Funny thing.  Right after we'd discussed my company's mark to market 
accounting in class on Monday, this article showed up on Wednesday.  Thought 
you might be interested.

TEXAS JOURNAL --- Energy Traders Cite Gains, But Some Math Is Missing ---- By 
Jonathan Weil Staff Reporter of The Wall Street Journal

Volatile prices for natural gas and electricity are creating high-voltage 
earnings growth at some companies with large energy-trading units. But 
investors 
counting on these gains could be in for a jolt down the road. 
 
  Shares of these companies have been on a tear lately. And some of the 
biggest 
players are in Houston, the center of the energy-trading industry. Dynegy 
Inc.'s 
stock is up more than fourfold so far this year at $53.438, and now trades 
for 
41 times what analysts project the company's 2000 earnings will be, according 
to 
First Call/Thomson Financial. Shares of Enron Corp., the largest trader of 
gas 
and electricity in North America, have nearly doubled this year to $84.875, 
or 
60 times earnings. Meanwhile, El Paso Energy Corp.'s stock has jumped 61% 
this 
year to $62.375, or 24 times earnings. 
 
  Traders at these and other companies are capitalizing on the wild price 
swings 
and supply fluctuations that have accompanied deregulation in some regional 
markets. Natural-gas prices have more than doubled in the past year, while 
supplies have tightened. And the rapid price fluctuations for electricity 
have 
prompted many large businesses to seek price protection through hedging or 
fixed-price contracts, generating large premiums for traders. 
 
  But what many investors may not realize is that much of these companies' 
recent profits constitute unrealized, noncash gains. Frequently, these 
profits 
depend on assumptions and estimates about future market factors, the details 
of 
which the companies do not provide, and which time may prove wrong. And 
because 
of minimal disclosure standards in these kinds of cases, it's difficult for 
investors to assess whose assumptions might be too aggressive, or what market 
changes might invalidate the assumptions -- and force earnings revisions. 
 
  "There could be a quality-of-earnings issue," says Tom Linsmeier, an 
associate 
professor of accounting at Michigan State University, who co-authored the 
U.S. 
Securities and Exchange Commission's rules on market-risk disclosures for 
financial instruments. "There certainly might be great volatility that could 
cause what now looks like a winning, locked-in gain to not arise sometime in 
the 
future." 
 
  The companies reject any suggestion that there may be quality problems with 
their earnings. 
 
  But at the heart of the situation is an accounting technique that allows 
companies to include as current earnings those profits they expect to realize 
from energy-related contracts and other derivative instruments in future 
periods, sometimes stretching over more than 20 years. 
 
  So-called mark-to-market accounting is mandated by accounting-rule makers 
when 
companies have outstanding energy-related contracts on their books at the end 
of 
a quarter, such as agreements to sell electricity or buy natural gas over a 
period of time at certain prices. Under those rules, companies estimate the 
fair 
market values of those contracts on their balance sheets each quarter as 
assets 
or liabilities. Changes in the value of a contract from quarter to quarter 
then 
are either added to or subtracted from net earnings. 
 
  If, for instance, the market price for natural gas rises above the price 
specified in a company's contract to buy gas, generally the company will 
record 
an unrealized gain. That gain is recognized as income and recorded as an 
asset 
on the company's balance sheet. At the end of each quarter, the contract is 
revalued. The value of the previously recorded asset is increased, and any 
increase in unrealized gain is recorded as additional income. Conversely, if 
the 
market value for gas falls, and the value of the contract has declined, any 
change in the contract's value is recorded on the company's balance sheet, 
and a 
loss is recorded on its income statement. e 
 
  Yet in their financial reports, the companies only vaguely describe the 
methods they use to come up with fair-value estimates on the contracts. 
Increasingly, quoted market prices offering independent guidance are becoming 
readily available for several years into the future. However, with some 
long-term derivative instruments, particularly electricity contracts, future 
market prices don't extend far enough to cover the full life of those 
contracts. 
And in those cases, companies are allowed to base valuations on their own 
undisclosed estimates, assumptions and pricing models. 
 
