The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, by the Fortune journalists Bethany McLean and Peter Elkind, is the definitive account of the company whose collapse in December 2001 produced the Sarbanes-Oxley Act, destroyed one of the five largest accounting firms, and gave the audit profession its modern vocabulary of related-party transactions, special purpose entities and management override. McLean had been among the first to ask the question publicly, in a March 2001 Fortune article titled “Is Enron Overpriced?”, and the book, published in 2003, reconstructs from the inside how a gas pipeline company became, in its own telling, the world’s leading energy trader and, in fact, a machine for converting accounting judgments into reported earnings. For an internal auditor it is the foundational case: every control the profession now treats as basic was absent or defeated at Enron, and the book shows how. This guide summarises the book without reproducing it, sets out the mechanisms and the people, maps each failure to audit practice, and ends with a worked example of a UK-listed company’s audit function applying the Enron questions to its own reporting.
In this guide
- The book in one page
- Who McLean and Elkind are, and how the book came about
- The timeline: 1985 to 2006
- The mechanisms: how the earnings were made
- The people, and what each represents
- The gates that failed
- The nine ideas worth keeping
- The vocabulary: fourteen terms defined for practitioners
- What it means for internal audit: the case behind the standards
- The aftermath: trials, Andersen and Sarbanes-Oxley
- The criticisms, and what the book leaves out
- Editions, reading time and how to read it
- A one-hour discussion guide for an audit team
- Worked example: Pennine Foods asks the Enron questions
- Frequently asked questions
- Related guides
The book in one page
| Question | The answer, in our words |
|---|---|
| What is it about? | Enron, formed in 1985 by the merger of two pipeline companies, which under Kenneth Lay and Jeffrey Skilling built an energy trading business, adopted mark-to-market accounting for long-term contracts, expanded into international power, broadband and water, and reported profits that depended on valuation judgments, off-balance-sheet partnerships and the price of its own shares. |
| What was the fraud? | Less a single lie than a system: earnings recognised at the signing of contracts on estimates the company controlled; debt and losses moved into partnerships that were not consolidated; hedges of the company’s own investments backed by its own stock; and a chief financial officer who ran the partnerships and was paid by them. |
| Who were the people? | Lay, the chairman and founder figure; Skilling, the chief executive who built the trading culture; Andrew Fastow, the chief financial officer who built the partnerships; Rebecca Mark, who built the international business; Sherron Watkins, the vice president whose memo warned Lay; and Arthur Andersen, the auditor that signed the accounts and shredded the documents. |
| How did it end? | Skilling resigned in August 2001; Watkins wrote her memo; the third-quarter results in October disclosed a $1.2 billion reduction in equity; the SEC opened an inquiry; the company restated four years of earnings in November; a rescue merger collapsed; and on 2 December 2001 Enron filed the largest bankruptcy in American history to that date. |
| What followed? | Andersen’s conviction and collapse; the Sarbanes-Oxley Act of July 2002; the convictions of Fastow, Skilling and Lay; and a generation of audit requirements built on the case. |
| Why read it as an auditor? | Because it is the origin story of the profession’s current rules, and because the mechanisms it describes, aggressive estimates, structures designed to pass tests, related parties at the top, a board that approved what it did not understand, and an auditor that was also a consultant, recur in every decade. |
| Reading time | About eighteen hours for the 440-page paperback; it is long, detailed and rewards the time. |
Who McLean and Elkind are, and how the book came about
McLean was a Fortune writer and former Goldman Sachs analyst whose 2001 article, prompted by a short seller’s question about how Enron made its money, was the first mainstream challenge to the company’s valuation; Skilling famously called her unethical for asking. Elkind was a Fortune editor-at-large with a long record in investigative reporting. They wrote the book in the eighteen months after the bankruptcy, with access to hundreds of former employees, the congressional and bankruptcy investigations, and the documents those produced. Portfolio, a Penguin imprint, published it in 2003, and an updated paperback edition followed in 2004. It became a documentary in 2005 and has remained the standard narrative of the case; McLean went on to write on the 2008 crisis and on corporate scandal more broadly. The book’s strength is its understanding of the business: unlike most scandal narratives, it explains how the trading operation, the international projects and the partnerships worked and why each produced the accounting it did.
