Case 3
Enter Mark-to-Market: Exit Accounting Integrity?
I know mark-to-market isn’t the right accounting answer. It’s too bad that Jeff Skilling doesn’t care about the merits of the case.
SERGE GOLDMAN WAS NOT LOOKING FORWARD TO TOMORROW’S MEETING. It was May 1991. Goldman, Arthur Andersen’s (AA) engagement partner on the Enron account, was being pushed by his client to allow mark-to-market (MtM) accounting at one specific Enron unit: Enron Finance (EF). EF was a new unit, formed in just the last year. Its head, Jeffrey Skilling, had been an Enron employee only since August 1, 1990. Skilling had made it known that he wanted MtM for his unit. In fact, he told Enron chairman Ken Lay and president Rich Kinder that using MtM in EF was a condition for Skilling’s leaving McKinsey to join Enron.
Goldman had several problems with Enron’s requested change. For one thing, he wasn’t that familiar with MtM. Mark-to-market accounting, a relatively recent development, was used by Wall Street banks that traded marketable securities. Use of MtM was nonexistent in the Texas oil patch. Oil and gas accounting, on the other hand, was both well established and understood by accountants like Goldman. Serge felt uncomfortable being the first public accountant to approve using MtM in the oil and gas business.
Moreover, Goldman had concerns about the technical appropriateness of Enron’s using MtM. True, EF resembled investment banks in some ways. EF lent money to gas producers in return for an interest in their future production. EF then sold the future production thus acquired to utilities and industrial customers under long-term supply arrangements. Skilling called Enron’s intermediary role the “Gas Bank.” In its fully developed state, EF was not only banking producers but also “securitizing” both the producers’ financing and the customers’ sales contracts. A complete outline of EF’s Gas Bank concept is provided in Attachment 1.
Much of this resembled what Wall Street firms were doing with real estate mortgages and financial derivative contracts. Hence, Goldman could not simply dismiss EF’s MtM request as being inappropriate to an oil and gas business. But there were issues. For one thing, the contracts EF was signing were not marketable securities; they did not have readily discernible values. Yet, Enron wanted to account for them as if they were like Treasury securities.
Upon signing a contract, Skilling wanted EF to book the deal’s entire expected net present value as profit. This would produce large reported accounting income, the cash for which would materialize only over the long life of the contract. Moreover, Skilling was not content just to book a deal’s present value as profit. He also wanted EF to record the present value of each sales contract as revenue. Using this approach would ensure a huge rate of growth for EF’s top-line revenue.
Goldman was not at all sure that such an approach would improve investors’ understanding of Enron’s financial reports; he rather suspected that it might confuse investors, serving up impressions of dramatic growth in revenue, lesser but still impressive growth in reported profits, and a large disconnect between accounting profits and cash flow.
But more than accounting questions were adding to Goldman’s discomfort. Jeff Skilling would certainly attend tomorrow’s meeting. Skilling had hit Enron like a force of nature. Described as “incandescently brilliant,” he was known to not take no for an answer. Skilling had assembled a team—all of them very bright—who took their cues from his lead. Goldman knew that he could expect to be browbeaten by all the Skillingites if he refused to approve MtM. Indeed, he could expect to be browbeaten if he gave any sort of answer other than “let’s do it.”
Delay tactics and/or asserting AA’s technical prowess also didn’t look like promising approaches. Skilling had quickly developed a reputation as a hands-on manager. When he wanted something done, he got personally involved to ensure that it got accomplished.
A final consideration was Enron’s emerging importance as a client. It was becoming clearer by the day that Enron was prepared to spend large dollars on consulting help. Indeed, Skilling had come on board after consulting for Enron for three years. In fact, Skilling had developed his Gas Bank scheme while working as a consultant. The problem this posed for Goldman concerned his own firm’s appetite for consulting business. Arthur Andersen increasingly viewed consulting as the growth engine for the firm; indeed, Goldman had heard the view expressed internally that the most important aspect of AA’s being retained as a public accountant was the possibility that engagements would open the door to consulting work. Enron looked to be a prime prospect. Not only was it likely to use consultants, but in hiring managers like Skilling, Enron was clearly signaling its intent to innovate. That would mean a continuous search for new ideas and for top consultants who could generate them. How would the increasing importance of consulting impact AA’s traditional commitment to public accounting? Would AA still be able to summon the wherewithal to say no to accounting clients if that put consulting engagements in jeopardy?
