Mark-to-Market Accounting and the Enron Scandal

Introduction: MTM Accounting and the Enron Collapse

One of the most fascinating — if not revolting — aspects of the Enron scandal is the degree of complicity that surrounded the Texas-based company and extended into the realm of United States accounting practices, federal regulations, and politics more broadly. Beyond the involvement of Arthur Andersen, formerly one of the most venerable accounting firms in the country, and former CEO Ken Lay's close relationship with President George W. Bush, the scandal's ramifications for the Securities and Exchange Commission remain among its most revealing dimensions. In hindsight, many have argued that Enron's reliance on mark-to-market (MTM) accounting was the company's ultimate downfall. However, a closer examination of MTM's history and its application at Enron demonstrates that, in the beginning at least, there was genuine value in the practice — before it became simply another instrument of exploitation and greed.

Historically, MTM has endured a lengthy legacy of controversy. According to Steve Forbes, editor-in-chief and chairman of Forbes magazine, MTM factored significantly into the Great Depression and was outlawed by President Franklin D. Roosevelt in 1938 (Bigman and Desmond, 2009). The core value of this accounting approach lies in its ability to ensure that certain assets are carried at their "fair value," based on publicly quoted prices or, if none are available, on management's best estimate using available information. Changes in value from quarter to quarter are recorded as gains or losses in the income statement (Monks and Minnow).

The History and Mechanics of Mark-to-Market Accounting

Several critical points of this definition bear directly on the Enron story. First, MTM works best when applied to certain types of assets — not all of them. MTM is most effective for assets that fluctuate frequently, where historical cost may not accurately reflect true value. Second, the definition establishes two hierarchical approaches: publicly quoted prices should determine MTM valuation; only in the absence of such quotes is it acceptable for an organization to substitute its own estimate. These distinctions prove essential to understanding both the legitimate and illegitimate uses Enron made of the practice.

Initially, Enron applied to the SEC to use MTM exclusively for Enron Gas Services, its gas trading business. Due to the nature of energy prices — oil, petroleum, and natural gas — Enron could readily consult public quotes in the early 1990s to determine the value of its natural gas trading positions. This specific usage was appropriate, which is why the SEC sanctioned it in 1991.

Enron's Legitimate and Illegitimate Uses of MTM

However, MTM accounting was never expressly granted to Enron for assets other than natural gas trading. Yet the flexibility inherent in MTM encouraged management to extend it throughout the company, so that "by December 31, 2000, MTM accounting had spread throughout Enron… and represented about $22.8 billion of Enron's assets. This was 35% of its $65.5 billion of total assets" (Monks and Minnow, 2008). It has since become clear that MTM was simply not appropriate for many of these other business areas. The primary reason is that in numerous instances Enron applied MTM to assets that lacked publicly quoted prices, allowing the company to rely on its own valuation — which consistently favored its own interests.

This point is pivotal to properly understanding the scandal. In and of itself, mark-to-market accounting is not a problematic measure. The core problem arises when there is no reliable means of determining a commodity's or asset's market value, forcing management to estimate independently. Enron's self-serving valuations — termed "valuation abuses" by court examiner Neal Batson (2003, p. 24) — were the true source of deception, not MTM as such. In his second examiner's report, Batson concluded that "the proper use of MTM accounting for assets and liabilities… provides more relevant and reliable financial information than historical cost" (2003, p. 24).

The valuation problems stemming from Enron's misuse of MTM are evident across the range of business areas to which the company applied it outside of natural gas trading. Enron extended MTM to profits and losses from paper, electricity, and coal ventures, and even to highly inappropriate assets such as its interest in the California Public Employees' Retirement System (CalPERS). A retirement system is not a commodity and does not exhibit the price fluctuations that MTM is designed to regulate. Furthermore, there is no public mechanism for gauging the market value of such an "asset," meaning Enron's management could assign whatever value it wished — and did so unerringly in the company's favor. The apparent success of this approach then served as a gateway to further misapplications.

Enron's use of MTM with CalPERS functioned as a precedent that management used to justify applying MTM to merchant investments. Merchant investments differ fundamentally from commodities like natural gas: they do not incorporate public pricing and are not subject to public market fluctuations. While the CalPERS experience provided a rationalization, the extension to merchant investments was not expressly permitted by Generally Accepted Accounting Principles (GAAP). What GAAP does permit is the use of MTM for venture capital investment companies (Batson, 2003, p. 28). Enron rationalized "that trading in Treasury securities was a regular part of Enron's venture capital business" (Batson, 2003, p. 28) and stretched this justification to cover merchant banking activities. The logic was far-fetched, and the application was clearly inappropriate.

Conclusion: MTM as a Tool, Not the Cause

Enron's improper use of MTM was considerably enabled by its abuse of Financial Accounting Standards Rule 140. Under this provision, Enron established additional entities that functioned solely as vehicles for shifting debt and profits to its advantage. When Enron sold, for example, a 30% share of its Eli Lilly venture to its Hawaiian FAS 140 entity, it could record that transaction as a profit while retaining effective control over the entity. In this way, the company preserved its economic exposure to the upside of the venture while offloading its liabilities on paper, recording profits that were dubious from the outset. This structural mechanism, combined with MTM's valuation flexibility and Andersen's cooperative auditing, completed the architecture of Enron's financial deception.

Enron was able to manipulate MTM accounting — alongside a host of other illicit business practices — to misrepresent itself on paper and sustain its inflated stock price. It is crucial to reiterate that MTM in and of itself is not a flawed financial practice. The abuse of it, however, certainly is. What Enron was genuinely guilty of was assigning ludicrous market values to its assets and applying the terms "assets" and "commodities" so broadly as to encompass ventures that could never be subject to public price discovery. This allowed the company to rely on its accounting and consulting partners to inflate valuations for deals projected to materialize years in the future. It was this confluence of factors — not MTM itself — that allowed fraudulent financial practices to persist for so long and ultimately devastate the savings and pensions of thousands of employees who had been encouraged to invest everything in Enron stock while its executives quietly sold their own shares.