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Enron unplugged

The spectacular implosion of Enron, ostensibly the seventh largest company in the US, not only rattled the audit profession to its roots, it also raised serious management and accounting questions for the entire energy sector – questions that reach to the heart of the debate over how, exactly, the world moves to a common and sensible set of accounting standards.

With the 20-20 vision brought by hindsight, the practice of allowing energy companies to report an entire $1bn trade as revenue, instead of the 1%, or 0.5% that actually constitutes their earnings from the deal, seems more than dubious. Without this practice, as the New York Times reported with more than a little irony, Enron would have been ranked as merely the 223rd largest company in the US. Then too, the weird US GAAP arrangement that allows a company to regard an entity as off balance sheet provided someone else owns just 3% of it, surely requires fresh thinking.

That there ever were such practices, and that they stood unscathed despite decades of more or less rigorous standard-setting, is testimony to the pressure US companies can bring to bear on the supposedly independent standard setting process. You will search in vain for sound academic reasons for such a daft set-up.

At the same time, these absolutely obvious reasons why this kind of jiggery-pokery should never have been available to the management of Enron are now so clear that the actions of poor old Andersen seem incredible. That calm, measured sentence in the audit report, the bit saying “the financial statements referred to above present fairly, in all material respects, the financial position of Enron Corp”, now provokes either gales of laughter or outright despair, depending on one’s temperament.

The only thing everyone seems to agree on was that Enron’s accounts were unreadable and that this was no accident, but rather the result of a deliberate policy by Enron management to make its activities and its actual financial position impenetrable to outsiders. The fact that Enron’s ex-CEO, Kenneth Lay, recently admitted to not understanding the finer details himself is just the final painful guffaw in the long running joke that was the company’s approach to crafting its annual report.

Whatever the legal outcome, Andersen’s “crime” will undoubtedly be that it condoned and gave its professional blessing to such opaque documents.

Granted, Enron’s accounting practices became more Byzantine with each passing year, but one is still left with the question of why they were regarded as acceptable for so long. After all, the company did not spring fully fledged from the head of a gas well. It grew over a period of 16 years, starting with a minor merger between two unremarkable US gas pipeline companies.

The world’s press has made much, by way of explanation, of the hoary old argument that audit independence is jeopardised when the audit client gives its auditor lucrative consultancy contracts on the side. However, this line of attack says nothing at all about why major companies and institutions, including a stellar collection of top banks, accepted Enron’s accounts at face value – without, apparently, understanding a line of them. It stretches credulity to breaking to believe they were all content to rest on Andersen’s audit report.

The answer, it seems, is that Enron was able to convince the market that its meteoric rise from humble regional gas distributor was testimony to its prowess as a sharp dealer in complex derivatives. It is only natural, the argument went, that the accounts of a smart derivatives player which dealt daily in billions of dollars of forward contracts, options and swaps, should be beyond the grasp of mortals.

But, as Robert McCullough, CEO of McCullough Research and a respected energy sector guru notes, whether Enron’s traders were brilliant or dodgy prognosticators on such unpredictable matters as the price of gas five years hence, is now wide open.

However, an ex-Enron insider pointed out to Financial Director that if Enron’s traders were all crap, they’d be out of a job, whereas in fact the entire division was grabbed by UBS Warburg and all remain gainfully employed. Yet this is a vital point for the energy sector as a whole, since a number of players – pre the Enron smash – were enthusiastically voicing their intention to achieve better than average growth through innovative merchant trading.

Enron was undoubtedly very good at generating the illusion of growth. McCullough says its primary tool for this purpose (aside from the effective weapon of shoving every non-performing or dubious asset, debt and speculative venture off balance sheet), was an accounting technique, much favoured by the energy sector, known as “mark-to-market” accounting.

Schroder Salomon Smith Barney, in its industry report Power Trading in Europe, points out that used properly, mark-to-market accounting enables a company to recognise the net present value of future profits and losses in year one. However, the company is supposed to subtract provisions reflecting, variously, the credit rating of the buyer, market liquidity, or the ease with which the business can unwind the position and operational risk.

McCullough argues that there are a number of reasons why even audited mark-to-market figures should be taken “with a grain of salt”. “Future estimates for natural gas and electricity are notoriously fickle – today’s estimates may simply be overwhelmed by tomorrow’s events,” he says. To achieve a degree of soundness, not to say plausibility, the estimate needs a liquid futures market. However, energy dealing, despite the huge numbers involved, is still an emergent phenomenon and such markets are hard to find for many of the transactions Enron was making. The best test of how real the sums Enron was recognising as profit from mark to mark accounting really were, McCullough suggests, is by reconciliation with cash flow.

The point here is that an energy company can recognise paper profits from one deal after another, but if those deals don’t turn into cash a crash is inevitable. However, cash analysis of Enron is difficult, since its year 2000 cash flows were dramatically impacted by the company’s decision to demand cash deposits from Californian customers during the Californian energy crisis. This brought Enron some $4.277bn in cash, against just $44m in cash deposits taken in the whole of the prior year – making cash flows look respectable.

But the deposit money was a short-term holding and had to be paid out again. McCullough argues that if you adjust Enron’s net cash flow for 2000 to remove the cash deposit, it ends up with a flow of approximately minus-$700m. The performance up to the third quarter of 2001 was somewhat better, showing around a billion in cash, but this is still very thin on trading volumes in excess of $100bn and is swamped by outgoings. He says this poor performance is one of the most pointed signs that Enron’s mark-to-market estimates were suspicious, and that the company was in effect engaging in bigger and bigger deals to cover price movements against it.

