Advanced Financial Accounting: Mark to Market Accounting, Special Purpose Entities, and Bond Amortization

This article discusses mark to market accounting, special purpose entities, and bond amortization in advanced financial accounting. It covers Enron's misuse of mark to market accounting, the use of special purpose entities to hide bookkeeping realities, and the effective interest rate method for bond amortization.

Running head: ADVANCED FINANCIA L ACCOUNTING 1
Advanced Financial Accounting
Your Name
Institutional Affiliation

Advanced Financial Accounting 2
Advanced Financial Accounting
Assessment Task Part A
a)
Mark to market (MTM) technique of accounting is the assessment of fair value of
accounts which fluctuate over time and examples are asset accounts and liability accounts (Allen
& Carletti, 2008). The main goal of mark to market accounting technique is to give appraisal of
organizations current market value of financial statements using the prevailing market rates and
quoted market prices. This method is used internationally and therefore in some cases it can be
manipulated. Mark to market method of accounting is used generally by firms which produce
their annual reports and financial statements in every fiscal year. After measurements of accounts
using this technique, profits and losses that results should be recorded in the statement of
income, (Bigman, Goldfarb & Schechtman, 1983).
Enron adopted this method of accounting and at the first point, they valued their accounts
correctly. Enron’s management started misusing this method in order to fulfil their own greedy
anticipations. It is alleged that the adoption of this method culminated to the fall of Enron as they
recorded profit estimates as if they were the actual ones (Schwarcz, 2002). The following are
some of the examples of circumstances where Enron misused this method.
Enron’s management signed a contract with the Indiana polis of $ 1.3 billion to supply
the Indian Eli Lilly Company with electricity for a 15-year period. Enron accounted for the
present value of the contract as profits and accounted for the cost of contract servicing as
expenses. The Indiana polis company had not deregulated the servicing cost of the contract and

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so it was inappropriate for Enron to record the servicing costs as expenses. This made their
reports to show high profitability (Nelson, Price & Rountree, 2008).
In the year 2000, Enron signed a 20-year agreement with Blockbuster a video rental chain
to introduce entertainment every end of the year. Enron estimated revenues of $ 110 million. The
accountants of Enron recorded this estimates as actual profits. They recorded this amounts in
their balance sheet even though the profit estimates were questionable.
Lastly, this method of accounting should only apply to the valuation of products which
fluctuate in value. Contrary, Enron valued all their products such as electricity using this
technique. Enron came up with an online trading website in the year 1998and acted as both the
purchaser and consumer at the same time (Markham, 2015). This was done in order to attract
shareholders and boost their image.
b)
Special purpose entities are entities which are formed to assist in obtaining tinny,
constricted and precise set (Chernov, & Sornette, 2016). Companies use these entities in order to
aid in the elimination of loans and other debts in their balance sheets. Enron used the special
purpose entities in hiding the bookkeeping realities.
Enron moved its stock to the special purpose entities and in exchange, it was given cash.
The special purpose used the stock transferred in hedging of assets which were listed in the
statement of financial position of Enron. According to Schwarz in exchange for transactions like
this, Enron will warranty the special purpose entity a value which will reduce the counteract risk.

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Enron acquired a joint venture and a special purpose entity called Chewco at a cost of $
383 million. According to AASB, this transaction was supposed to be recorded as debt in the
balance sheet. Enron did not record this debt in order to show high profits (Benston, &
Hartgraves, 2014; Healy & Palepu, 2013).
Enron in the year 1997 wanted to purchase one of the partner's ownership in a joint
venture, the management did not want to record this transaction as debt in the statement of
financial position. The act of not recording debts and recording only profits made their liabilities
to be understated and made their assets to be highly overstated.
c)
The main motive behind the issue of stock options by Enron's management was to ensure
that there was an alignment between the precise interest of Enron's management and those of the
shareholders. In addition to that, the other reason for stock options issue was to show the center
of Enron in creating the anticipation of speedy growth and its endeavor to raise their reported
earnings in order to achieve their expectations. According to agency theory, managers should
represent the interest of shareholders, (Bergstresser & Philippon, 2012). Enron's managers
represented their own interest as they listed the stock options to the managers and made them be
short term and formulated policies that favored compensation of their shares.
Assessment Task Part B
The five main elements consist of assets, liabilities, equity, revenues and expenses
(Rezaee, 2012). Assets can be defined as resources which are owned and controlled by a firm as
a consequence of past transactions and actions. Liabilities are obligations to a firm as a
consequence of past transactions which are supposed to be settled by the resources of a firm.

