The Enron Collapse

The Enron Collapse

The world’s view of Enron changed dramatically in October of 2001. The accounting team reported a non-GAAP “pro forma” net income of $393 million. However, with the GAAP rules enforced, their net loss was $644 million (a billion dollar difference!). The notes to the financial statements didn’t explain in detail where this $1 billion difference came from. There was evidence of a $1 billion charge that was due to related party transactions.

Investors were extremely suspicious of the overall health of the company and within weeks the stock price had plummeted to around 25 cents per share. This story really demonstrates the importance of trust. Once investors no longer trusted Enron’s accounting, they immediately took their money elsewhere. Later that year (in 2001) Enron claimed bankruptcy.

Enron Scandal Explained

The Enron accounting scandal is complex, but it basically stemmed from two areas: (1) Special Purpose Entities and (2) Gross Trading Revenues.

Special purpose entities are basically companies that are formed to help the main organization. For example, if a company needs someone to take care of their landscaping and there is no other legitimate company around that can do this for them, then they can form their own company to perform the landscaping function. Seems innocent enough right? Well the problem is that Enron used these companies to drive up their own profits. Enron would make deals with its special purpose entities (SPEs) that were not arm’s length transactions. The deals would hurt the SPEs financially, but dramatically increase Enron’s financial position. Many believe that the auditors from Arthur Anderson should have seen the way that these SPEs were being abused and should have made investors aware of the situation. Arthur Anderson, then one of the largest accounting firms in the world, collapsed within months.

In addition to SPEs, Enron used a loophole in the way they recognized revenue. This loophole allowed them to...