Enron Essay: Mark-to-Market Accounting, Special Purpose Entities, And Stock Options.

Analysis of Enron Case Study

In addition, to other relevant articles, for assessment task part A, please read the following 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 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.

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 very satisfactory 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).

The report has presented an analysis of the downfall of Enron on the basis of evaluation of the article entitled ‘The Fall of Enron’ that has highlighted the major reason for its collapse. In this context, it has mainly addressed the contribution of mark-to-market accounting, special purpose entities and stock options for manipulation of its financial information and reporting higher profits.

(a)The mark-to-market accounting approach is also known as fair value accounting that refers to valuing an asset or liability on the basis of its current market price and as such is sued for reporting the current financial performance of an entity. It is sued mainly by business entities for valuing the assets on the basis of their future selling price and therefore is largely adopted for value the transactions in the future markets. However, the approach is criticized severely after the occurrence of financial crisis as it enabled the accountants to present manipulated financial information to the end-users as that occurred in Enron (Kolb, 2010).

The downfall of Enron Corporation, an American energy, commodity and service company, in the year 2007 is stated to be one of the biggest frauds in the history of accounting. The major reason for the occurrence of accounting fraud is the use of Mark-to Market (MTM) accounting approach by the company that enables it to record higher profits in its financial statement than actually gained. The business expansion of the company outside the US due to deregulation of energy market that is responsible for the emergence of accounting issues due to stretching of the accounting limitations. The company’s trading business involves the use of complex long-term contracts that involves recording the accounting transactions whose value is forecasted on the basis of future earnings (Healy and Palepu, 2003). This infers that the present value of cash flows to be realized from the long-term contacts are reported as revenue and the present value of expenses to be incurred during the contract are recorded as expenses during development of its financial reports. The accounting approach is known as mark-to-market accounting and its resulted in reporting of unrealized gains and losses associated with long-term contracts resulting in disclosure of manipulated financial information to the users (Dembinski, 2005).

(b)Special purpose entity can be regarded as a subsidiary company that is isolated from the parent company and have a legal status. It is developed by the parent company on a temporary basis to achieve some specific objectives. It founding corporation usually incorporates its use for recording some unrelated activities and risk away from its financial statements. There are specific requirements to be met by the special purpose entity for enabling its founding entity to not depict special purpose entity in its financial reports. This involves having 3 per cent stake by an independent third-party owner and such an owner should have at least 50 per cent financial interest in the special purpose entity. However, in the case of not meeting such requirements the special purpose entity will be consolidated with the financial reports of the founder corporation. Enron has incorporated the use of such entities for funding the buying of forwards contracts with the gas producers under its long-term fixed contracts (Russakova, 2005).

Mark-to-Market Accounting

However, besides this Enron has developed special purpose entities for achieving its determined objective of financial reporting to report overstated profits. The use of these entities was done primarily for hiding the debt that result from funding an acquisition or a joint venture. It does not consolidate the financials of the special purpose entities and thus successfully carry out its acquisition without reporting the debt it have on its balance sheet. The special purpose entities of the corporation has not met the requirements for existing s a spate legal entity that does not need to be consolidated into the financial of its founding corporation. The requirement of having a 3 per cent stake by an independent equity investor was not met in its special purpose entities. Thus, the use of such entities was done primarily by Enron to understate its liabilities and overstate the earnings in order o record its high performance (Healy and Palepu, 2003).

(c)The wide number of large public corporations adopts the use of employee stock options for attracting and retaining employees and this provides an option to the employees to purchase specific number of company shares at a determined price within a specified period of time. The main objective of the use of stock options by the owners of a company is to reach a consensus between the goals of management and the shareholders as per the agency theory. The theory ahs depicted their relation between the managers and shareholders on the basis of principal and agent model in which the principal, that are the business owners appoint the managers that are agents, to act on behalf of their interest in return for achieving some specific awards. As such, the use of these stock options plans provides a best mechanism before the shareholders to monitor and control the performance of the business managers so that their action are directed towards maximizing the wealth of an entity that is linked with their own remuneration the form of incentives. As such, business managers emphasizes on adopting strategies that maximize the profitability position of an entity in order to achieve high remuneration in the form of incentives received through stock options plan (Thorne, 2001).

However, this may also prompt the business managers to adopt the use of unethical means for reporting higher profits for maximizing their returns and promoting their own welfare as that occurred in the case of Enron. It has been reported that the business managers of Enron received high compensation through the use of stock options and this induced unethical practices to be adopted by business managers to meet the expectations of Wall Street’s by creating expectations of rapid growth (Niskanen, 2007). The stock options plan is likely to exercise within 3 years but the employees are awarded sizable option grants based on the short-term stock performances. It resulted in motivating managers to take illegal actions for raising the short-term stock performances and receiving higher returns (Healy and Palepu, 2003).

Special Purpose Entities

Conclusion

It can be said from the overall discussion that Enron collapse was mainly due to the lack of effective corporate governance practices that results in occurrence of unethical behavior by the business managers mainly for achieving higher remuneration that is linked with company performance. As such, it is recommended to the business to place special emphasis on ensuring that they have developed and adopted effective governance practices to restrict the occurrence of any fraudulent behavior during their financial reporting process.

References

Dembinski, P. 2005. Enron and World Finance: A Case Study in Ethics. Springer.

Healy, P. and Palepu, K. 2003. The Fall of Enron. Journal of Economic Perspectives 17 (2), pp 3–26.

