Mark to Market Accounting and

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 on its financial statements (Batson, 2003, p. 28) This quotation shows how arbitrary MTM can be.

Simply by terming Enron's cash shortage a sa minority interest as opposed to the proper term for it, debt, Enron was able to manipulate MTM to prevent such a sizeable loss from appearing on its balance sheet. Moreover, MTM's role in this transaction allowed Enron to repair its problem of a cash flow shortage since it credited $500 million via its sale of Treasury securities.

The relative short duration in which Enron was able to take out a loan and repay it indicates how effective MTM was in providing Enron a favorable balance sheet, and in singled-handedly dancing around the reality of its shortages. Additionally, it also kept others (shareholders, stakeholders, not to mention its hard working employees) to know how tenuous an economic position the company was actually in.

In discussing Enron's MTM approach to accounting and the considerable role it played in the facilitation of greed and immorality on the part of its upper level management, it is crucial to analyze the sort of valuation it utilized to monetize its assets. Originally, Enron used the most acceptable form of valuation, the public quoting of price information, to properly evaluate the worth of its natural gas commodities.

Still, it is crucial to note that of the two forms of evaluation of MTM (publicly quoted prices and management prognosis in the event of a lack of the former), the vast majority of Enron's MTM utilized the former. Again, it is noteworthy to mention that this fact alone reveals that these aspects of business were inappropriate for MTM. Also, this fact reveals that back in 1991, the SEC actually was not complicit in Enron's later nefarious practices, since it only sanctioned MTM for natural gas commodities.

However, the highly subjective nature of Enron's MTM accounting for assets that had no publically quoted prices reveals that a fair amount of this blame falls not only on the company itself, but on its accounting firm, the once renowned Arthur Andersen. Still, it would be unfair to issue the degree of culpability of Enron's asset and commodity appraisals to solely lie with Andersen. Other firms, such as Houston's KMG consulting, were also utilized for the purpose of valuation.

The interest that such firms had in providing favorable estimates, however, seems to be well aligned with their own interests in terms of profiting from Enron's alleged financial prowess. Such a statement certainly appears to be of true Andersen, which had a longstanding, confidential relationship with its top client. Regardless of ulterior motives, however, Enron's valuation for its MTM accounting did utilize some sound financial practices, such as employing outside entities to assist in the process.

Both directly through its own upper level management and through the aforementioned consultants, Enron also employed statistical analysis as a means of determining asset worth when there was a dearth of publicly quoted prices. One of the more frequently used tools is known as Monte Carlo systems analysis, which is used to "simulate probable outcomes given a set of variables. Through multiple iterations of simulations, the probable outcomes will cluster around a normal bell curve distribution table" (Batson, 2003, p. 34).

The probable with such statistically sound measures is the fact that most of Enron's MTM reflected future earnings that were highly difficult to gauge, regardless of what means of statistics was used. The company had a propensity to determine potential gains and losses (the latter of which there were not too many) immediately after conceiving of any number of far flung ideas that it believed would generate earnings up to 10 years in advance.

There are a number of specific examples that proves that much of Enron's MTM valuation was based on future activity. One of the most egregious of these is the deal that Enron established with Blockbuster in 2000 in which it attributed $53 million in earnings, despite some considerable setback and developments that were to take place in the future -- and which never did. The Blockbuster deal was based on the notion that the pair would service direct to television movies to people at home.

However, Enron never had the technology to facilitate such a move, and Blockbuster itself did not have the rights to movies to carry out this transaction. Still, these circumscriptions did not prevent Enron from selling a portion of its subsidiary that it set up for this transaction to its Hawaiian securitization company under Federal Accounting Standards rule 140 -- which accounted for its allgeged $53 million.

There are several dubious factors in the confluence of events that led to Enron's recording of profits via MTM in this particular business venture, not the least of which the Hawaiian securitization structure was merely an extension of Enron itself. However, what is most egregious about this particular act of duplicity involving MTM is Arthur Andersen's valuation of this transaction.

As Enron's primary accounting firm, representatives at Andersen were well aware of the fact that Enron lacked the technology and the rights to major motion pictures (as did Blockbuster) to actually accomplish its objective of streaming movies to television sets.

Yet that did not stop the accounting magnate from making some pretty bizarre assumptions in evaluating the net worth of this future venture including a growth rate of digital subscribers by 70% in 2010, a growth rate of digital subscriber lines by 80% in 2010, a market of 10 metropolitan areas in its first 12 months of operation with 1.6 million people which was projected to expand to eight additional metropolitan areas until 2010, and the fact that Enron would capture 50% of the market share.