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Abstract
This paper contributes to the debate on the use of mark to market accounting in financial reporting by means of a case study-based examination of the use of mark to market accounting by Enron Corp. in the years immediately preceding its collapse. Set in the context of historical developments in and theoretical discussion upon asset valuation and income measurement, the case study highlights: (i) the ease with which Enron was able to ‘monetize’ physical assets so as to bring them within the remit of mark to market accounting; (ii) the unreliability of valuation estimates provided by independent third parties; and (iii) the asymmetry between management desire to recognise mark to market gains through the income statement in contrast to their desire to avoid recognising mark to market losses.
Acknowledgements
The authors gratefully acknowledge the helpful comments and suggestions of Richard Macve (London School of Economics and Political Science, UK), Robert Parker (University of Exeter, UK), Carl Chadwick, the Editor and two anonymous reviewers. Any errors remain the responsibility of the authors alone.
Notes
1 These authors identified measures such as deprival value, i.e., how much worse off an entity would be if an asset was taken away from it, as possessing characteristics which might be considered more suitable for financial reporting than a strict historical cost approach. See, inter alia, CitationBell and Peasnell (1997), CitationStark (1997), CitationClarke (1998), CitationAustralian Accounting Research Foundation (1998) and Citationvan Zijl and Whittington (2006) for more recent contributions to the historical cost/deprival value/fair value debate.
2 See CitationSraffa (1951–1973).
3 A number of the leading studies in this field, including some of those referenced above, are reproduced, together with an overview of the relevant issues, in CitationParker, Harcourt, and Whittington (1986).
4 This debate was live elsewhere, including the US and Australia—albeit those jurisdictions experienced lower levels of price inflation.
5 As CitationSolomons (1961, p. 374) noted: ‘In recent years discussion of the measurement of income has been largely colored and dominated by changes in the value of money. Serious as these problems are, they are really secondary ones, for they presuppose some basic agreement about the nature and measurement of income during a period of stable prices. Between accountants and economists, it need hardly be said, no such agreement exists’.
6 Statement of Standard Accounting Practice 16, Current Cost Accounting, Accounting Standards Committee, UK, 1980.
7 SSAP 16 required supplementary current cost disclosures, but also permitted companies to use current cost as the sole basis for their accounts (thereby necessitating a change in the UK Companies Act). Its requirements became non-mandatory in 1986 and it was withdrawn in 1988 (CitationPong & Whittington, 1996).
8 Found in Part C of Schedule 4 of the UK Companies Act 1985.
9 The Joint Working Group comprised representatives from the IASC, FASB and eight other international bodies.
11 For a chronology of the development of IAS 39 and a summary of its present requirements see http://www.iasplus.com/standard/ias39.htm.
12 UK Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004.
13 This standard and other material (including a raft of comments on earlier exposure drafts) relating to FASB's Fair Value Measurement project is available on the FASB website at http://www.fasb.org. See also CitationDean and Clarke (2005) for an overview of related issues.
14 In FASB Proposed Statement Fair Value Measurements.
15 Available via http://www.iasb.org.
16 The CitationBenston (2006) analysis is framed specifically in the context of the levels 1, 2 and 3 ‘fair-value hierarchy’ referred to above as a benchmark against which to assess the nature and quality of the valuations.
17 For example, in Australia, the development and various manifestations of AAS 25 Financial Reporting by Superannuation Plans (latest compiled 2006); AASB 1023 General Insurance Contracts (latest compiled 2006) (and, earlier, AAS 26 Financial Reporting of General Insurance Activities); and AASB 139 Financial Instruments: Recognition and Measurement (latest compiled 2007).
18 That is, selling the securities at the end of the relevant accounting period and repurchasing at the commencement of the next period.
19 See CitationMacve and Jackson (1991).
20 The bases of the JWG's conclusions are set out at http://www.iasplus.com/agenda/jwg.htm. CitationBarth and Landsman (1995) provide a more general review of the arguments for and against the use of fair values and mark to market accounting in financial reporting.
