Ha 3011 : Advanced Financial Assessment Answers

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.

Assessment Task Part B 
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. 

Introduction:

The main discussions of the study have been segregated two sections. The first part of the study has explained concepts associated to the mark to market accounting in terms of the approach followed by Enron’s management. The discussions pertaining to the study has also identified the motive of the management in terms of funding the contracts and achieving the objectives associated to the financial reporting. In addition to this, the discourse of the study has also showed how the top management of Enron has enjoyed the high remuneration/ compensation. This is inclusive of the stock options and the purpose of the reports which are seen to be considered in terms of the various aspects of the reporting has been discussed with the main purpose of the stock options compensation scheme facilitated by the top management. The second section of the study has included the different measures pertaining to assessment of the annual report of the company and at the same time clearly referring to the sources. This section has further explained on how company measured the important elements of the decision making. The report has also provided the critical analysis of the approaches selected as per the techniques which are used by the companies and practical method of using the same (Goh et al. 2015).

Assessment Task Part A

a) Mark to market accounting approach

Mark to market measure of the company is identified as a fair value of the accounting concept which changes over time like liabilities and assets. This concept aims to depict the realistic appraisal of the present financial situation of the company (Ellul et al. 2014).  Enron’s trading business has been identified to adopt the M-to-M approach accounting. This suggests that once the long-term contract is signed with the PV pertaining to the stream of cash flows, PV of the stream of future cash flows were expensed. The primary hurdles faced by Enron by mark-to-market accounting was recognised as per the use of MV agreements which was considered for more than 20 years. In case of Enron the income was carefully expensed at PV of the net future cash flows even though there was a serious concern of viability pertaining to the associated costs and contracts. In July 2000 the company signed a 20-year agreement with Blockbuster Video to introduce for entertainment on demand. As per the consideration of this case Enron went ahead to identify the profit as more than $110 million from the Blockbuster deal, even if there was a serious question of technical feasibility and market demand (Haswell and Evans 2018).

b) Special purpose entities and how management of Enron has used to fund the contract and achieve the reporting objectives  

In general, special purpose entities are considered as legal Limited companies or partnerships which aimed at fulfilling temporal or narrow objectives. The use of SPE is mainly evident among companies which try to isolate the different types of financial risk. Typically, entities transferred assets to SPE for better management or providing the rights to the larger projects so that they are able to achieve narrow set of goals without putting the operations of firm at risk (Sainati, Brookes and Locatelli 2017).

The use of SPE by Enron is evident with managing or funding dangers concerned with specific assets. Enron used such methods for funding the acquisition pertaining to gas reserves from the producers. Due to this, the investors in the SPE received a source of revenues associated to selling of reserves. Since 2001, Enron has utilised more than 100 such SPEs. In 1997, Enron aimed at buying out the partner’s stake in one of the leading joint ventures dealing (Coyne 2017). However, the company did not want to account for any debt pertaining to financing of any business combination. The company used Chewco as a SPE entity to raise the debt and guarantee that the company acquired joint venture stake worth $ 383 million. Moreover, the deal was planned in such a manner that Enron was not required to consolidate either joint venture or the SPE entity into its financials, thereby allowing for acquiring partnership interest in absence of any additional debt. Furthermore, the details of Chewco was duly provided under the appendix of the company. In October 2001 it was revealed that Enron violated the accounting standards by not maintaining a minimum ownership of independent equity investors of 3%. The ignorance of such a requirement Enron was able to dodge consideration of SPEs (Demere, Donohoe and Lisowsky 2017).

c) Main purpose of the stock options compensation scheme  

Agency theory is described as the relationship of agents and principles in a business. The main concerns associated to agency theory is related to the resolution of the problem is which may exist in agency relationships because of non-aligned goals and differing versions of this level pertaining to risk. In common parlance, the relationship in agency theory is identified among shareholders who are known as the principal and executives of company who are considered as agents (Bosse and Phillips 2016).

