Financial Statement Manipulation: The Enron Saga

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*****On this anniversary of what's regarded as the stock market bottom of 2009, I can't think of a better time to tell this cautionary tale. 

Although Enron was not a small-cap stock when its troubles came to light, the problems disclosed are instructive and can serve as an objective lesson on why you need to be careful when relying on financial statements.

In hindsight, the name is synonymous with a vast array of unsavory doings. Once esteemed as a big player in the big business of energy, Enron was a disaster, and its management fooled many people. Those deceived include the Dow Jones Company, which added Enron to its prestigious Dow Jones Utility Average (and then quickly removed it once the real problems were disclosed). Enron, indeed, turned out to be a house of cards. Thousands of jobs lost, and billions of market capitalization evaporated in a short period of time, wiping out the investment accounts of employees and investors. Reputations, careers, and lives were devastated.

What started as a legitimate energy pipeline company that turned out big profits for years, Enron altered its numbers to continue reporting ever-greater profits and stock price, reporting inflated and non-existent profits through intentional and illegal accounting tricks. The greed of management drove a series of bad decisions to report growth where there simply was none. Remember, investors love growth. Wall Street analysts and investors want to see consistent improvements in the key financial metrics, including revenues, net income, EPS, gross margins, and cash flow.

*****And, boiling it down to its essence, the debacle that was Enron largely focused on bookkeeping—or, more accurately, bookkeeping that's sole reason for existence was to hide the financial iceberg that Enron was doomed to strike. Making matters worse, Enron's auditing firm of Arthur Andersen, once hailed as beyond reproach, was charged with conspiring to help Enron hide the truth, a fact that led to the dissolution of the entire auditing company.

Here are the details, in a nutshell: Enron created offshore entities, units used primarily to avoid taxes and to hide operating losses. They also provided the company's principals and managers with full anonymity that would shield the massive losses. As with many lies, small ones spawned larger ones, which then made it necessary to cover up more. The idea was to make Enron look more profitable than it actually was; moreover, the scheme created a maelstrom in which corporate officers went deeper and deeper into deception every quarter to foster the illusion of billions in profits while the company was bleeding losses.

For a while, it worked. Enron's stock soared. Company executives leveraged the inflated price to cash in their stock options and sell the stock, making them millions in gains that were used to buy multimillion dollar homes in Houston's nicest neighborhoods as well as vacation homes around the country. This all occurred because Enron executives were lured by incentive compensation. Their annual bonuses and options were all tied to profits and stock price levels, so they had a direct financial incentive to lie.

*****Yet another problem was the involvement of ambitious partners in Arthur Andersen's Houston offices. Originally, the firm was known for its ethical standards (founder Andersen himself was once fired by a client for refusing to cook the books; that company went out of business soon after, but this set the tone for Andersen as the most ethical of the public auditing firms). However, in more recent times, management changed the rules and instituted a requirement that all auditing partners had to bring in two dollars of non-audit revenue for every dollar earned from audits. This made it increasingly difficult for auditors to blow the whistle and, in the case of Enron, put the partner right in bed with the false statements prepared by Enron.

Some revisionists have tried to portray the Enron story as an unfortunate series of poor decisions. The ugly truth was, while Enron insiders knew all too well that the company was teetering on financial collapse, the company's investors were kept completely in the dark. We all know too well how that little tableau played out. But, within the devastation that Enron wrought, there's a vital lesson for everyone, including small-cap investors. For all the importance that we place on the numbers and reports companies are required to provide, there are many ways to make all that data appear far rosier than it is, and many of those ways are all too easily manipulated.