  "Ultimately they're telling you what they think the answer is, but they're 
not 
telling you how they got to that answer," says Stephen Campbell, an analyst 
at 
Business Valuation Services in Dallas. "That is essentially saying `trust 
me.'" 
 
  Accounting-rule makers at the Financial Accounting Standards Board have 
debated the subject of how to value energy-related contracts extensively in 
recent months. "Two companies in similar circumstances might apply different 
methods to estimate the fair value of their energy-related contracts and may 
arrive at widely different values," an FASB task force studying the issue 
wrote 
in a June report. "Those differences lead to the question of whether some of 
the 
methods in practice yield estimated amounts that are not representative of 
fair 
value." 
 
  Despite this concern, FASB isn't inclined to offer any explicit guidance 
for 
how such contracts should be valued. "There are just too many models and too 
many different types of instruments for us to have a one-size-fits-all type 
of 
model," explains Timothy Lucas, FASB's director of research in Norwalk, Conn. 
 
  One way to determine the size of a company's unrealized gains is to compare 
the change in the values of net assets from risk-management activities from 
quarter to quarter. Some companies also disclose how much they're adjusting 
their cash-flow statements to reflect unrealized gains that have been booked 
as 
earnings. That's how one can determine the size of the unrealized gains at 
Dynegy and Enron, for example, the two companies confirm. 
 
  A reporter's examination of Dynegy's financial filings shows the company's 
earnings are highly dependent on unrealized gains from risk-management 
activities. For its most recent quarter, ended June 30, Dynegy reported 
earnings 
of 38 cents a diluted share -- 71% of which came from unrealized gains, the 
company confirms. (The company's per-share earnings would have been 20 cents 
higher if not for a one-time stock dividend.) For all of 1999, Dynegy 
recorded 
$115 million in unrealized gains, accounting for 51% of its earnings. 
 
  Enron confirms it booked $747 million in unrealized gains from 
risk-management 
activities during the second quarter, more than the company's total $609 
million 
in earnings before interest and taxes. Absent unrealized gains, the company 
would have reported a quarterly loss. For the quarter, the company reported 
earnings of 34 cents a diluted share, up 26% from a year earlier. 
 
  But not all companies disclose enough information for investors to 
calculate 
how large their unrealized gains are. El Paso says that's the case with its 
own 
quarterly reports, which disclose short-term assets and liabilities from 
risk-management activities -- but not long-term risk-management assets and 
liabilities. 
 
  For the second quarter, El Paso reported that its energy marketing and 
trading 
unit earned $152 million before interest and taxes, 24 times what it earned a 
year earlier. In an interview, El Paso's chief financial officer, Brent 
Austin, 
says unrealized gains represented about a third of that total. He says most 
of 
the cash from those gains will materialize within a year. 
 
  In its financial reports, Dynegy highlights the uncertainties with some 
contract valuations. It explains that with some long-term contracts for which 
market-price quotes aren't available, "the lack of long-term pricing 
liquidity 
requires the use of mathematical models to value these commitments . . . 
[using] 
historical market data to forecast future elongated pricing curves." Dynegy 
cautions that actual cash returns may "vary, either positively or negatively, 
from the results estimated." 

 But like Enron, El Paso and others, Dynegy provides scant details about its 
mathematical models -- such as the assumptions they use for market volatility 
and long-term price forecasts for natural gas and electricity. Nor is the 
company required to disclose more. 
 
  "The disclosure mentions risks," says John Cassidy, an analyst who tracks 
Dynegy for Moody's Investors Service in New York. "But I don't know that the 
disclosure offers enough detail for you to be able to quantify how much risk 
there is." 
 
