The Enron Accounting Happening on Farms

SW Financial Literacy

The Enron Accounting Happening on Farms

I’m listening to "The Smartest Guys in the Room" by Bethany McLean and Peter Elkind right now, and I’m only halfway through the book, but there have been too many lessons to share, so it was time to make this post now. For those of you who don't remember the downfall of Enron, it is work a Google or AI search. In the meantime, here are lessons that you can take away from this disaster.

Mark-to-Market Accounting on Steroids

One thing about Enron, which most people now know, but I’m able to listen to in good detail, is how the company did so much mark-to-market accounting, which brought future earnings forward into the present time.

Mark-to-market started in 1991 with just their natural gas business, and they actually got SEC approval to do it this way, but slowly and quietly they began to extend that type of accounting to all areas of their earnings.

How this would work: Enron would put a natural gas contract together with a third-party company, agreeing to provide 20 years of a certain amount of natural gas to them at a set price, or a price agreed upon by both parties. Enron was then allowed to bring all 20 years’ worth of estimated earnings from this contract deal forward, using 20 years’ worth of contract earnings in just one quarter’s worth of earnings.

Twenty years’ worth of earnings in one quarter. No wonder they were growing so fast. This made Wall Street and investors very excited when the “returns” were happening so quickly.

Once they got desperate for earnings in the late 1990s, they began to reappraise those old mark-to-market contracts and pull additional earnings forward out of those projects that they had already counted quarters or years ago. So they showed 100% of the “estimated” earnings in 1992, and then, when they needed more earnings to keep their stock prices up, they started to report earnings from that exact same contract again in 1997.

Not only were they counting unrealized earnings from a decade into the future, but sometimes they were counting them twice.

Another problem with showing these earnings on their statements is the fact that they were only getting cash one quarter, one month, or one week at a time from these contracts. Twenty years’ worth of earnings, but only one month’s worth of income flowing in to support your cash position. This is completely backwards, insane, and should never have been allowed. This inaccurate balance sheet did not allow for cash buildup in the entity.

Application to Farmers

I see the double counting of income mostly in two specific scenarios:

1. Monthly cash flow statements

The cash flow statement is typically going to show one year’s worth of income. That is the same for most businesses and agriculture alike. I don’t typically see this problem with annual cash flow statements, but the problem occurs more frequently when it is an annual statement with a monthly breakdown of income.

Here’s what happens:

The producer will show old crop grain sold in January, March, and June while there are no old crop expenses on the cash flow. They will then show 100% of new crop grain sales in November or December of that same year. I see this with livestock as well. They are essentially showing all, or at least part, of two crops while only showing one year’s worth of expenses.

They fool themselves into thinking that the cash flow is positive for this upcoming year, but they aren’t accounting for any of the old crop expenses. This is a dangerous game to be playing with yourself.

While this type of cash flow is helpful to manage funds and make sure you have enough money to get the new crop paid for, we can’t be using this type of accounting to determine profitability for the operation as a whole. Even though your CPA may view it this way, it is a surefire way to operate with losses every single year while thinking you are making money.

No one should be doing that.

2. Livestock or business monthly contracts

I will typically see this one more often on a farmer’s balance sheet when they are a contract grower, say for a chicken or hog facility where they are paid monthly and don’t own the livestock themselves.

Producers will sometimes show one full year of accounts receivable on their balance sheet or cash flow. While it makes sense to show this income on a cash flow, not all of those earnings 12 months out are liquid and should be showing on your balance sheet.

Too many producers will have a propped-up working capital position on their balance sheet because they are showing this full contract under current assets when they actually won’t have access to the funds 11 months in advance.

This is creating an inaccurate balance sheet position, and you run the risk of poor decision-making by a propped-up statement. I’ve actually also seen full years’ worth of salary shown under accounts receivable or in the checking account before it has been earned on the balance sheet as well. Please don’t do this.

Your Cash Flow or Mine?

In the mid-1990s, they ran into another set of problems after changing leadership. They stopped putting realistic earnings goals together. They started to simply ask Wall Street what earnings were needed to keep their stock price moving higher, and when they got the answer, they used those earnings on their statements.

In order to make those earnings a reality in their public reports, they jumped through all types of hoops and did all types of creative accounting that they had pushed on their accounting and audit team to meet these quotas.

