2. Enron’s adoption and use of fair-value accounting
Enron’s initial substantial success and later failure was the result of a succession of decisions. Fair-value accounting played an important role in these decisions because it affected indicators of success and managerial incentives. These led to accounting cover-ups and, I believe, to Enron’s subsequent bankruptcy. I present these developments essentially in chronological order, which shows how Enron’s initial ‘‘reasonable’’ use of fair-value accounting evolved and eventually dominated its accounting and corrupted its operations and reporting to shareholders.
2.1. Energy contracts
Enron developed from the merger of several pipeline companies that made it the largest natural gas distribution system in the United States. In 1990, Jeffrey Skilling joined Enron after having been a McKinsey consultant to the company. He had developed a method of trading natural gas contracts called the Gas Bank. Enron’s CEO, Kenneth Lay, persuaded him to join the company. Skilling became chairman and CEO of a new division, Enron Finance, with the mandate to make the Gas Bank work, for which he would be richly compensated with ‘‘phantom’’ equity (wherein he received additional
毕业论文 pay in proportion to increases in the market price of Enron stock). Enron Finance sold long-term contracts for gas to utilities and manufacturers. Skilling’s innovation was to give natural gas producers up-front cash payments, which induced them to sign long-term supply contracts. He insisted on use of ‘‘mark-to-market’’(actually ‘‘fair-value,’’ as there was no market for the contracts) accounting
to measure his division’s net profit. In 1991 Enron’s board of directors, audit committee and its external auditor, Arthur Andersen, approved the use of this ‘‘mark-to-market’’ accounting. In January 1992 the SEC approved it for gas contracts beginning that year. Enron, though, used mark-to-market accounting for its not-as-yet-filed 1991 statements (without objection by the SEC) and booked $242 million in earnings. Thereafter, Enron recorded gains (earnings) when gas contracts were signed, based on its estimates of gas prices projected over many (e.g., 10 and 20) years.
In 1991, Enron created a new division that merged Enron Finance with
Enron Gas Marketing (which sold natural gas to wholesale customers) and
Houston Pipeline to form Enron Capital and Trade Resources (ECT), all of which were managed by Skilling. He adopted fair-value accounting for ECT
and he compensated the division’s managers with percentages of internally generated estimates of the fair values of contracts they developed. An early (1992) example was a 20-year contract to supply natural gas to the developer of a large electric generating plant under construction, Sithe Energies. ECT immediately recorded the estimated net present value of that contract as current earnings. During the 1990s, as changes in energy prices indicated that the contract was more valuable, additional gains resulting from revaluations to fair value were recorded, which allowed Enron to meet its internal and external quarterly net income projections. By the late 1990s, Sithe owed Enron $1.5 billion. However, even though Enron’s internal Risk Assessment and Control (RAC) group estimated that Sithe’s only asset (worth just over $400 million) was inadequate to pay its obligation, the fair value of the contract was not reduced and, consequently, a loss was not recorded. In fact, the loss was not recorded until after Enron declared bankruptcy.
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