The report is undertaken to present a critical evaluation of an article highlighting the issues related with the downfall of Enron entitled as ‘The Fall of Enron’. The report has examined the issues specifically in relation to the use of mark-to-mark accounting approach, special purpose entities ad sue of employee stock options compensation scheme by Enron to manipulate its financial results and deliver high performance.
Analysis of the Case Stud of Enron based on Article ‘The Fall of Enron’
Explanation of mark-to-market accounting approach and its use by Enron’s management for depicting its high performance
Mark-to-Market (MTM) approach of accounting is also known as fair value accounting that is based on the use of current market price of an asset or liability known as fair value for their valuation during financial reporting. The method is used in accounting for gaining an estimate of the accurate price at which an asset could be sold under the current market conditions. Enron, was an American energy, commodities and service company that was established in the year 1985 as a result of merger between two companies, that are, Houston and InterNorth. The privatization and deregulation of energy markets has provided the opportunity to the company to enter into new markets to met increasing demand of energy products across the world. As such, the business model of the company has become increasingly complex by inclusion of different range of energy products. The company adopted the use of different physical assets and trading operations to meet the energy demand of new markets. This promoted the company to adopt the use of limitations of accounting for managing its earnings and reporting increased profits (Fusaro and Miller, 2002).
The company adopted the use of mark-to-mark accounting for recording the transactions of its long-term contracts in its trading business. The approach adopts the use of the present value for recording such transactions by making an estimate of their future earnings. The initial business of Enron has adopted the use of simple accounting policy of recording the realistic costs involved in gas supplying and recording the revenue realized (Dembinski, 2005). The company has however adopted the use of mark-to-mark accounting for recording the transactions of its trading business. This implies that the company by entering into a long-term contract recognized revue on the basis of present value of the future cash inflows and expenses on the basis of present value of expected cost to be incurred in meeting the contract. The unrealized gains and losses that occurred in the market value of such contracts were reported later as annul earnings when they are actually realized. Thus, this accounting approach involves the use of predicting the market value of contracts which have lead to the occurrence of misrepresented financial information in relation to its actual income realized and expenses occurred. The company management has adopted the use of this approach to inflate their earnings and thus reporting false profit leading to negatively impacting the interest of the end-users of financial information (Healy and Palepu, 2003).
Explanation of special purpose entities and their use by Enron’s management
Special purpose entities can be regarded as the temporary legal firms that are created by an entity for fulfilling its some desired objective. An entity is regarded as a special purpose entity when it is financed both by independent equity investors and also by minas of debt financing. Also, it is categorized as a distinct entity from its sponsor only when an independent third-party owner have at least 3 per cent equity stake and have more than 50 per cent controlling financial interest in it. However, if a special purpose entity does not meet these conditions then it is required that it should be consolidated with the business of sponsor only. Enron has also been alleged for using special purpose entities to report high profits (Fox, 2004). The company has created such entities as stated for funding its long-term contracts purchase from the gas producers for supplying gas to utilities. However, it has been claimed that the company has created several such type of entities for achieving its objective of financial reporting of overstating the profits. The company uses such entities to report less value of liabilities in its balance sheet and overstating the profit. This is carried out primarily by the use of special purpose entity that is controlled by the company’s executive to raise debt for acquisition or buying a stake in one of its several joint ventures. The transaction was conducted in a manner that the company did not have to consolidate its financial reports with that of its special purpose entity enabling it to carry out an acquisition without reporting its debt liabilities in the balance sheet. The company was accused of violating the accounting rule that special purpose entity need to have 3 per cent stake from independent equity investors. This was done by Enron for avoiding the consolidation of the special purpose entities with its major financial statements (Healy and Palepu, 2003).