As evident in most of the US companies, the management at Enron highly relied on using stock options. Moreover, the high amount of use of stock options are associated with the short-term stock price evaluations which focuses on the Enron’s management and creation of expectations associated with rapid growth and its reporting is related to online for meeting the expectation of Wall Street. The application of agency theory is evident with the intention of the company to align with the welfares of the management (agents) and shareholders or principal. However, it was noted that in majority of the programs the sizable amount for the option grant was suffering from short-term accounting performance and typically there were only few requirements for the managers for holding the stock purchased with option program exercised in the long-term. Moreover, the overall experience of Enron with other firms raise significant issues for the possibility of stock compensation programs which was presently designed to motivate the executives and boost the short-term stock performance thereby including the long-term value (Shi, Connelly and Hoskisson 2017).

Assessment Task Part B

a) Examples of measurement methodologies from the annual report 

As per the depictions made in the annual report published by the company in 2000 it can be seen that FASB issued several statements pertaining to “SFAS No. 133” and “Accounting for Derivative Instruments and Hedging Activities”. This was subsequently provided and amended in “SFAS No. 137” and “SFAS No. 138”. Moreover, the application of SFAS No. 133 was applied to David instruments and certain derivatives which included hybrid instruments record the balance sheet as either an asset or liability measure with fair value through earnings and allowance specific type of qualifying hedges. For instance, the adoption of “SFAS No. 133” by Enron was evident with the recognition of after-tax non-cash loss of $ 5 million in earnings and PAT non-cash gains. Therefore, the total impact of such a measure on Enron was identified with other comprehensive income which were dependent on pending interpretations (Picker.uchicago.edu. 2018).

The on comparing the results with company such as Nordstrom which relies on US GAAP and applies measurement provisions of SFAS No. 123 seen with significant difference among the stock-based compensation program and expenses. More evidently, the overall evaluation under such accounting system not only considers fair value of the options at the date of branding was also risk-free interest rates for measuring the volatility of shares. This particular phenomenon was absent in case of company like Enron following requirements prescribed by IASB (About.nordstrom.com 2018).

b) Measurement of the elements and methods useful for the decision making 

The concept of measurement in accounts is associated with quantification of business transactions into financial terms by using monetary units. In case, and even cannot be quantified in monetary terms it is not regarded as being recorded under financial accounts. This is the main reason why important decisions such as appointment of new manager, possible changes in personnel and entering into new contracts are generally not revealed in the books of accounts. The implementation of diagnostic measurements by Enron shows that the incorporation of Enron PMC is responsible for real-time monitoring of events which tracks unusual changes pertaining to energy demand which instantly helps in addressing problems prior to energy costs getting out of control (Shi, Connelly and Hoskisson 2017).

Secondly, the measurement date of Enron plan and ESOP was set in September 30, 2000. The benefit plans under the ESOP considered the consolation of the amount pertaining to concentrate on the balance sheet and other assets. For the purpose of measurement, the 10% and 6% annual rate is where identified with annual increase of per capita which addressed the healthcare benefits considered during 2000 to 2001 for general post retirement plans (Ferrell and Fraedrich 2015).

Lastly, the chief operating decision-making group of Enron allocated resources as for income before minority interest, net income, interest and IBIT. In addition to this, certain costs related to the company by functions were incorporated into the segments. Despite of this, interest worn by corporate debt was primarily maintained among the corporate segments. Therefore, the management of the company believed that measurements pertaining to IBIT was dominant in nature and segment and profits consisted of consolidated financial statement of Enron. In the beginning of 2000, the company’s communication was managed separately by operating segment which was named after broadband services and the important criteria set under this was identified with SFAS No. 131 (Collier 2015).

c) Critical analysis of company’s techniques deployed 

The fall of the company in 2000 was evident with the deployment of its own techniques. The CEO Enron Jeffrey Skilling was identified with using different types of unscrupulous methods for hiding the financial losses pertaining to trading and other operations. This is mainly referred as mark to market accounting. This technique implemented by the company was used for measuring the value of security as for the current MV instead of PV. Despite of its success among trading securities, this technique can be disastrous when implemented into actual practice (Iphofen 2016). This practice was used by the company in building assets such as construction of power plant and subsequently claiming for profit even though the property did not generate even a dime.

