Enron, 2001Medium

Profit recognised at the moment a contract was signed, and the obligations that funded it parked in entities the accounts did not consolidate. Both halves were disclosed somewhere; neither was legible.

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What happened

• The business — a pipeline company that reinvented itself as a trader of energy and other contracts, many of them long-dated and not traded on any exchange.
• The accounting — permission was obtained to use mark-to-market accounting for those contracts. The present value of a contract's expected profit over many years was recognised when the contract was signed rather than as it was performed.
• The vehicles — a large number of special purpose entities held assets and obligations, structured so that they did not appear in the consolidated accounts. Some were capitalised in part with the company's own shares or commitments referencing them.
• 2001 — restatements, a rapid loss of confidence, credit downgrades, and a collapse of the funding those structures depended on. The company filed for bankruptcy in December 2001.
• Afterwards — criminal convictions of executives followed as a matter of public record, the auditing firm ceased to operate, and the Sarbanes-Oxley Act of 2002 changed the rules on internal control, auditor independence and executive certification of accounts.

The mechanism

• Mark-to-market on something with no market is mark-to-model. A twenty-year contract for a commodity nobody quotes twenty years out has no observable price, so the recognised profit is the output of assumptions the company chose. That is the fair-value hierarchy's level three, and model risk is the general form of it: the arithmetic can be flawless while the frame around it is somebody's forecast.
• Recognising profit early does not accelerate cash. The earnings arrived at signature; the cash arrived, if at all, over decades. A company can therefore report growing profit while consuming cash every year, and the two statements are both correct. Reading financial statements is where that gap is visible, and it is visible in the cash flow statement rather than in the headline.
• Consolidation is a question about control, not ownership. An entity structured to sit outside the group's accounts removes its obligations from the balance sheet without removing them from the economics. The rules that decided which entities came in were the thing being engineered.
• Capitalising a vehicle with your own equity is a circular hedge. If the vehicle's ability to pay depends on the share price of the company it is protecting, then it works in every state of the world except the one where it is needed. That circularity is the structural defect, and it is the same shape as any hedge whose collateral correlates with the exposure — see hedging.
• Complexity is not the same as concealment, and is nearly as effective. Much of this was in the filings. Enough of it was distributed across enough footnotes that assembling the picture required more work than almost anybody did.

What it teaches

• Ask which measurement rule produced a number before interpreting it. The same holding is worth three different figures under three different classifications, and the classification is a separate fact from the market — how a position hits the books sets out all three.
• Reconcile profit to cash, every time. Persistent profit without cash is not proof of anything, and it is the single most reliable thing to look at when the story is complicated.
• Read what is not consolidated. The interesting obligations in any complex group are the ones whose entity is described rather than added up.
• A structure that only works while the share price holds is not a structure. Ask what each arrangement pays in the state of the world that would make you want it.
• Disclosure and legibility are different things. A fact spread across nine footnotes has been disclosed and has not been communicated, and the reader is entitled to notice the difference.

The mechanisms behind this

• How a position hits the books — the three measurement categories, and day-one profit on unobservable inputs.
• Model risk — what a number assumes when no market quotes it.
• Securitisation — special purpose entities used the way they are meant to be used.
• Reading financial statements — where profit and cash part company.