Term Paper on "Mark to Market Accounting and Its Relation to the Enron Scandal"

Term Paper 10 pages (3061 words) Sources: 3

[EXCERPT] . . . .

Mark to Market Accounting and Its Relation to the Enron Scandal

One of the most fascinating (if not revolting) aspects of the so-called Enron scandal is the degree of complicity that surrounded the actual Texas-based company and which extended into the realm of United States account practices, federal regulations, and even politics in general. Aside from the involvement of what was formally one of the most venerable accounting firms in the country, Arthur Andersen, and former CEO Ken Lay's sizeable contributions and close relationship to former president George Walker Bush, the ramifications that the scandal produced on the Securities Exchange Commission is one of the most revealing aspects of this instance of greed and immorality. In hindsight, many have posited that Enron's reliance upon mark-to-market (MTM) accounting was the company's ultimate downfall and nadir of impecunious impropriety. However, a closer examination of the history of MTM and its relevance to Enron demonstrates the fact, in the beginning, at least, there was some value in this practice -- before it simply became another means of exploitation and greed for this country.

Historically, MTM has endured a lengthy legacy of controversy. According to Steve Forbes, both editor-in-chief and chairman of Forbes magazine, MTM factored significantly into the Great Depression and was outlawed by former president Franklin Delano Roosevelt in 1938 (Bigman and Desmond, 2009). The true value in this accounting tactic, so to speak, lies in its ability to ensure that certain assets are carried at their "fair value," based on publicly quoted prices, or if none are available, based on management's estimate using the best information available to determine the fair value of assets. Changes in values from quarter-to-quarter are recorded as gains or losses in the income statement (Monks and Minnow).

There are many critical points of this definition as it relates to Enron's fairy tale and tragedy. One is that MTM applies best when utilized for certain assets, not all of them. Initially, Enron applied to the SEC to utilize MTM for Enron Gas Services, a gas trading business. MTM is most effective when applied to an asset that frequently fluctuates, to the point where historical cost may not be an accurate indicator of the true asset's true value. Additionally, there are two principle points of the aforementioned definition: that public price quotes should determine MTM, and that only in the absence of such quotes is it acceptable for an organization to put its own estimate for a particular value. Due to the nature of the price of energy sources, such as oil, petroleum, and natural gas, then, in the early 1990's Enron could readily utilize public quotes for determining the value of its natural gas trading. There was a degree of apropos for this specific usage of MTM, which is why the SEC sanctioned it.

However, MTM accounting was never expressly granted to Enron for usage in assets other than natural gas trading. Yet the degree of flexibility and autonomy allowed by MTM encouraged Enron management to readily utilize this tactic in other areas of business, so that "By December 31, 2000, MTM accounting had spread throughout Enron…and represented about $22.8 billion of Enron's assets. This was 35% of its $65.5 billion of total assets" (Monks and Minnow, 2008). Despite the wild profits (many of which were purported and in several instances outright fictional) associated with this financial decision, it has become clear to everyone familiar with the scandal that MTM simply was not appropriate for other aspects of Enron's company. The primary reason it was not appropriate was because in many instances, Enron was using M2M for the valuation of assets that did not have publicly quoted prices. Therefore, the company was able to rely on its own valuation -- which wildly benefitted its own interests.

This point is pivotal for properly contextualizing and understanding the Enron scandal in terms of its relevance to MTM. In and of itself, MTM is not a problematic measure of ensuring accounting. The principle problem with using MTM occurs when there is no proper means of determining the market value of a commodity or an asset. In this case, management is supposed to estimate value on its own. Enron's partisanship valuation, termed as "valuation abuses" (Batson, 2003, p. 24) was the true problem in its deceptive accounting practice, not MTM. In the second Examiner's report, the examiner posited that "the proper use of MTM accounting for assets and liabilities….provides more relevant and reliable financial information than historical cost" (Batson, 2003, p. 24).

The valuation problems that Enron had for its misuse of MTM are evinced in the various areas it used this accounting principle that were outside of its natural gas trading commodities. Enron used MTM for everything from the profits and losses of other commodities such paper, electricity, and coal ventures that were extremely inappropriate, such as its interest in a retirement system for California employees (California Public Employees Retirement System -- CalPERS). Such a venture does not meet the stipulated reasons necessary for employing MTM. CalPERS is not commodity, and certainly does not fluctuate with the degree of inconsistency in which MTM accounting is designed to regulate. Moreover, there certainly is no public means of gauging the value of such a "commodity" (other than talking to the individual retirees about their financial information), which means that Enron management was able to issue whatever sort of value it desired to this "asset." That valuation unerringly favored the energy magnate. Even worse, its success with MTM accounting spurred the company to extend this accounting practice into other areas, which were also highly inappropriate.

Enron's usage of MTM with CalPERS essentially functioned as a gateway in which it would utilize this accounting experience as an analogy to justify the usage of MTM in other aspects of its business. Its employment of MTM became pervasive and unethical when it was applied to merchant investments. Merchant investments are extremely unlike those of commodities such as natural gas, primarily because they do not necessarily incorporate public pricing. Additionally, they are not prone to public fluctuations. Although the CalPers experience served as a watershed moment for the company and could be used to justify MTM for merchant investments, it is not expressly permitted by Generally Accepted Accounting Principles (GAAP). What is permitted by GAAP is the deployment of MTM for venture capital investment companies (Batson, 2003, p. 28). Enron, therefore, rationalized "that trading in Treasury securities was a regular part of Enron's venture capitals business" (Batson, 2003, p. 28) and made the rather far-fetched stretch between utilizing MTM for venture capital investment companies and to merchant banking. Thus, it is fairly apparent that MTM was not appropriate for merchant activities.

However, the real proof in understanding why MTM was not apropos for use in merchant investing lies in its ability to provide the company with far too much autonomy and license in creatively doctoring its books to dissemble positive earnings that simply were not there. Despite the fact that Enron could employ MTM to record net profits (which inherently boosted its stock value, a crucial aspect in propagating the fantasy of its economic prowess), its real problem was that it allowed the company to record such profits well in advance of operations or any practical initiating of whatever product or purchase it was purported to make. Additionally, the discretion (or indiscretion, as it turns out) of upper level management in ascribing values that always benefited Enron was detrimental in the sense that it exacerbated the company's lack of cash flow. Having little cash flow is certainly problematic in and of itself. Yet it becomes worse when one is claiming net profits without any cash flow earnings to substantiate it. Enron's liberal and creative usage of MTM certainly created this negative situation by the end of the 1990's, and is certainly a testament to why MTM is inappropriate for various aspects of business other than the SEC sanctioned natural gas contracts that was initially approved in 1991.

More disturbingly, however, Enron's use of MTM in a substantial amount of its business activities allowed it to willingly deceive the general public and other financial institutions -- which was how it was able to take the life savings and pensions of employees who were told by Lay and former CEO Jeff Skilling to invest all they had in its stock while the pair were feverishly selling their own stock in the first few years of the new millennium. An excellent example of this fact is provided in an analysis of its use of MTM in Project Nahanni, which occurred in 1999 when Enron, despite whatever surplus its net profits might indicate, was nearly half a billion dollars short in its cash flow. With the assistance (and complicity) of Citibank,

Enron borrowed $500 million, bought Treasury securities with it, sold the securities, recognized $500 million of operating cash flow, and repaid the loan -- all within 30 days straddling its 1999-year end -- and without reflecting the loan as debt… READ MORE

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