Dynegy Corporation: Inflating Operating Cash Flow

• In Event: Session D: Financial Accounting and Reporting

Abstract

In 2004 three employees of Dynegy Corporation were prosecuted and served time in federal prison for complicity in Project Alpha, a gas financing and sales project that resulted in a material overstatement of operating cash flow. The project was carried out through the use of two special-purpose entities, one to achieve a tax saving and one to increase reported operating cash flow. In this paper we will describe the cash flow part of the plan, including details about negotiations between Dynegy and Citibank that ultimately caused the failure of the rationale for the desired accounting treatment. The cash flow part of the plan called for ABG Gas Supply, an SPE, to borrow $300 million to finance the sale of gas at a deep discount to DMT LP, an entity consolidated into Dynegy that sold the gas in the market, thus creating a large increase in reported consolidated operating cash flow. In effect loan proceeds were converted into operating proceeds by the transactions. The desired effect on Dynegy’s financial statements would be achieved only if ABG was not consolidated, and under GAAP this required that 3 percent of ABG’s capital be in the form of at-risk equity investment. Negotiations with Citibank resulted in hedging of the 3 percent, invalidating the basis for nonconsolidation. Nonetheless, Dynegy failed to consolidate ABG in its 2001 financial statements until it was forced to restate the statements in 2002. Interestingly there was no inflation of earnings or understatement of liabilities, only a misreporting of financial cash flows on the cash flow statement. A major factor in the motivation, design and execution of Project Alpha was the impact of mark-to-market rules on corporate financial reports.

Author

• Fred E. Sellers, Southwestern University