Mark-to-Market Accounting

Mark-to-market accounting is a method of valuing assets and liabilities at their current fair market value rather than historical cost. Under this approach, companies can recognize the present value of expected future cash flows from contracts at the time of signing, rather than waiting until cash is actually received. Governed by accounting standards including SFAS 157 (now ASC 820 under US GAAP) and IFRS 13, mark-to-market is a legitimate and widely used methodology for financial trading operations where market prices are transparent and liquid.

At Enron, mark-to-market accounting was the foundational technique that transformed the company from a natural gas pipeline operator into an energy trading powerhouse. Jeff Skilling, a former McKinsey consultant who joined Enron in 1990, championed the company’s adoption of the method, securing SEC approval in 1992 for its application to energy trading operations. For legitimate commodity trading with observable market prices, mark-to-market provided a more accurate picture of trading positions than historical cost accounting. However, Enron progressively extended the methodology to increasingly inappropriate assets, including long-term contracts in illiquid markets, international power projects, and speculative broadband ventures. This abuse of mark-to-market enabled the company to manufacture earnings that existed only on paper, most notoriously generating $111 million in fraudulent profits from a video-on-demand partnership with Blockbuster that never produced a single dollar of actual revenue.

The email archives of 51 different Enron employees contain discussions of mark-to-market accounting, with 775 messages spanning January 2000 to November 2002 documenting the method’s pervasive role in the company’s operations.

Origins and SEC Approval

Skilling’s Vision

When Kenneth Lay created Enron Finance Corporation in 1990, he appointed Jeffrey Skilling to head the new entity. Skilling had developed the “Gas Bank” concept while working as a McKinsey consultant, proposing that Enron could act as an intermediary in the newly deregulated natural gas market, buying gas from suppliers and selling to consumers while assuming price risk. To make this trading model work financially, Skilling needed an accounting framework that would reflect the value of long-term trading contracts on current financial statements.

One of Skilling’s first major efforts at Enron was to migrate the company from traditional historical cost accounting to mark-to-market accounting. Under historical cost, a ten-year gas supply contract would generate revenue only as gas was delivered and payments received over the contract’s life. Under mark-to-market, Enron could calculate the present value of all projected future profits from that contract and book them immediately upon signing. This transformation fundamentally changed how the company measured and reported its performance.

The 1992 SEC Approval

In 1992, the Securities and Exchange Commission approved Enron’s use of mark-to-market accounting for its energy trading and price risk management activities. The approval was predicated on the existence of transparent, liquid markets where fair values could be objectively determined. For natural gas trading, where market prices were readily observable and contracts were standardized, this rationale held. Enron could demonstrate that its trading positions had verifiable market values based on quoted prices and active trading.

What the SEC approved was mark-to-market for energy trading contracts where market prices were readily observable and verifiable. What the SEC did not approve was the extension of mark-to-market to illiquid assets, long-term speculative projects, and merchant investments where fair value could not be objectively determined.

Legitimate Applications

How It Was Supposed to Work

Mark-to-market accounting serves a legitimate purpose in trading operations. When a company holds financial instruments that trade in active markets, historical cost accounting can understate or overstate the actual economic value of those positions. A futures contract purchased at $100 that is now trading at $150 has a real market value of $150, regardless of its historical cost. Mark-to-market allows financial statements to reflect this economic reality.

For Enron’s gas trading business in the early 1990s, mark-to-market made sense. The natural gas market had developed sufficient liquidity after deregulation, with transparent pricing and standardized contracts. When Enron entered into derivatives and hedging instruments tied to observable market prices, fair value measurement provided meaningful information about the company’s financial position.

The trading operations that emerged under this framework generated substantial legitimate profits. Monthly reports from Errol McLaughlin in 2000 documented the scale of mark-to-market valuations across the US Gas EOL trading desk, showing total MTM values of $534 million in May, $439 million in June, and $274 million in July. These figures represented actual trading positions tied to observable market prices and legitimate hedging activities.

Daily Operations

Mark-to-market became deeply embedded in Enron’s operational culture. Skilling himself took a direct interest in MTM valuations for financial reporting. In March 2000, Sheri Thomas sent an email explaining: “Just to give you all a heads up… Jeff Skilling has asked for a revenue number for EOL that represents what Enron reports on our financial statements (including the Mark-to-Market value of all of our open positions resulting from EOL trading). We are specifically looking for MTM value as of the close of trading on the 15th and would like to be able to review the results by mid-afternoon (Houston) on the 16th.”

This level of executive attention to MTM valuations underscores how central the methodology had become to Enron’s business model. The company even maintained internal training materials on the subject, as evidenced by an August 1999 email exchange regarding a “Mark-to-Market Accounting Video” stored in “the Swaps library.”

