ACCTING 7023 : Advanced Financial Accounting : Mark to Market Accounti

Introduction:

Enron founded by Kenneth Lay in 1985 was a result of merger of two natural gas pipeline companies Houston Natural Gas and Internorth. There had been several changes in regulation for natural gas market in the mid-1980s. This led to deregulation of prices and allow the arrangements among producers and pipelines thereby increasing the use of is what market transaction. By 1990s, more than 75% of the gas sales were identified at spot prices rather than result of long-term contracts. During the 1990s it was evident that Enron’s stock increased to 311% which is only modestly higher than the growth stated in S&P 500. However, the stock even increased to 56% in 1999 and 87% in 2000. This is depicted with an increase of 20% and 10% decrease of index in the same year (Rose & Biles, 2017).

The present study will evaluate the strategies which were incorporated by Enron pertaining to misleading financial reporting objectives. In addition to this, it could also consider several measurement methodologies from other company’s financial statements and referr the same with Enron to critically analyse the rationale for techniques which were incorporated.

Part A

a) Mark to Market accounting

The concept of MTM relates to the measurement of fair value which can go through several changes in a particular timeline due to assets and liabilities. This concept is often implemented in the accounting practice for recording the present value of an asset as per the current levels of market. For instance, companies associated to financial services industry may consider making several adjustments in accounting for the assets pertaining to the events in which there may be defaulters of loan. Therefore, at the time of assessment of financial statement, the bank film marks such assets as bad debt and at the same time mark down the fair value associated with them. Similarly, a company offering discounts to its customers will also mark its current assets account to a significantly lower value for fastening of the process of collecting Accounts Receivable (Nguyen, 2016).

The accounting process for natural gas business in Enron had been fairly reliable in each financial year and the company was recognised to list its actual cost incurred and revenue generated from supplying the gas. However, the application of MTM accounting was particularly evident in the trading business of the company. This meant that at the time of signing long-term contract the PV of the future cash flows needed to be recognised as revenues along with expensing the cost of fulfilling the contract. The main challenge faced in terms of MTM was depicted with estimating the market value of the contracts. This led to estimation of income as PV of net future cash flows even though there was a serious question on viability of contracts and the costs associated with the same (Sullivan, 2017).

b) Defining SPE and use by the management of Enron to achieve financial reporting objectives

SPEs are often identified as “bankruptcy-remote entity” which is used by a parent company for securitising or isolating the assets and portray the same in their off-balance-sheet exposures. These are often stated as “bankruptcy remote entity” and “variable interest entities”. This is due to the fact that the operations are restricted to acquisition and financing of certain assets as per the method of isolation of risk. In general, companies may form the SPV/SPEs by the means of limited partnerships, corporations and trusts from other entities. Additionally, these may be designed for the independent ownership, management and protection of project from operational or insolvency issues (Edel Lemus, 2014).

Enron used such entities for funding its perils concerned with certain assets. Enron mainly took support of SPE in financing the acquisition for the gas reserves pertaining to the producers. As a result of this the investors in the SPE received a certain revenue for sale of the reserves. Enron engaged in designing several controversial SPE for achieving financial reporting objectives. For instance, in 1997 the company tried to buy out a certain percentage of partners stake in one of the many JVs (Betta, 2016). However, in the process of this acquisition it did not wanted to portray any debt in their balance sheet due to financing of the JV. It used Chewco as its main SPE raised the debt which was confirmed by Enron after investment of $ 383m in the JV. The structuring of transaction was done in such a way that Enron didn’t have to consolidate the SPE or the JV in their financial statement thereby allowing it to effectively acquired the partnership interest without the need of recognising any additional liability in the balance sheet (Edel Lemus & Orta, 2015).

c) Rationale for stock options compensation scheme

It is discerned that agency theory and enumerates the Association of principles and agents in a business. This theory is mainly identified with resolution of the problems which may exist in the relationship of agency with an alignment of the goals. This theory for the addresses the issues pertaining to desires and goals between the principal and agent.

To be seen that the main reliance of Enron was depicted with its reliance on stock options. Therefore, the high usage of search tools was concerned with short-term stock price evaluation focused with management expectations and growth factors at Enron. Moreover, the application of agency theory was concerned with the main intention of company for aligning the welfare is of the agents and principles. In this case, the agents are the management of Enron and principles are the shareholders. Despite of this, in a number of programs suffered from problems associated to short-term accounting performance. Additionally, the experience of Enron pertaining to other firms they’re concerned with several issues, such as including the possibility for stock compensation program to motivate executives and stimulate the short-term stock performance and enhancing the long-term value (Connell, 2017).