Discussion of Employee stock options compensation scheme and its use by top management of Enron on the assumption of agency theory
The business corporations often have dispersed ownership consisting of different shareholders. The overall activities of a business entity are managed by the CEO and they are acting of the behalf of the owners as stated by the agency theory. Agency theory has stated there is a distinction between the owners that are the principal and the management, that is, the agent who enter into a contract with each other. However, there is a difference of interest between them and this can lead to arousal of agency problem as they seek to maximize their own benefits. As such, it is stated by the theory that there is a need to attain a consensus between both the parties. The shareholders can use the method of executive compensation scheme for aligning the management and the owner’s goal. The owners uses the incentive pay systems such as bonus and stock options that is related with the performance of a firm and motivates them to adopt the use of aggressive policies for firm growth for maximization of their incentives (Bebchuk and Fried, 2003).
However, there have been highlighted many cases in which executive’s has adopted the use of such compensation schemes to maximize their own interest rather than placing focus on increasing value for the shareholders leading to a goal misalignment between them. The management of Enron was identified to receive heavy compensation from the use of stock options. These compensation schemes promote the managers to increase the short-term stock performance by use of unethical means in order to maximize their personal interests of realizing larger incentives (Healy and Palepu, 2003). Thus, it can be said from the case of Enron that audit and risk committee established by the Board of an entity need to monitor and control such incentive scheme to avoid the possibility of goal misalignment and occurrence of fraudulent activities within an entity (Brooks and Dunn, 2017).
It can be stated from the overall analysis that Enron downfall was mainly due to lack of adequate policies and practices of corporate governance. As such, there was use of mark-to market accounting, special purpose entities and stock options scheme that resulted in occurrence of fraudulent behavior within the corporation and depicted higher profits than that actually realized by it.
Bebchuk, L. A., and Fried, J. M. 2003. Executive compensation as an agency problem. The Journal of Economic Perspectives, 17(3), pp.71-92.
Brooks, L. and Dunn, P. 2017. Business & Professional Ethics for Directors, Executives & Accountants. Cengage Learning.
Dembinski, P. 2005. Enron and World Finance: A Case Study in Ethics. Springer.
Fox, L. 2004. Enron: The Rise and Fall. John Wiley & Sons.
Fusaro, P. and Miller, R. 2002. What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in U.S. History. John Wiley & Sons.
Healy, P.M. and Palepu, K.G. 2003. The Fall of Enron. Journal of Economic Perspective 17 (2), pp.3-26.
Assessment Task Part B
In order to perform this task two companies have been selected, they are Walmart from United States and Tesco Plc from United Kingdom. It has been reviewed that Walmart applied US GAAP while Tesco Plc applies International Financial Reporting Standards as endorsed by the European Union. The purpose of this task is to evaluate the difference in measurement methodologies for recognizing the items of five major elements of financial statements.
Measurement Methodologies employed by both the companies in relation to the items of elements of financial statements
Income: In order to measure the income earned by the company in the income statement, Tesco plc has used an approach defined in IFRS which is divided in four broad categories i.e. sale of goods, rendering of services, other use of assets and construction contracts (Walmart: Annual Report, 2017). Tesco uses cost to cost percentage of completion method to measure the value of services rendered while Walmart applies proportional performance model to measure the value of services provided (Tesco PLC: Annual Report, 2017).
Expenses: Leases represents significant part of the expenses that bears on various lease payments. There was a major difference in measurement value of leases under US GAAP and IFRS standards (Tesco PLC: Annual Report, 2017). Walmart has applied straight line rent expenses method to measure the value of lease payments while Tesco record lease liabilities at discounted basis (Walmart: Annual Report, 2017).
Assets: Walmart has employed two step impairment test model (Walmart: Annual Report, 2017) for calculating the value of long lived assets but Tesco uses single step model to calculating the value of impairment of long lived assets (Tesco PLC: Annual Report, 2017).
Liabilities: Provisions are frequently discounted by the Tesco (Tesco PLC: Annual Report, 2017) while Walmart shows the provision of liabilities at exact amount payable in future (Walmart: Annual Report, 2017).
Equity: Transaction with related party on equity instrument requires fair value measurement in IFRS while there is no such requirement in US GAAP (Tesco PLC: Annual Report, 2017). However US GAAP provides to determine the nature of instrument to record the transaction (Walmart: Annual Report, 2017).
