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HA 3011 Advanced Financial Accounting

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Question:

Assessment Task Part A
a) Define and explain mark-to-market accounting approach and give examples where Enron’s management / accountants perhaps misused this approach to portray a rosy picture of its performance / profitability?
b) What are special purpose entities and how Enron’s management used them to fund contracts or achieve financial reporting objectives?
c) Enron’s top management enjoyed high compensation/ remuneration including stock options, what was the main purpose of the stock options compensation scheme provided to top management. Your explanation, discussion and argument should principally be based on the assumption of the agency theory.

Assessment Task Part B
a) Quote examples of measurement methodologies from company’s annual reports and clearly reference your sources.
b) In explaining how a company has measured an element, explain how the measurement method provided decision-useful information and what you understand decision-useful information to be.
c) Provide a critical analysis of the techniques the selected company has used and why a technique deployed may be more useful or practical than another method.
 
 

Answer:

Introduction

From the article of Paul M. Healy and Krishna G. Palepu, it is notable that Enron undertook massive risks while presenting its financial statements that resulted in its downfall. The accounting standards were used by the Enron in a wrong manner that led to the reflection of wrong details. The mark-to-market mechanism was used to fool the public followed by the wrong usage of SPE and then using the stock options in a complex manner.

a) Mark-to-market strategy

In relation to fair value accounting, mark-to-market strategy is more likely to be regarded as such fair value accounting of liabilities and assets that relies on the market prices. Further, in such accounting measure, the present market prices are accounted for as the primary base of every transaction and the same is also prone to immense fluctuations owing to the volatility in market. Nonetheless, this strategy is utilized by the organization in association with the long-term contracts in association with mark-to-market accounting. In addition to this, the expenses and income for long-term contracts are also accounted for by depending on the present value of the future flow of cash (Healy & Palepu, 2003). Therefore, when the prices are more volatile in the market in the sense that they decrease or increase, the same cannot be properly adjusted or aligned in the company’s books. Overall, the flaws in company’s profits were huge in the sense that resulted in the downfall of Enron and its misguiding financial statements. In addition, Enron also ascertained its revenues as the fair values of all inflows of cash in the upcoming tenures and the booked expenses on a whole. The losses and gains were also unrealized in the upcoming years when that happened. Nonetheless, the company was involved in various long-term business contracts that reflected the present value of all future flows of cash as the income and present value of expenses to be incurred during the overall contract as the service cost. Nevertheless, there were various contracts that also failed to pass the viability test in the upcoming year of the contract that permitted Enron to depict a false picture of its financial performance (Hoffelder, 2012).

b) SPE or special purpose entities

SPE or special purpose entities are defined as that shell firms that can be framed by the sponsor but its funding is facilitated through independent equity investors. Besides, this can also happen through debt financing. Further, such entities are used for various motives like sharing of risk, transfer of assets, financing, loan securitization, etc (Gay & Simnet, 2005). In relation to the company, it has framed various SPE’s to facilitate financing of forward contracts so that financial reporting goals can be addressed. The company endeavoured to buy the partner share in a joint venture agreement but it had no motive to disclose the amount of debts from the acquisition transaction or from the agreement in the financial statement (Berensen, Richard & Oppel, 2001). Moreover, the controlling strength of such special purpose entity was controlled or procured by the company’s executive (Chewco) who had raised a guarantee of debt. Further, the firm had used such acquired debts for the motive of procuring the relationship of joint venture agreement. Nevertheless, the structure was made in such a manner that nothing associated to the debt transaction was being portrayed in the financial statements of the company, thereby making it easier for it to procure the partnership in relation to the joint venture agreement. Besides, the special purpose entity on the part of Chewco also resulted in the violation of several standards of accounting and hence, the company made attempts to prohibit itself from consolidating its accounts with that of Chewco. This resulted in the overstatement of equity and earnings and understatement of liabilities and debts.

c) Stock options

The company’s top most authority was provided additional rewards in the form of compensation that also comprised of stock options. They were obtained the same because it could facilitate in attracting both shareholders and management. Further, employees were also provided the same because a variation in decision-making can be attained so that a false picture of the company’s performance can be reflected. Such stock options were offered without any limitations on further resale that was a major issue (Healy & Palepu, 2003). Besides, the management was in no requirement for such stock options and therefore, it sheds light on such fraudulent activity undertaken on behalf of the company. Agency theory can be reflected through such activity undertaken by Enron because it also attempted to maximize its wealth for maximizing self-interest objectives. Thus, to address the assumption of such issue, the agent is bound to operate from one side. In other words, he can either work in alignment with the principles to enhance the wealth or can compromise the work for self-interest motives (Anthony, Shelley & Catanach, 2003). Similarly, the top most authorities were also offered compensation like the agents and that included stock options as well.

