Greetings Jeff,
Thanks.  I will make copies and bring it to class.
Kindly,
Salvador

--
Salvador D. Aceves
Assistant Professor, Accounting
Director, Executive Education
School of Business and Management
University of San Francisco
2130 Fulton Street
San Francisco, CA  94117
Tel (415) 422-6263 fax (415) 422-2502
e-mail: acevess@usfca.edu




> 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."
>
>
> - - - - - - - - - - - -  Document Released on 2000-09-20 02:20:08.0 EST - -
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>
>