Enron's Business Practices: Analysis Of Mark-to-Market Accounting, Special Purpose Entities, And Stock Options.

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

Mark-to-market accounting is the method of valuing an asset at its current market level. It shows the amount of money or benefit a company receives after selling an asset today. (Allen and Carletti, 2008 pp 358-378). The reporting entity should include in its annual financial report, the current market value of such an asset (Ellul, et al. 2014 pp 297-341). Mark – to – market method incorporates fair value technique in valuing the asset.

Enron dealt mostly with long-term contracts and faced severe challenges in using mark-to-market accounting technique to estimate the value of these projects. The estimation of the income was therefore done as the present value of the net future cash flows.

In its operations, Company also went into 20-years agreement with Blockbuster Video in July 2000, to introduce to multiple US cities an entertainment on demand by the end year. These included the testing projects in Portland, Salt Lake City and Seattle that were made to stream movies to undisclosed dozen apartments from servers set up in the basement floor. Based on these projects, an estimated profit of more than $110 million was recognized by Enron even though there was a big question about its technical capability and market demand which remains unanswered.

In other instance was, Enron signed again a 15-year contract valued at $1.3 billion, to provide power to the Indianapolis Company Eli Lilly, This made Enron able to provide the present value of the project amounting to more than 0.5 billion dollars as a realized revenue. The Enron Company had to provide the current value of the costs of servicing the project. At that time Indiana had not yet deregulated power hence Enron had to forecast when deregulation was to be done and the resultant impact on cost of servicing the project over the mentioned duration of ten years.

Special purpose entities are shell firms created by a facilitator but financed by independent financiers/investors and debt financing to meet narrow, specific or temporary goal. These special purpose entities also help to mitigate risks accompanied with specific assets. In most cases, the company transfers assets to the special purpose entities for management or use them to finance big projects, and therefore achieving the targeted set of objectives without exposing the entire organization at risk. These special purpose entities have been mostly used to finance complex contracts to separate multiple layers of equity infusion.

For financial reporting, certain considerations are made to find out whether a special purpose entity is a different entity from the facilitator or not. In this case, an independent third-party owner is required to have an essential equity stake in the special purpose entity. The stake has been equated as at least three percent of the special purpose entity's total short and long term liability. It is also required that the independent third-party owner is in control of above 50% of the financial interest in the special purpose entity. Un-satisfaction of these conditions leads to consolidation of the special purpose entities with the facilitator's solid business.

Enron's Business Practices with Long-Term Contracts

Enron used these special purpose entities to finance many projects as in the acquiring of the forward contracts with gas producers to supply gas to utilities under long-term fixed contracts. Some of these special purpose entities were designed initially to achieve financial reporting objectives.

In a case study, in the year 1997, when company wanted to purchase out a partner’s stake in one of its joint ventures, it didn’t need to reveal any debt from financing the acquisition. A special purpose entity, Chewco that was governed by an Enron executive acquired the joint venture stake for $383 million. The structuring of this transaction was made in a way that Enron did not have to consolidate Chewco into its financials. This enabled Enron to effectively acquire the partnership interest without any recognizable addition of debt on its books.

Enron used special purpose entities to achieve its financial reporting objectives where they violated the accounting standards that require at least three percent of the involved assets to be owned by independent equity investors as revealed in October 2001. By this, Enron was able to avoid consolidation of these special purpose entities. Due to this, Enron's balance sheet provided inaccurate data on its liabilities, equity, and earnings.

A stock option is a contract that a company gives to its employees to buy a certain amount of shares of the company stock at a fixed price for a given limited period. This gives the buyers rights but not obligation, to buy or sell the futures contracts and underlying stock at a specified price till the 3^rd Friday of the expiration month. Purchase of an option has no margin requirements because the risk is limited to the price of the option as opposed to option sellers who require a healthy margin since they have obligations to buy or sell the underlying instruments in case an assigned option holder exercises their option.

Enron’s top management was highly compensated using stock option awards that were linked to short-term stock prices. The management focused on creating expectations of rapid growth to its employees with the aim of puffing up reported earnings to meet the Wall Street’s expectations.

The main intent of using stock options for compensations was to align the interest of the management with shareholders as a motivation that could help in better decision making and help pump up short-term stock performance.

Examples of measurement methodologies from a company's annual reports include; cost value to measure asset, historical cost base, fair value to measure asset and liability, cash basis and accrual basis to measure expenses (Walmart Annual Report, 2015). These methodologies are commonly used in measuring the financial elements and at the same time evaluating the Company performance.

Please note, on our case here, we will us Walmart Company, one of the leading American retail corporations with chain of stores around US and it is formed in 1962 by Sam Walton.

Following criteria has used by the Walmart Company to measure the following financial elements;

Revenue/Receivables – the company measure receivable at their carrying value of the consideration received or receivable less cash and cash equivalent or net of a reserve for doubtful accounts. That is, revenue or receivable is reported at the current market fair value at the time of the transaction.

Special Purpose Entities in Enron's Business Practices

Assets - The assets are stated at the fair value, and the gains or losses on disposal are recognized as incurred. The cost of the additional asset is capitalized, less the expense when incurred. Expense is charged on expense account in the income statement. The gain on disposal is treated as other income in the income statement and the loss on disposal is deducted.