The timeline: 1985 to 2006
| Date | Event | Why it matters |
|---|---|---|
| 1985 | Houston Natural Gas merges with InterNorth; Lay becomes chief executive of the combined company, soon renamed Enron | A regulated pipeline company with a leader who wanted it to be something else |
| 1990 | Skilling joins from McKinsey to build the gas trading business, the “Gas Bank” | The trading model and the culture arrive together |
| 1992 | The SEC permits Enron to use mark-to-market accounting for its gas trading contracts | Earnings become estimates; the whole future profit of a contract can be booked at signing |
| 1993 to 1998 | International expansion under Rebecca Mark, including the Dabhol power plant in India; the retail energy business; the performance review system known as “rank and yank” | Growth bought with capital that did not earn its cost; a culture that rewarded reported results |
| 1997 | Chewco, a partnership controlled by an Enron employee, is created to keep a joint venture off the balance sheet when a partner withdraws | The first structure that failed the consolidation rules in substance |
| 1999 | Fastow forms LJM1 and then LJM2, partnerships he manages and profits from, which buy assets from Enron and hedge its investments; the board waives its code of conduct to allow it; EnronOnline launches | The related-party machinery, approved by the board |
| 2000 | The Raptors, structures that hedge Enron’s merchant investments using Enron’s own stock; the broadband business and a deal with Blockbuster that is booked on projections; the share price peaks near $90 in August; the California energy crisis begins | Peak earnings, peak fragility |
| March 2001 | McLean’s Fortune article asks how Enron makes its money | The first public question |
| August 2001 | Skilling resigns after six months as chief executive; Watkins sends her memo to Lay warning of an accounting scandal | The insiders know |
| October to November 2001 | Third-quarter results disclose a $618 million loss and a $1.2 billion equity reduction from the partnership unwinds; the SEC inquires; Enron restates 1997 to 2000, reducing earnings by $586 million; Andersen shreds documents | Collapse of credibility |
| 2 December 2001 | Bankruptcy; about $63 billion in assets | The largest to that date |
| 2002 to 2006 | Andersen convicted of obstruction in June 2002 and ceases auditing (the conviction is later overturned); Sarbanes-Oxley enacted July 2002; Fastow pleads guilty in 2004; Lay and Skilling convicted May 2006; Lay dies in July 2006 and his conviction is vacated; Skilling sentenced to 24 years, later reduced | Accountability and reform |
The mechanisms: how the earnings were made
The book’s central achievement is to explain the accounting in terms a reader can follow, and an auditor should be able to reproduce the explanation. Four mechanisms did most of the work.
| Mechanism | How it worked | The judgment it depended on | The control it defeated |
|---|---|---|---|
| Mark-to-market on long-term contracts | The estimated present value of a twenty-year energy contract was booked as profit when it was signed; later changes in estimates were booked as further profit or loss | The price curves and discount rates for years in which no market existed, set by the traders whose bonuses depended on them | Independent valuation; a price-verification function separate from the front office; the model risk audit of the curves |
| Special purpose entities and consolidation | Assets and debt were placed in partnerships that met the accounting test for non-consolidation (3 percent outside equity at the time) in form but were controlled by Enron in substance; Chewco failed even the form | Whether the outside equity was real and at risk | Substance-over-form review of structures; the audit committee’s understanding of each; the auditor’s independence from the structuring fees |
| Related-party partnerships | Fastow managed LJM1 and LJM2, which transacted with Enron at prices that produced the earnings Enron needed and returns that enriched the partners | That the board’s waiver of the conflict and the “procedures” to manage it were sufficient | Conflict of interest prohibition; independent review of each related-party transaction; disclosure that said what the structures were for |
| Hedges backed by Enron’s own stock | The Raptors hedged declines in Enron’s merchant investments, but their capacity to pay came from Enron shares, so when both fell the hedge failed and the losses returned | That a company can hedge itself with itself | Economic-substance review of hedges; counterparty credit analysis that looks through to the source of funds |
Around these sat the supporting practices: prepays with banks that were loans in substance and operating cash flow in presentation; the broadband business booked on projected revenues from a service that did not exist; international assets carried at values nobody would pay; and a performance culture in which the quarter’s number was the only truth. The audit risk guide describes inherent risk; Enron is the illustration of what high inherent risk looks like when every mitigating control is captured.
