Mark-To-Market Mark

I have been arguing that investors need more than just raw financial data. (Of course, CEOs like rah, rah data…) Investors also need financial statements that analyze, organize, and compress all of this information. But, I am not arguing that we should let accountants do all of the valuation work. That is “mark-to-market” accounting, which was the most important factor in Enron’s problems. [Haters of early 1990s pop music insert Funky Bunch jokes here.]

Under mark-to-market accounting, all of a business’ assets (and liabilities) are revalued (“marked”) to fair market value. Any increase (decrease) in the net value is added to (subtracted from) any profit distributions to shareholders (like dividends and share buybacks) in determining the business’ profit or loss. (Adjustments also are made for share issuances and the like.)

In theory, mark-to-market gives investors the most useful information, since it presents management’s stewardship of all of the busines’ resources, not just of financial transactions. In reality, however, matters are much different.

Reality is in the footnote.

Enron, with the SEC’s blessing (!!!!), marked a wide variety of assets to market. For example, when Enron signed a long-term contract to provide power out of a new power plant still under construction, they immediately recorded all profits estimated to be made under the contract. One condition that Jeff Skilling put on joining Enron was that he be allowed to use mark-to-market. Skilling thought that the deal was all that matters. Executing the deal (and actually making money) was for the little people. Mark-to-market enabled Skilling to book the deal and not worry about reality. It was when reality intervened and his deals started hemorrhaging money that he had to turn to Fastow for a little SPE juice (not only for profits, but also for the balance sheet and the operating cash flow portion of the cash flows statement).

What was wrong? Easy: there was no market to mark to. Enron created the markets used to determine the values of its assets. These values were Enron’s dreams, not money in the bank. Today, brokers and dealers in marketable securities and commodities use mark-to-market. They can look in the Wall Street Journal or on Bloomberg to get values. (OK, if one had to dump a large holding, that could push the price down, but that is a relatively small glitch in the scheme of things.) In contrast, Enron made up its own numbers! And this was the SEC in the Clinton Administration.

Which gets to the point here: Accountants are not appraisers, actuaries, investment bankers, or economists. They cannot value things for which there is no ready market. As to these things, accountants need arms’-length transactions to evidence value. This means that accounting numbers are not as useful as they could be. This also means that financial statements are not just some CEO’s dreams.

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3 Responses to Mark-To-Market Mark

  1. Shawn says:

    Financial statements should give you all the information you could ever need. A good analyst can weed out all the weird things that a company is doing on their financial statements and can compare apples to apples. So as long as they’re following GAAP (Enron obviously did not), it doesn’t matter what other methods they use.

  2. William Osler says:

    Was anyone at the SEC who approved MtM for Enron held accountable? My limited research says no.
    What is the incentive then for the “watchmen” to do the right thing?

  3. I can tell that Enron scandal is an output of a conspiracy among many interested internal and external parties. The most important thing is that we should find out the reason(s) which made all of these harms and loss for the innocent people.
    I think many areas in allover the business community needs to be revalued including the external auditor standards and ethics.

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