Fair-value accounting: A cautionary tale from Enron

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 generally 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.