With an eye to figuring out how best to respond to Skilling’s expected salvos, Goldman reviewed his file’s brief history of Skilling’s career.
Jeff Skilling’s Association with Enron
Jeff Skilling started working on Enron issues in 1985. By that time, he had been at McKinsey for five years. The big Omaha pipeline company, InterNorth, was an established client. When InterNorth merged with Houston Natural Gas to form Enron, Skilling was asked to work on a politically sensitive question: Should the headquarters be in Omaha or in Houston? He gave the politically incorrect but substantively correct answer of Houston, catching Ken Lay and Rich Kinder’s eyes in the process. Lodged in McKinsey’s Houston office, Skilling continued to consult for Enron after the company’s headquarters moved to its soon to be famous 1400 Smith Street location.
Skilling worked on several issues but all were connected in some way with Enron’s central preoccupation: How could a gas pipeline company make money under deregulation in a low natural gas price environment? Skilling’s eventual answer was the Gas Bank.
Skilling first pitched the idea to Rich Kinder in December 1988. In classic Skilling fashion, the pitch consisted of one chart scrawled on a piece of notepad paper. The industry’s basic problem, Skilling argued, centered on the gas producers. Those with reserves were reluctant to sign long-term contracts at the rock-bottom prices then prevailing. Producers also lacked internal funds to finance new drilling, and in the wake of Houston’s oil price bust were finding it difficult to get financing from banks. Meanwhile, industrial consumers were reluctant to build new gas-fired power or manufacturing plants when they couldn’t obtain term supply commitments with firm prices. The natural gas industry was thus stalemated; producers weren’t growing production and consumers weren’t growing demand. This meant depressed volumes moving through the pipelines of companies like Enron and poor prospects for growth any time soon.
Skilling’s chart was based on the fact that in such an environment an intermediary could buy natural gas reserves for a low dollar/thousand cubic feet price and then commit to sell the future production to end users at a significant premium. Potential consumers were prepared to pay that premium to obtain supply and price commitments against which they could then run their own economics for generating power or producing aluminum or chemicals. Skilling saw Enron playing this intermediary role. It would be the “bank,” taking gas commitments from producers and providing ensured supply to consumers in return for a markup. Kinder saw the price spread that had attracted Skilling and also saw that this intermediary role might get Enron’s pipelines full again. Any demand growth for natural gas had to be positive for transportation providers. Kinder encouraged Skilling to develop his concept more fully.
Although Kinder and Ken Lay liked the Gas Bank, much of Enron’s existing organization was opposed or indifferent. The concept languished until Lay became convinced that the Gas Bank would never get off the ground without Skilling being in charge of execution. Kinder agreed. In April 1990, Lay and Kinder set out to persuade Skilling to leave McKinsey. Skilling was a partner at McKinsey, which implied that he made more than $1 million per year. Enron was not able to match such a salary. Enron could, however, offer Skilling an incentive scheme whereby he would share in the profits generated by his new business unit, Enron Finance. Bored with McKinsey’s internal workings and eager to prove the viability of the Gas Bank, Skilling eventually agreed to a $275,000 annual salary plus the incentive scheme. EF would have to become nicely profitable for Skilling to match, let alone exceed, his McKinsey remuneration; on the other hand, if EF became a homerun profit generator, Jeff Skilling could reap an altogether different level of compensation.
Since coming on board, Skilling had refined the Gas Bank and built a team to roll it out. The initial problem had been the reluctance of producers to commit gas volumes under long-term contracts. Skilling overcame this by offering financing for their new drilling. The lure of upfront money to fund drilling proved enough for producers to agree to grant Enron long-term “production payments” as the means to repay their financing. What looked to the producers to be loan repayment was to Skilling a committed supply of gas at a fixed price. The Gas Bank now had the long-term gas supplies it needed to extract the premium that gas customers were willing to pay.