21 For example, although the revaluation of long-term liabilities has not been permitted under UK company legislation, it has always been open to a company financed by bonds to refinance those bonds in a manner which will enable any valuation change reflecting movements in interest rates to be incorporated in the income statement for the period in which the refinancing takes place, notwithstanding the fact that, abstracting from transaction costs, there may be no cash flow effects.
22 For more detailed discussion of these issues in the context of fair valuation of liabilities, see CitationHorton and Macve (2000). For a recent critique of the Hicksian approach to income measurement, see CitationRayman (2007).
23 The price of a barrel of standard crude oil on the New York Mercantile Exchange (NYMEX) rose from under $25 a barrel in September 2003 to $78 a barrel in July 2006.
24 There has, however, in the UK been a long history of legal interest in accounting valuations in relation to issues such as the propriety of dividend distributions and equity to minority shareholders. For example, in Dimbula Valley (1961) All ER 769, the legality of distribution from an unrealised reserve was upheld (this is now prohibited by legislation first introduced in the UK Companies Act 1980)—see CitationFrench (1977) for a detailed review of more than a century of dividend law; and in re Press Caps [1949] Ch.434, in the context of whether or not a buyout offer was fair to the minority shareholders, there was some discussion of whether financial statements in which a fixed asset was shown at an historical cost far below its current value did, in fact, appropriately reflect the true position of the entity.
25 The authors also supply general caveats concerning methodology, sample availability and interpretation in the research literature; not least of which is that much of the research evidence concerns firms whose core operating assets comprise financial instruments, i.e., financial institutions. Another useful review of the empirical literature in the field is to be found in CitationLandsman (2007).
27 A constructed measure encompassing fair value accounting for all financial instruments with gains and losses thereon being taken through the profit and loss account—as compared with the limited use of fair valuation under SFAS115/SFAS 130 Reporting Comprehensive Income/SFAS 133 Accounting for Derivative Instruments and Hedging Activities.
28 For a sample of 145 Fortune 500 manufacturing firms, CitationWong (2000) found no evidence that SFAS 119 provided incremental risk exposure information.
29 See, for example, CitationRyan, Scapens, and Theobald (2002).
30 Income (before interest, minority interests and taxes) from wholesale services rose by 133% between 1998 and 2000, from $968 million to $2260 million; whereas income from gas transportation and electricity generation combined increased by only 15%, from $637 million to $732 million.
31 Testimony to the US House Committee on Energy and Commerce sub-committee on oversight and investigations, February 2002, available at http://energycommerce.house.gov/107/hearings/02072002Hearing485/Olson793.htm.
32 It is perhaps a reflection both on corporate culture and the vagaries of human existence that, arguably, one of the main contributors to Enron's collapse, Rebecca Mark, should, having left Enron in 2000 and cashed in her stock options for $83 million, now be enjoying family life raising cattle on a New Mexico ranch (see http://www.fastcompany.com/magazine/74/enron_mark.html); whereas her nemesis within Enron, Skilling, who perhaps might plausibly claim to have created something of lasting economic value in terms of the opening up of energy markets, faces a much more bleak future. Ms Mark, as CEO of Azurix, oversaw Enron's disastrous venture into water services, having previously been responsible for negotiating and managing many overseas projects, including Enron's foray into power supply in the Indian sub-continent—projects which had, at best, mixed results.
33 And a film, ‘The Smartest Guys in the Room’, based upon the book by CitationMcLean and Elkind (2003).
34 For example, and in contrast to the situation in the UK, upward revaluation of property was not permitted by the SEC.
35 CitationColson (2006) attributes this to the effect of the FASB adopting a conceptual framework that: ‘shifted the financial accounting paradigm from revenue recognition and expense matching measured at historical cost to asset and liability recognition measured at fair value’.
36 See, for example, Schuetze (Citation1993, Citation2001, Citation2003).
40 Emerging Issues Task Force (EITF) 98-10 (FASB, 1998). Following the collapse of Enron, in 2002 EITF 02-3 (FASB, 2002) significantly restricted the use of mark to market accounting for energy contracts.