Kolb, R. 2010. The Financial Crisis of Our Time. Oxford University Press.

Niskanen, W. 2007. After Enron: Lessons for Public Policy. Rowman & Littlefield.

Russakova, Y. 2005. Objectives and Techniques to consolidate Special Purpose Entities in International Financial Reporting Standards and US Accepted Accounting Principles. GRIN Verlag.

Thorne, L. 2001. The Effectiveness of Stock Option Plans: A Field Investigation of Senior Executives. Journal Of Management Inquiry 10(3), pp.250-266.

In this assessment task the aim is to evaluate the different ways used to measure the five elements of the financial statements. Most countries have adopted IFRS but a United States still uses its own set of GAAP known as US GAAP. To have the proper understanding of methods used measure the five elements of financial statement by different companies it has been decided to select one company that uses US GAAP and other companies that uses IFRS as the basis of preparation of financial statements. Apple Inc. from United States uses US GAAP and Wesfarmers from Australia uses IFRS as their method preparation of financial statements. The main five elements defined by the IFRS conceptual framework are income, expenses, assets, liabilities and equity.

Income: It has been noted that in IFRS income has been measured at fair of amount received or receivable but in US GAAP the revenue is generally measured through the exchange value of assets or liabilities involved in the transaction. In US GAAP there is some specific measurement guidance for particular revenue transaction (Wesfarmers: Annual Report, 2017 and Apple: Annual Report, 2017).

Expenses: Cash settled transactions with employees are measured at fair value of liability in case of IFRS (Wesfarmers) but in case of US GAAP (Apple Inc.) it is measured according to ASC 718 measurement basis i.e. variable accounting until the cash awards are settled or expires (Wesfarmers: Annual Report, 2017 and Apple: Annual Report, 2017).

Stock Options

Assets: The investment in equity instruments (Whose fair value is not available) by both the companies are measured at cost in case of Wesfarmers while in US GAAP it is measured at cast less impairment (Wesfarmers: Annual Report, 2017 and Apple: Annual Report, 2017).

Liabilities: Compounded instruments such as convertible debt held by Apple and Wesfarmers have different accounting measurement methods such as split accounting in case of IFRS and debt accounting method in case of US GAAP (Wesfarmers: Annual Report, 2017 and Apple: Annual Report, 2017).

Equity: Basically there is no difference in accounting method applied in case of equity items as both uses effective interest rate on estimated cash flows on the expected life of the instruments (Wesfarmers: Annual Report, 2017 and Apple: Annual Report, 2017).

Decision usefulness means that whether information provided is useful from the point of views of investors and it must satisfy the theory of decision making criteria of inventors.

Income: The method applied by the Apple Inc (US GAAP) seems to provide more decision usefulness information as there are separate method for specific transactions and value of assets and liabilities are evaluated before measuring the revenue. The fair value of consideration used in IFRS means actual consideration received for each transaction should be recognised as revenue and it is net of trade discount and any offer (PWC, 2017).

Expenses: Among both methods of measuring the value of cash awards paid to the employees the method of fair value of liabilities seem to provide more decision usefulness information. The fair value of liability requires entity to measure and re-measure the value of cash payment at the end of each reporting period so that any change would be clearly reflected.

Assets: The value of investment in equity is need to measure at fair value in order to be provide the decision usefulness but due to unavailability of fair price, the cost basis is used which does seem to provide decision useful information as there are many ups and downs in value of investment that needs to reported.

Liabilities: The method applied by the Apple (Debt method) seems not to provide decision useful information while split accounting method is useful as it helps to recognize debt and equity part of convertible debt separately.

Equity: Effective interest method is provides decision usefulness information as it takes into account all the factors required to report the equity (Grant Thornton, 2016).

Income: The measurement technique used in measure the revenue are fair value of consideration under IFRS and “exchange value of assets or liabilities involved in transaction” under US GAAP. Between both of these methods it seems that method provided by the US GAAP is more practical and useful as compared to another method. The reason for this is that fair value of consideration method does not have practical capability in certain cases and in many cases there is need to refers judgments to recognize the revenue like revenue received in case of construction contracts (PWC, 2017).

Expenses: The methods of measuring cash based rewards for employees are fair value of liability and variable accounting method. Between both the methods the method applied by the Wesfarmers is more appropriate and useful as compare to method applied by the Apple Inc. because it is important to re-measure the value of liabilities required to settle at every reporting period (Grant Thornton, 2016).

Assets: The two methods to value of equity investment (whose fair value not available) are cost basis and cost less impairment value. Under both none of them is practical and useful as investment in equity shares must be valued at market value.

Liabilities: Between both the methods used to measure the convertible debts, the split accounting methods is more practical and useful.

Equity: as there is no difference in accounting of equity so there is no need to define any accounting method as more useful or practical (PWC, 2017).

References

Apple: Annual Report. 2017. [Online]. Available at: https://www.annualreports.com/HostedData/AnnualReports/PDF/NASDAQ_AAPL_2017.pdf [Accessed on: 28 September, 2018].

Grant Thornton. 2016. Comparison between U.S. GAAP and International Financial Reporting Standards. [Online]. Available at: https://www.grantthornton.ie/globalassets/1.-member-firms/ireland/insights/publications/grant-thornton---us-gaap-comparison.pdf [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].

Wesfarmers: Annual Report. 2017. [Online]. Available at: https://www.wesfarmers.com.au/docs/default-source/default-document-library/2017-annual-report.pdf?sfvrsn=0 [Accessed on: 28 September, 2018].