A second problem concerned Enron’s limited supply of finance capital. In 1990, Enron had barely recovered from its 1987 near-death experience of weak financial results and the Valhalla trading scandal. The company still carried a junk bond rating. There would not be enough Enron capital available for EF to build the Gas Bank as rapidly as Skilling thought the opportunity demanded.
Skilling’s answer was to securitize both sides of the natural gas trades done by Enron’s Gas Bank. Production payments acquired by Enron from gas producers would be pooled and interests sold to outside investors. The same could and would be done with the supply contracts Enron signed with gas customers. This approach freed the Gas Bank from Enron’s internal-funding constraint. It also paid another enormous dividend: It opened EF’s eyes to the fact that it could originate and then trade components of its long-term contracts; these components would be useful to other gas market players as hedges of their different positions. Skilling and his new team—Gene Humphrey, Lou Pai, George Posey, Amanda Martin, and new “securitization hire” Andrew Fastow—were mesmerized by the potential. Through origination and securitization of natural gas contracts, Enron could do more than rejuvenate its pipeline business. It could create and then dominate an entire new industry activity: the trading of natural gas futures contracts.
As Skilling saw the trading potential of his original Gas Bank scheme, his resolve to use MtM only intensified. It hardened even more when Oil and Gas accounting (OGA) turned out to pose a specific problem. When it sold interests in its sales contracts to third parties, EF would not, under OGA, be able to match the gas acquisition price embedded in production payments against the sales price embedded in customer supply contracts. Instead, the sale of interests in a gas-supply contract resulted in an immediate gain or loss, depending on how the term sale contract price compared with the spot gas price then prevailing. In theory, Enron could end up realizing an initial accounting loss if spot prices happened to be high when a term sales contract was securitized. The fact that this same contract was already hedged by a fixed-price production payment would be recognized only down the road when gas was actually produced.
This mismatch further irritated Skilling and led directly to the scheduling of the meeting for which Serge Goldman was now preparing.
Serge Goldman Prepares to Meet Jeff Skilling
When news of the OGA mismatch problem reached Goldman, he had asked his young associate, David Duncan, to contact AA’s Professional Standards Group (PSG) to discuss the matter. PSG was an elite group of AA’s best accounting technicians; its writ was to assist AA accountants when client engagements posed especially difficult technical issues. If there was conflict between the engagement team and PSG, the latter was to have the last word. Goldman had asked Duncan to secure both a pros/cons discussion of using MtM at EF and any specific ideas PSG might have on the OGA mismatch issue. PSG’s response is provided in Attachment 2.
To better prepare, Goldman divided up the issues into major baskets. In the first, labeled Technical Accounting, the challenge was to enumerate the specific issues under scrutiny and to discern the best technical accounting answers. Goldman expected that Skilling and his team would try to reduce the accounting issues to a simple “MtM: yes or no?” As PSG’s memo makes clear, EF was seeking a variant of MtM, one that went well beyond that used by Wall Street firms. Goldman felt that each of the issues broached by PSG deserved its own discussion. He wondered how he could achieve such a conversation as opposed to having the discussion polarize quickly over whether AA would say yes or no to MtM.
This conundrum led directly to a second basket, which Goldman labeled Achieving the Client’s Business Objective. The title contained an implicit assumption—namely, that the client’s objective could be obtained in a fashion consistent with a sound accounting approach. Goldman knew that he must explore such possibilities. An acceptable solution might mean that AA would not demand use of the best technical approach. However, the method chosen would still have to satisfy several tests, including being technically sound, comprehensible to the financial markets, and satisfactory to regulators. Obviously, if there was a way to use the best accounting method to achieve the firm’s objectives, so much the better.