41 CitationBatson (2003a, p. 25). In respect of its merchant investment ventures Enron justified the use of mark to market accounting on the basis that these investments were analogous to venture capital investment companies which were, under US GAAP, permitted to use mark to market accounting. CitationBatson (2003a, p. 28) labelled this stance as ‘aggressive’ and indicative of the problems that both Enron and Arthur Andersen had in addressing the quality of earnings problem.
44 CitationBatson (2003a, p. 29) notes that: ‘the Examiner has not engaged valuation experts or otherwise undertaken to determine whether Enron properly valued the assets subject to its MTM [Mark to Market] accounting. Under MTM accounting, assets for which there are not publicly quoted prices are to be valued by management based upon the best information to determine the fair value of the assets. Many of Enron's assets were in this category, including most of its merchant investments and all of the Total Return Swaps it entered into in connection with the SFAS 140 transactions (and treated as price risk management assets or liabilities). In addition, the Examiner has not considered the propriety of Enron's extension of its MTM accounting to commodities not covered by EITF 98-10, or, other than the Prepays, whether contracts that Enron claimed were ‘energy trading contracts’ or ‘energy-related contracts’ under EITF 98-10 were in fact those types of contracts’.
45 CitationHaldeman (2006) suggests, on the basis of the shortfall of assets available in bankruptcy as compared with those disclosed in the financial statements for 2000, that the valuations placed upon the trading activities must have been inappropriate. No specific examples are provided, however, and, although the overall insight is of indicative value, a number of potential intervening factors might be relevant to the accuracy of the analysis.
47 Enron's purchase agreement did in fact prohibit the hedging of its stake before November (CitationBatson, 2003a, Appendix L, Annex 2, p. 13).
48 The actual transactions, which were complex, were executed with a subsidiary of LJM 1—but for ease of exposition here they are referred to having taken place with LJM 1. For a more complete analysis, see CitationBatson (2003a, Appendix L, Annex 2, pp. 1–46).
49 PwC received a fee of $800,000 for its opinion that the values attributed to the option and the shares were fair—see below for Goldin's critique both of the manner in which PwC arrived at its opinion and more generally of its relationship with Enron and LJM 1.
50 CitationBatson (2003a, Appendix L, Annex 2, p. 24) notes that for the purpose of this valuation the restrictions on the sale of the stock were ignored (some doubt is also cast, p. 17, on whether there had ever been any intention to enforce the restrictions). Batson also notes, p. 23, that there was, apparently, no fairness opinion as to the termination transaction, nor was there any evidence that it was approved by the Enron board.
51 This deconsolidation was achieved by means of the sale of a 13% interest in Cuiaba to LJM 1 (subsequently repurchased at a price which yielded a profit to LJM 1). Accompanying this interest was the right to nominate one of the four directors (a right that was not taken up)—which allowed Enron to argue that, as it no longer had the right to appoint a majority of the directors, it was no longer in a position to control Cuiaba. CitationBatson (2003a, Appendix L, Annex 3, p. 13) considers that this decision was inappropriate and that Enron should have continued to consolidate its interest in Cuiaba.
56 SPEs were commonly highly geared entities which, provided they met the SEC ‘rules’ in terms of the percentage of total assets financed by outside equity (then a minimum of 3%) and they were not controlled by the ‘parent’, were not required to be consolidated.
57 CitationBatson (2003a, p. 30): ‘Andersen appraised the value of this contractual arrangement at between $120 million and $150 million, even though the anticipated business did not have the technology to deliver its product or any rights to the product that it proposed to deliver’. The valuation was obtained on the basis of a number of assumptions as to likely market penetration and the cash flows associated therewith. These cash flows were then discounted at rates ranging from 31 to 34% to arrive at the valuation. In this context the Examiner opined (CitationBatson, 2003a, p. 31) that: ‘While a venture capitalist might find the analysis informative in assessing whether to make a seed investment in a speculative start-up situation, given the underlying facts, the Examiner questions whether it was appropriate for a public company to transfer this contract to a structured finance vehicle, assign it a speculative value and recognise that amount as current income and cash flow from operating activities’.
