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June 24, 2005

"Enron: The Smartest Guys In The Room"

Nate, Jo, Cintra and I caught the 9:20 of "Enron: The Smartest Guys In The Room" at the Varsity tonight. (Richard bagged out after viewing the trailer, claiming that his "blood was boiling, and he didn't want to spend the evening pissed off.")

As it happens, Richard was right. The movie is really, really, really depressing. Colin Covert of the Minneapolis Star Tribune calls it "the horror movie of the year" and he's not too far off.

I'd followed the Enron story in the papers, of course, but had never seen the whole atrocity put together in a coherent, linear, accessible fashion. Director Alex Gibney, working from the book of the same name by Bethany McLean and Peter Elkind (and interviewing both of them for the film), has put together the pieces.

The spark that touched off Enron was a financial innovation called mark-to-market accounting. It allows me to book the estimated future value of a given asset in today's dollars, and claim that value on my balance sheet.

I know not everyone reading this blog has an MBA, so let me put it in English.

Let's say I've closed a piece of business with Customer X. The core is a $1,000,000 project, with ongoing fees of $50,000 a month. Under conventional, accrual-based accounting, my business can only recognize (or "book") revenue as I do work. Thus, when the project is 10% complete, I can claim 10% of $1,000,000, or $100,000. Assuming that I am able to get the whole project done in six months, and am able to get six months of monthly revenues from Customer X, I will be able to book $1,000,000 for the project and 6 x $50,000 = $300,000 or $1,300,000 in the first year. I then give this number to the public - analysts, shareolders, and so on - to let people know how well my business is doing. $1.3M in sales! Go team!

Mark-to-market accounting is wildly different. In this case, I am estimating future cash from this transaction - basically, guessing - so I can claim it today. So let's say that I guess that this client will like me, and will stay my customer for ten years. Let's further say that I guess this customer will need two more of these kinds of $1,000,000 projects over those ten years. Under mark-to-market, I can justifiably claim all ten years of recurring revenue and all three $1,000,000 projects on today's books.

In case you're not handy with the calculator, my $1,300,000 in the first year just turned in to $9,000,000. Go team!

Now. You're Enron. You want your stock price to go up. Stock prices are a function of many things, but one biggie is smooth, predictable earnings - as long as a business is ever-more-profitable, its stock will rise.

Do ya think there might be the teeniest, tiniest bit of pressure inside a company using mark-to-market to, oh, say, be pretty flamboyant with their estimated future projections?

Do ya think that, oh, maybe, golly, a few of those flamboyant estimates might not pan out? Those ten-year super-happy customers might actually leave in Year 2 or something, taking the remaining 8 years of projected future revenue with them?

What do you do then?
(How do you cover it up?)

Well, one thing you can do is to manipulate the California electricity market to the tune of $30 billion. That might buy some time.

But here's the deal: Enron had help. Since they were printing (counterfeiting) money, they had plenty to go around to the lawyers, the bankers, the watchdogs, the auditors, the analysts, the politicians, everybody. Everybody got a taste. People who didn't play ball - analysts, for example, that had the temerity to ask hard questions - lost their jobs. So why not just shut up and cash the check? Everybody is doing it.

So the Enron story is really about the damage we all do when we observe wrongdoing - when we know something stinks - and yet we do nothing. In the Enron mess, this silent complicity led to tens of millions of people getting screwed - customers, employees, shareholders, citizens of California - and for what? A measly few hundred million dollars in ill-gotten gains?

Think about that. The combined value of the looting from Enron's top executives - $200 million here, $39 million there - is still less than Jeff Bezos' net worth. And they had to screw tens of millions of people to pull that off?

The justice system seems somewhat ... inadequate to deal with this.

I need to go take a shower.

See this movie.

UPDATE, September 10, 2005: One or more of the original hyperlinks on this page expired, and has been dereferenced. The hyperlinked text is now underlined.

UPDATE, November 18, 2005: One or more of the original hyperlinks on this page expired, and has been dereferenced. The hyperlinked text is now underlined.

Posted by Gavin Shearer at June 24, 2005 12:47 AM. Posted to Entertainment.

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