The people, and what each represents
| Person | Role | What the book shows |
|---|---|---|
| Kenneth Lay | Founder, chairman, chief executive at the end | A leader who delegated the business, cultivated politicians and believed the company’s story; convicted of fraud and conspiracy in 2006 |
| Jeffrey Skilling | Chief operating officer, then chief executive for six months in 2001 | The architect of the trading culture and the mark-to-market model; the man who called a questioning fund manager a name on a public call; convicted on nineteen counts |
| Andrew Fastow | Chief financial officer | The builder of the partnerships, paid by both sides of the transactions he arranged; pleaded guilty and testified against the others |
| Rebecca Mark | Head of Enron International and later Azurix | Growth by deal-making with capital that never earned its return; the book’s study of incentives for closing rather than operating |
| Sherron Watkins | Vice president of corporate development | The internal warning: her August 2001 memo to Lay described the Raptors as an accounting scandal waiting to happen; the response was to ask lawyers whether she could be fired |
| Arthur Andersen | Auditor and consultant | Fees of about $52 million in 2000, roughly half for consulting; the engagement team overrode its own technical experts; the document shredding ended the firm |
| The board | Directors including an audit committee chaired by an accounting professor | Approved the conflict waivers and the structures; relied on management and the auditor; later found by a Senate subcommittee to have failed in its oversight |
| Bethany McLean | The journalist | The outsider who asked the question the insiders had stopped asking |
The gates that failed
- The board and audit committee. The directors three times waived the code of conduct to allow the chief financial officer to run partnerships trading with the company, approved structures they did not understand on presentations lasting minutes, and accepted the auditor’s assurance. The 2002 Senate report concluded that the board had knowingly allowed high-risk accounting and conflicts of interest.
- The external auditor. Andersen’s Houston office signed the accounts, earned consulting fees from the structures, overruled its own professional standards group on the Raptors, and destroyed documents when the SEC inquiry began.
- Internal audit. Enron had outsourced its internal audit function to Andersen in the 1990s, so the internal and external auditors were the same firm; the book treats the arrangement as part of the capture.
- The lawyers. Inside and outside counsel reviewed the partnerships and drafted the disclosures; the Watkins memo was referred to the company’s law firm, which reviewed it and concluded that no further investigation was needed.
- The banks. Several major banks structured the prepays and invested in the partnerships, and later paid billions in settlements.
- The analysts and rating agencies. Buy recommendations persisted until weeks before the bankruptcy; the rating agencies kept the company at investment grade until it was too late to matter.
- The regulator. The SEC had approved mark-to-market in 1992 and reviewed none of the company’s filings after 1997.
- The gate that worked, partly. Short sellers, McLean, and Watkins asked the questions; none had the power to force an answer until the numbers did.
The nine ideas worth keeping
- Earnings built on estimates are earnings built on who controls the estimates. Mark-to-market was permitted; the failure was leaving the curves with the people paid on them. The control is independence of valuation.
- A structure designed to pass a test has already failed the substance. The 3 percent rule, the hedges backed by the company’s own stock and the prepays all complied in form. An auditor who asks what a structure is for, in one sentence, learns more than one who checks its compliance.
- Related parties at the top compromise everything below. A chief financial officer on both sides of a transaction cannot be controlled by procedures he supervises; the board’s waiver was the fraud’s licence.
- Cash is the check on earnings. Enron reported rising profits with cash flows that depended on prepays and asset sales to its own partnerships; the gap between profit and operating cash was the public signal.
- Culture is a control, and it can be designed to fail. The forced-ranking review system, the trader bonuses on booked value and the public contempt for questioners made the reported number the only acceptable truth.
- An auditor that consults is an auditor with a client to keep. The fee mix and the outsourced internal audit made Andersen a participant. The post-Enron rules on auditor independence exist because of this.
