The Enron and WorldCom Accounting Frauds
If the financial statements lie, no amount of hard analysis helps. Enron and WorldCom showed how powerless an investor becomes "when the numbers themselves cannot be trusted."
Enron: Hidden Debt
Enron was a giant U.S. energy company, once praised as the most innovative firm around. But in reality it was hiding enormous debt off its books using complex special-purpose entities and inflating its profits.
When the truth came out, its stock became essentially worthless, and in December 2001 Enron filed for bankruptcy with about 65 billion USD in assets. It was the largest bankruptcy in U.S. history at the time.
WorldCom: an Even Bigger Bankruptcy
Before the shock of Enron had even faded, an even bigger accounting fraud came to light at the telecom giant WorldCom. WorldCom inflated its profits by about 3.8 billion USD by improperly (deliberately) treating expenses as assets.
On July 21, 2002, WorldCom went bankrupt with about 107 billion USD in assets. It surpassed Enron as the largest bankruptcy in U.S. history at the time. Both cases shook market trust at its foundation, in that even the accounting firms supposed to audit them were implicated.
The bankruptcy of an individual company is a different risk from a crash of the whole index. One reason for diversifying is precisely to reduce this risk of "a single company going to zero."
The Birth of the Sarbanes-Oxley Act
As these successive accounting frauds destroyed investor trust, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002. This law made executives directly responsible for the accuracy of financial statements and sharply strengthened auditing and internal controls.
Enron and WorldCom seared in the idea that the question "can this financial statement be trusted" matters as much as "how to read financial statements." And they once again showed the pattern of regulation being strengthened only after a major crisis.
Preguntas frecuentes
Q. Can individual investors detect accounting fraud in advance?
It is hard to know perfectly. These were cases that even professional auditors missed. However, a few signals — such as profits surging while operating cash flow fails to follow — can be worth watching. Fundamentally, not betting everything on one stock through diversification is the realistic defense an individual can take.
Q. Did accounting fraud disappear after SOX?
It decreased but did not disappear entirely. Regulation only makes certain types of fraud harder; new forms of problems keep appearing. So rather than "the system exists, so I'm safe," an attitude of pairing diversification with risk management is needed.
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