From Enron to Here on In: Unravelling the mysteries of financial reporting and valuation

Back in the 1990s, Enron Corporation was the darling of Wall Street. The energy company, one of America’s largest, was riding a tide of deregulation, hailed for its innovative use of technology and enjoying the considerable spoils of its ambitious expansion efforts. At its peak in 2000, Enron shares were trading at $90.75. Then the unthinkable happened. In October 2001, the share price tumbled to $0.26—and the company subsequently declared bankruptcy. The American Dream turned into a nightmare—and it happened almost overnight.

Enron effectively buckled under the weight of its own expansion, but the company’s downfall still came as a massive shock to its investors. How could any organisation see its share price skyrocket only to become the largest bankruptcy reorganisation in US history in less than a year? Customers, employees and shareholders, who saw the value of their stock plummet to less than $1 by November 2002 wanted answers.

History tells us that Enron’s woes were essentially concealed by high-risk accounting and auditing practices. When the US Securities and Exchange Commission investigated the bankruptcy, they found that the company had shifted to mark-to-market (MTM) accounting—a method that meant they could report expected profits as actual profits, and measure the value of a security based on market instead of book value. When the crash hit Enron hard, MTM accounting enabled top brass to essentially write off its debt and hide its losses from its shareholders, but the strategy could only hold for so long. As its true value went into freefall, the company was forced to acknowledge its failure and shift to liquidating assets to pay its creditors—all this to the shock of Wall Street.

But some had seen the spectacular Enron bankruptcy coming. At Cornell University, a handful of MBA students had prepared a project for an accounting class; one that took a hard look at Enron’s actions against the probability of energy deregulation, the prospects of international power projects, and the position of Enron’s main competitors. What they found was that Enron stock was hugely overpriced—a result, they surmised, of the company manipulating its earnings.

Enron cooked the books, and its demise led to sweeping regulatory reforms in the US. But why were so few analysts aware of what had been going on? And why did the downfall of the darling of Wall Street come as such a shock?

In reality, financial reporting can be a minefield for prospective investors. Reading, understanding and competently interpreting financial statements is absolutely critical to forming any kind of accurate valuation—and making sound investment decisions. What’s more, financial statements are only as good as the information they rely on. If you can’t determine the quality of that information—if you can’t spot inaccuracies, distil and rectify distortions in the data—it becomes hard to ascertain true value from face value from over-inflation.

And even when financial reporting sits squarely within the rules, those rules are prone to change. The financial regulatory landscape was re-drawn in the fallout of the Enron scandal, but continues to evolve dynamically in more than 20 years since then. Had more of Enron’s investors bothered to dig a little deeper and do the forensic work of looking beyond the numbers, comparing across like-for-like firms and looking at accounting rules—had they gone into more aggressive financial detail to ascertain the true value of the company, like the Cornell MBA students did — they might have been able to strip away the inaccuracies and foresee what was coming.

At LSE, our faculty dedicate their careers to understanding the complexities of financial reporting and auditing, and making sense of the data inputs used by organisations. And we share the insights of our research with executives and leaders to help you make the best-informed decisions based on all of the data available.

To that end, we are launching a new programme that seeks to empower decision-makers to interpret financial statements and forensically evaluate their quality in order to accurately forecast future earnings.

Financial Statement Analysis and Equity Valuation leverages case studies and real-world financial statements to help you develop an integrated approach to fundamental analysis and equity valuation. We teach you the tools and techniques to challenge assumptions, to cleanse financial information, and to spot and correct biases in the data. Having identified potential distortions, you are then better equipped to make accurate assessments of the real or underlying value of any kind of equity investment in front of you. Together, we explore the regulatory landscape and see how changes in legislation impact information shared in financial statements – and your capacity to make well-informed valuations.

Financial reporting and equity valuation can be a minefield for even the most seasoned managers and decision-makers. With the best will in the world, and even assuming that most financial statement preparers have no incentives to cheat, people will make mistakes. A financial report might be essentially right, or it might be fatally flawed. Keeping up with the latest rules, the latest regulations and innovations in the accounting and reporting space is of paramount importance in deciphering the reality from the projected or the wishful. And while all of this may sound impossibly hard, it is in fact, straightforward with the right guidance and support.

To paraphrase Cornell Professor Charles Lee, whose students unearthed overpricing in Enron’s stock long before the company crashed: “All the facts were hiding in plain sight. With the right tools and motivation, it was no real mystery.”