Enron: An Accounting Scandal That Changed Everything
- By Matthew Briggson
- May 2nd, 2023
Heading into the new millennium, Enron was on top of the world. Or at least, most people on the outside thought so. Enron was ranked in the top 10 on the Fortune 500 list for largest companies in the U.S. and their revenue growth was exponential. They were highly touted as a company of innovation and beloved by most analysts on Wall Street. In a matter of months, the house of cards began to fall, cumulating in the shocking news of the December 2001 Enron bankruptcy.
At the heart of the scandal were fraudulent and manipulative accounting practices which involved hiding billions in debt, inflating revenue, and misstating financial reports. In the accounting world, no other single event has had such a profound impact on the profession in decades.
The Enron scandal was based on three accounting tactics that lead to grossly inflated revenue in their financial statements.
One of the first actions Jeffrey Skilling took when joining Enron was to seek approval from the SEC (Securities and Exchange Commission) to use “mark-to-market” accounting. Enron used mark-to-market accounting to book revenue from long-term contracts, including energy supply agreements, as soon as the contracts were signed, rather than waiting for the revenue to be earned over time. This allowed Enron to book revenue for future transactions that may never have occurred, and to inflate their revenue and profits.
Special Purpose Entities (SPEs)
Enron used special purpose entities (SPEs) to offload troubled assets, conduct risky transactions, and hide debt. SPEs are separate legal entities that are set up to hold assets or liabilities, often to keep them off the balance sheet of the parent company. Enron would often use SPEs to conduct transactions with other companies, booking revenue from the transactions immediately, even though the revenue would not be earned for years to come.
Agent versus Merchant Model
In 1999 Enron launched “Enron Online” which was an electronic trading platform that allowed buyers and sellers to trade a variety of energy-related commodities, such as natural gas, electricity, and broadband capacity.
Under revenue recognition rules, a company that acts as a “broker” of financial transactions between a buyer and seller would recognize revenue under the “agent” model. They act as an intermediary and recognize only the commission or fee collected as part of the transaction.
Enron somehow convinced their auditor, Aurther Anderson, that it was appropriate to recognize revenue in the Enron Online transactions under the “merchant” model. Under this model they recognized the full value of the trades as revenue. They made the argument that they were taking on counterparty risk in the trades even though there was almost always a buyer and seller on each side of the trades.
The abuse and fraudulent practices around mark-to-market accounting, SPEs, and the merchant model resulted in Enron’s reported revenues being roughly 95% overstated. When the dust settled, congress, the SEC, and the FASB rolled out measures that had a substantial impact on the accounting profession. Most notably, the Sarbanes-Oxley Act of 2002 which emphasized auditor independence among other regulations. The Enron scandal and resulting regulatory action shapes much of the accounting industry more than 20 years later.
For more detailed insight into the Enron scandal, you can check out our podcast episode on this topic and earn 1 hour of free CPE. Click on any of the links below to listen!
- special purpose entities
- merchant model