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Enron Accounting Scandal

enron accounting scandalDespite constant discussion in the news, what Enron's business was, and what it did wrong is rarely discussed.

There is such a contrast with most Enron scandal reporting. The financial press discusses the accounting treatment as if that's the core issue, while assuming that laypeople have detailed knowledge of the Enron accounting scandal intricacies.

 

What really went wrong with the Enron scandal wasn't an issue of spurious accounting so much as a catastrophic failure of a business model. The accounting scandal, of course, was the means by which Enron hid its poor performance, but that's only one of three major issues swirling around the story.

The Enron accounting scandal boils down to three main issues:

1- energy trading is an invalid business model;

2- extremely high-volatility businesses ought not to be publicly traded;

3- lastly, the shared dependence among finance, auditing, and legal providers and their corporate clients, lead to irredeemable agency conflicts.

The last point has been commented on extensively, but it seems that the first two have largely gone unaddressed.

Energy trading as a failed business model is complex, but deals with the opportunities to game the system when only part of the market is deregulated.

Markets don't like risk. Investors hate surprises, and will hammer stock value over small deviations from consensus estimates (which are, it's worth mentioning, just guesses after all). Companies with high volatility must hedge their risk in order to viably participate in equity markets.

Creative markets have devised any number of clever mechanisms for diversifying risks, including such things as insurance, futures, options, and an astonishing array of derivatives.

 

If a company's core business is in an area of high ongoing volatility that cannot be effectively diversified - it is far better off as a privately held firm, with a close group of investors who understand the risks and can adjust their expected returns accordingly.

For a public company faced with high volatility, the pressure to cook the books to smooth earnings is very high, as we've seen with even quasi-governmental agencies such as Fannie Mae.

Smooth earnings are what the market wants, but is that reasonable? Is the natural profile of corporate performance a steady march to the upper right? If we were in a world where there was no economic cost involved in dissolving companies when their profit trend blipped, perhaps these expectations would be valid.

However, there is significant cost to the company, both in terms of capital availability and employee incentives, when the share price takes a beating. While that threat does provide a powerful motivation for companies to stay on top of their markets, and to deliver the performance necessary to fulfill expectations, the 'no excuses' mentality of the market easily leads to destructive short-term practices. Managers have powerful incentives to hit the numbers no matter the cost, whether it's through layoffs or questionable accounting.

The point is that the focus shifts from the customer-facing side to the accounting side. Investment in and support of new and existing products suffer as all stops are pulled out to make past investments pay off. Between merciless pressure from markets and increased overhead from compliance with Sarbanes-Oxley, many companies are rethinking the value created from being publicly-traded.

There's a good case to be made for public markets taking the focus off of customers in favor of shareholders. After all, customers are easier to satisfy.

 

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