Enron Accounting Scandal Explained! A Frequent Accounting Interview Question!

hey guys welcome to another video by the Financial Controller my name is Bill Hannah and in this video I'd like to discuss another interview question that comes up in accounting and Finance interviews and that is the Enron bankruptcy and the fallout that followed and so we'll be going over the timeline of events as well as the accounting practices that Enron adopted and that led to its demise the story begins with a merger that happened in 1985 between two companies the Houston natural gas company and into North Inc and then that resulted in the formation of the combined entity in Iran the CEO of Houston natural gas at the time was a Ken Lay and he continued to become the CEO of the combined entity and Ron then in 1990 Ken Lay who was still the CEO hired Jeff Skilling Jeff Skilling will become really important in a story later because he becomes the architect of a an accounting technique which will discuss mark-to-market Jeff Skilling was at the time one of the partners at McKinsey & Company which was the consulting company advising Enron in 1992 Jeff Skilling devised a new accounting technique called mark-to-market by which he can adjust the value of an asset on the balance sheet from its historical cost up to the fair market value and capture that difference as a gain or revenue so basically this allowed him to when he built the power plant to look at the value of the power plant today when you built it and then look at its future revenue and then adjust the value of the plant based on the cash flow that it's expected to generate allowing him to capture the projected revenue from that plant as revenue today which is crazy but believe it or not this technique got approved by the SEC in 1992 the effect of using the mark-to-market technique has been incredible for revenue and for the stock performance in general so as you can see the stock has gone from 1990 to the year 2000 from somewhere around $10 a share to somewhere around 85 dollars a share also in the year 2000 Ronn entered the deal with blockbuster to provide a service video on-demand service and so basically this partnership was gonna allow blockbuster to streamline movies online this was before Netflix created the video on-demand service and Enron was gonna provide broadband or the Internet service behind it then what Enron did is that took the profits from the contract that they expect to make in the future and booked it as revenue today in the year 2000 obviously inflating revenue by a big margin and so obviously this deal went nowhere because the technology wasn't there yet and so this was the beginning of the end for Enron because the performance of the business as far as the cash that's coming in wasn't matching up was the revenue that's being booked but for investors including retail and institutional investors the start was a no-brainer to invest in because of the mark-to-market practice that Enron did revenue growth was incredible so this is a stock that had amazing revenue growth and also the debt to equity ratio because you had such an amazing revenue on your books you're able to show tons of profit and that inflated your retained earnings and in the end your debt debt to equity ratio was really appealing and as a result when you have these two factors the stock price was going through the roof and so you really had to invest in the stock if you wanted to make money and because so many people and institutions and pension funds were invested in the stock the fallout of the bankruptcy of Enron in 2001 has such a huge effect on Wall Street a lot of people lost their pensions lost their retirement funds and it was just like a bad situation for many people in 2001 after Enron declared bankruptcy obviously the stock went from 85 or 88 dollars a share all the way down to about 50 cents per share and so as you can imagine Ken Lay and Jeff Skilling were arrested and prosecuted basically the prosecution lasted from 2001 all the way to 2006 during which in 2006 Ken Lay died from a heart attack as he was having health issues prior and I imagine the stress from the prosecution was pretty tough and so he died while in custody and then Jeff Skilling was convicted and sentenced to 12 years in jail Jeff Skilling by the way just got out of jail in 2019 and surprisingly he's back in the business he said that during his jail time he came up with a business plan for an energy software business and so it's amazing I'm not sure how he's gonna be able to get back into the business or if anyone was going to trust him but that's that's basically the news now as far as who's accountable for this disaster at Enron I think you have to think of two parties one is management which was Ken Lay and Jeff Skilling and then two you have to think of the auditors which at the time was the firm Arthur Andersen at the time there were five big accounting firms KPMG PricewaterhouseCoopers Ernst and Young and Arthur Andersen and because of this fiasco here at Enron Arthur Andersen went out of business because many of the big public companies that were using Arthur Andersen for the audit engagements or advisory engagements let go of Arthur Andersen and hire another firm because the public trust was just eroded and nobody trusted also Andersen anymore and so it was a big exodus of partners and staff from Arthur Andersen that went to work then later for the other became big for after the dissolution of Arthur Andersen the other big consequence of the fall of Enron was the enactment of the sarbanes-oxley Act also known as Sox 404 basically sarbanes-oxley states that every company has to have a framework of internal controls the purpose of the internal controls is to ensure the integrity of its financial statements and that management has to sign off on the integrity of the financial statements and on the effectiveness of its internal controls sarbanes-oxley also states that the auditors who signs off on the financial statements of the company not only signs off on the financial statements but also signs off on the effectiveness of the internal controls of the company that's it for this video if it adds any value to you please give me a thumbs up hit the subscribe button and share this video with anyone who you think might benefit from it and see you in the next one [Music]

Channel: The Financial Controller

Views: 187,078

Keywords: Enron, Accounting Fraud, Accounting Scandal, Financial Crimes, Accounting Interview, SOX 404, Sarbanes Oxely

Id: SMT5v5zT5KQ

Length: 6min 58sec (418 seconds)

Published: Sun Feb 23 2020