For most normal humans, discussions on accounting principles are about as much fun as a prolonged session at the business end of a dentist's drillbit. But Enron Corp.'s accounting foibles were part and parcel of the company's failure. So take a bit of Novocaine and relax. This primer on accounting won't hurt (much). For panhandlers, housewives and small businesses, money means one thing and one thing only: cash. For them, money is legal tender or coins that can be redeemed almost anywhere, almost anytime, in exchange for goods and services. But in the Brave New World of Accounting, that's not the case. And the failure of Enron was substantially caused because the company had so much noncash revenue. Let me say that again, because it's one of the fundamental reasons why Enron went bankrupt: its revenues did not equal cash. And Enron's ability to show sky-high revenues without generating comparable amounts of cash was due to its adoption-at the prodding of future-CEO Jeff Skilling-of mark-to-market accounting. Accounting has been called the science of business. It's an appellation that was likely put forth by a lonely pocket-protector-wearing certified public accountant with too much time on his hands. In a real science, like chemistry or physics, there are laws. In physics, certain forces, like, say, gravity, cannot be denied. They are inexorable truths that simply must be accepted. For chemists, no matter how much they'd wish it to be otherwise, lead cannot be turned into gold. It just can't happen, ever. But in the modern world of accounting, there are no laws. Almost everything depends on "best professional judgment." Better still, Enron and its auditing and consulting firm, Arthur Andersen, knew that there were no cops patrolling their turf, so they could act with almost complete impunity. And they did just that. First a bit of history. There are more than 500 years of reliable use behind modern accounting methods. They started with a Franciscan friar, Frater Luca Bartolomes Pacioli, who believed that Renaissance businessmen needed a reliable way to assess their financial condition. A pal of Leonardo da Vinci, Pacioli was a polymath. Born in Tuscany in the mid-1400s, he studied religion, business, military science, mathematics, art, music and law. In his spare time, he helped Leonardo figure out how much bronze he needed for some of his sculptures. Pacioli's patrons included the traders of Venice and Florence, who needed to be able to analyze their finances on a daily basis. His answer was dual-entry accounting. Every transaction was followed by an entry of both a debit and a credit in a journal. If a trader sold a boat for $100 in cash, he entered a debit for $100 in his asset column and a credit of $100 in his liabilities column. Pacioli decreed that at all times, debits and credits must be equal. If the two sides didn't balance, wrote Pacioli "that would indicate a mistake in your ledger, which mistake you will have to look for diligently with the industry and intelligence God gave you." Pacioli's concepts were so brilliant that within a century or so, his treatise on accounting, originally published in 1494, had been translated into five languages and the "Italian method" of bookkeeping became the standard throughout Europe. And although the world has changed radically since the Renaissance, Pacioli's bookkeeping methods have remained largely unchanged. Under Pacioli's method, known as cost, or accrual accounting, Enron would only have been able to recognize revenues from each deal that it did as the money came in. For example, assume Enron was a Venetian company that signed a contract to sell another company one boat each year for 10 years, with each boat costing $100. Under Pacioli's rules, Enron would have only been able to record the $100 debit (and credit) for the sale once each year. But under mark-to-market accounting, Enron could estimate the total value of the 10-year deal at any price it chose. So although total revenue was projected at $1,000, Enron could slap a net present value on the deal of, let's say $800, and enter that $800 debit in its ledger right away. The deal gets completed by the entry of an $800 liability on Enron's balance sheet. The problem was, of course, that Enron didn't have $800 in cash. It only had $100 cash from the sale of the first boat and a promise from the buyer that he would buy another boat per year during the next nine years. Further assume that Enron, being an aggressive trader in Venice, saw that the price of boats was increasing and that in three years' time, a boat that they were now selling for $100 might be selling for $150. That meant that under the mark-to-market method, they could increase the value of the 10-year contract to $1,050, or even more, and book that revenue right away. They'd arrive at that value by creating a price curve. The price curve Projections of future pricing are mapped on a price curve. Optimistic promoters always use price curves that look like a hockey stick. That is, they assume future prices of the widgets they are selling will soar. Estimating future prices of anything is difficult. But traders of commodities have to do it to protect themselves from price volatility. For some commodities and time periods, creating price curves is a snap. For instance, the New York Mercantile Exchange has readily available prices for crude oil that will be delivered at the New York Harbor in 60 days. Similar prices are available for commodities like orange juice, coffee, pork bellies and cotton. But price curves have a limited utility, particularly when the time lines are extra long. For instance, who can say with any accuracy, how much