Enron: The Fall Due to Accounting Standards

The fall of Enron was due to the wrong usage of accounting policies such as mark-to-market, SPE, and stock options. This report discusses Enron's policies and measurement methodologies, US GAAP and IFRS, and more.

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Advance financial accounting

Enron
Executive Summary
The fall of Enron can be cited as one of the graves falls that happened due to the problem in
the accounting standards. The directors and the management continued to present a rosy
picture that misleads the stakeholders. The accounting policies were used in a manner that
projected a fabricated position of the company in its balance sheet whereas the entire position
was prone to risks. In this report, the policies of Enron are discussed such as mark-to-
marketing, SPE and the stock options. To ensure an exhaustive coverage, the article written
by Paul M. Healy and Krishna G. Palepu is considered.
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Contents
Contents................................................................................................................................................3
Introduction...........................................................................................................................................4
a) Mark-to-market accounting approach............................................................................................5
b) SPE................................................................................................................................................6
c) ‘Main purpose of the stock option.................................................................................................6
Part B.....................................................................................................................................................7
a. Measurement methodologies...........................................................................................................7
b. Explanation of the method............................................................................................................7
c. US GAAP and IFRS..............................................................................................................................8
Conclusion...........................................................................................................................................10
References...........................................................................................................................................11
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Enron
Introduction
The downfall of Enron can be linked to the wrong usage of the accounting policy by the
management. Further, SPE was one of the major factors that created immense threats to the
company. The false charges and statements made in the financial statements led to the
massive fall. The rosy picture of Enron claimed a different position while it was altogether
different for the company. The rosy picture influenced the investors but to their dismay, it
came out to be forge and eroded all the wealth of the investors.
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a) Mark-to-market accounting approach
The case study of Enron has been described in the case of Pual M.Healy and Krishna
G.Palepu that shed light on the loopholes and the mechanism that were undertaken.
Going by the competition prevailing in the current era, it can be commented that the company
is providing assets, as well as liabilities under the Fair value so that the concept of mark-to-
market is followed. As per the theory, it can be stated that the base is one that prevails in the
normal course of action while the expected price are considered so that the changes in the
prices are considered (Berensen, Richard & Oppel, 2001). The present value of the future
cash flow is a vital arena where the cost, expenses, and assets can be framed if the company’s
vision pertains to the long term. When the price prevailing in the market goes for alteration,
the database tends to be acquainted with prices. The expected values to be projected in the
annual report were not in link to the real value and this coins the fact that the company was in
full scope to alter the financial reports (Rezaee & Kedia, 2015). From the data that is
gathered, it became clear that the alterations in the prices will establish a new peak or can
lead it to severe crash in comparison to the past data.
The database was decorated with the clash flow amount that is expected and the expenses
were there on the FV list that was the major fact that the company was in a position to
transform their income in a short span of time. However, the process turned out to be severe
because the company ignored many aspects of the profit and loss. There were numerous
contract under which Enron entered but failed to keep an eye on the long term perspective.
Further, the percentage of profit and losses in the contract was treated under present value of
cash flow and was pre decided by the company (Hoffelder, 2012). The devastating procedure
followed by the company was seen in the contracts that were fatal and this is the main reason
why the company decided to go for fabrication in the financial reports so that the status of the
company can remain undisturbed (Ross et. al, 2014).
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b) SPE
In the wake of the Joint venture, Enron decided to buy the partner shares. The company
decided to manage the duties without considering the fact that the treaty will cause a reveal of
the profit and loss statement of the company in the public. It was decided by Enron to launch
a completely new structure because all the doubts need to be clarified and the company needs
to show that the accounts were free from all obstacles. When the company adopted Chewco
SPE in the company books, it led to the exposure of the company to various accounting
standards and the company in a diligent manner did not expose all the elements in the
financial statements (Brigham & Daves, 2012). Hence, the debt and liabilities were not
exposed and understated in the Enron balance sheet, on the contrary, the equity and earnings
were exaggerated. The SPE acted as a base for all statements of the company. The public
was able to have a slight indication but going by the credentials of the company they believed
in it and still invested. The main aim of the company was to conceal all the working of the
SPE from the public and maintain the status as was present in the market. This was done by
tampering the financial statements as a whole. ‘
c) ‘Main purpose of the stock option
