Effects Of Creative Accounting In Book Keeping: An Essay.

In addition,to other relevant articles,for assessment task part A, pleaseread thefollowing article written by Paul M. Healy and Krishna G. Palepu, the fall of Enron case study by Paul M. Healy and Krishna G and write a report that addresses the following issues:The Article is on Bb.

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.

Describe and analyse the different ways that the five elements of financial elements, as defined in the International FRS conceptual framework, can be measured by listed companies. You are not constrained in this analysis to any one country or set of national accounting standards. Of course Australia is under International Financial Reporting Standards but your research could identify    examples    of    companies    operating    under    U.S.    GAAP    or    some    other regulations/guidelines that illustrate what you want to discuss. In completing this assignment, you are required to:

a) Quote  examples  of  measurement  methodologies  from  company’s  annual reports  andclearly 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. 

As  an  example,  two  (2)  techniques  have  been  appended  that  show  how  bond  liabilities  and interest expense  are reported and measured in Australia and the USA. The first technique is called  The  Effective  Interest  Method  and  the  other  is  called  the  Straight  Line  Method.  The Effective  Interest  Method  is  permitted  under  both  IFRS  and  US  GAAP.  The  Straight  Line method is only permitted under US GAAP. If you were writing on example on bond liabilities you could get into a discussion on these different techniques and whether one provides more decision useful information than the other. Or you may conclude that neither technique is verysatisfactory  and  the  bond  liability  should  be  reported  in  the  balance  sheet  at  market  value because if the company wanted to redeem the debt by buying back the securities in the open market it would have to pay fair value (and that would be based on a current trading price for the bond).

Mark-to-Market Accounting Design

The main purpose of this assignment is to show the effects of creative accounting in book keeping. It also outlines the main reason of using and following the accounting rules that is; GAAP and IFRS. This assignment is aimed at giving a better understanding on the various financial Measurement method and the different conclusions and decision that arise from the measurements. It will also show a better understanding of the various bond amortization methods, and the most effective and efficient method to be used during amortization. 

(a) Mark to market is an accounting design that is aimed at valuing most of the Company's Assets and Liabilities at their current rates, which is also commonly referred to as ‘Fair value’ in basic accounting terminologies (Healy and Palepu, 2003.Pg.17.) It portrays a picture of what the company is entitled if they chose to dispose of the assets

Before the expansion of Enron companies, He ensured that all bookkeeping rules were followed. Revenue earned and any expenses incurred form the oil business was transferred to the accounting books as they were according to the accounting standards of the company. At the time gaps existed in the accounting regulation methods therefore Enron took advantage of this for his benefit. His top managers used Mark to Market approach when reporting their final accounts at the end of the period, where current assets were published based on their current market values or fair values (Heaton, Lucas, and McDonald, 2010.Pg.67.)  

Revenue streams had to be predicted due to the decision. Enron’s top management had to come up with revenue projections even though there was no certainty that they would eventually earn them. It gave the short-term impression that the company was financially stable because their actions facilitated short-term gain on the shared trading at the NYSE. Confidence was displayed among the potential shareholders trading the company shares.

Another example where Mark to Market approach is portrayed is when Enron managed to come to a contract agreement with a company known as Eli Lily Indianapolis. Enron and the company managed to sign a deal worth $3 billion which was aimed at supplying electricity to the company based in Indianapolis (Healy and Palepu, 2003.Pg.8) As a result of the agreement, 500 billion dollars revenue projections were reported by Enron’s as part of the actual revenue to be earned at the end of the financial period.

Enron did this even though the state of Indiana had not deregulated electricity (Sapra, H., 2008.Pg.380.) Deregulation led to Enron estimating the period at which this would happen in order to predict the costs to be incurred to service the contracts. The company portrayed the profitability picture, revenue projections were reported as actual revenue while cost said as expenses. In the real sense, very little had been earned from the signed deals.

Due the rapid expansion of Enron’s companies, he chose different accounting approach and adopted the Mark to Market system especially when he was able to secure long-term period contracts with other companies (Allen and Carletti, 2008.Pg.362.)