- Complexity that nobody can explain is a finding. Directors approved structures in minutes; analysts admitted they did not understand the business. An audit committee should be able to explain the three largest structures in plain words or should not approve them.
- The warning will come from the middle. Watkins saw it because her job touched the structures; the board and the auditor saw presentations. A function that wants early warning listens below the executive.
- Reform follows catastrophe, and then fades. Sarbanes-Oxley, auditor independence rules and audit committee requirements all date from this case; the corporate scandals guide shows the same mechanisms reappearing within a decade.
The vocabulary: fourteen terms defined for practitioners
| Term | What it means in the book | What it looks like in an audit |
|---|---|---|
| Mark-to-market | Valuing contracts at current estimated value with changes through earnings | Appropriate with observable prices; dangerous with internal curves; see the market risk guide |
| Special purpose entity (SPE) | A vehicle created for a defined purpose, often to hold assets off the sponsor’s balance sheet | Substance-over-form consolidation review |
| Three percent rule | The outside-equity threshold for non-consolidation at the time | The form test the structures were built to; replaced after 2001 |
| Related-party transaction | A deal with a person or entity connected to management or directors | Independent review and disclosure; prohibition where the party is an officer |
| Prepay | A commodity sale with payment up front that is economically a loan | Classification of cash flows; look through to the counterparty |
| Raptor | Enron’s name for the structures hedging its merchant investments with its own stock | A hedge whose counterparty cannot pay if the hedge is needed |
| Merchant investment | An equity stake carried at fair value with changes in earnings | Valuation and the independence of the valuer |
| Rank and yank | Forced-ranking performance review with the bottom dismissed | A culture indicator in the culture audit guide |
| Gas Bank | Skilling’s model: intermediating between producers and users with long-term contracts | The business that justified mark-to-market |
| Restatement | Correcting previously issued financial statements | The November 2001 restatement of 1997 to 2000 |
| Auditor independence | Freedom of the auditor from financial and relationship interests in the client | Fee mix, consulting, rotation; the post-Enron rules |
| Outsourced internal audit | Internal audit performed by an external firm, here the same firm as the external auditor | Prohibited for public companies’ external auditors since 2002 |
| Tone at the top | The example set by leadership | Lay and Skilling’s treatment of questioners |
| Obstruction | Destroying evidence after an inquiry begins | Andersen’s shredding; document-retention controls |
What it means for internal audit: the case behind the standards
Much of the modern control environment is the Enron case turned into rules, and an auditor who knows the case understands why the rules are shaped as they are. The table maps each failure to the control that now exists and the test the function performs. The SOX 404 guide, the audit committee playbook and the management review controls guide carry the detail.
| Failure at Enron | The control that followed | Test that produces evidence |
|---|---|---|
| Estimates controlled by the people paid on them | Independent price verification and valuation review; model validation; the auditor’s own testing of significant estimates | Select the three largest estimates; confirm who set the inputs, who reviewed them, and whether the reviewer is independent of the result |
| Structures compliant in form, controlled in substance | Consolidation rules rewritten (variable interest entities); substance-over-form review by the audit committee and auditor | For each off-balance-sheet structure, obtain the one-sentence purpose and the analysis of who bears the risk |
| Officer on both sides of transactions | Related-party policies with prohibition for officers, independent approval and disclosure; conflict declarations | Read the declarations; test the approval of every related-party transaction in the year; see the corporate governance audit guide |
| Board approved what it did not understand | Audit committee financial expertise requirements; committee charters; the expectation that the committee can explain what it approves | Interview the committee chair on the three largest judgments; the playbook gives the questions |
| Auditor earning consulting fees; internal audit outsourced to the auditor | Auditor independence rules; prohibited services; partner rotation; the external auditor may not perform the company’s internal audit | Review the audit committee’s pre-approval of non-audit services and the fee mix |
