Arnold Kling

Enron Specifics

Arnold Kling, Great Questions of Economics
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Most pundits who have commented on Enron have dealt in generalities. For some specific understanding of how Enron hid its problems and then collapsed, this testimony by law professor Frank Portnoy is worth reading. For example, Enron parked shares of some high-flying stocks in a subsidiary called Raptor, using a complex loan transaction.

Enron got the best of both worlds in accounting terms: it recognized its gain on the technology stocks by recognizing the value of the Raptor loan right away, and it avoided recognizing on an interim basis any future losses on the technology stocks, were such losses to occur.

It is painfully obvious how this story ends: the dot.com bubble burst...at the start of these deals, Enronís obligation amounted to seven percent of all of its outstanding shares. As Enronís share price declined, that obligation increased and Enronís shareholders were substantially diluted. And here is the key point: even as Raptorís assets and Enronís shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

Of course, what is on every investor's mind is the question of how many other Enron's are hiding out there? Portnoy says,

...accounting subterfuge using derivatives is widespread. I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a companyís transactions.

After reading this testimony, I am struck by the amount of effort and expense required to construct Enron's Potemkin Village. Although it is possible that there are other companies that are as focused on creating an accounting mirage of profitability, it strikes me as unlikely.

Discussion Question. Portnoy lists a number of "gatekeepers" who might have made a fuss over Enron's business and accounting practices: auditors, investment bankers, law firms, credit rating agencies, and stock analysts. What can be done to increase the incentives of such parties to blow the whistle on abuses?

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