Enron's Use of Mark-to-Market Approach

An example is showing this; Enron secured a 20-year agreement with blockbuster video in July 2000, which was aimed at providing entertainment to various U.S cities for a fee under the global broadband Network. As a result of this contract Enron went ahead and recognized revenue projections of $110 million without the actual revenues from the contract being earned in the financial period.

(b) A company that is established to facilitate achievement of an objective is known as a special purpose entity. The objective of this company is to act as a buffer zone to protect the parent company from facing financial risk (Hartgraves and Benston, 2002.Pg.252.) The company can buy assets without the same transactions being recorded in the parent’s company balance sheet. The unique purpose entity is protected by having its assets and liabilities if the parent company becomes bankrupt.

The main aim of Enron having the individual purpose entities was to help in generating capital to fund contracts and also achieving financial reporting objective. Hundreds of individual purpose entities were owned under Enron’s name with the goal of acquiring the forward contract with gas companies (Larson, 2008.Pg.43.) These contracts were aimed at supplying gas according to the long-term contracts signed. Enron failed in disclosing debt that had been brought about by the takeovers of the business ventures in the balance sheet at the end of the financial period. This was brought about by Enron’s an interest in acquiring parts of many various investments.

Chewco was a unique concept that Enron had identified at the time and under the leadership of Enron; the management ensured that the debt issued on behalf of Enron was managed. Out this, an acquisition investment interest of $380 million was made by the unique purpose entity (Schwarz, S.L., 2001.Pg.1309.) The financial reporting of this acquisition was done separately for Chewco and the Joint venture. Enron was able to acquire partnership interest regardless of him reporting debt in the final accounting books of the company.

By Enron having the individual purpose entities, he used this aspect to provide false information to the investors and shareholders. Enron made them believe that he had diversified any risk that would arise from any of the non-cash assets owned by the company (Aerts, W., 2004.Pg.49.) By the use of financial guarantees and stock Enron managed to diversify risk, and by this, he managed to keep the information from the investors. The investors were convinced that no threat existed on the non-cash asset and this was the opposite of their expectations.

(c) Stock options, it is also a form of compensation in many organizations. The senior managers of these organizations are given an opportunity to buy the shares belonging to the company at a certain period and a pre-determined price (Hall, B.J. and Murphy, K.J, 2000.Pg.210.)The main purpose for this is to ensure alignment of the goals of the investors and the executive.

The company executives work to ensure that the share prices of the company increase, which is the goal of the investor. Executives are given an incentive of stock option and ensure this happens.

Special Purpose Entities

Enron used this mode of compensation for his management; his goal is that he would create a short-term increase in the stock prices to meet the NYSE expectation at the time on rapid growth. This motivated the management, but in the long run, it was not valuable to the company.

(a) Fair value is one of financial measurement method.This method involves giving out information between the buyer and seller when they exercise the option of either buying or selling and an asset and with both of them agreeing on the selling price (Borio and Drehmann, 2009.Pg.9.) These two methods are used in very different ways in the statement of financial position. One of the historical costs involves the valuation of assets and liabilities based on their original in the balance sheet.

While on the other hand fair value, value assets and liabilities based on their current values or market value. Due to the limitations on financial regulation Enron as the owner of the group of companies took advantage of this and measured his financial statements based on fair value. All Asset and liabilities were recorded in the balance sheet based on their current market rates (Ittner, C.D., Larcker, D.F. and Randall, T., 2003.Pg.720.)

According to GAAP, the measurement method in accounting is referred to as Historical Cost. Historical cost is an accounting measurement tool that values asset on the company’s balance sheet according to their initial costs of purchasing the assets (Melnyk, Bititci, Platts, Tobias and Andersen, 2014.Pg.180.) In spite of the asset changing its value over time, the regulation requires that all assets be recorded on the balance sheet based on their historical costs.

After critically reviewing the financial statements an investor makes an objective decision out of the reports. This depicts the accounting theory of decision usefulness. This of the decision-usefulness argument is used by shareholders potential investor’s creditors and other stakeholders to facilitate making conclusions on the performance of the company. Using Enron as an example, he used the fair value measurement method.

