Balance Sheet Classification - Vagaries of Structured Financing?



The Enron debacle shows that investors and financial statement readers need to understand the details disclosed in a company's financial reports and be willing to ask critical questions about items that are not well explained in footnotes or other places. For example, Enron's balance sheet for the 2001 third quarter included $350 million in price-risk management liabilities, which in essence were a short-term bank loan from J. P. Morgan Chase Bank to Enron. In this case, a popular and legitimate financial engineering technique called "structured finance" was exploited by Enron to practice aggressive accounting, while apparently following legal requirements. At the end, both Enron and Chase were burned by the financial commitments they made to each other.


A Further Look

Enron's last available published financial reports were the Form 10-Q filed in November 2001 for the third quarter 2001. Enron filed for bankruptcy on December 2, 2001, and subsequent disclosures have cast doubt on the usefulness and reliability of those financial reports. These disclosures have shown that Enron made several desperate last-minute attempts to make those third quarter 2001 numbers look good using aggressive accounting and the tools of modern finance. A case in point is the "structured finance" transaction which took place on September 28, 2001, by which Enron was able to hide a $350 million six-month bank loan from Chase. The loan was instead reported by Enron as a normal merchant liability from its trading business.

To do this miraculous transformation of an ordinary loan into a derivative, a series of fixed-price and variable commodity trades were transacted between Enron, Chase and an offshore entity called Mahonia Ltd, owned by Chase. The net result of these was the following:
- Chase/Mahonia agreed to buy natural gas for delivery in six months, and pay Enron $350 million upfront. Enron reported this transaction in its books as cash and a prepaid futures contract liability.
- Enron agreed to buy the same amount of gas and pay Chase/Mahonia $356 million in six months. Enron reported this transaction in its books as cash-settlement futures contract asset and a corresponding payment liability.

Of course, to an outside observer, these transactions look no different from a normal loan receipt and loan repayment. However, to make this loan look like several independent and presumably arms-length derivative deals, Enron and Chase entered into a series of variable-price commodity delivery contracts, which transferred a certain payment amount from Enron to Mahonia, then from Mahonia to Chase, and finally from Chase back to Enron. In other words, the variable payment obligations would merely cancel out, leaving only the fixed payment of $350 million from Chase to Enron, and the fixed payment from Enron to Chase after six months of $356 million.

An interesting aspect to these transactions is their timing. All the derivative transactions were entered into on September 28, 2001, the very last day of Enron's third quarter for financial reporting.

Like all finance tools, structured finance can be beneficial to a company if it is used to raise loans at a low cost and provide liquidity and capital for projects that add value. However, Enron seems to have used the terminology and tools of structured finance merely to borrow money in a way that it would not show up in the balance sheet as a liability. No other business intent seems to have been accomplished.

Ultimately, the courts will have to deal with the question of whether Chase was acting as just a legitimate bank or an accomplice to Enron's scheme. No matter their intent, the bankers got burned at the end by these transactions. Enron's bankruptcy seriously disrupted the round-trip transactions, leaving Chase with an uncollected $350 million loan.


"Enron Hid Big Loans, Data Indicate," New York Times, by Kurt Eichenwald, February 27, 2002.


Click here for Instructor Discussion Notes

1. What are the guidelines for a company to determine whether a transaction creates a liability or not?

2. Discuss the differences between liabilities that are reported as a loan and those reported as a trade payable.

3. Do you think Enron's income statement for the third quarter 2001 was affected by the transactions described in the article? If so, by how much?

4. Do you think Enron's cash flow from operations for the third quarter 2001 was affected by the transactions described in the article? If so, by how much?



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