In late July of 2000, Jonathan Weil, A reporter at the Dallas bureau of Wall Street Journal, got a call from someone he knew in the investment-management business. ‘ You really out to check out Enron and Dynegy and see where their earnings come from’ and Weil 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 know until then whether you’ll show a profit on the deal or a loss. Nonetheless, that is $100 million promise clearly matters to your bottom line. If the electricity steadily drops in price over the next several years, the contract is going to become hugely valuable asset. But if electricity starts to get more expensive as 20016 approaches, you could be out of 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 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 the money may not actually change hands for years.” – Malcom Gladwell
How much of Enron’s earnings was “real”?
His conclusions – in the second quarter of 2000, $747 million of the money Enron said it had made was unrealized– that is, it was money that executives thought they were going to make at some point in the future. – Malcom Gladwell -| What the dog saw.
When life gives you lemons. Short seller James Chanos build on Weil research and concluded that Enron’s profit margins and its return on equity were plunging. Cash flow- the life line of any business – had slowed to a trickle, and the company’s rate of return was less than its cost of capital: it was as if you had borrowed money from the bank at 9 percent interest and invested it in savings bond that paid you 7 percent interest. – What the Dog saw- Malcom Gladwell