Journal of Accounting and Public Policy l Assignment

Fair-value accounting: A cautionary
tale from Enron
George J. Benston *
Goizueta Business School, Emory University, Atlanta, GA 30322, United States
Abstract
The FASB’s 2004 Exposure Draft, Fair-Value Measurements, would have companies
determine fair values by reference to market prices on the same assets (level 1), similar
assets (level 2) and, where these prices are not available or appropriate, present value
and other internally generated estimated values (level 3). Enron extensively used level
three estimates and, in some instances, level 2 estimates, for its external and internal
reporting. A description of it’s use and misuse of fair-value accounting should provide
some insights into the problems that auditors and financial statement users might face
when companies use level 2 and, more importantly, level 3 fair valuations. Enron first
used level 3 fair-value accounting for energy contracts, then for trading activities gener-
ally and undertakings designated as ‘‘merchant’’ investments. Simultaneously, these fair
values were used to evaluate and compensate senior employees. Enron’s accountants
(with Andersen’s approval) used accounting devices to report cash flow from operations
rather than financing and to otherwise cover up fair-value overstatements and losses on
projects undertaken by managers whose compensation was based on fair values. Based
on a chronologically ordered analysis of its activities and investments, I believe that
Enron’s use of fair-value accounting is substantially responsible for its demise.
Ó 2006 Elsevier Inc. All rights reserved.
0278-4254/$ - see front matter Ó 2006 Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2006.05.003
* Tel.: [phone]; fax: [phone].
E-mail address: [e-mail]
Journal of Accounting and Public Policy 25 (2006) 465–484
www.elsevier.com/locate/jaccpubpol

Keywords: Fair-value accounting; Enron
1. Introduction
The US and International Financial Accounting Standards Boards (FASB
and IASB) have been moving towards replacing historical-cost with fair-value
accounting. In general, fair values have been limited to financial assets and lia-
bilities, at least in the financial statements proper.1 A Proposed Statement of
Financial Accounting Standards, Fair-Value Measurements (FASB, 2005, p.
5), specifies a ‘‘fair-value hierarchy.’’ Level 1 bases fair values on ‘‘quoted
prices for identical assets and liabilities in active reference markets whenever
that information is available.’’ If such prices are not available, level 2 would
prevail, for which ‘‘quoted prices on similar assets and liabilities in active mar-
kets, adjusted as appropriate for differences’’ would be used (FASB, 2005, p.
6). Level 3 estimates ‘‘require judgment in the selection and application of val-
uation techniques and relevant inputs.’’ The exposure draft discusses measure-
ment problems that complicate application of all three levels. For example,
with respect to levels 1 and 2, how should prices that vary by quantity pur-
chased or sold be applied and, where transactions costs are significant, should
entry or exit prices be used? As difficult as are these problems, at least many
independent public accountants and auditors have dealt with them extensively
and are aware of measurement and verification pitfalls. However, company
accountants and external auditors have had less experience with the third level
(at least for external reporting), which use estimates based on discounted cash
flows and other valuation techniques produced by company managers rather
than by reference to market prices.
Indeed, there are few situations that have revealed the problems encountered
when companies use third level estimates for their public financial reports.
Instances in which transaction-based historical-based numbers have been mis-
leadingly and/or fraudulently reported abound, such as companies reporting
revenue before it is earned (and sometimes not ever earned), inventories misre-
ported and mispriced, and expenditures capitalized rather than expensed. Mul-
ford and Comiskey (2002) and Schilit (2002) provide many illustrations of such
‘‘schenanigans’’ (as Schilit characterizes them). But they (and to my knowledge,
few, if any, others) do not describe how fair-value numbers not grounded on
actual market prices have been misused and abused. Enron’s bankruptcy and
the subsequent investigations and public revelations of how their managers used
level 3 fair-value estimates for both internal and external accounting and the
1 The exceptions include goodwill impairment and, in Europe, appraisals of other assets under
specified conditions.
466 G.J. Benston / Journal of Accounting and Public Policy 25 (2006) 465–484