You don’t have enough earnings for this month? Let’s create a new special entity to take out a loan and buy some of our assets. We can show this arrangement as additional earnings for this year and pay them back in two weeks.

Oh, by the way, that new entity was owned by individuals within Enron, and they would take a cut of the fees of this transaction to pad their own pockets.

Once they started to realize they could get away with these fictitious transactions and faulty cash flow statements, they kept doing it and got deeper into the gray area. Cash flows never actually represented what was happening within the operation, but were just there to increase stock value.

Application to Farmers

This is exactly what a ton of farmers do: they create a cash flow projection at exactly breakeven for their operation. They will either decrease expenses in various areas or inflate their actual income potential. Oftentimes, I get cash flow projections that show income at higher levels than they’ve ever been able to raise in their history. This is straight-up sabotage of your operation and your position.

This is exactly what Enron did and why they’re one of the biggest black eyes in American business history. You can only run a stable, functional, and profitable business if you’re real with the numbers.

If you are altering your projections for your lender, or not even putting one together because you’re too lazy to, you are hurting no one but yourself. This should be alarming to you and get your attention immediately. And it also needs to stop.

Build a cash flow projection for you, even if it’s bad news. Then use that statement with your lender and find ways to move forward. Improve expenses, find waste, generate additional income. If it cannot be done, start selling assets until your cash flow gets back to breakeven.

We see this frequently in large businesses all over the globe. They’ll shut down offices or locations and lay off massive amounts of staff after they have a few bad quarters of earnings. Large businesses know that if things are heading in the wrong direction, you need to slash expenses to get in front of your financials and create potential income in the future.

If others are doing this to create profitable and sustainable businesses, why aren’t we doing this in agriculture? Oftentimes, I think the fear is because we don’t know how. We don’t realize this is what others are doing and that this is what is best for the business. There is a lack of knowledge and learning in the sector, which I myself am trying to catch up on. But if we don’t put those realistic statements together, we do all risk the same phase Enron ran into: bankruptcy.

Year-End Lies

Enron worked really hard to push the envelope of what was legal and realistic. When they went bankrupt, their books were showing roughly $13 billion worth of debt on their balance sheet. When investigators were done looking through their accounts, it was believed that their real debt exposure was closer to $30 to $38 billion.

How did this happen?

Again, for their year-end statements, they worked hard to prop up their position before they had to report earnings. Oftentimes, they would take out a budget note or bridge note from a bank before year-end, as I alluded to earlier. These $100 million loans could be to “prepay” Enron for future energy deliveries, sometimes many years in advance.

Enron would show those prepaid assets on their balance sheet and earnings statements, then sell the assets and pay the loan off once the calendar year changed.

However, they wouldn’t show a loan on the other side of their balance sheets. The budget note was not listed as a liability, but was viewed more as a “trading liability” or “deferred revenue.”

Take out a loan against future earnings, show all the money on your books, but don’t show the loan anywhere as a debt. A little shady, don't you think?

Application to Farmers

As farmers we need to make sure we are showing all debts and contract liabilities on our balance sheet.

Just because your spouse doesn’t sign on your farm loan, and they use their salary to pay for your mortgage, does not mean that you can’t show that mortgage loan on your financial statement. You are still held liable for those payments.

Another common one I will see are long-term contract payments with a related party. An individual may be buying land on contract from the landlord but doesn’t want to show those payments on the balance sheet because it’s not a loan.

If the ground is deeded in your name and there’s an agreement in place, all current and future payments need to be shown. This actually applies to lease contracts on equipment as well. Just the same as a contract to buy land, you have a legal obligation to fulfill all of the payments on the equipment that you’re leasing. (This would not apply to a short-term rental, such as a combine used for one week while yours is in the shop. For that, you would just show the accounts payable for the bill if it has not been paid yet.)

Another item that is left off statements on occasion would be any debt not through my lending institution. I’ve seen credit cards, boat and vehicle loans, and land debt through other lenders that individuals don’t think I have the right to see on their statement.

Just because I didn’t finance the asset or can’t take the asset as collateral does not make this OK. These are fraudulent statements which misrepresent your position and the risk being brought on by me as the lender.

The best way to make educated decisions for your operation and to grow toward profitability is through accurate statements, both on the balance sheet and cash flow. The best thing you can do for yourself is do it right.

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Grant