  El Paso's filings warn that "because the valuation of these financial 
instruments can involve estimates, changes in the assumptions underlying 
these 
estimates can occur, changing our valuation and potentially resulting in 
financial losses." Enron cautions that the values it assigns to various 
transactions are based on "management's best estimate." 
 
  The companies are required to disclose what they think their maximum 
potential 
single-day risk-management losses might be, figures that also are based on 
various undisclosed market assumptions. But energy traders cite competitive 
reasons for not disclosing more. 
 
  "You don't necessarily want to tip off everyone to what you're doing," says 
John Harrison, chief financial officer for El Paso's merchant-energy unit. 
 
  Echoing remarks by executives at other energy traders, Enron's executive 
vice 
president and chief accounting officer, Richard Causey, says Enron runs a 
relatively balanced portfolio and that the estimates factored into his 
company's 
valuations are conservative. In large part, he says, those estimates are 
based 
on quoted market prices where available. Where they're not available, Mr. 
Causey 
says Enron bases its estimates in part on long-term pricing trends, as well 
as 
the company's own trading experience, which dates to 1990. 
 
  Further, Mr. Causey says, Enron's unrealized gains don't depend heavily on 
gains from long-term contracts that extend beyond the periods for which 
market 
quotes are available, reducing the potential for significant earnings 
revisions. 
The average length of Enron's risk-management contracts is just two years, he 
says. To be sure, though, some of Enron's electricity contracts extend for 25 
years. 
 
  "We're getting the cash in quicker than you might think," Mr. Causey says. 
"They don't stay unrealized very long." 
 
  El Paso says its contracts have an average life of six years, with some 
running as long as 20 years. Dynegy says the longest risk-management 
contracts 
for which it uses mark-to-market accounting are 10 years, though it doesn't 
disclose an average length. Dynegy's chief financial officer, Robert Doty, 
says 
96% of the company's gas contracts close out by 2002, while 75% of its power 
contracts expire by 2003. "The cash will come in," he says. 
 
  As for why the company doesn't disclose the extent of any bias, bullish or 
bearish, it has in the market, Dynegy executives say that information, like 
the 
estimates behind its mathematical models, is proprietary. Such disclosures 
may 
be outdated anyway by the time they could be included in public financial 
filings, says Michael Mott, a Dynegy vice president. Mr. Mott further 
explains 
that Dynegy could be realizing more cash earnings now if it wanted to. But 
"we 
don't see that would be in the best interests of shareholders," Mr. Mott 
says, 
because the company figures it can earn more later by leaving much of its 
gains 
unrealized for now. 
 
  Mr. Linsmeier of Michigan State compares the current situation for energy 
traders with the accounting controversies that engulfed subprime automobile 
and 
residential lenders during the late 1990s, though he emphasizes it's too far 
early to tell whether the consequences will be similar. Using so-called 
gain-on-sale accounting (a form of mark-to-market accounting), those lenders 
booked earnings from loans as soon as they were made, rather than having to 
wait 
for them to be paid off, as banks typically do. 
 
  But as interest rates fell in 1998, many customers paid off their loans 
earlier than expected, slashing lenders' profit margins. Compounding matters, 
the market for mortgage-backed securities dried up in the wake of financial 
chaos in Russia and other foreign markets, leaving lenders to bear the higher 
risks of many new loans. 
 
  Many investors complained they were blindsided, in part because these 
lenders 
generally hadn't disclosed their assumptions about prepayment rates and other 
variables. After the crash, subprime lenders routinely began disclosing the 
key 
assumptions used to value their mortgage portfolios. 
 
  At New York University, accounting professor Baruch Lev says investors 
would 
be better served if energy traders' financial filings explained the effects 
of 
hypothetical commodity-price movements on the values of their risk-management 
assets, and disclosed the basic assumptions about future commodity-price 
movements ingrained in their mathematical models. Says Mr. Lev, "I would like 
to 
see much more disclosure, particularly given that this is now becoming a 
significant component of their earnings." 
 

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