Lessons of Enron

Enron Lesson No. 1: Mark To Market (Fair Value) Accounting

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Jeffrey Skilling, a former McKinsey & Company consultant, made switching to mark-to-market accounting a condition of his hiring.

Abuses specifically related to mark-to-market, or fair value, accounting helped to facilitate the fraud and deceipt that occurred at Enron.  Although gaining in usage, mark-to-market accounting can be easily manipulated as lesson No. 1 in this 10-part series clearly documents.

On January 30, 1992, a champagne celebration took place on the thirty-first floor of the Enron corporate office in Houston, Texas.  No, the celebration wasn't for a record quarterly or annual performance.  Not even to commemorate an executive retirement or achievement.  No, this celebration -- enjoyed by Jeffrey Skilling and 50 or so of his employees -- took place after the Securities and Exchange Commission (SEC) notified Enron that it would not object to its use of mark-to-market accounting. Yes, a champagne celebration over a method of accounting. 

Thus, with a simple accounting change, Enron started along an accounting primrose path that would ultimately lead to the largest corporate fraud in United States history culminating in chapter 11 bankruptcy on December 2, 2001, almost exactly eight years later.  At the time of its bankruptcy filing, Enron reported revenues of over $100 billion. 

Mark-to-market accounting is lesson No. 1 in the lessons of Enron section of CreditPulse because the change to this form of fair value accounting from the more coventional historical cost method essentially laid the groundwork for much of the accounting abuse and fraud that would occur at Enron during the next eight years. 

Basically, mark-to-market is a type of accounting that enables a company to book the value of an asset or a liability, not based on the cost of that asset, but based on current market valuations or perceived changes in market valuations.  It differs significantly from the historical cost method of asset valuation in that with historical cost the cost of an asset is known whereas the market value of an asset often is unknown until the asset is sold. 

Mark-to-market, or fair value, accounting has been used by banks and financial service firms for years to account for assets that typically fluctuate in value based on changing market conditions, i.e. mutual fund portfolios, asset-backed mortgages held for sale, and derivatives.  It typically works well as long as the asset being valued resides in a market liquid enough to provide accurate, ongoing valuation because it's only when the asset is sold, or those like it are sold, that "fair value" can be determined to any reliable degree. 

Proponents of fair value, which reside mainly in financial and economic circles, argue that this form of accounting more accurately reflects the economic substance of a transaction.  They also claim that transparency is greater.  Opponents of mark-to-market accounting, however, which reside mainly in the accounting profession and within some industry groups, argue that it leaves too much to the imagination.  In other words, the opponents argue, its often based on estimates and valuations that are too subjective in nature and, thus, ripe for abuse. 

No where was that more evident than at Enron.   

Enron, which prior to Skilling's arrival used historical cost accounting, thrived under mark-to-market accounting primarily in two ways: First, mark-to-market accounting requires a constant adjustment of asset values based on market fluctuations and, in large part, subjective judgements.  This enabled the Enron executives, who were constantly trying to stay one step a head of Wall Street estimates, to regularly report increased asset valuations regardless of whether they had actually increased or not.  In reality, the actual worth of many of Enron's assets was below cost, not above it. 

But it was in the second advantage of Enron's shrewd switch to mark-to-market accounting, revenue recognition, that really gave Skilling and his company the financial reporting license to perpetuate fraud.  Under conventional accounting, in the vast majority of cases, revenue is recognized from a sales contract when the product is delivered, the service is performed, or in the case of the construction industry, as project costs are incurred.   

Under mark-to-market accounting, the entire estimated value of a sales contract or project can be recognized as revenue on the day the deal is completed before any work has been done or costs incurred to fulfill the contract.  It was in this area of mark-to-market accounting that Enron had a field day.

Case-in-point was a deal made by Enron in 1992 to supply Sithe Energies, a New York utility, with 195 million cubic feet of gas per day for 20 years for its new plant in upstate New York, according to an excerpt in the now classic Enron book, The Smartest Guys in The room.  The estimated value of the contract was $3.5 to $4 billion.  Using mark-to-market accounting, Enron began recognizing revenue and recording profits even before the plant began operating, or more importantly, before Enron began receiving payments. 

USA Today photo
McLean and Elkind's outstanding
book on Enron will provide the basis
for the this 10-part series.

According to business writers Bethany McLean and Peter Elkind, authors of the book, Enron continued to "book profits from Sithe well into the late 1990s by restructuring the deal on multiple occasions when the company was scrambling to meet its quarterly projections."  Eventually, the deal became so complex that it would later produce a huge liability that the company never fully disclosed, according to the book. 

So in 1992, Enron would book some $3.5 billion in revenue and profits on its income statement based on the proceeds from a 20-year contract.  The problem?  Enron would go bankrupt nine years later.  Thus, over half of the revenue booked in 1992 from the Sithe Energies sales contract was never earned.  As a result, shareholders, creditors and investors were really misled into thinking that Enron was a bigger company in terms of revenue than it actually was.  Hence one problem with mark-to-market accounting. 

But perhaps the biggest problem, for the company, as well as creditors and investors, is the revenue to cash-flow differential created when recognizing revenue all at once on long-term sales contracts.  Recognizing revenue all at once provides a big boost to the income statement and earnings, but it doesn't necessarily bring cash in the door.  As Enron found out, companies cannot run on revenue alone; they must also generate cash. 

Another example involving asset valuations was Enron's investment in Mariner Energy, a Houston-based deepwater exploration oil and gas company.  According to McLean and Elkind's book, Enron acquired Mariner in a private-equity buyout worth $185 million.  By the second quarter of 2001, using fair value accounting, Enron reported in its financial statements that Mariner was worth $367.4 million.  It's own internal-control group, according to the book, placed its value somewhere between $47 million and $196 million.  A post-bankruptcy review by the company's new chief accountant placed the value of Mariner at around $110.5 million resulting in a write-off of $256.9 million. 

In an article in the November 2006 edition of CPA Journal, Robert G. Haldeman Jr., President of Zeta Services in Mountainside, New Jersey, referred to Enron's use of mark-to-market accounting as "mark-to-estimate."  He went on to say "it could even be argued that Enron resembled an organized crime syndicate; efforts to mislead investors required the coordinated efforts of many people."  Haldeman also cites a quote from a court-appointed examiner who said that Enron's financial statements "bore little resemblance to its actual financial condition or performance." 

Although few can legitimately question the role of mark-to-market accounting in the fraud that took place at Enron, it is important to remember that the accounting method itself did not commit the fraud; those using it did.  Few can have any doubts that the level of arrogance, cunning and deceipt prevalent throughout the managerial ranks at Enron would have produced fraud in any method of accounting.

But Jeffrey Skilling, found guilty on May 25, 2006 of 19 counts of conspiracy, fraud, false statements and insider trading, did not wish to operate in any accounting system.  He specifically chose mark-to-market. 

Next: Lesson No. 2: Special-purpose entities and securitization.