McCullough was one of the first to float the idea that Enron can be seen as analogous to a pyramid selling scheme, with mark-to-market accounting as the key mechanism. “The central characteristic of such a scheme,” he says, “is that while financial reports may show vast profits, actual cash flows are minimal.” The discrepancy is hidden until the point is reached where the escalating growth becomes impossible to sustain and the scheme implodes.

“Enron’s revenues in 2001 had increased 132% over the previous three quarters in 2000. In any normal business the cash flow from this immense growth should have dwarfed any temporary problems. Its average quarterly revenue growth was 39% per quarter over 2000. This compounds to 371%.

This rate of growth is not impossible, but it is remarkable considering Enron’s main products were neither new nor terribly well implemented,” McCullough says.

The question of the propriety of mark-to-market for energy trading is important, especially since it does not look as if mark-to-market will be dumped. Schroder Salomon Smith Barney, for example, argues that it is not only a good technique but the most appropriate one.

The issue hinges on the difference between earnings and cash. Motor manufacturers which attempted to account on a cash basis would show a loss in good years because of the time lag in receivables, so accounting on an earnings basis makes sense for them.

Schroder Salomon Smith Barney argues that despite the “down side” of the disjunction between cash and revenue that mark-to-market accounting entails, it remains the preferable treatment for European utilities to adopt in their trading. It points out that a traditional accruals-based accounting approach can create an even more misleading impression.

Take the example of a trader who does a five year deal at a fixed price, where he expects to be in profit in years one and two, and to make a loss in years three to five. An accruals based approach would show strong profits in years one and two and would be silent on the losses expected in years three to five (though this could be handled by a note to the accounts).

The same deal reflected in mark-to-market terms would show an overall loss for the contract in year one, which, the analysts argue, constitutes a better reflection of the deal’s real value. SSSB is more than aware of the fact that the trading curve used to project forward prices in mark-to-market accounting is subjective in its initial position, as well as vulnerable to movement in the market. But it argues that “it all comes down to the risk management procedures of the business”.

“If a trading business has an unrealistic view of the forward curve, the value of open positions could be seriously misstated. The onus here is on auditors and risk managers to make sure the curve is reasonable,” it says.

All this is fine in theory. In practice, given an aggressive growth posture by an energy trading operation, things can go very wrong – particularly if the company concerned is also basically in the business of taking bets on the ability of its share price to fly ever higher, as Enron appears to have been doing.

The antidote, as always, has to be provided by a blend of common sense and transparency. Sir David Tweedie, chairman of the International Accounting Standards Board, argues that Enron appears to have been practising not so much mark-to-market accounting – since there were no demonstrable liquid markets to draw on – as a mark-to-model policy.

“If you are going to do mark-to-model accounting, then the correct approach is to show absolutely all your assumptions, so that shareholders and users of accounts can form their own opinion about the validity of those assumptions,” he says. Given that the underlying volatility of energy pricing is unlikely to be tamed, what such an approach may well end up doing is simply to achieve some consensus about the market’s appetite for risk.

The irony is that energy trading should be far more about risk avoidance than about taking positions on pricing movements with an eye to making a profit. As a hedging exercise, trading is an essential component of a utility’s day-to-day operation. However, as one utility expert from a Big Five firm told Financial Director, if you’re going to trade you have to employ traders – and, because traders love trading, you’re likely to end up with a profit centre that can end up betting the bank.

Paul Marsh, formerly chief finance officer at energy group TXU Europe and now chief operating officer, argues that the market will come to realise that all pure energy trading companies are ultimately on a road to nowhere.

TXU prides itself on being an integrated company, by which it means that it rests on a three-pronged foundation. It has generating and supply assets, it has a merchant trading operation and it has a retail base. Having all three components is essential if your traders are really going to develop an understanding of the dynamics of the market, he argues.

Marsh points out that TXU’s strategy in developing a new geographic market is to go in as a pure trading operation with a limited amount of risk capital. By trading it gets a feel for the game in that country. If things look promising, it then looks to buy an asset or forge a significant joint venture on the generation side, and then on the retail front.

“The important thing for us is that unlike Enron, ours is not a pure scale play. We don’t have to be the biggest, and we don’t need stellar growth to succeed. We are predicting between 11% and 13% year-on-year growth and we believe this is achievable,” he says.

It seems as if the dance between prudence and greed, which is at the heart of most accounting issues, will have a merry time in the energy market for many years yet …


– Daniel Martin, energy analyst, Schroder Salomon Smith Barney:
“US companies are very heavily weighted on price-earnings ratios, so you have to get your earnings per share up. Enron was very aggressive in trying to get its EPS as high as possible, but there is no necessity for other energy trading operations to go down this same route. What we will find is that power traders which do not have physical generation and supply assets are likely to be viewed by the market with some suspicion for the time being, so this will favour the incumbents.”

– Chris Jenkins, partner & energy sector specialist, KPMG
“Post-Enron, people will be paying much more attention to basic issues such as counter-party credit risk, as well as to more sophisticated credit management. You can control these issues but companies need to establish appropriate risk management processes and they should certainly state their policies.”

– Sir David Tweedie, chairman, International Accounting Standards Board
“The Enron case does not say a great deal for the individual auditors or for the market analysts. If they do not understand a company’s accounts, how can they make recommendations? At this stage we cannot tell if Enron’s failure was due to a failure of accounting standards, or a misapplication of standards. IASB has already sent out draft proposals on special purpose vehicles (the partnerships used by Enron) and we are waiting for the big firms to say how these can be improved.”

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