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The failure of Enron in the early 2000’s is one of the largest bankruptcies in US history (with Lehman Brothers in 2008 as the largest). Its accounting scandal led to Enron’s bankruptcy as well as the dissolution of Arthur Andersen, one of the big five accounting firms. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts.
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Today the name “Enron” still evokes a reflexive repulsion, a feeling that these were simply bad people doing illegal things. But, we think, that’s in the past. Surely we’ve evolved as a society, and by thinking hard enough, you or I can avoid these problems.
In reality, when you dig into the details, Enron’s downfall is the predictable mixture of human greed, poorly structured incentives, and lack of sanity checks when everyone has their fingers in the pie.
You might be surprised to learn that most of Enron’s accounting tactics were not technically illegal at the time - they were actually publicly celebrated for being financial innovations. Shareholders, employees, investment bankers, and accountants all benefited from the situation and enabled Enron for years. They only stopped when it became untenable.
The most important takeaway from The Smartest Guys in the Room is to understand the key enabling conditions for Enron’s deception. When multiple conditions mutually reinforce each other and create positive feedback loops, a massively outsized result - a lollapalooza - can happen.
These are also the warning signs you can use to detect unstable situations and desist from bad behavior.
Accounting practices that disguised the fundamentals
The root of Enron has to be the accounting tactics that enabled deception. They let Enron book more revenue than they actually earned; keep losses and debt off balance sheets. If these were disallowed, the money-losing state of Enron would have been apparent far sooner.
- Mark-to-market accounting allowed booking the total value of a deal immediately, rather than spaced out over time.
- Complicated SPE deals allowed Enron to borrow money while keeping it off their balance sheet
- One-time asset sales were booked as recurring revenue
- Deals that were actually dead were fictitiously kept alive to avoid a writedown that quarter
All this structure became so convoluted that no one totaled up the big picture. No one pieced together the dependencies between Enron’s deals, and how the dominoes would fall if Enron’s stock price fell.
Lesson: Resist the temptation of clever accounting tricks that mislead on fundamentals, even if they’re technically legal. You may eventually deceive even yourself on the true fundamental strength of the situation.
Poorly constructed compensation structures that rewarded unprofitable behavior
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A pattern of Enron’s compensation style was to reward short-term behaviors (like stock price or closing deal sizes) without concern for long-term value (like profitability). And according to the book’s author, Skilling happily fed greed, believing it was the best motivator for performance.
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- Deal makers were given bonuses for the deal value when it closed, not on the generation of actual cashflow. With optimistic projections, deal makers got paid for bad unprofitable deals.
- Employees got bonuses for short-term stock prices, thus incenting bad behavior to prop up stock price.
- Senior managers like Skilling got large bonuses for stock performance. This prompted over-optimistic projections to Wall Street, which intensified the speed of rushing into bad businesses (Enron Broadband) and created end-of-quarter scrambles to make earnings.
Lesson: Make sure your compensation structures align with the fundamental goals of the business, and that there are balancing check points
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Believable guiding visions
These party lines began with good intentions, but as Enron slipped into a gray zone, they helped justify bad behavior.
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Enron saw itself as revitalizing an industry populated by dinosaurs and bringing efficiency through privatization and free markets. With a missionary
Andy Fastow’s department saw itself as a financial wizard, pushing the boundary of possibility while staying within the lines of...
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