| Warning memo referred to counsel | Whistleblower protections; audit committee procedures for complaints about accounting; independent investigation | Trace the handling of the last accounting complaint; who investigated and who received the result |
| Profit without cash | Analysis of earnings quality; the audit committee’s review of cash flow against profit | Reconcile profit to operating cash flow over eight quarters; explain persistent gaps |
| Document destruction | Document retention and legal hold controls; obstruction as a criminal offence | Test the legal hold process on the last litigation or inquiry |
The aftermath: trials, Andersen and Sarbanes-Oxley
The consequences unfolded over five years. Arthur Andersen was indicted for obstruction in March 2002, convicted in June, and surrendered its licences; the Supreme Court overturned the conviction in 2005 on the jury instructions, but the firm was gone, and the Big Five became the Big Four. The Sarbanes-Oxley Act, signed in July 2002, created the Public Company Accounting Oversight Board, required management and auditor reports on internal control over financial reporting, restricted the non-audit services auditors could sell, required audit committees to be independent and to oversee the auditor, protected whistleblowers, and made executives certify their financial statements personally. Fastow pleaded guilty in January 2004 to two counts, agreed to a ten-year sentence later reduced to six, forfeited about $24 million, and testified against Lay and Skilling, who were convicted in May 2006. Lay died in July 2006 before sentencing and his conviction was vacated under the rule that abates a conviction when the defendant dies before appeal. Skilling was sentenced to twenty-four years, reduced to fourteen in a 2013 agreement, and released in 2019. Banks that had structured the prepays and partnerships paid settlements running to billions of dollars to investors. For an auditor the aftermath is the current rulebook; the SOX 404 guide is its practical form.
The criticisms, and what the book leaves out
The book was written before the trials, and its account of individual culpability, particularly Lay’s, was the subject of argument at the time; the 2006 verdicts largely confirmed it, though the trials themselves came after the book. Some readers find the business explanations heavy going, which they are, and which is why the book is more accurate than the lighter accounts. The portrait of Skilling is unsparing and the authors’ sources were disproportionately people he had crossed; his defenders argue that the trading business was real and profitable and that the book underweights it. And the book, being a narrative of one company, does not do what the corporate scandals guide does, which is to show that the same mechanisms produced WorldCom the following year, the banks’ structured products in 2008 and Wirecard in 2020. Read it for the depth, and the comparative guide for the pattern.
Editions, reading time and how to read it
| What | Details | Best for |
|---|---|---|
| Hardback | Portfolio, October 2003, about 440 pages | The first edition |
| Paperback | Portfolio, 2004, updated with new material; reissued in 2013 | The edition to read |
| Documentary | The 2005 film of the same name, narrated by Peter Coyote | A team introduction; the book is far deeper |
| Reading plan | The chapters on the Gas Bank and mark-to-market, on Fastow and the partnerships, on the Raptors, and on the final months | An auditor who wants the mechanisms in two evenings |
| Companion reading | The Powers Report (the board’s own special investigation, 2002) and the Senate subcommittee report on the board (2002), both free; the Why They Do It summary for Fastow’s own account | From narrative to evidence |
A one-hour discussion guide for an audit team
- Fifteen minutes: the one-sentence test. Take the organisation’s three most complex structures, contracts or arrangements and have someone state the purpose of each in one sentence a shareholder would understand. Note where it cannot be done.
- Ten minutes: who sets the estimates. For the three largest estimates in the financial statements, name who sets the inputs and whether that person’s pay depends on the result.
- Fifteen minutes: profit and cash. Compare reported profit with operating cash flow for the last eight quarters. Discuss any persistent gap and what explains it.
- Ten minutes: the memo. Trace what would happen to a Watkins memo in the organisation today: who receives it, who decides whether to investigate, who tells the audit committee.
- Ten minutes: the plan. Decide which tests in the map belong in the next plan and who performs them; the risk assessment guide describes the documentation.
