Are you using Enron Accounting?

Over 10 years ago the high flying ENRON corporation came crashing down.

enronOne of the things that was responsible for their high flying and for the delayed recognition of their actual underlying troubles was their accounting. Arthur Andersen, their external auditors, went up in smoke 10 years ago also over related issues.

At its heart, Enron’s problems were caused by greed and a 65 multiplier.  Their stock was valued at 65 times earnings at its peak.  So a $1 increase in earnings meant a $65 increase in stock price.

And earnings were determined by accounting rules.

In Enron’s case, they were taking an approach to long term projects that fronted profits to an early stage in the life of the long term contract.  They often reported present value of all future profits from a new project when the project was contracted.  A long term energy delivery contract would have 5 or 10 years of future projected profits reported when the deal was closed.

This was called a mark to market approach.  But in fact it was almost always a mark to model.

But both systems can lead to risk management problems.  The fronted profits may or may not emerge. Some of these contract’s value were subsequently marketed down as market conditions changed in future years.  And in Enron’s case, the later adjustments became more and more on the down side because of optimistic original booking.  This then put pressure on management to find a larger and larger quantity of “new” deals where they could report large up front and possibly inflated pv of future profits.  Eventually it crashed like the ponzi scheme that it was.  They got too big.  They just couldn’t find enough new deals to paper over the losses from write downs adjustments to previously deals.

There are two other choices to accounting for long term transactions.  The profits could be recognized over the life of the deal or the profits can be recognized when the deal is completed.  That later approach seems so, so dated.  How 19th century. Let’s call these three types of accounting Type E, Type L and Type C.

But the risk manager needs to understand the accounting treatment of every deal that is not closed in the same accounting period that it is opened.

  • Type E accounting means that the company probably put up an asset for future profits.  The risk capital that should be associated with that asset may well be very high.  The firm is at high risk that that asset will not be worth what the books say.  Proponents of this approach say that all it takes to get this right is the correct discount rate.  With the right discount rate, the E approach is more or less the same as the L approach.  That discount rate is the rate that makes the activity break even at inception.
  • Type L accounting means that in some cases, the company is still setting up an asset, albeit small, at the inception of the deal, since in many cases there are either more expenses or less revenues at the outset of a long term project than there are over the life o the deal on the average.  That is the usual objective of Type L accounting, to make every year look like an “average” year on an expected basis.  This smoothing also carries some accounting risk, but much less than Type E.
  • Type C accounting means that profits are realized when cumulative revenues exceed cumulative expenses on the deal.  Deals that are expected to be profitable (and what company enters into long term deals that are not?) are usually reported as losers at the outset.  You could argue that this is just another discount rate applied to the future cashflows.  But this discount rate is infinite, making future cashflows worthless until they happen.

RISKVIEWS opinion is that one approach is not necessarily superior to another.  However, if the financial statement contains various projects that are not treating the future consistently, then there will be major distortions of perception about results.  That distortion is itself a major risk.

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