Over the years, Goldman had learned that how AA orchestrated a client meeting often determined the outcome of the accounting discussion. Generally, it was better to start with positive news—what AA could agree to—before getting into what was still under review or, worse, what could not be accepted. Here, Goldman felt nervous. He did not yet have any good news to offer up. He did not have a technical fix for EF’s mismatch problem and had not been authorized by AA to agree to MtM. Once all that bad news got out on the table, he doubted that Skilling and his team would want to sit still for a detailed discussion of the reasons.
As the thought of Jeff Skilling’s likely reaction flitted through his mind, Goldman grew even more apprehensive. He could easily imagine Skilling starting to scream denunciations and then retreating to his office to call AA in Chicago. No doubt, Goldman would be portrayed as a bean-counting dolt who didn’t “get it.” That wasn’t what bothered Serge the most. Rather, it was the risk that if/when Skilling’s call hit Chicago, Goldman’s superiors, eager to placate this lucrative client, would cave on the matter. MtM in principle might be conceded. Goldman would be told to work out the details. Once Chicago showed that it wasn’t standing behind Goldman, those details would end up being pretty much whatever Skilling would settle for. Goldman might also receive a quiet black mark for not having managed the client, such that an Enron “rocket” didn’t land on AA Chicago.
Was there a better way to manage the client and the meeting? Goldman went back over his file on Skilling and his Gas Bank. How much of Skilling’s passion for MtM concerned its role in making the Gas Bank work? Would the Gas Bank remake EF into the equivalent of a Wall Street firm? Did Skilling believe that a trading-oriented accounting system was needed to recruit the type of individual needed to succeed at such activities? Was it more a matter of Skilling, the former high-flying consultant, believing that design/origination of the idea was the true value-creating event? Or, was it all about Skilling’s personal compensation: his need to cover his former McKinsey’s remuneration and eventually to move well past it?
Goldman reflected that if he could pin down Skilling’s MtM motives, he stood a better chance of holding his own at the meeting, keeping the discussions “localized” in Houston, and eventually developing an answer that might also be acceptable from a technical accounting standpoint.
He poured another cup of coffee and turned back to the PSG memo.
Attachment 1
EF’s Gas Bank involves the following participants: 1) gas producers, 2) Enron Finance, 3) a special purpose entity (SPE), 4) institutional investors, and 5) term gas customers.
A standard Gas Bank transaction, as shown in the diagram below, would unfold as follows:
- EF agrees to loan money to gas producers in return for an ownership interest in a portion of future gas to be produced: a production payment. The volume of gas committed in the production payment is sized to generate ample cash to pay interest and principal on the loan.
- EF forms an SPE, meeting the tests of 3 percent minimum independent capital and an independent “mind and management” determining the SPE’s commercial decisions.
- (a) SPE sells ownership interests to institutional investors, using the proceeds to (b) buy EF’s production payment. EF is now “whole” as regards cash, and the SPE is “long gas.”
- EF repurchases the SPE’s gas over time under long-term, fixed-price contract. The SPE now expects to realize the cash flow from EF’s original producer loan but paid in the form of sales proceeds from gas it delivers to EF.
- EF enters into long-term gas sale contracts with end users at prices that carry a premium over the acquisition price paid to the SPE.
As additional steps, EF can sell off portions of either its gas repurchases from the SPE or its sales to end users. EF can also cover the open position so created by buying or selling gas from/to other third parties. These operations allow EF to benefit from (1) being a market maker in natural gas purchases and sales for all terms and regional markets, (2) from “customizing” coverage for specific counterparties, and (3) taking a speculative position if it senses that gas prices are likely to move in a particular direction. Diagrammatically, the Gas Bank looks as follows:
Attachment 2—Historical Recreation (HRC)
| To: | Mr. Serge Goldman |
| From: | Professional Standards Group |
| Subject: | Adoption of Mark-to-Market Accounting by Enron Finance |
You have asked that the PSG consider three questions:
- What is the general suitability of using “mark-to-market” (MtM) accounting for the oil/gas financing and trading business under development at Enron Finance (EF)?
- What are the pros/cons of having EF shift from using conventional Oil/Gas accounting (OGA) to MtM?