59 SFAS 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (issued September 2000; a replacement of FASB Statement No. 125).
62 CitationBerenson (2002) and CitationBaker and Hayes (2004). Other than in relation to the Eli Lilly valuation, there is little discussion in the reports of the bankruptcy examiners as to the quality of the valuation procedures employed in respect to these contracts or the appropriateness of the accounting treatment employed.
63 CitationBryce (2002) gives an example of such a deal, signed in February 2001 with Quaker Oats: ‘Enron Energy Services agreed to supply 15 different Quaker plants with natural gas, electricity, and trained personnel to maintain the company's boilers. Under the terms of the deal … the company guaranteed Quaker would save about $4.4 million per year in energy costs. Then, before turning on a single light, Enron projected it would make $36.8 million profit over the life of the 10-year deal and immediately booked … $23.4 million of that amount’.
64 Although, as we note above, CitationAhmed et al. (2006) found there to be value-relevant differences in market reaction to banks’ recognition of fair values as compared to disclosure (without recognition) of fair values.
65 Enron Annual Report (2000, p. 36). Enron's financial statements for the year ending 31 December 2000 are available at http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf.
66 Enron Annual Report (2000, p. 40).
67 Enron Annual Report (2000, p. 38).
68 Quoted in CitationQuoted in Batson (2003a, p. 26).
69 CitationGoldin (2003, pp. 14–16) outlines the basic requirements of SFAS 140 and its predecessor SFAS 125 with respect to when, under US GAAP, it is and is not appropriate to recognise a sale.
72 For example, WorldCom, Xerox, Tyco and many others (see CitationGwilliam & Marnet, 2006).
74 The case also illustrates the ease with which Enron was able to ‘monetize’ (to use the bankruptcy examiner's term) physical assets—which in turn may have implications for those who consider the debate over IAS 39, and the similar FASB proposals, to be confined more strictly to conventional financial assets and liabilities.
75 Strictly speaking, not all the valuations discussed above were directly for mark to market purposes—for example the Blockbuster and Eli Lilly valuations provided by Arthur Andersen and KPMG, respectively, were for the purposes of the SFAS 140 transaction whereby a ‘sale’ of the relevant interest was recorded.
76 It is, of course, not possible to infer directly from this that the valuations were necessarily inappropriate at the time that they were made. Valuations representing point estimates will incorporate a probability distribution of likely outcomes and it could be argued that the actual outcomes were suitably incorporated into that distribution.
79 ‘This material conflict of interest could have compromised PwC's independent judgment on its fairness opinions. PwC not only failed to declare this conflict of interest to Enron's board of directors, but represented affirmatively that it had no conflict, in violation of both PwC's internal guidelines and industry standards which require that those who render fairness opinions be completely impartial’ (CitationGoldin, 2003, p. 306).
81 More generally CitationGoldin (2003, pp. 304–452) provides a wealth of detail as to PwC's role with respect to the Rhythms and Raptor 1 (Talon) transactions.
83 Most notably the Raptor transactions which the Powers report described thus: ‘Enron's use of the Raptors allowed Enron to avoid reflecting almost $1 billion in losses on its merchant investments over a period spanning just a little more than one year’ [from the 3rd quarter of 2000 through to the 3rd quarter of 2001] (CitationPowers et al., 2002, p. 132).
84 ‘Each of us sees the future differently no doubt. But my own guess is that, so far as the history of accounting is concerned, the next 25 years may subsequently be seen to have been the twilight of income measurement’. CitationSolomons (1961, p. 383).
85 Enron Annual Report (2000, p. 2).
86 CitationBarker (2004, p. 159) notes that ‘standard setting is moving inexorably toward a fair value model, making the concept of earnings increasingly difficult to interpret’.