The Abuse of Mark-to-Market

Extension to Illiquid Assets

The problems began when Enron extended mark-to-market accounting beyond liquid trading markets to assets and projects where no observable market prices existed. Without market verification, “fair value” became whatever management’s internal models projected. This transformation turned mark-to-market from a market-based valuation methodology into assumption-based speculation.

By the late 1990s, Enron was applying mark-to-market to twenty-year power contracts where no liquid market existed to verify valuations, international power projects like Dabhol Power Company in India where political and operational risks made future cash flows highly uncertain, broadband and video-on-demand ventures in markets that had not yet developed, and merchant investments where values were based on internal projections rather than market transactions.

A September 2000 email from Fred Mitro illustrates how deals were consciously structured to qualify for mark-to-market treatment. Discussing a term sheet with Commonwealth Edison, Mitro noted: “I inserted a section on the last page related to finance/accounting issues which Buyer (ComEd) shall reasonably co-operate with. I will meet with Herman Manis next week to discuss the specific issues/language needed to maintain mark-to-market viability.”

The phrase “maintain mark-to-market viability” reveals that accounting treatment was driving deal structure, rather than economic substance driving accounting treatment.

The Dabhol Example

Enron’s application of mark-to-market to the Dabhol Power Company project in India exemplified the methodology’s inappropriate extension. In January 2000, Pinnamaneni Krishnarao emailed colleagues about a meeting with Bob Butts to “give a overview of what we (Sandeep & co) are trying to do for DPC (Dabhol power) and ask him to clarify the mark-to-market issues related to those deals.”

Dabhol was a massive power plant in Maharashtra, India, facing significant political opposition, payment disputes with state electricity authorities, and fundamental questions about whether it would ever operate profitably. There was no liquid market for twenty-year power purchase agreements with Indian state utilities. Yet Enron sought to apply mark-to-market accounting to these positions, using internal assumptions about future cash flows that would prove wildly optimistic.

Internal Warnings

Not everyone at Enron accepted the expanding use of mark-to-market without question. On August 25, 2000, John Arnold, a senior natural gas trader who built a legendary career at Centaurus Advisors, sent an email to a colleague that cut to the heart of the methodology’s potential for abuse:

“Dave: I was thinking about our conversation yesterday. If El Paso, absent this power deal, were to give us physical gas for 8 years discounted at their WACC in exchange for an upfront cash payment from ENE, is that transaction a mark-to-market gain for us? If not, what’s the difference in paying them with an asset rather than cash. If it is a mark-to-market gain, isn’t this a way to generate false P&L? John”

Arnold’s question “isn’t this a way to generate false P&L?” articulated the fundamental concern that mark-to-market could be manipulated to manufacture earnings that had no economic substance. The fact that a senior trader was raising this question internally in August 2000, more than a year before Enron’s collapse, demonstrates that the potential for abuse was recognized within the organization.

The Blockbuster Fraud

Project Braveheart

The most egregious example of mark-to-market abuse was the Blockbuster video-on-demand partnership, known internally as “Project Braveheart.” In July 2000, Enron Broadband Services announced a twenty-year agreement with Blockbuster to deliver movies on demand to consumers through Enron’s fiber optic network. The deal was announced with great fanfare as evidence of Enron’s transformation into a broadband powerhouse.

There was only one problem: the technology did not work, consumers showed little interest, and the venture never generated any actual revenue. Blockbuster terminated the contract on March 9, 2001, less than a year after it was announced.

Manufacturing $111 Million

Despite the deal’s complete failure to produce revenue, Enron used mark-to-market accounting to book $111 million in earnings from the Blockbuster partnership. The company recorded $53 million in the fourth quarter of 2000 and $58 million in the first quarter of 2001, based entirely on projections of future profits from a venture that was already failing.

To accomplish this accounting alchemy, Enron created a special purpose entity and sold a portion of the projected future profits from the Blockbuster deal. By structuring the transaction as a “sale” to a third party, Enron could argue that the projected value had been monetized and therefore should be recognized as current earnings. The fact that these projected profits were based on a contract that would be terminated months later, for a service that never achieved commercial viability, apparently did not trouble the accountants who approved the treatment.

The Department of Justice later characterized the Braveheart transaction as generating “$111 million in fraudulent earnings relating to Enron’s contract with Blockbuster.” Kevin Howard, the former CFO of Enron Broadband Services who oversaw the transaction, was convicted of conspiracy, wire fraud, and falsification of books and records.

Never Reversed

Perhaps most remarkably, Enron never reversed the $111 million in Braveheart earnings after Blockbuster terminated the contract. Under proper mark-to-market accounting, when the underlying asset loses value, the company must “mark down” and recognize the loss. Enron continued to carry the Blockbuster earnings on its books even after the deal fell apart, compounding the initial fraud with ongoing misrepresentation.