natural gas will cost in 20 years? The Amazing Kreskin might be able to predict that, but no one in the energy business can. For years, futurists and hopeful oilmen have been predicting crude oil would cost $50 per barrel within two decades of whatever day they were making their prediction. Those dire predictions have, so far, been proven wrong. Oil exploration and production companies continue to find ever more oil and natural gas in ever-more-remote locales. The ability to change price curves to suit the needs of a particular deal can create a tempting option for an accountant. If a company needs extra revenues, an (unscrupulous, or perhaps "creative") accountant can simply "move the curve"-that is, adjust the price curve on a particular deal. With a fatter curve, the company can magically generate additional revenue (noncash revenue) without having to go to the trouble of actually providing any goods or services to a customer. Enron's ability to manipulate price curves on its long-term contracts would become very important as its energy derivatives business grew ever-larger. Many accountants and traders believe that mark-to-market accounting is the best way to reflect the true value of a business, particularly one that does complex or long-term financial deals with contracts or investments that fluctuate in value. Mutual funds are a good example of mark-to-market accounting. Every trading day, every publicly traded mutual fund prices all of the securities it holds. And at the end of the day, it publishes the net asset value of those securities. Mark-to-market works particularly well for items like stocks that are fungible, which is a fancy word for something that is easily bought or sold on the open market. Big Macs and Bic pens are fungible. Nuclear missiles are not. Mark-to-market accounting is useful, too, when valuing items that are common but not easily exchangeable, like office space. Suppose a real-estate leasing company owns an office building that is leased to five tenants, each of whom uses 2,000 square feet costing $1 per square foot per year. Lease costs are increasing. So the company renegotiates one lease for $1.25 per foot. Under mark-to-market accounting, the company recalculates the value of its other four leases, which, given the new valuation from the new lease, are worth more, even though their rents cannot be increased until the old leases expire. The old leases are only paying $8,000 but under mark-to-market accounting, their true value is $10,000. Add in the value of the new lease, $2,500, and the real estate company now has revenue of $12,500 even though it is only receiving cash of $10,500. ($2,500 from the new lease plus the $8,000 from the old leases). "Mark-to-market accounting was Skilling's brainchild," says one executive familiar with the accounting change at Enron. "He convinced Ken Lay on it. Then he convinced the audit committee and the board." Skilling began seeing the potential for the new accounting method in late 1990, about the same time a group of Enron salespeople closed one of the biggest long-term gas supply deals in the history of the energy business. The contract with the New York Power Authority called on Enron to deliver 33 million cubic feet of natural gas per day to power plants built or operated by the authority. The 23-year-long deal gave the authority fixed price gas for 10 years and adjustable prices based on index prices for the remaining 13 years. The total value of the contract was $1.3 billion. But under accrual accounting rules, Enron could only take 1/23 of the revenues from that contact every year. If Enron could use mark-to-market accounting, Skilling could pull most of that future revenue into the current quarter to make his business unit, Enron Finance Corp.-and himself-look better. Enron was particularly aggressive in selling long-term gas contracts like the one with NYPA that extended out 10, 15 or even 20 years. At that time, no other energy company was willing to make long-term bets like those because there were no reliable pricing schemes that allowed them to quantify their risks. But Enron saw that as an advantage. If gas was selling for $2 per thousand cubic feet in 1990, Enron could simply assume that it would cost $8 in 2010. And through the magic of malleable price curves and mark-to-market accounting, Enron could then assume a juicy hunk of revenue from that contract right away, and enter it on its books. In short, nobody had ever done the type of transactions that Enron was doing, so no one could evaluate whether the contract was good or bad. The elasticity of the price curve mechanism allowed Enron a way to continually adjust the amount of revenues the business was making. By getting mark-to-market, Enron started a series of events that took its focus away from cash and cash flow and put it on revenue growth. And therein lies one of the seeds of Enron's destruction. Revenue growth became more important than cash. Enron's audit committee approved the switch to mark-to-market accounting in 1991, and Enron and Andersen immediately began lobbying the Securities and Exchange Commission for permission to use the method. The SEC approved Enron's request in 1992. With that approval, Enron became the first nonfinancial company to be given approval to use mark-to-market accounting. That approval also marked the beginning of Enron's race toward bankruptcy. M Robert Bryce, author of Pipe Dreams: Greed, Ego, and the Death of Enron (PublicAffairs, New York, 2002), lives in Austin, Texas. For more on the book, see RobertBryce.com. For more on the Amazing Kreskin, see AmazingKreskin.com.

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