Even though it's easy to ignore at this point, investors should pay attention to the Enron trial. After all, the collapse of Enron occurred nearly five years ago. It's ancient history, and there's more than enough current bad news in the world. Some really young investors may not even remember Enron.
The arcane details of an accounting scandal don't usually excite the general public. However, by some measures, Enron was the seventh-largest company in the country, and it imploded in a matter of months, essentially becoming worthless, and over $60 billion of investor wealth simply disappeared.
The Enron collapse was far worse than the problems at Tyco International (NYSE: TYC ) , Martha Stewart's personal foibles and their impact on Martha Stewart Living Omnimedia (NYSE: MSO ) , or the snafus at Krispy Kreme (NYSE: KKD ) . Enron was a catastrophe in the public markets. Individual investors should take a hard look at the trial so they know what happened and how it came to be, with the intent of learning to avoid companies that exhibit the same characteristics in the future.
A brief history of the scandal
For those who want the full story, there are a number of great resources, including the following:
For those who want the story in an abbreviated, more entertaining format, I highly recommend the movie Enron: The Smartest Guys in the Room.
Before jumping to conclusions and thinking, "I would have never bought that dog," it's important to remember what people knew at the beginning of 2001. Investors were looking at a company that was a darling of Wall Street, with dynamic leaders who appeared to be revolutionizing the energy and trading markets. Revenue and earnings growth were consistent and stunning. Even one of the sharpest Fools, Bill Mann, admitted to believing that Enron was a tremendous growth story.
Hindsight and previously hidden information now expose the sad truth behind the astonishing revenue growth and mysteriously disappearing debt. Hyperaggressive accounting generated the massive revenue growth. This article shows just how they did it. To make its debt "disappear," Enron set up the now infamous third-party partnerships. These entities were funded by outside investors, who received Enron stock as collateral. Enron would sell non-performing (i.e., debt-laden) assets to the third-party partnerships, get the cash from the investors, record the cash received as earnings, and no longer show (i.e., hide) the debt. Unfortunately, the debt wasn't gone -- it was in the partnerships, and Enron was guaranteeing a return to the investors in those partnerships with Enron stock. The scheme worked while Enron stock was going up, but when the stock went down, the magic bus went over the cliff.
The Enron case is an extreme example of just how malleable accounting can be. Knowing this garbage can pass the scrutiny of corporate lawyers and accountants should remind us to look twice at our investments. Here are a few simple questions that would have helped investors steer clear of Enron, or at least get out before the total collapse:
How does the company make money?
Back in 2001, Bill Mann couldn't answer this one, and that's what kept Enron out of his portfolio. Peter Lynch is famous for advising investors, "Buy what you know." I've interpreted this to mean: "Buy what you understand." If you know where the money is coming from, it will be a lot easier for you to know when things aren't right.
Does the company provide clear financial statements?
Enron's financial statements were a labyrinth, omitting both the balance sheet and cash flow statement. Companies should make it easy for you to know what's going on, not difficult.
Is management forthcoming when asked about the company's financial condition?
When Jeffrey Skilling was asked why the financial statements did not include a balance sheet or cash flow statement, he insulted the analyst with profanity.
Do the rats leave the sinking ship?
Skilling quit in August of 2001 and promptly sold all of his shares. Here's my take: Young, driven guys at the head of successful companies don't often call it quits to spend more time with their families.
The Enron story is tragic on so many levels. Investors thought they were buying into a large profitable company. They convinced themselves it was a modern utility company -- a turbocharged, but conservative investment. At the end, many thought that the government would prevent the collapse because Kenneth Lay had friends in the White House. However, not even size, a stable industry, and friends in the most powerful places could save Enron in the end. Individual investors and employees were duped and lost big.
If management is intent on deceiving investors, there's always a chance that one of your holdings will fall apart even in the face of your best efforts. Diversification of your portfolio is one method you can use to protect your money. You can also sign up for access to the Motley Fool message boards, where community members will help you keep tabs on your current holdings.
For other Foolish lessons on bad accounting:
- The Lessons of Livedoor
- JDS Uniphase's Accounting Woes
- Chicago Bridge Topples Executives
- Joe Nacchio: CEO or Secret Agent?
Robert Aronen owns no shares of any company mentioned. If he were in charge of the trial, he'd find Kenneth Lay and Jeffrey Skilling GUILTY AS CHARGED!!! The Motley Fool is investors writing for investors.