- Is there a technical fix for the asymmetric treatment OGA affords to EF’s acquisition of production payments versus its sale of interests in term contracts with end users?
Below please find specific answers to these questions and some general observations on whether this is a matter that EF and AA may settle between themselves.
General Suitability of MtM for EF
MtM is a recent development in financial accounting and is used by a variety of banking and commodity trading firms. As of this moment, its use is not mandatory. A draft FASB Statement is being developed; its focus is financial assets that have readily ascertainable market values, including stocks, bonds, and market-traded futures and options.
MtM’s focus concerns the treatment of marketable securities and financial contracts. When MtM is used, these assets must be reported on the balance sheet on each statement date at their ascertainable current market value rather than historical acquisition cost. Any change in value versus the prior period gives rise to gain or loss to be reported on the firm’s income statement.
The principal rationale for MtM is that it updates valuation of a financial firm’s assets. This process more accurately reflects a firm’s current worth. For firms that continuously buy and sell marketable securities, using MtM thus represents an improvement in recognizing the results from trading. MtM also reduces a firm’s ability to manage earnings by selling appreciated assets while holding on to assets that are worth less than their historical cost.
In terms of suitability for use at EF, there are some parallels between that unit’s activities and businesses that already use MtM. EF seeks to create value via financial structuring. In this sense, it is different from an oil/gas business concerned with the discovery, production, and physical movement of hydrocarbons. More specifically, EF intends to create tradable futures instruments in natural gas purchases and sales. This, EF can plausibly argue, is analogous to what Wall Street firms do when they originate and securitize financial instruments, such as collateralized mortgage obligations or “synthetic” zero coupon bonds. EF may also argue that it will be looking to attract professional traders away from Wall Street firms; undoubtedly, EF feels that to compete for such resources, it will need to recognize and reward trading performance. The use of an MtM accounting approach, it can be argued, is thus consistent with EF’s trading business model and incentive systems for key personnel.
There are also several aspects of EF’s business model that don’t fit well with using MtM. These include the following:
- Most, if not all, of EF’s assets will not involve widely traded instruments. As such, they may not have readily ascertainable market values. This causes such instrument’s valuation to become a function of assumptions and analysis done internally at EF. Technically, the valuing of these instruments will be challenging. Of even more concern, there will be serious potential for objective valuation to be compromised by other agendas. Without adequate and sustainable controls, the risk of accounting abuses at EF would be high.
- Should EF use MtM, a large and growing variance will develop between reported profits and cash flow. Investors will need to puzzle through reports of large “unrealized” gains/losses to figure out the extent to which EF is contributing cash to parent Enron. The problem will not be dissimilar to that encountered some years back on foreign exchange translation accounting; there unrealized gains/losses swung earnings and earnings per share back and forth without materially influencing near-term cash flow. Ultimately, unrealized foreign currency effects were consigned to a cumulative translation account (CTA) in the net worth portion of the balance sheet to eliminate this confusion.
- For Wall Street firms, this gap between reported earnings and cash flow is less of an issue; the assumption is that their assets are readily salable into liquid markets. Should it face a cash flow crunch, the firm can be expected to liquidate some assets at values reasonably close to those reflected in its most recent financial statements. This assumption cannot be made for EF; its unique and nonstandard assets cannot be assumed to be easily liquidated at prices near to values on the books, especially if accounting values reflect internal assumptions that become skewed over time in an optimistic direction. Thus, the risk of EF’s being unable to generate cash resembling its value on the books is substantially higher than for most firms currently using MtM.
We conclude from this that although EF has some arguments that could justify adoption of MtM, there are equally weighty, if not stronger, arguments suggesting that serious problems could arise.
Accordingly, the pros/cons of any EF decision on MtM must be weighed in terms of (1) the specific form of MtM that EF proposes to adopt and (2) such modifications of MtM, measures of control, and additional disclosure that EF would undertake to address the identified risks.
Specific Pros/Cons of an EF Switch to MtM
If we correctly understand what you have told us, EF’s proposal goes beyond adoption of conventional MtM. Indeed, it seems that EF is intent on combining certain features of MtM with others of OGA into a hybrid system. This approach appears to magnify the potential for aggressive, potentially abusive, accounting and for the distortion of published statements.