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Equity arises as a residue of subtracting liabilities from assets. Revenues are described as
increases in benefits from an accounting period (Henderson, & Howieson, 2015). Expenses are
cash outflows in the business due to either purchase of an equipment or payment of workers.
a)
Assets can be measured using many ways and bases. According to Parkinson (1998),
assets can be measured using the historical cost, fair value, net realizable value, current cost and
present value. According to the annual report of Australia and New Zealand bank for the year
2017, the assets of the bank were measured at cost using the fair value method.
Liabilities are also measured using historical cost, current cost, fair value, present value
and net realizable value. In the annual report of Australia and New Zealand bank for the year
2017, liabilities were measured using the historical cost and prevailing market price.
Equity is measured using the fair market value. Australia and New Zealand bank
measured its Equity using the fair market value and quoted prices for the year 2017.
Revenues are calculated using fair value. According to the annual report of Australia and
New Zealand for the year 2017, their cash revenue was measured using the fair market value.
Expenses are calculated using operational costs. Australia and New Zealand bank in the
year 2017 calculated its expenses using the operational costs (Shareholder.anz.com, 2018.).
b)
Australia and New Zealand bank calculated its assets, equity and revenues using the fair
values. The liabilities also were measured using the fair market value and the historical costs.
Fair value method gives a true indication of a business performance, correct worth of the

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business and helps make the financial statements have materiality. Expenses were calculated
using the operational cost and this was useful as it brought about prudence in the financial
statements hence making the statements to provide decision-useful information. Decision useful
information is information that is accurate, timely and is faithfully represented which helps the
external users like investors to make wise decisions.
c)
Australia and New Zealand bank measured its assets mainly using the fair market value
method. This method was important because it helped the bank to produce realistic financial
statements, the investors also benefited from the information. Expenses were measured at cost
and this method is important methods because it helped avoid overstatement of profits and
understatement of liabilities.
Bonds
Bonds are a form of borrowings to a business and are issued in form of money by the
bond issuer. The bond interest payment is done after a period of every six months. The payment
of the actual face value of the bond is usually paid at the time the bond matures. Bond by
borrowers is reported as bond payable (Iasplus.com, 2018.).
Bond Amortization with the Effective Interest Rate
A bond can be sold at a premium and the premium of the bond ought to be amortized to
interest expense during the life of the bond. The bond premium credit balance has to be
transferred to interest expense account and the interest expense reduces on yearly basis. This
process is the same with regards to bond discounts.

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At the end of each year, the amortized amount and the carrying value are added together,
and the results help in the calculation of subsequent years’ premiums and interest expense of
bonds (Prosic, 2014).
Effective interest method is highly preferred in amortization of bond premiums. When
there is a decrease in a book value of the bond there is also a decrease in interest expense value.
Straight Line Method
Under this method, when a bond is sold at premium the premium of the bond is supposed
to be discounted to zero (Marzo & Pagnozzi, 2011). For example, if a bond issuer trades a bond
with a face value $ 100000, at a premium of $ 12000.This premium amount should be discounted
over the life of the bond to zero in amortization process. Every end of the year the interest of the
bonds is credited as interest expense and bonds payable are debited. The straight line method is
easy as the above steps are repeated annually in order to get the subsequent year’s bond payables
and interest expense (Prosic, 2014). Under this method discount on bonds is calculated using the
same steps.
Conclusion
To sum up, it is evident that both straight-line method and the effective interest rate
methods are useful in the calculation of bond interest, premiums and discounts. During the
maturity of the bond, the two methods calculations should give the same information. The
effective interest method should be more preferable because it results in more accurate figures
than the straight-line method. The second reason why it should be preferred is that the
amortization of bonds under this method is done in a logical manner. Bonds should not be
recorded as debt in the balance sheet using the fair value because the effective interest method

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and the straight-line method give accurate values and are effective. In situations where accurate
figures are required the effective interest method should be used.

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References
Allen, F., & Carletti, E. (2008). Mark-to-market accounting and liquidity pricing. Journal Of
Accounting And Economics, 45(2-3), 358-378. doi: 10.1016/j.jacceco.2007.02.005
Benston, G.J., 2017. Fair-value accounting: A cautionary tale from Enron. Journal of Accounting
and Public Policy, 25(4), pp.465-484.
Bergstresser, D. and Philippon, T., 2012. CEO incentives and earnings management. Journal of
financial economics, 80(3), pp.511-529.
Bigman, D., Goldfarb, D. and Schechtman, E. (1983). Futures market efficiency and the time
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Markham, J.W., 2015. Financial history of the United States: From Enron-era scandals to the
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