It was the requirement to increase public wealth but Enron only inflated its development or performance in a false way and public wealth was not at all affected. In relation to the company, it has framed various SPE’s to facilitate financing of forward contracts so that financial reporting goals can be addressed. Therefore, the study clearly emphasizes that Enron used different mechanism to depict a false picture to the public.

Part B

Based on the framework of International Financial Reporting Standards, it must be noted that there are five elements of conceptual framework for financial reporting namely assets, liabilities, equity, expenses, and income. Furthermore, based on measurement of these elements, different companies implement different methods of measurement like fair value accounting, current cost accounting basis, historical method, etc.

  1. The elements of financial statements can be determined through various measures. The most perfect example in relation to such can be visible in the case of Wesfarmers Ltd that is listed on the Australian Stock Exchange. In relation to the annual report of the company, the computation of revenues has been conducted at the received consideration or consideration that is receivable. Further, the computation of inventories is being undertaken based on net realizable value or cost whichever is lower, and such cost is ascertained as per the requirements of weighted average method (Kaplan, 2011). It can also be seen from the annual report of the company that its trade and other receivables are being valued at fair value and thereafter, determined at amortized cost by using the strategy of effective interest and in alignment to this, a deduction is being facilitated for the allowance part. Moreover, in association with the fixed assets of the company like Property, Plant, and Equipment, such measurement has been undertaken at cost minus the depreciation. Moreover, the amount of depreciation has been computed based on the requirements of straight-line basis over the useful life of the asset for the rest of its life (Geoffrey, Joleen, Kelli & Davied, 2016). Nonetheless, the borrowings of the company are being valued at their fair values with lower transactions and are amortized afterwards. Overall, the distinction betwixt these two is clearly visible in the financial statements of the company.

Income statement

For the motive of comparison, a company from United States is being taken into evaluation that has adopted and implemented US GAAP standard into its framework for financial reporting. In relation to this, Mackay Golf Club has been opted for a better understanding and difference betwixt the requirements of IFRS and US GAAP. Based on this company, the revenue recognition is being undertaken based on the percentage of completion method and such strategy is being calculated based on the input method. This method is also undertaken for the recognition of expenses of the company. In addition, the inventories measurement is being done or undertaken at their respective market prices or cost and the ones with the lowest is also evaluated. Further, ascertainment of cost is facilitated through two ways namely FIFO for determining raw materials and finished goods or work in progress for determining manufacturing costs. In addition, the trade and other receivables of the company is measured on the basis of their current values that have been estimated (Matthew, 2015). Further, the company’s fixed assets like property, plant, and equipment are measured through the system of straight-line basis over the useful life of an asset. Nevertheless, the company’s annual report depicts crucial details in various segments.

  1. In association with the previously mentioned companies, it can be seen that there are two distinct measures for the presentation of financial statements of companies. It cannot be stated with primary efficiency that which method is more advantageous than the other. Further, it can be stated that the measurement recognition of one strategy is primarily superior or beneficial than the other method (Pilbeam, 2009). Besides, there is one segment wherein the second matter is more beneficial than the first method. Hence, for such purpose, different examples are being taken into evaluation that plays a key role in portraying the various recognition methods used by companies. Further, if the revenue measurement is being undertaken by accounting for the International Financial Reporting Standards, they it may become simpler or effective to ascertain the statement of income when compared to the US GAAP measure. The reason behind this can be attributed to the fact that IFRS has been playing a relevant role in using the most usual method of recognition of revenues. Nevertheless, going through the US GAAP principle, it can also be observed that the classification or segregation of costs are done based on function and in the case of IFRS, the same is done through two ways that is function and nature of such expenses. This makes it simpler and easier for users to understand the financial information if the same has been reported through implementation of IFRS standards. Nonetheless, when it comes to reflection of financial information in the annual report of companies under the US GAAP principle, there are various strict needs that must be given due consideration and that makes it inferior to the IFRS standard (Ross et. al, 2014). Overall, through the provision of remaining illustrations, the recognition and measurement of assets and liabilities under the system of IFRS are simpler and more understandable in nature in comparison to the US GAAP principle. Besides, this can play a key role on the part of users in their decision-making process.
  2. IFRS and US GAAP principle

