Enron's mark-to-market accounting and the earnings gap
At Enron, mark-to-market accounting allowed projected income to reach its books before the money arrived. The company began with Kenneth Lay's merger of Houston Natural Gas and InterNorth in 1985. Its business later shifted from producing and supplying natural gas toward trading energy derivative contracts, with Jeffrey Skilling helping that transition. Enron also pursued growth through pipelines, electricity plants, water plants, paper plants, and broadband services around the world. By 1992, Enron had become the largest seller of natural gas in North America. EnronOnline, a trading website created in November 1999, improved management of its contracts trading business.
The earlier natural gas business had used a relatively straightforward approach: list the costs of providing gas and the revenue received from selling it in each period. Skilling demanded that the trading business adopt mark-to-market accounting instead. Once a long-term contract was signed, its income could be estimated as the present value of future net cash flow. The viability of those contracts and the costs associated with them were often difficult to estimate. Project income could nevertheless increase reported earnings even when Enron might never receive the money. Investors faced large differences between the company's reported profits and its cash. Enron was the first nonfinancial company to use mark-to-market accounting for its complex long-term contracts.
The SEC approved mark-to-market accounting for Enron's natural gas futures trading on January 30, 1992. Enron later extended mark-to-market accounting into other parts of the business to help meet Wall Street projections. Recognizing anticipated income early created another pressure: profits already included could not be included again in future years. Additional projects were needed to generate further reported growth. Skilling emphasized meeting Wall Street expectations and pushed executives to find new ways to conceal debt. Those demands sat alongside financial statements whose complexity made them confusing to shareholders and analysts, while failed speculative ventures added to the company's financial strain.
The Blockbuster Video deal shows how mark-to-market accounting worked within a particular project. In 2000, Enron and Blockbuster signed a 20-year agreement to bring on-demand entertainment to various U.S. cities by the end of the year. Following several pilot projects, Enron claimed estimated profits exceeding $110 million. Analysts questioned both the technical viability of the proposed service and whether there was market demand for it. The parties withdrew from the contract in March 2001. Enron continued to claim future profits despite the deal resulting in a loss.
Trading companies including Goldman Sachs and Merrill Lynch used an agent model, reporting trading or brokerage fees as revenue. Enron chose a merchant model and reported the entire value of its trades instead. Other energy trading companies adopted that approach while trying to compete with Enron's revenue expansion. Between 1996 and 2000, Enron's reported revenue rose from $13.3 billion to $100.7 billion, an increase of about 657%. In the first nine months of 2001, it reported $138.7 billion in revenue. Enron ranked sixteenth on Fortune's 2001 Global 500, based on its reported revenue for 2000.
Debt concealment involved special purpose entities, partnerships or companies established for temporary or specific purposes. Enron disclosed minimal details about them and had used hundreds by 2001. One arrangement began with JEDI, an energy investment joint venture with CalPERS established in 1993. When CalPERS sought to leave that venture, Enron wanted to avoid showing debt from taking over its stake. Andrew Fastow developed Chewco, which raised debt guaranteed by Enron to acquire the stake for $383 million. Discovery of the arrangement in autumn 2001 required reported earnings to fall by $405 million and indebtedness to rise by $628 million.
Whitewing offered a different financing structure. Formed in December 1997, it received $579 million from Enron and $500 million from an outside investor. Its arrangement later changed so it would no longer be consolidated on Enron's balance sheet. Between 1999 and 2001, Whitewing bought $2 billion of Enron assets using Enron stock as collateral; those transfers should have been treated as loans rather than sales. Fastow also created the LJM partnerships to buy poorly performing holdings and improve Enron's financial statements. Managing those partnerships required a board exemption from the company's code of ethics because Fastow was its chief financial officer.
Alongside mark-to-market accounting and those financing structures, compensation encouraged a focus on short-term earnings. Employees pursued deals to improve performance ratings, sometimes disregarding cash flow or profit quality. Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees from Enron during 2000. Enron's audit committee struggled to question the auditors about special purpose entities and faced pressure when questioning management. After the SEC began investigating, a proposed purchase by Dynegy failed. On December 2, 2001, Enron filed for bankruptcy under Chapter 11, with employees and shareholders losing billions in pensions and stock prices.
- Wikipedia, Enron scandal — en.wikipedia.org