This article is an excerpt from the Shortform summary of "The Smartest Guys in the Room" by Bethany McLean and Peter Elkind. Shortform has the world's best summaries of books you should be reading.
Like this article? Sign up for a free trial here .
What did Enron do wrong, and what do Enron do that was illegal? And why does it still matter now?
You may have heard of Enron, a company that went bankrupt in 2001. But what did Enron do wrong? Amongst other things, Enron’s bad business practices, including dishonest accounting, led to its downfall. Learn the answer to the question “what did Enron do wrong” below.
What Did Enron Do Wrong?
The failure of Enron in the early 2000’s is one of the largest bankruptcies in US history. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts. The Smartest Guys in the Room recounts the rise and fall of Enron, and how the company constructed a massively complex accounting scandal that was doomed to failure.
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. In smaller ways, we too are subject to the same pulls as Enron managers and employees. The warning – if we were put into the same situation, we might not have behaved any differently. The questions “What did Enron do wrong?” and “what did Enron do that was illegal?” have interested analysts for years.
1. Accounting practices that disguised the fundamentals
The root of Enron has to be the accounting tactics that enabled deception. But what did Enron do that was illegal? Accountants 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.
2. Poorly constructed compensation structures that rewarded unprofitable behavior
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.
- 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.
3. Stakeholders/watchdogs overlooking bad behavior as long as they were profiting
Could people have raised the alarm at Enron earlier? What did Enron do wrong? People who could have stepped in and intervened didn’t, often because they had a large personal stake in Enron’s success. Further, the more Enron became a success (like in terms of stock price or deal flow), the more beholden the stakeholders were to Enron.
———End of Preview———
Like what you just read? Read the rest of the world's best summary of Bethany McLean and Peter Elkind's "The Smartest Guys in the Room" at Shortform .
Here's what you'll find in our full The Smartest Guys in the Room summary :
- How Enron rose to become one of the world's most promising companies
- How Enron management's greed led it to start cutting corners
- The critical failures that crashed Enron's house of cards to the ground
