Accounting Case Study: Investment in Sunk and Enron's Bankruptcy

Investment in Sunk: Journal Entries and Accounting Method

1.On January 1, 2019, Roberts Inc. purchased 10% of the outstanding 1,000,000 common shares of Sunk for $200,000. Roberts Inc. considers this investment to be a non-strategic investment. At the 

December 31, 2020-year end, the fair value of this investment was $208,000. Sunk's profit in 2020 was $100,000. Sunk paid a dividend of $.60 per common share. On January 1, 2021, Robert decided to buy an additional 25% of Sunk's 1,000,000 common shares for $500,000. This second purchase allowed Robert to significantly influence Sunk. In 2021, Sunk's profit was $140,000. Sunk paid dividends of $.50 per common share in 2021. (20 marks) 

For 2020, the investment is considered to be a fair value through profit and loss investment: 

Required: 

(a)Make journal entries for 2020 and 2021 on Robert’s books with respect to the Investment in Sunk.  

For 2020, the investment is considered to be a fair value through profit and loss inv. 

(b)Which method of Investment Accounting is Robert Inc using? Justify your response. 

2.In 2001, Enron Corporation filed for Chapter 11 bankruptcy protection, shocking the business community: How could a company this large and this successful go bankrupt? 

Unknown to investors and lenders, Enron also controlled hundreds of partnerships that owed vast amounts of money. These special-purpose entities (SPEs) did not appear on the Enron financial statements. Assume that the SPE’s assets totaled $7,000 million and their liabilities stood at $6,900 million; assume a 10% interest rate on these liabilities.  

During the four year period up to December 31st, 2000, Enron’s stock price shot up from $17.50 to $90.56. Enron used its escalating stock price to finance the purchase of the SPEs by guaranteeing lenders that Enron would give them Enron stock if the SPEs could not pay their loans.  

In 2002, the SEC launched an investigation into Enron’s accounting practices. It was alleged that Enron should have been including the SPEs in its financial statements all along. Enron then restated net income for years up to 2000, wiping out nearly $600 million of total net income (and total assets) for this four year period. Assume that $300 million of this loss applied to 2000. Enron’s stock price tumbled, and the guarantees to the SPE’s lenders added millions to Enron’s liabilities (assume the full amount of the SPE’s debt). To make matters worse, the assets of the SPEs lost much of their value; assume that their market value is only $500 million

Requirements: 

1.Compute the debt ratio that Enron reported at the end of 2000. Compute Enron’s Return on Total Assets (ROA) for 2000. For this purpose use only total assets at the end of 2000, rather than the average of 1999 and 2000.  

2.Compute Enron’s leverage ratio. Now compute Enron’s Return on Equity (ROE) by multiplying the ROA computed in part 1 by the leverage ratio. Can you see anything unusual in these ratios that might have caused you to question them? Why or why not? 

3.Add the asset and liability information about the SPEs to the reported amounts provided in the table. Recompute all the ratios after including the SPEs in Enron’s financial statements. Also, compute Enron’s Times Interest Earned ratio both ways for 2000. Assume that the changes to Enron’s financial position occurred during 2000. 

4.Why does it appear that Enron failed to include the SPEs in its financial statements? How do you view Enron after including the SPEs in the company’s financial statements?