Task Part B

a) Examples of measurement methodologies from the annual report 

The new accounting pronouncements published by the company in 1998 very seen to be in accordance with “Statement of Financial Accounting Standards (SFAS)” in terms of recording derivative instruments and hedging activities in the balance sheet in form of either a liability or asset. This is required for fair value measurement for qualifying to the hedges. Enron was depicted to adopt SFAS number 113 for recognition of its ATNL worth $ 5m (Wu & Olson, 2015). There are several evaluations of measures in terms of managing the marketing risk pertaining to investments on a daily basis. The process of quantifying the market risk is used with consistently measuring the risk pertaining to diverse markets and products. The notable amounts for accurately measuring the risk of exposure of Enron’s is further depicted with credit risks (Reiche et al., 2016).

The US companies such asBroadcom Inc is identified with the preparation of financial statements by using GAAP framework which is similar to the application of SFAS 113. However, Broadcom Inc has estimated their assumptions based on current facts and there is no historical experience of other factors which are hampering the decision-making of the organisation. Moreover, the estimates pertaining to revenue recognition is based on revenue from the sales for the products to distributors based on delivery. Moreover, there is an alliance for distributor credit which is seen to cover the price adjustments pertaining to the estimates of historical experience rates and economic conditions as per contractual terms. Till date, the company’s actual claims form a trilogy concerned and historical estimates is seen to be significantly based on the differences between the actual amounts and the estimates. Moreover, the recording of reductions pertaining to revenue and rebate is also recorded in the same financial period (Tansey, Neal & Carroll, 2018).

b) Elements measured and beneficial decision making 

The measurement factors can be immediately considered with identifying the shareholders’ value associated with offering of services pertaining to contract value and providing other services. Moreover, the company is also involved in measuring of diagnostic measurements which has been beneficial for real-time monitoring of unusual changes in the demand (Micklethwait & Dimond, 2017). It is also addressed to several problems prior to running out of energy costs. The measurement of network control is identified with broadband operating system which is based on Enron BOS measure pertaining to real-time monitoring of each layer of network and ensuring that service and quality is delivered on time. The measurement of scalability component is implemented with “The Enron Intelligent Network (EIN)” which is identified with an extensive reach across the United States thereby connecting both Europe and Asia. The application of “SFAS No. 137” and “SFAS No. 138” had proved to be substantially useful in determining the use of derivative instrument on its liability measurements (Yu, Xin, Chen & Kim, 2018).

c) Determining the techniques employed by company through a critical analysis

The trading business of Enron were often based on complex business models associated with long-term contracts. The application of current accounting procedures with the use of PV framework was evident in regarding the transactions related to future earnings. The main techniques applied by the company can be identified with MTM approach which was central to its recognition of income and forecast of energy prices along with interest rates in the future. Secondly, there was an extensive reliance on financial transactions which considered of the using SPE. Such transactions included the shared ownership for certain cash flows which went outside the domain of lenders and investors (Saleuddin, 2016). Therefore, the traditional accounting implemented by the company often involve several arm’s-length transactions among the independent entities suffering from several issues in the transactions. The accounting rule makers at Enron are also debated for using inappropriate accounting tools for several years. On the other hand, the company use mechanical conventions to record the transaction which resulted in a divergence among the accounting numbers and economic reality (Khdir, 2016).

Conclusion:

The discourse of the study has identified that accounting process for natural gas business in Enron had been fairly reliable in the initial years. However, as the business progressed, the company used several malpractices such as MTM approach. MTM was depicted with estimating the market value of the contracts. This led to estimation of income as PV of net future cash flows even though there was a serious question on viability of contracts and the costs associated with the same. Enron used SPE to mitigate the risk associated with certain assets. Enron mainly took support of SPE in financing the acquisition for the gas reserves pertaining to the producers. It used Chewco as its main SPE raised the debt which was confirmed by Enron after investment of $ 383m in the JV. However, it was later revealed that the company violated the accounting standards which required at least 3% of the assets to be returned in ownership of the equity investors. Moreover, the investors we are unaware of the fact that Enron was using its own financial guarantees and stocks to carry out the process of hedging. So, there was no real protection provided by Enron to its shareholders.

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