Mark-to-Market: The Fall of Enron
John Smith State University

Mark-to-Market: The Fall of Enron Enron was the face of business in the 1990’s. Rising to meteoric heights never seen before in the business world, to having just as epic of a fall. The core reason behind this meteoric rise and epic fall? Mark-to-Market (M2M) accounting principles. This paper will be presented in four sections. The first section defines and explains the term of M2M. The second section discusses the way M2M was used in the business environment before and after the Enron collapse. The third section focuses on the views of the current business environment on using M2M, both for and against its use. In the fourth and final section, the author gives their opinion on the practice of M2M, and if it is still a viable accounting principle.
Mark-to-Market Defined In the private sector all accounting principles and standards are gathered together and organized by the Financial Accounting Standards Board (FASB). They are then put into what is called the FASB Codification. The FASB Codification (2015) defines M2M as a valuation method that uses current market prices and other useful information that is supplied by market exchanges between similar items such as assets, liabilities or a similar business (“FASB Codification,” 2015). Basically what this accounting principle does is use the fair value of the current market price to determine what an asset or liability is worth. Using traditional accounting practice values are achieved by using cost accounting. This is when the actual cost to acquire an asset or liability is recorded at the actual cost. This is usually referred to as using the “sunken cost” because they are not relevant to anyone investing in the company because they are already in place. Investors focus remains primarily on cash flow (Bell, 2012). This is where the difference in M2M and cost accounting exists. Values using M2M fluctuate with the market while in cost accounting they remain constant.
Mark-to-Market Before and After Enron Collapse
Before Enron Collapse When Jeffery Skilling came to Enron in 1990 as CEO, he insisted that Enron be allowed to use the accounting practice of M2M. Using M2M was not a traditional approach to accounting at that time but Skilling convinced the SEC and Arthur Anderson, Enron’s accounting firm, to approve it. When the move from cost accounting to M2M was approved it allowed Enron to go from an accountability model to a valuation model that allowed for “creative accounting” (Colson, 2005). This quickly changed Enron from a mediocre business to a dynamic player, especially in the energy market. What M2M allowed Skilling and Enron to do was take profits that were to be earned and booked over the life of a contract of 10 to 20 years and record them in a single year (Stewart, 2006). Skilling believed that all the hard work was done in making the contract. Therefore, all the perceived profit should be rewarded to who was making the deal not some end user at the end of a contract. One example of Enron putting M2M in action is a deal it had with Blockbuster in July of 2000. It was a 20 year contract that was supposed to use Enron technology to deliver on demand movies. This contract was valued by Arthur Anderson to be worth somewhere between $120-150 million over the life of the contract. Enron put this contract on the books at a perceived profit of $111 million dollars in the fourth quarter of 2000. Enron’s technology to deliver on demand movies never fully developed and in March of 2001 the contract with blockbuster was terminated. In the span of less than a year Skilling and Enron had reported the $111 million dollars in gains and an additional $115 million in cash flow from operations that were never actually realized (Gwilliam & Jackson, 2008). Skilling rewarded himself for making the contract even though the contract never reached its completion. Enron really made a statement using M2M in the energy market. When valuing the contracts they were making they valued the market at whatever they wanted it to be. There was not an already existing market to compare it with so they made the market themselves. The auditors did not have with what to evaluate Enron’s valuation against since Enron made up its own market to value their assets against. By the end of 2000 Enron’s market value was at $75.2 billion while on the balance sheet or book value it really only had $11.5 billion worth of equity (Lev, 2002). This difference in intangibles is what made some people to start questioning their books.
After Enron Collapse After Enron collapsed the rules changed some. The Sarbanes-Oakley act was passed requiring stricter accounting practices. Businesses were no longer allowed to use M2M in the energy market. Allowing M2M would give the opportunity for manipulation of the market in order to achieve desired results. Many companies shifted back to traditional accounting methods of using cost accounting. The collapse of Enron made it very clear that a company should be better off to lead with their balance sheet while understanding that every lending transaction is a risk (The Effect of Enron, 2001). No matter what the possible reward is. During the 2000’s the business environment was shaken by the collapse of Enron. There were questions asked about how come the accounting firm of Arthur Anderson did not see what was going on. Before the collapse of Enron, the Big 5 accounting firms did both auditing and consulting for the same businesses. They are now forced to disclose if they provide consulting services and if they do then they are not supposed to be the firm auditing the books as well. This forced many of the accounting firms to split off their auditing and non-auditing revenue streams. For instance, Arthur Anderson split up into Arthur Anderson, the auditing company, and Accenture, the consulting firm (Schneider, 2012). Arthur Anderson is longer around while Accenture is still a very profitable business. Even with all these changes happening in the accounting world it still did not prevent the financial crisis in the late 2000’s. Banks were still using M2M to value their lending transactions with some made up value based on credit ratings from prior years. This turned out to be a major cog in the collapse of the big banks in 2007 and 2008. Merrill lynch had reported losses of $15 billion, Citigroup had about $12 billion in losses, and Bear Stearns failed due to its losses using M2M (Flegm, 2008).
Pros and Cons for Mark-to-Marketing
Pros
There is still much debate going on as to the validity of M2M. There are those who still favor M2M and think that it’s a valid form of accounting. One main reason that M2M is favored by those supporting its use, is the difference in relevance between using M2M and using historical cost. Assets and liabilities that are recorded using historical costs become valueless over time. This is because these historical costs become less sensitive to what the market thinks about a certain instrument, and it does not give investors the signals that they are interested in (The role of mark…, 2009).

Cons Those on the other side of the M2M debate have a few solid reasons for calling for its suspension. One of them is seen in the examples with the subprime mortgage collapse in the recent financial crisis. Some banks that were in financial trouble had to fire-sell their assets to raise capital. What this does is bring down the market prices for all of the securities in that market and sets a new value standard (Gingrich, 2008). Any other lending institutions that use M2M now have their assets valued at this lower price as well. This causes a downward spiral and continues until either some banks collapse or the market recovers. What happened during the crisis was that the government had to step in and bail the banks out. If they had not, then the entire banking system might have collapsed.
Author’s Opinion After researching the topic of mark-to-marketing accounting this author has mixed feelings on the validity of its use. The benefits of using it include keeping a relevant cost associated with the assets or liabilities that a firm has. This is extremely important due to the fact that investors want and need to know up-to-the-minute well-being of a company. Having current market price valuations helps determine the health of a company in investor’s eyes. On the other side, the market volatility in some confusing markets like derivatives trading, a historical cost might be more useful in keeping the balance sheet more stable. The best way might be is to have a mixture of both. In areas where there are readily available markets then M2M could probably be used. If the market for an asset or liability is not readily available and no other assets or liabilities are available to measure up against, then the historical cost accounting method should be used.
References
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