He was able to secure long-term contracts where revenue projection of the deal was treated as actual revenue in the financial period. While all cost to be used to finance the agreements were treated as actual expenses (Hall, B.J. and Murphy, K.J, 2002.Pg.34). Management of Enron companied resonated with the choice to forecast for the future earnings due to the mistake of recognizing revenue even before earning it. The decision was purely based on the measuring tool they chose to measure the company’s financial elements with.

(c) Enron chose to measure the financial elements using the fair value method because it made more sense to him at the time regarding the objective he set out to achieve. The aim on Enron mind was to create a short-term increase in the price of shares trading at the NYSE. This created interest from the potential shareholder trading the shares of the company. The method involved valuing assets and liabilities in their current market value.

There two methods that are used by companies to amortize bond. One of the ways is the Effective interest rate method, and the other is the Straight line method. When the book value of a bond decreases which results due to an increase in expense in a financial period then this describes the Effective interest rate method. The interest rate remaining constant despite having or not having a decrease in the book value of the bond this describes the straight-line method. The straight line method becomes much easier to use because it does not have a lot of complication. (Murphy, K.J, 2002.Pg.847.)

The two method results in the same face value of the bond liability being amortized (Tucker and Laipply, 2010.Pg.15.) Out of the two ways the Effective Interest Rate Method has an advantage over the Straight line method because the calculation of the bond premiums or discount is done in small amounts. This depicts a more realist picture of the bond’s liability value. The straight line method can be used in situations where the bond liability amortization is not very significant to the company.

References

Aerts, W., 2004. Special Purpose Entities. In Business combinations: tendensen in groepsverslaggeving.-Antwerpen, 2004 (pp. p-49).

Allen, F. and Carletti, E., 2008. Mark-to-market accounting and liquidity pricing. Journal of accounting and economics, 45(2-3), pp.358-378.

Benston, G.J., 2006. Fair-value accounting: A cautionary tale from Enron. Journal of Accounting and Public Policy, 25(4), pp.465-484

Borio, C. and Drehmann, M., 2009. Towards an operational framework for financial stability:'fuzzy'measurement and its consequences.

Hall, B.J. and Murphy, K.J., 2000. Optimal exercise prices for executive stock options. American Economic Review, 90(2), pp.209-214

Hall, B.J. and Murphy, K.J., 2002. Stock options for undiversified executives. Journal of accounting and economics, 33(1), pp.3-42.

Hartgraves, A.L. and Benston, G.J., 2002. The evolving accounting standards for special purpose entities and consolidations. Accounting Horizons, 16(3), pp.245-258.

Healy, P.M. and Palepu, K.G., 2003. The fall of Enron. Journal of economic perspectives, 17(2), pp.3-26.

Heaton, J.C., Lucas, D. and McDonald, R.L., 2010. Is mark-to-market accounting destabilizing? Analysis and implications for policy. Journal of Monetary Economics, 57(1), pp.64-75.

Ittner, C.D., Larcker, D.F. and Randall, T., 2003. Performance implications of strategic performance measurement in financial services firms. Accounting, organizations and society, 28(7-8), pp.715-741.

Larson, R.K., 2008. An examination of comment letters to the IASC: special purpose entities. Research in Accounting Regulation, 20, pp.27-46

Melnyk, S.A., Bititci, U., Platts, K., Tobias, J. and Andersen, B., 2014. Is performance measurement and management fit for the future?. Management Accounting Research, 25(2), pp.173-186.

Murphy, K.J., 2002. Explaining executive compensation: Managerial power versus the perceived cost of stock options. U. Chi. l. reV., 69, p.847.

Sapra, H., 2008. Do accounting measurement regimes matter? A discussion of mark-to-market accounting and liquidity pricing. Journal of Accounting and Economics, 45(2-3), pp.379-387.

Schwarz, S.L., 2001. Enron and the use and abuse of special purpose entities in corporate structures. U. Cin. L. Rev., 70, p.1309.

Tucker, M. and Laipply, S., 2010. Understanding bond ETF premiums and discounts: A conceptual framework. Investment Insights: The Investment Research Journal from Blackrock, 13, pp.1-20.