In relation to the above, it can be stated that a proper comparison betwixt IFRS and US GAAP cannot generate a valid conclusion. However, there are major reasons behind the effectiveness and superiority of IFRS in comparison to the other method. Besides, since both companies have been performing in distinct operations, a thorough analysis or evaluation of the same cannot assist in ascertaining a conclusion and instead, a general idea can be helpful (Vaitilingam, 2014).

Basis

IFRS

US GAAP

Valuation of inventories

Valuation of inventories are done based on weighted average cost basis of FIFO.

Valuation of inventories are done based on LIFO system.

Recognition and classification of expenses

There are dual requirements that is by classification and by nature.

In US GAAP, such basis is fulfilled only through classification by function.

Income statement rules

There is no prescribed format in the case of IFRS.

There must be various step formats or a single format in the case of US GAAP.

Disclosure of extraordinary items

Disclosures associated to the income, non-recurring costs, and extraordinary items is not feasible. It is reflected in the notes to financials of companies.

In relation to US GAAP, all extraordinary items are being reflected in the notes or income statement.


It is observable from the previously mentioned table that both the methods of presenting financials are distinct in nature and a comparative analysis cannot assist in coming at a valid conclusion. However, it is clearly observable that IFRS requirements are not so stern in nature in comparison to the US GAAP principles. This makes it easier for users to understand the IFRS presented financial information in a better way. In addition, the measurement or valuation of financial statements can be easily conducted in the prevalence of minimal requirements like in the case of IFRS. Therefore, it can be stated that IFRS is a better measure when talked about the utilization of US GAAP principle. Moreover, since understanding and evaluation of information is easier in the IFRS requirements, users can take maximum benefits out of the same for making decisions based on their interconnections with the company. This is the major reason why IFRS standard is primarily superior to the US GAAP method and users or companies can attain maximum efficacies from the usage of such method for presentation and preparation of their financial data (Vaitilingam, 2014).

References

Anthony H., Shelley, C,J., & Catanach, R. (2003).  Enron: A Financial Reporting Failure. Available from: https://digitalcommons.law.villanova.edu/cgi/viewcontent.cgi?article=1339&context=vlr [Accessed 26 September 2018]

Berensen, A.,Richard, A., and Oppel, JR. (2001) Once-Mighty Enron Strains Under Scrutiny. Available from https://www.nytimes.com/2001/10/28/business/once-mighty-enron-strains-under-scrutiny.html [Accessed 26 September 2018]

Gay, G. and Simnet, R. (2015)  Auditing and Assurance Services. McGraw Hill

Geoffrey D. B, Joleen K, K,  Kelli S. and David A. W. (2016) Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors. Accounting Horizons. [online] 30(1), pp. 143-156. Available from https://doi.org/10.2308/acch-51309  [Accessed 26 September 2018]

Healy, P.M &  Palepu, K.G. (2003) The Fall of Enron. Journal of Economic Perspectives. 17(2), 3-26. Available from: https://www.aeaweb.org/articles?id=10.1257/089533003765888403

Hoffelder, K. (2012)  New Audit Standard Encourages More Talking. Harvard Press.

Kaplan, R.S. (2011) Accounting scholarship that advances professional knowledge and practice. The Accounting Review [online]. 86(2), pp. 367–383. Available from https://doi.org/10.2308/accr.00000031 [Accessed 26 September 2018]

Matthew, S. E. (2015) Does Internal Audit Function Quality Deter Management Misconduct?. The Accounting Review. [online]. 90(2), pp. 495-527. Available from https://doi.org/10.2308/accr-50871 [Accessed 26 September 2018]

Pilbeam, K. (2009) Finance and Financial Markets. Palgrave Macmillan

Ross, S., Christensen, M., Drew, M., Bianchi, R., Westerfield, R. an Jordan, B.(2014) Fundamentals of Corporate Finance, 7th ed. North Ryde: McGraw-Hill Australia Pty Ltd.

Vaitilingam, R. (2014) The Financial Times Guide to Using the Financial Pages. London: FT Prentice Hall

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