Enron
An American energy group collapsed in 2001 after hiding debt in outsourced companies for years. The case led to major reforms in corporate accounting.
Enron was seen as one of the most innovative companies in the US and seemed to grow brilliantly for years. In summer 2000 the share cost about 90 dollars. In 2001 it came out that large debts weren't on the group balance sheet at all. They sat in companies set up specially for the purpose.
On top of that, income was booked early, sometimes before it had even arisen. The balance sheet therefore showed a company that didn't exist in that form.
When this became known, things moved fast. By the end of 2001 the share was worth less than a dollar. About 4,000 employees lost their jobs straight away, out of roughly 21,000 in total. Many also lost their retirement savings, because a large part of them was in shares of their own employer.
That's an important lesson for you: if your income and your investments depend on the same company, you carry the same risk twice. If it goes bust, you lose both at once. Shares in your own employer are therefore the worst diversified investment there is.
The core of the trick was so called special purpose entities into which debt was moved. Under the rules of the time, Enron didn't have to include them in its group balance sheet. So the group looked far less indebted than it was. There was also a valuation method that booked profits from long term contracts immediately, although they would only arise years later.
In 2002 the US passed a law, the Sarbanes Oxley Act. Since then executives have had to confirm personally that the accounts are correct, and stricter independence rules apply to auditors. The audit firm Arthur Andersen, then one of the five largest in the world, didn't survive the case either.
For your own analysis, Enron shows how important the notes to the accounts are, especially on holdings not on the group balance sheet and on off balance sheet obligations. If you can't work out from the accounts how a company is intertwined, it can't be valued, however good the figures look.
Summary
- Debt kept off the balance sheet makes a company unevaluable.
- Earnings booked before they accrue are a warning sign.
- Your own employer's stock bundles income risk and investment risk.
Did you get it?
How was the debt hidden?
Through companies set up specially for the purpose, which under the rules of the time Enron didn't have to include in its group balance sheet.
Why did it hit employees doubly hard?
Because their jobs and their retirement savings depended on the same company.
What should you watch for in financial statements?
On the notes about holdings and obligations that aren't on the group balance sheet.
Your task
A company reports high profits, but its notes list holdings and obligations you cannot follow. Do you buy the stock anyway? Pick the annual report of a company of your choice and find the notes on holdings and on obligations outside the balance sheet. Write down whether you understand them.
Sources and further reading
- US Congressional investigation reports from 2002 and 2003. View source ↗
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