EF’s version of MtM involves the application of “merchant investment” accounting to its origination or trading of purchase and supply contracts. This differs markedly from how MtM is used by the financial firms that EF supposedly is seeking to emulate.
Financial firms that use MtM typically do not reflect expected cash flows from purchased or sold instruments in either revenue or cost of goods sold. Instead, such firms simply put purchased assets on the balance sheet, reflect changes in value on statement dates while these are held, and then reflect any gain or loss versus the last updated value when said assets are finally sold. Even when it originates and retains an instrument, a financial firm does not book expected revenues or costs immediately. Stating things more simply, financial firms book their “trading spreads and fees” into income and then reflect market fluctuations on financial assets held in inventory.
Under EF’s version of MtM, the expected net present value (NPV) of originated/acquired customer supply contracts is to be booked immediately as revenue and the NPV of materials purchase contracts as costs of goods sold.
EF’s intended approach appears to magnify a distortion discussed earlier and to create two entirely new issues. The magnified distortion concerns the discrepancy between reported income/losses and cash flow. Under EF’s approach, it will not simply be recording profits that will be realized only years hence; it will be reporting current revenues that in fact will materialize only years into the future. EF talks in terms of natural gas supply/sales contract with tenors of ten years or more. This means that the magnitude of the discrepancy between reported current revenues and revenue as “earned and collected” will be substantial.
One new issue concerns the conditions typically applied to justify recognition of revenue. Traditionally, revenue recognition has required the service that generates the revenue to have been rendered and that cash collection has either occurred or is highly probable. EF’s approach departs from both of these principles on the grounds that it will be dealing in financial instruments whereby underlying service and credit risk are minimal. However, EF’s basic concept is tied to the purchase, sale, and physical delivery of gas. To the extent that the instruments EF will be creating and trading are not divorced from underlying production, delivery, and credit risk, its version of MtM unduly minimizes the risks facing the firm.
The second issue involves a wholly new distortion to EF’s business model. By immediately recognizing all expected future revenues at the time of contract signing or acquisition, EF commits itself to start over at zero revenue at the outset of each new accounting period. There will be no “book” of already contracted business ready to generate revenues into the future. This will put pressure on EF to generate at least as many contracts or trades as in prior periods just to match the revenues already booked.
These multiple possibilities for distorted financial reporting and the abuse of basic accounting controls imply considerable potential for deterioration in the quality of EF’s financial reports; quite possibly, this reduction in quality would exceed whatever would be gained via having updated valuations of contract assets on the balance sheet.
Technical ‘Fix’ in Asymmetric Treatment
More details are needed about the specifics of the transaction you described as having upset the client. However, two things are already clear from the brief outline provided to date.
First, a full-scale switch to MtM is not needed to address asymmetric treatment that current rules may be applying to one portion of EF’s planned business model. Any decision on whether to let EF adopt MtM should not be driven by this issue alone.
Second, there are a variety of precedents for addressing asymmetric treatments of two-side transactions. Examples include hedge accounting and “integrated financial transactions.” With more details, PSG may be able to suggest an approach that could alleviate the objectionable asymmetric treatment. Be advised, however, that developing and implementing such an approach may require time and involve obtaining approval from regulatory authorities.
Comment on Resolution of Client’s Request
As indicated, serious technical and financial-control issues exist about the advisability of EF’s adopting its preferred version of MtM. The client may be able to resolve some of these issues by agreeing to modify its approach.
The adoption of any form of MtM by a unit of a publicly traded oil/gas firm, such as Enron, is likely to attract the attention of regulators. We therefore suggest that you advise EF that the consent of the SEC may be required.
If, after your next discussion, the client still wishes to pursue a change to any form of MtM, PSG will make a definitive assessment as to whether SEC approval of the change will be necessary.