Liability – The Company also measure the liabilities at the fair value. That is, the amount that would be paid to transfer the liability to a new obligor. Liability is reported in the balance sheet as current or noncurrent liability. It is only recognized when occurred..

Expenses- It's measured at the cost when incurred. This means the recognition of expenses which relates to the business. Other expenses include an increase in liability and decrease in the asset. The recognition of the both increase and decrease in liability and asset respectively only occurs when the transaction is completed.

Decision-useful information is described as information about reporting entity which is useful to existing and potential stakeholders and shareholders in deciding on when and how to provide resources to the entity (Concepts Statement No.1, FASB 1980, para. 34). Decision-useful information gives a clear picture of the company’s performance and also the future company prospect. Reporting entity should adhere to Generally Accepted Accounting Principle (GAAP) and International Accounting Standards (IAS), failure to which the information provided can mislead the general investors. Decision- useful information provides the base information to the investors to make winning decision and be able to make conclusive decision on regards to funding the entity.

Measurement methods by Walmart provide the decision-useful information in the following ways;

Fair value – Help the investors or rather stakeholders in making prospect for the cash flow since the value of an asset and liability will be reported with exact amount to be paid to receive the asset or transfer the liability to the new obligor.

Cost value- This is the measure of expenses, which shows the actual amount to be paid or incurred. The cost value information is helpful to the investors in making the decision towards company’s spending and whether worthy to invest in.

It enables the investor to have the correct and accurate information in regards to revenues, assets, liabilities, and equity which are the basis for the financial analysis.

In measuring the financial element, Walmart has used several techniques to proof information reported in the income statement, balance sheet and cash flow, and to explain the criterion used to achieving such result as required by the accounting standard. For instance, the company has used free cash flow technique to which is considered as non-GAAP financial measure to evaluate the company's financial performance. Free cash flow is net cash from operating activities minus payment for the property and asset within a certain period. This technique enables the company's to know its ability to meet short and long-term expenses.

Another technique used by the Walmart Company is the liquidity ratio to measure the ability of the company to meet long-term debts. The asset debt ratio has been used to measure and evaluate whether the company has enough assets to cover available liabilities or not. This method enables the company to weigh out and decide on which source of finance to use in future (Walmart annual report 2015)

The company also uses Return on Investment (ROI) technique which is more useful in evaluating how efficient the company is using assets to generate the income. This method is considered as a non-GAAP method financial measure because it excludes and includes the amount that is included and excluded in most directly GAAP financial measures (Hail and Wysocki, 2010 pp 355 -394).

These non-GAAP techniques used by Walmart in the presentation and analysis of financial statement are better because they give an insight on how the company is doing and its current situation (Zdenek and Dana, 2009 pp 445-460). They go further to helping investors to make a useful decision towards the company. They use the current information to project company's future standing. The use of these non-generally accepted accounting principles should not be used to violate the reporting standards provided to be used by the reporting entities.

Please note, these non-GAAP financial measures provides a nuanced view of the company’s financial picture and they should used as provided by supervisory authorities such as ESMA.

It is also said these non – Generally Accepted Accounting Principles provides most accurate financial performance analysis for the company (Liu, and Sun, 2015 pp 250 -275)

References

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

Christensen, H.B., Lee, E., Walker, M. and Zeng, C., 2015. Incentives or standards: What determines accounting quality changes around IFRS adoption?. European Accounting Review, 24(1), pp.31-61.

Christoffersen, P., 2011. Elements of financial risk management.  Academic Press.

Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.

Ellul, A., Jotikasthira, C., Lundblad, C.T. and Wang, Y., 2014. Mark-to-market accounting and systemic risk: evidence from the insurance industry. Economic Policy, 29(78), pp.297-341.

Florou, A. and Kosi, U., 2015. Does mandatory IFRS adoption facilitate debt financing?. Review of Accounting Studies, 20(4), pp.1407-1456.

Gertler, M. and Kiyotaki, N., 2015. Banking, liquidity, and bank runs in an infinite horizon economy. American Economic Review, 105(7), pp.2011-43.

Henderson, S., Peirson, G., Herbohn, K. and Howieson, B., 2015. Issues in financial accounting. Pearson Higher Education AU.

Liu, G. and Sun, J., 2015. Did the mandatory adoption of IFRS affect the earnings quality of Canadian firms?. Accounting Perspectives, 14(3), pp.250-275.

Malhotra, N.K. and Peterson, M., 2014. Basic marketing research. Pearson.

Mehrotra, A. and Yetman, J., 2015. Financial inclusion-issues for central banks.

Rosemann, M. and vom Brocke, J., 2015. The six core elements of business process management. In Handbook on business process management 1 (pp. 105-122). Springer, Berlin, Heidelberg.

Vogel, H.L., 2014. Entertainment industry economics: A guide for financial analysis. Cambridge University Press.

Zdenek, Z. and Dana, D., 2009. Company financial performance prediction on economic value added measure by simulation methodology. In 27th International Conference on Mathematical Methods in Economics, Mathematical Methods in Economics (pp. 352-358).