Lesson 5.1 · 1 of 5 · Red flags
The Enron case: profit without cash, mark-to-market and the red flag
For years Enron reported rising profits, but part of them were estimated gains rather than cash collected, and some of its debt sat off the balance sheet. The warning sign any investor can track: profit growing much faster than operating cash flow, year after year.
Terms in this lesson
- Cash conversion
- How much of the accounting profit actually lands in the bank as cash.
- Sloan ratio
- How much of profit is only on paper and has not arrived as cash yet.
- Cash flow statement
- The money that actually came into and went out of the bank account over a period.
- Net income
- What is left for shareholders after all costs, interest and tax.
What happened to Enron: a timeline of the collapse
Enron was a Houston energy company with a large business trading gas and electricity contracts. Its annual report for 2000 showed revenue of $100.8bn, two and a half times the 1999 figure, and net income of $979m. The share price had climbed from around $30 in early 1998 to over $80 in January 2001. Within a year, the company was bankrupt.
| Date | What happened |
|---|---|
| 14 August 2001 | Chief executive Jeffrey Skilling resigns; Kenneth Lay takes charge again. |
| 16 October 2001 | Enron announces a third-quarter loss of $618m. |
| 8 November 2001 | Enron announces it is restating its results for 1997-2000. |
| 2 December 2001 | Enron files for bankruptcy protection (Chapter 11). |
| June 2002 | Arthur Andersen, Enron’s auditor, is convicted of obstruction of justice. |
| 30 July 2002 | The Sarbanes-Oxley Act is signed into law. |
| 25 May 2006 | A jury finds Lay and Skilling guilty of fraud and conspiracy. |
From Enron’s SEC filings, the US Department of Justice and news agency reports (CNN, AP).
Lay died in July 2006 before he could be sentenced, and in October 2006 his conviction was vacated for that reason. Skilling was first sentenced to 292 months in prison, cut to 168 months in 2013, and he was released in February 2019.
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Create a free accountWhat is mark-to-market accounting
Definition
What does mark-to-market mean?
A contract goes on the balance sheet at today’s value, and the estimated gain is booked as profit now, not when the cash arrives.
Say a company signs a ten-year deal to supply gas at a fixed price, and its model says the deal will make $50m in total. Under mark-to-market, today’s value of that gain goes into profit in year one, and the contract is revalued every quarter after that. The cash, though, arrives over ten years, if it arrives at all. The method is standard for securities with a daily market price. It becomes risky when there is no market price and the value rests on the company’s own assumptions about future prices. Enron’s 2000 annual report said its trading contracts were accounted for this way.
What are special purpose entities (SPEs) and the 2001 restatement
Definition
What is a special purpose entity (SPE)?
A separate company set up for one particular deal, which can hold assets and debt off the parent company’s balance sheet.
SPEs are legal and common, for example to package loans and sell them to investors. The risk comes when the parent in fact keeps the control or the risk but does not consolidate the entity: its debt stays off the balance sheet, and deals with it can generate gains. In its report for the third quarter of 2001, Enron accepted that the entities Chewco and JEDI should have been consolidated from November 1997, and LJM1 in 1999 and 2000. Consolidating Chewco and JEDI alone added $711m to reported debt for 1997 and $628m for 2000. Separately, it cut shareholders’ equity by $1.2bn to correct an error linked to other entities, known as the Raptors.
How much Enron’s net income fell after the restatement, in millions of dollars: 79 in 1997, 139 in 1998, 258 in 1999 and 137 in 2000. In total, 613 million.
The red flag for investors: profit rises, cash does not
Real case
Enron, first half of 2001
In its report for the first six months of 2001, Enron made a profit but paid out more cash than it brought in from its operations. The company put much of the gap down to cash collateral it had received from trading counterparties in late 2000 and handed back in 2001 as price volatility eased (margin deposits, $2,342m). Without it, the report said, operating cash flow would have been positive. The right conclusion is not that one half-year proved fraud, but that profit and cash were heading in different directions and needed explaining.
What changed
Arthur Andersen and the Sarbanes-Oxley Act
Since Enron, the bosses of US-listed companies answer personally for the figures they report.
Arthur Andersen had audited Enron for 16 years. Convicted of obstruction of justice in June 2002, it closed its audit practice that August. The Supreme Court unanimously overturned the conviction on 31 May 2005, but by then the firm, which had employed around 85,000 people worldwide, was down to about 200. The Sarbanes-Oxley Act, signed on 30 July 2002, requires the chief executive and the finance director to vouch personally for the accounts, puts auditors under an independent oversight board and raised the maximum sentence for common types of fraud from five to 20 years in prison.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: Enron, 10-K annual report for 2000 (revenue $100,789m, net income $979m, mark-to-market method) and 10-Q reports for 30 June 2001 (net income $829m, operating cash flow -$1,337m, +$1,005m before margin deposits) and 30 September 2001 (1997-2000 restatement, Chewco, JEDI, LJM1, the $1.2bn equity reduction), SEC EDGAR; US Department of Justice, press releases of 25 May 2006 and 21 June 2013 and the Skilling case page; US Senate Permanent Subcommittee on Investigations, hearing of 23 July 2002 (statement by Senator Carl Levin and testimony of chief investigator Robert Roach); the White House, 30 July 2002; AP (31 May 2005, 18 October 2006); Accounting Today; CNN, Enron timeline.