Worked example: Pennine Foods asks the Enron questions
Pennine Foods plc is a fictional UK-listed food group with £900 million of revenue, a December year-end, a four-person internal audit function and an audit committee supporting the board’s first declaration under Provision 29 of the UK Corporate Governance Code. Enron is an American case about an energy trader, and the committee chair asked whether it had anything to say to a food company. The function’s answer was the review below, run in the first quarter of 2027 against the group’s reporting.
| Enron question | What Pennine found | Result |
|---|---|---|
| Who controls the significant estimates? | The customer-rebate accrual and the inventory provision were set by commercial finance, whose leaders were bonused on operating profit; the review was by the group financial controller, who was not | Adequate design; the function tested the controller’s challenge record and found two instances of changed estimates in the year, which it reported as a strength |
| Can each complex arrangement be explained in one sentence? | A sale-and-leaseback of a distribution centre and a supplier-financing facility were in the accounts; the committee chair could explain the first and not the second | The function wrote the one-sentence purpose and risk analysis of the supplier-financing facility for the committee; the disclosure was expanded |
| Are there related parties at the top? | Annual declarations were complete; a director’s family company supplied packaging under a contract approved before the director joined | The contract was reviewed for arm’s-length terms and disclosed; no finding |
| Does profit convert to cash? | Operating cash conversion averaged 92 percent over eight quarters with one quarter at 60 percent explained by a working-capital timing effect | No finding; the analysis was added to the committee pack |
| Is the auditor independent? | Non-audit fees were 18 percent of audit fees, all pre-approved; the firm had been in place eleven years, with tender due | No finding; the tender timetable was noted |
| What happens to a warning from the middle? | The speak-up channel routed accounting concerns to the general counsel; the committee did not see the log | Finding: accounting concerns to be routed to the committee chair; the log reported quarterly; the management review controls guide and the playbook cited |
The review produced one finding and one expanded disclosure, and the committee chair’s conclusion was that a case from 2001 about a Texan energy company had given a food group in Yorkshire its most useful hour of the year. The Enron questions are not about energy trading. They are about who controls the numbers, whether anyone can explain the structures, whether the profit is real, whether the auditor is free, and whether a warning can reach the people who should hear it. Every reporting entity can be asked them, and the function that asks them once a year has learned what the book teaches.
Frequently asked questions
Why is Enron still the reference case two decades on?
Because it produced the rules the profession works under, because the mechanisms were a complete set, and because the book explains them better than any later account of any later case. Sarbanes-Oxley, auditor independence and audit committee requirements all trace to it; the SOX 404 guide is the practical descendant.
Was mark-to-market accounting the problem?
Not in itself; it is appropriate where prices are observable. The problem was applying it to twenty-year contracts valued on internal curves set by the people paid on the result, with no independent verification. The control lesson is independence of valuation, not prohibition of the method.
What did the board do wrong?
It waived its conflict-of-interest rules for the chief financial officer, approved structures it did not understand on brief presentations, and relied on the auditor it should have been overseeing. The Senate subcommittee’s 2002 report on the board is the clearest statement, and the audit committee playbook describes the opposite stance.
How does the book treat Andersen?
As a participant rather than a victim: the consulting fees, the outsourced internal audit, the overruling of the firm’s own technical experts and the shredding. The firm’s conviction was overturned on technical grounds in 2005, but the book’s account of the engagement has not been seriously disputed.
Which later cases follow the same pattern?
WorldCom in 2002, the structured-finance businesses of 2008, Wirecard in 2020 and others; the corporate scandals guide compares them, and the Money Men summary gives the Wirecard case in full.
Where does the book sit in the reading list?
At the head of the fraud and scandal group in the internal audit reading list; read it before the others.
Related guides
- SOX 404 Explained: The Complete Guide — the rulebook the case produced
- The Audit Committee Playbook — the committee that can explain what it approves
- How to Audit Corporate Governance — related parties, conflicts and board oversight
- Corporate Scandals and the Internal Audit Lessons — Enron beside the cases that followed
- Why They Do It: Summary and Lessons for Auditors — Fastow’s own account of following the rules
- Money Men: The Wirecard Fraud, Summarised for Auditors — the same mechanisms, twenty years later
- The Best Books for Internal Auditors — where this book sits among the others
- All book summaries — the full set of summaries for auditors
- Extraordinary Circumstances by Cynthia Cooper: WorldCom, Summarised for Auditors — WorldCom, found by internal audit
- Financial Shenanigans by Schilit, Perler and Engelhart: Summary for Auditors — the fifteen ways accounts are manipulated
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