effect of those measurements on their operations and performance should pro-
vide some useful insights into the problems that auditors are likely to face
should the proposed SFAS Fair-Value Measurements be adopted.
Although Enron’s failure in December 2001 had many causes, 2 both imme-
diate (admissions of massive accounting misstatements) and proximate (more
complicated, as described below), there is strong reason to believe that Enron’s
early and continuing use of level 3 fair-value accounting played an important
role in its demise. It appears that Enron initially used level 3 fair-value esti-
mates (predominantly present value estimates) without any intent to mislead
investors, but rather to motivate and reward managers for the economic ben-
efits they achieved for shareholders. Enron first revalued energy contracts,
reflecting an innovation in how these contracts were structured, with the
increase in value reported as current period earnings. Then level 3 revaluations
were applied to other assets, particularly what Enron termed ‘‘merchant’’
investments. Increasingly, as Enron’s operations were not as profitable as its
managers predicted to the stock market, these upward revaluations were used
opportunistically to inflate reported net income. This tendency was exacer-
bated by Enron’s basing managers’ compensation on the estimated fair-values
of their merchant investment projects. This gave those managers strong incen-
tives to over-invest resources in often costly, poorly devised, and poorly imple-
mented projects that could garner a high ‘‘fair’’ valuation. Initially, some
contracts and merchant investments may have had value beyond their costs.
But, contrary to the way fair-value accounting should be used, reductions in
value rarely were recognized and recorded because they either were ignored
or were assumed to be temporary. Market prices, specified as level 2 estimates
in Fair-Value Measurements (FASB, 2005), were used by Enron to value
restricted stock, although in most instances they were not adjusted to account
for differences in value between Enron’s holdings and publicly traded stock, as
specified by the FASB. Market prices were also used by Enron’s traders in
models to value their positions. In almost all of these applications, the numbers
used tended to overstate the value of Enron’s assets and reported net income.
As the following largely chronological description of Enron’s adoption of
level 3 fair-value accounting shows, its abuse by Enron’s managers occurred
gradually until it dominated their decisions, reports to the public, and account-
ing procedures. Although, technically, fair-value accounting under GAAP was
limited to financial assets, Enron’s accountants were able to get around this
restriction and record present-value-estimates of other assets using procedures
that were accepted and possibly designed by its external auditor, Arthur
Andersen.
2 See Partnoy (2002), who blames Enron’s use of derivatives, and Coffee (2002), who points to
inadequate ‘‘gatekeepers,’’ particularly external auditors and attorneys.
G.J. Benston / Journal of Accounting and Public Policy 25 (2006) 465–484 467

In the following section, I describe Enron’s initial and then widespread use
and abuse of level 3 fair-value in its accounting for energy and other commod-
ity-trading contracts, energy production facilities, ‘‘merchant’’ investments, its
major international projects and energy management contracts, investments in
broadband (including particularly egregious accounting for its Braveheart pro-
ject with Blockbuster), and derivatives trading. 3 This is followed by a descrip-
tion of the incentives from basing management compensation on fair-value
estimates. I then show how Enron, by structuring transactions so as to report
cash flows from operations, ‘‘validated’’ the profits it reported. Finally, I con-
sider why Enron’s internal control system and its external auditor, Arthur
Andersen, did not prevent Enron’s using fair-value estimates to produce mis-
leading financial statements.
2. Enron’s adoption and use of fair-value accounting 4
Enron’s initial substantial success and later failure was the result of a succes-
sion of decisions. Fair-value accounting played an important role in these deci-
sions because it affected indicators of success and managerial incentives. These
led to accounting cover-ups and, I believe, to Enron’s subsequent bankruptcy. I
present these developments essentially in chronological order, which shows
how Enron’s initial ‘‘reasonable’’ use of fair-value accounting evolved and
eventually dominated its accounting and corrupted its operations and report-
ing to shareholders.
2.1. Energy contracts
Enron developed from the merger of several pipeline companies that made it
the largest natural gas distribution system in the United States. In 1990, Jeffrey
Skilling joined Enron after having been a McKinsey consultant to the com-
pany. He had developed a method of trading natural gas contracts called the
Gas Bank. Enron’s CEO, Kenneth Lay, persuaded him to join the company.
Skilling became chairman and CEO of a new division, Enron Finance, with
the mandate to make the Gas Bank work, for which he would be richly com-
pensated with ‘‘phantom’’ equity (wherein he received additional pay in pro-
portion to increases in the market price of Enron stock). Enron Finance sold
long-term contracts for gas to utilities and manufacturers. Skilling’s innovation
3 Although Enron used the term ‘‘mark-to-market’’ accounting, it rarely based the valuations on
actual market prices. Hereafter, ‘‘fair value’’ refers to level 3 valuations, those based on present-
value and other estimates that are not taken from market prices.
4 This description is largely derived from and documented in McLean and Elkind (2003) and (to a
much less extent) Bryce (2002) and Eichenwald (2005), as well as other sources, as noted.
468 G.J. Benston / Journal of Accounting and Public Policy 25 (2006) 465–484