ENRON AND ARTHUR ADNDERSEN: THE CASE OF THE CROOKED E AND THE FALLEN A

Global Perspectives on Accounting Education, 2006 by Cunningham, Gary M, Harris, Jean E

How did mark-to-market accounting work at Enron? Assume Enron had two option contracts matched over the same time period for the same amount of a commodity; one contract was to buy the commodity and the other contract was to sell the commodity. Enron would look into the future, assume both contracts were exercised and net the results. After allowing for delivery costs and for reserves for other unforeseen costs, the net income (loss) was estimated over the life of the matched contracts. Then this estimated net income (loss) was discounted for the time value of money, to its present value and recorded as a gain (loss). The method required that each year the estimated future earning be re-estimated and marked up or down.

At Enron, the earnings reported under mark-to-market accounting were easy to manipulate because active markets did not exist for contracts that sometimes had terms as long as 20 years. So it was necessary to estimate future earnings. Enron controlled the estimation of its earnings, earnings which were recognized for the entire term of the contract in the first year of the contract. The assumption is that earnings are created by securing contracts rather than by rendering performance on contracts. One advantage for Enron's management of immediate recognition of earnings was that executive compensation, which was based on earnings, was inflated.

Enron exacerbated many problems by using mark-to-market accounting. Because earnings were recognized immediately for the entire life of the contract, a short-term focus was encouraged and earnings were volatile. Additional contracts had to be sold in the immediate short-term to report any earnings. So Enron expanded mark-to-market accounting to trading in electricity, broadband, fuel additives, and other items that were not commodities, such as deferred tax benefits. For many of these commodities there was no active market, even in the short-term. Because, in many cases, it is doubtful the underlying assets existed, it appears Enron reported fictitious earnings. A major problem was that these estimated earnings did not generate liquidity; cash flow from actual execution of the contracts lagged far behind the recognition of earnings.

The risk was enormous. If the market reversed, mark-to-market accounting required the recognition of losses, possibly enormous losses. A huge gap opened between realistic estimation of earnings and Enron's estimations based on aggressive assumptions about interest rates, continuing viability of other parties to contract, taxes, regulations, technology, demand, etc. When changing market conditions necessitated a mark down and the recognition of a loss, Enron hid, delayed or ignored the loss. Andersen apparently did not question any of the values assigned to the contracts or object to tactics to hide, delay or ignore losses. Some of Enron's most abusive SPEs were created to avoid reporting mark-to-market losses.

Financial Reporting of Enron's SPEs

SPEs are typically created for purposes such as owning and leasing real estate. Enron had over 3,000 SPEs, many times more than any other company. Initially, some SPEs were legitimate for risk management. However, the vast majority of the SPEs in the years preceding bankruptcy were used to manipulate financial reports. The SPEs almost always had complex structures with interlocking ownership and with Enron sometimes holding an equity interest. The CFO of Enron and/or other employees held equity interests. Senior executives or other employees of Enron managed and operated the activities of the SPE while being paid salaries by Enron and receiving no compensation from the SPE. Enron's board of directors exempted its CFO from Enron's conflict of interest policies. As a result, he was able to control both sides of transactions and enrich himself.