Henceforth, in case the revenue associated with the power plant was more than the actual amount. Instead of bearing the loss, the company transferred into an asset into the books of Corporation which led to several losses going unreported. This kind of accounting led for writing off several types of unprofitable activities without having any detrimental effect on Enron (Fischer and Marsh 2017). Moreover, the mark to market practice gave rise to several types of other schemes which were construed to hide losses and make the company appear to be more profitable than it was in reality. In order to compensate the mounting liabilities, the CFO in 1998 came up with a solution of making the company appear to be having a more stable financial condition despite of the subsidiaries losing considerable amount of money.

Moreover, the use of techniques such as using of off-balance sheet SPVs for special purpose entities concealed the mounting amount of debt pertaining to toxic assets from creditors and investors. Enron would you such SPV for subsequently using the stock foraging and assets listed in the balance sheet of the company and guarantee that such tools reduced counterparty risk (Mixa, Bryant and Sigurjonsson 2016).

Conclusion: 

The study of Mark to market accounting approach for Enron is recognised with signing long-term contract with the current value pertaining to the source of cash flows. At the time of this signing of the PV of the stream of future cash flows were expensed. Enron further used SPE methods for funding the acquisition pertaining to gas reserves from the producers. The company used Chewco as a SPE entity to raise the debt and guarantee that the company acquired joint venture stake worth $ 383 million. Moreover, the deal was structured in such a manner that Enron was not required to consolidate either joint venture or the SPE entity into its financials, thereby allowing for acquiring partnership interest in absence of any additional debt.

References:

About.nordstrom.com. 2018. What makes Nordstrom unique? [online] Available at: https://about.nordstrom.com/aboutus/investor/ar/2000/NOR2000AR.pdf [Accessed 23 Sep. 2018].

Bosse, D.A. and Phillips, R.A., 2016. Agency theory and bounded self-interest. Academy of Management Review, 41(2), pp.276-297.

Collier, P.M., 2015. Accounting for managers: Interpreting accounting information for decision making. John Wiley & Sons.

Coyne, M.P., 2017. A Historical Examination of the Mark to Market Accounting Rule. Journal of Economics and Banking, (1).

Demere, P., Donohoe, M.P. and Lisowsky, P., 2017. The economic effects of special purpose entities on corporate tax avoidance.

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.

Ferrell, O.C. and Fraedrich, J., 2015. Business ethics: Ethical decision making & cases. Nelson Education.

Fischer, M. and Marsh, T., 2017. Special Business Entity Reporting: One Plugged Hole is better than none. ASBBS Proceedings, 24(1), p.188.

Goh, B.W., Li, D., Ng, J. and Yong, K.O., 2015. Market pricing of banks’ fair value assets reported under SFAS 157 since the 2008 financial crisis. Journal of Accounting and Public Policy, 34(2), pp.129-145.

Haswell, S. and Evans, E., 2018. Enron, fair value accounting, and financial crises: a concise history. Accounting, Auditing & Accountability Journal, 31(1), pp.25-50.

Iphofen, R., 2016. Ethical decision making in social research: A practical guide. Springer.

Mixa, M.W., Bryant, M. and Sigurjonsson, T.O., 2016. The reverse side effects of mark to market accounting: Exista and the saga of leveraged paper profits. International Journal of Critical Accounting, 8(5-6), pp.463-477.

Picker.uchicago.edu. 2018. Enron Annual Report 2000 [online] Available at: https://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf [Accessed 23 Sep. 2018].

Sainati, T., Brookes, N. and Locatelli, G., 2017. Special purpose entities in megaprojects: empty boxes or real companies?. Project Management Journal, 48(2), pp.55-73.

Shi, W., Connelly, B.L. and Hoskisson, R.E., 2017. External corporate governance and financial fraud: Cognitive evaluation theory insights on agency theory prescriptions. Strategic Management Journal, 38(6), pp.1268-1286.