Decision useful information provided by methods of measurement applied by the companies
Decision usefulness in financial reporting means preparation of financial statements in such a way that it satisfies the theory of investor’s decision making in relation to the type and nature of information needed by the users.
Income: The cost to cost percentage of completion method is most easy to apply and also aims to provided useful information to the users as it helps them to analyse the how the company has recorded their service income. On the other hand the performance model is difficult to apply and it does convey proper information to the users (IFRS, 2018).
Expenses: The lease measurement method applied by the both the companies provide decision useful information to the users of the financial report. Measuring the lease expenses at discounted basis is correct as company generally enter in lease for more than one year. So it provides users of report information on how much lease expenses company has to be in subsequent year. Straight line method to record the lease payment is also effective as in this method each year same amount of lease expenses are recorded as such expenses are computed using total expenses divided by the total lease terms (PWC, 2017).
Assets: The method of impairment used in US GAAP provides decision useful information but it does not allow reversal of impairments that has been done previously. On the other hand, impairment measurement method employed in IFRS is easy to use and also convey decision useful information as in US GAAP and allows the reversal of impairments (IFRS, 2018).
Liabilities: The discounted method of measuring provisions seems to more decision useful as it shows the liabilities of company at the present value that means it considers time value of money. While non-discounted method measuring the provision does not consider the time value of money (PWC, 2017).
Equity: The method fair value to measure the related party transactions convey exact value of transaction reduces the chance of fraud while mere disclosing the related party transaction without considering arm’s length price is not right in case of US GAAP (PWC, 2017).
Critical analysis of techniques employed by the selected companies
Income: In relation to measure the service revenue there are two methods to measure them as used in United States and in United Kingdom. These two methods are cost to cost percentage method and performance based model. The cost to cost percentage method has proved to be more decision useful as compared to performance based model as cost to cost percentage completion method allows to recognize revenue earned on services on the basis of proportion of service rendered divided with whole amount i.e. part of service revenue can be recognised irrespective of its completion. On the other hand, performance based method allows to record revenue when whole service has been performed irrespective of time taken (Quick Books, 2018).
Expenses: The discount based model is more decision useful as compared to straight line basis for computing the lease payments. Both the methods are provided in US GAAP as well as in IFRS but in general company who uses US GAAP applies straight line method as it is easy to apply and also provides decision useful information as compare to the discount based model (PWC, 2017).
Assets: The two step impairment as used in US GAAP provides detailed information of calculation of impairment. On the other hand, one step test of impairment model used in IFRS is easy but provides limited information on calculation of impairment. It is difficult to judge which is provide more decision useful information as both methods are equally right and helps the users in their decision making process (IFRS, 2018).
Liabilities: It can be said that discounted method of measuring provisions is convey more decision useful information as compared to non discounted model. So it can be said that discounted model is more effective (PWC, 2017).
Equity: The method of fair value measurement to calculate the value of related party transaction is more decision useful as compared to method applied under the US GAAP. US GAAP allows to record the related party transaction at cost without considering the fair value concept (PWC, 2017).
IFRS. 2018. List of Standards. [Online]. Available at: https://www.ifrs.org/issued-standards/list-of-standards/ [Accessed on: 26 September, 2018].
PWC. 2017. IFRS and US GAAP: similarities and differences. [Online]. Available at: https://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-ifrs-us-gaap-similarities-and-differences-2017.pdf [Accessed on: 26 September, 2018].
Quick Books. 2018. Top 10 Differences Between IFRS and GAAP Accounting. [Online]. Available at: https://www.firmofthefuture.com/content/top-10-differences-between-ifrs-and-gaap-accounting/ [Accessed on: 26 September, 2018].
Tesco PLC. Annual Report. 2017. [Online]. Available at: https://www.tescoplc.com/media/392373/68336_tesco_ar_digital_interactive_250417.pdf [Accessed on: 26 September, 2018].
Walmart. Annual Report. 2017. [Online]. Available at: https://s2.q4cdn.com/056532643/files/doc_financials/2017/Annual/WMT_2017_AR-(1).pdf [Accessed on: 26 September, 2018].