What the Dog Saw [65]
If you sat through the trial of Jeffrey Skilling, you’d think that the Enron scandal was a puzzle. The company, the prosecution said, conducted shady side deals that no one quite understood. Senior executives withheld critical information from investors. Skilling, the architect of the firm’s strategy, was a liar, a thief, and a drunk. We were not told enough — the classic puzzle premise — was the central assumption of the Enron prosecution.
“This is a simple case, ladies and gentlemen,” the lead prosecutor for the Department of Justice said in his closing arguments to the jury:
Because it’s so simple, I’m probably going to end before my allotted time. It’s black-and-white. Truth and lies. The shareholders, ladies and gentlemen… buy a share of stock, and for that they’re not entitled to much but they’re entitled to the truth. They’re entitled for the officers and employees of the company to put their interests ahead of their own. They’re entitled to be told what the financial condition of the company is. They are entitled to honesty, ladies and gentlemen.
But the prosecutor was wrong. Enron wasn’t really a puzzle. It was a mystery.
3.
In late July of 2000, Jonathan Weil, a reporter at the Dallas bureau of the Wall Street Journal, got a call from someone he knew in the investment-management business. Weil wrote the stock column called “Heard in Texas” for the paper’s regional edition, and he had been closely following the big energy firms based in Houston — Dynegy, El Paso, and Enron. His caller had a suggestion. “He said, ‘You really ought to check out Enron and Dynegy and see where their earnings come from,’ ” Weil recalled. “So I did.”
Weil was interested in Enron’s use of what is called mark-to-market accounting, which is a technique used by companies that engage in complicated financial trading. Suppose, for instance, that you are an energy company and you enter into a $100 million contract with the state of California to deliver a billion kilowatt hours of electricity in 2016. How much is that contract worth? You aren’t going to get paid for another ten years, and you aren’t going to know until then whether you’ll show a profit on the deal or a loss. Nonetheless, that $100 million promise clearly matters to your bottom line. If electricity steadily drops in price over the next several years, the contract is going to become a hugely valuable asset. But if electricity starts to get more expensive as 2016 approaches, you could be out tens of millions of dollars. With mark-to-market accounting, you estimate how much revenue the deal is going to bring in and put that number in your books at the moment you sign the contract. If, down the line, the estimate changes, you adjust the balance sheet accordingly.
When a company using mark-to-market accounting says it has made a profit of $10 million on revenues of $100 million, then, it could mean one of two things. The company may actually have $100 million in its bank accounts, of which $10 million will remain after it has paid its bills. Or it may be guessing that it will make $10 million on a deal where money may not actually change hands for years. Weil’s source wanted him to see how much of the money Enron said it was making was “real.”
Weil got copies of the firm’s annual reports and quarterly filings and began comparing the income statements and the cash-flow statements. “It took me a while to figure out everything I needed to,” Weil said. “It probably took a good month or so. There was a lot of noise in the financial statements, and to zero in on this particular issue you needed to cut through a lot of that.” Weil spoke to Thomas Linsmeier, then an accounting professor at Michigan State, and they talked about how some finance companies in the 1990s had used mark-to-market accounting on subprime loans — that is, loans made to higher-credit-risk consumers — and when the economy declined and consumers defaulted or paid off their loans more quickly than expected, the lenders suddenly realized that their estimates of