
• Documents. Section 802 set criminal penalties for destroying or altering records to obstruct an investigation.

The accounting rules for SPEs were also tightened, so that a company has to consolidate an entity it effectively controls, whatever its formal ownership.

Still argued

Whether Sarbanes-Oxley was worth its costs has been argued since it passed. Supporters say it improved the reliability of company accounts and made fraud on Enron's scale harder. Critics, including many smaller companies, say the internal-control rules in section 404 cost far more than expected and discouraged companies from listing their shares in the United States. Studies have found evidence for both effects, and the balance differs for large and small firms.

Enron is not a Ponzi scheme: it had real pipelines, real trading and real revenue, and the fraud lay in how the results were reported. It belongs with the dot-com bubble, which burst in the same years, as a lesson in what investors in the stock market can't see. That lesson comes back in every boom built on numbers few people check, including the arguments over the AI bubble.

Check yourself

• Explain how an off-balance-sheet partnership could make Enron's debt look smaller and its profits look larger.
• Why did the 3% rule fail to protect investors in Enron's case?
• Name two things Sarbanes-Oxley changed and the Enron failure each one was meant to prevent.

Sources

• Complaint: SEC v. Andrew S. Fastow — U.S. Securities and Exchange Commission, 2002
• Arthur Andersen LLP v. United States, 544 U.S. 696 — Supreme Court of the United States, via Legal Information Institute, 2005
• Sarbanes-Oxley Act of 2002, Public Law 107-204 — U.S. Government Publishing Office, 2002
• Arthur Andersen LLP v. United States — Oyez
• Enron scandal — Wikipedia