Author’s Note
This case captures Enron at a pivotal early moment. Enron is still a conventional company from an accounting perspective. Oil and gas accounting is still used throughout the company. Arthur Andersen still has a powerful voice, even a veto, in determining what accounting methods are acceptable. However, a powerful force for change has entered the picture. The case explores how AA can defend its convictions in the face of Jeff Skilling’s determination to have his way and against a backdrop of AA’s having a major commercial interest in preserving good relations with the Enron client.
Conspiracy of Fools identifies the AA engagement partner with whom EF and Jeff Skilling held discussions on switching to MtM. Serge Goldman is a fictitious name given to this real person. Since few details are public about his interaction with other partners at AA, it was deemed prudent to fictionalize this person. Also, this case does not intend to imply that it is a historical account of AA’s discussions of Skilling’s request. Neither does it intend to offer a historical account of Goldman’s pre-meeting strategizing. Indeed, the published sources rather imply that Goldman did not come to this Skilling meeting with a well-orchestrated plan in mind. Rather, the case attempts to present the dilemmas—technical and otherwise—which Skilling’s MtM demand posed for AA. That story is a matter of public record. The pre-meeting planning thoughts projected into Goldman’s mind are an effort to begin the issue identification for students.
Skilling’s background, his decision to join Enron, and his approach to EF are as outlined in Conspiracy of Fools (pp. 40–45, 53–58) and The Smartest Guys in the Room (pp. 32–39). The former outlines Skilling’s Gas Bank concept, providing the basis for the description in this case.
The analysis of MtM accounting issues draws on the two texts just referenced and also Enron: Corporate Fiascos and Their Implications, edited by Nancy B. Rapoport and Bala G. Dharan, in which Dharan and William R. Bufkins provide a detailed discussion of the distortions and risks associated with EF’s version of MtM (pp. 97–112). Peter C. Fusaro and Ross M. Miller’s What Went Wrong at Enron (pp. 33–37, 62–64) highlights how the discrepancy between reported earnings and cash flow helped undermine Enron’s spending discipline. This in turn reinforced Enron’s insatiable appetite for financing, putting pressure on Enron’s investment-grade credit rating. Investment-grade status was essential to Enron’s lucrative trading businesses. The resulting collision between Enron’s “need to feed the beast” with fresh capital pushed the company toward off-balance-sheet financing and the use of special purpose vehicles. It was on this playing field that Andy Fastow would operate.
Dharan and Bufkins’ article (pp. 101–123, especially pp. 102–105) and Dharan’s testimony before the House Energy and Commerce Committee highlight Enron’s adoption of the “merchant investment” model and its resulting inflation of accounting revenues. Professor Dharan’s work is a significant contribution, underscoring how Enron aggressively reached beyond conventional MtM. This impression coincides with the account of David Woytek’s conversation with EF CFO George Posey, described in Conspiracy of Fools (pp. 55–57). In that discussion, Woytek points to the issue of inflating revenues:
“You’re saying you want to recognize revenues from twenty-year contracts in the first year. I don’t know what that is, but that’s not mark-to-market.”1
This text suggests that EF adopted the “merchant investment” version of MtM from the outset. It is clear from Dharan and Bufkin’s article (p. 103) that by the time Enron On-Line came into operation, Enron was using this aggressive interpretation more broadly; this led to staggering increases in reported revenues between 1998 and 2000. For the sake of crystallizing the full slate of accounting issues latent in EF’s request, the case assumes the “merchant investment” model to be embedded in EF’s approach from the beginning.
Although it is likely that Goldman discussed EF’s request with AA’s PSG, there is no evidence that he received detailed written advice prior to his planned meeting with Skilling. Attachment 2 is thus an HRC intended to lay out the technical issues and provide certain warnings on the control and transparency issues at stake in the upcoming meeting. Conspiracy of Fools indicates that Goldman received advice that any switch to MtM would require SEC approval (p. 55). When he tells Skilling that SEC approval is needed, Goldman makes clear that his advice “came from Chicago.” Attachment 2 has thus been crafted to mention this as a possibility so as to encourage students to use this fact in developing their strategy for managing the meeting with Skilling.