Other Fraudulent Applications

Mariner Energy

The Blockbuster deal was not an isolated incident. According to Department of Justice documents, Enron fraudulently increased the mark-to-market value of Mariner Energy by $100 million in the fourth quarter of 2000 specifically to close a budget gap. This manipulation had no basis in any market transaction or fair value assessment; it was simply an accounting entry designed to meet earnings targets.

The Raptor Connection

Mark-to-market accounting intersected with another major Enron fraud through the Raptor special purpose entities. When Enron’s merchant investments declined in value, proper mark-to-market accounting would have required the company to recognize those losses on its income statement. Instead, Enron created the Raptor structures to “hedge” these positions through off-balance-sheet arrangements, allowing the company to avoid marking down failing investments.

The Raptors were capitalized primarily with Enron’s own stock, creating a circular arrangement: Enron was essentially hedging itself. When Enron’s stock price declined in 2001, the Raptors became insolvent, forcing a $710 million loss recognition that contributed to the company’s collapse.

Role in Enron’s Collapse

The Earnings Management Cycle

Mark-to-market abuse created a self-reinforcing cycle that ultimately proved unsustainable. The pattern worked as follows: Enron would sign a long-term contract and immediately book all projected future profits under mark-to-market accounting. This generated strong reported earnings, which supported the stock price. Management compensation was tied to reported earnings, creating incentives to maintain the illusion.

When projects underperformed or failed, Enron resisted marking down the valuations, which would have revealed the original projections as unrealistic. Instead, the company used SPEs like the Raptors to transfer troubled assets off the balance sheet, transferred losses to unconsolidated entities, and signed new deals to generate fresh mark-to-market gains that could offset problems with earlier transactions.

This cycle could continue only as long as Enron could find new deals to book and new structures to hide losses. When both ran out in 2001, the accumulated fiction collapsed.

Cash Flow Disconnect

The fundamental flaw in Enron’s mark-to-market abuse was the disconnect between reported earnings and actual cash generation. A company can only survive if it generates sufficient cash to meet its obligations. Mark-to-market allowed Enron to report profits that existed only as accounting entries, while actual cash flows lagged far behind.

When investors and creditors finally began scrutinizing Enron’s cash flow statements rather than its income statement, they discovered a company that had reported billions in earnings but was struggling to generate cash. This disconnect, once revealed, destroyed confidence in the company’s reported results and triggered the collapse.

Legal Consequences

Executive Prosecutions

The abuse of mark-to-market accounting contributed to multiple criminal prosecutions. On May 25, 2006, a federal jury convicted both Ken Lay and Jeff Skilling on fraud, conspiracy, and related charges. Skilling, who had championed mark-to-market accounting from his earliest days at Enron, was convicted on 19 counts and ultimately sentenced to 14 years in federal prison.

Richard Causey, Enron’s Chief Accounting Officer who oversaw the implementation of mark-to-market across the company, pleaded guilty to securities fraud for making false statements in Enron’s SEC filings about the company’s financial condition. His position made him directly responsible for the accounting treatments that enabled the fraud.

Broadband Convictions

Kevin Howard, the former CFO of Enron Broadband Services, was convicted in connection with the Blockbuster/Braveheart fraud. His prosecution specifically addressed the use of mark-to-market accounting to manufacture earnings from a failed venture.

Aftermath and Reforms

The Enron scandal prompted significant regulatory attention to mark-to-market accounting and fair value measurements. The SEC conducted studies on the methodology’s appropriate application, emphasizing the importance of market liquidity and observable prices as prerequisites for fair value accounting.

The fundamental lesson of Enron’s mark-to-market abuse is that the methodology works only when genuine markets exist to verify valuations. When companies extend fair value accounting to illiquid assets and use internal projections in place of market prices, the potential for manipulation becomes essentially unlimited. Management can manufacture whatever earnings it desires simply by choosing optimistic assumptions.

This does not mean mark-to-market accounting is inherently flawed. For actively traded financial instruments with observable prices, it remains the most appropriate valuation methodology. But Enron demonstrated that without external verification of fair values, mark-to-market becomes a vehicle for fraud rather than a tool for transparency.

References

This article is based on 775 email messages in the Enron corpus discussing mark-to-market accounting, spanning January 2000 to November 2002, with correspondence from 51 distinct individuals including Jeff Skilling, John Arnold, Sheri Thomas, Errol McLaughlin, Fred Mitro, and Pinnamaneni Krishnarao. Secondary sources include U.S. Department of Justice press releases and prosecution documents (March 2003, December 2005, May 2006), SEC testimony and studies on mark-to-market accounting, St. Louis Federal Reserve publications on fair value accounting, and academic analysis of the Enron fraud.