The company’s management decided to provide stock option feature to the employee. The
terms were similar to the ones that were provided to the investors. The main aim of going for
stock options resides in the fact that the company wanted to conceal the facts from the public
because if leaked it would lead to the severe crash of the company. A difference was
observed when it comes to the stock options because the stock options were strange in nature.
the major reason for calling it a strange resides in the fact that the stock could not be resold
and this lead to immense questions on the working of the company. The action of the
company and stock options matter can be best described with the help of agency theory. The
theory resides on the terms of ownership interest. It is well understood that the employee
works for their own benefit and the company (Niemi & Sundgren, 2012). Hence, two major
point comes in this discussion is that the employee works for their own benefit and a second
point arise is that the employee works for the benefit of the company as a whole.
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Part B
a. Measurement methodologies
International Financial Reporting Standards have provided five different components of
conceptual framework for presentation of financial information in the annual reports. These
components are assets, income, equity, liabilities, and expenses. Such components can be
ascertained by companies in the following ways:
In the situation of Wesfarmers Ltd that is an Australian company listed on the ASX, it is
observable that the company has calculated its revenues based on the amount of consideration
that is received or is yet to be received. In addition, the inventories calculation has been
facilitated through lower of net realizable amount or the actual cost. Moreover, this cost is
determined through the implementation of weighted average method. Furthermore, the
company’s trade and other receivables are measured or recorded at their fair value and are
amortized later using effective interest. Further, the company’s fixed assets like machineries
and PPE are being valued at their respective costs less depreciation that is also ascertained
through the implementation of straight-line method (Needles & powers, 2013). Lastly, in
relation to the company’s borrowings, the same is valued at their respective fair values with
lesser transactions and thereafter, amortization process is being facilitated.
b. Explanation of the method
In order to undertake a proper comparative analysis, it is beneficial to choose one company
from the US so that the principles of GAAP can be compared with that of the IFRS standards.
Therefore, Mackay Golf Club has been selected for this study so that a comparison can be
made betwixt both these standards (Brigham & Daves, 2012). It is observable from the
company’s annual report that recognition of revenue is being performed on the basis of
percentage of completion manner and the same is computed through the usage of input
method. Furthermore, for recognition of expenses as well, this same method is being chosen.
Moreover, the fixed assets are recorded based on straight-line basis over the asset’s useful
lives.
In relation to the companies mentioned in the previous segments, there are two primary
methods for the presentation of financial statements of companies. However, which method is
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far above than the other cannot be determined through a comparative analysis. Further, both
the methods have their own efficacies and inefficacies and this is the reason why choosing
one single method only through a comparative analysis is problematic in nature. In relation to
this, various examples are accounted for so that the recognition methods can be assessed
altogether. Hence, if the revenue measurement is chosen based on the IFRS requirements, it
must be noted that the same can be easier and simpler to understand in relation to
determination of income and when compared to the US GAAP requirements. Moreover,
IFRS has been very convenient in this segment as it utilizes the most effective method of
revenue recognition (Leo, 2011). In contrast to this, there are major requirements while
complying with the US GAAP principles and that makes it complicated and harder to
understand for users in their decision-making process. The following table can be referred for
a better comparison between these two frameworks.
c. US GAAP and IFRS
Details IFRS framework US GAAP
Classification and
recognition of
expenses
There are dual
requirements in IFRS
frameworks.
This framework
follows only one
basis that is through
classification by
function.
Rules of income
statement
IFRS does not
specify any rules in
relation to income
statement.
There are several
formats or single
format in US GAAP
framework.
Inventories valuation Only FIFO and
weighted average
cost method is being
followed in IFRS.
Only LIFO system is
being followed in the
case of US GAAP.
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The aforesaid table clearly sheds light on the fact that IFRS requirements are easier to
understand in comparison to the US GAAP framework. Even though both the methods of
preparing financials are different in nature, a comparative analysis cannot help in offering a
conclusion as to which method is superior above the other.
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Conclusion
Based on the aforesaid discussion, it can be said that IFRS framework is more efficient than
the US GAAP framework because users can make better decisions from the same. This is the
reason why IFRS requirement is more suitable for companies in the current scenario.
Nevertheless, the preparation and presentation of financial statements from the perspective of
IFRS is easier to understand on the part of users in their decision-making process.
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References
Berensen, A.,Richard, A., and Oppel, JR. (2001) Once-Mighty Enron Strains Under Scrutiny.
Available from https://www.nytimes.com/2001/10/28/business/once-mighty-enron-strains-
under-scrutiny.html [Accessed 26 September 2018]
Brigham, E., & Daves, P. (2012) Intermediate Financial Management. USA: Cengage
Learning
Healy, P.M & Palepu, K.G. (2003) The Fall of Enron. Journal of Economic Perspectives.
17(2), 3-26. Available from: https://www.aeaweb.org/articles?
id=10.1257/089533003765888403 [Accessed 26 September 2018]
Hoffelder, K. (2012) New Audit Standard Encourages More Talking. Harvard Press.
Leo, K. J. (2011). Company Accounting. Boston:McGraw Hill
Needles, B.E. & Powers, M. (2013) Principles of Financial Accounting. Financial
Accounting Series: Cengage Learning.
Niemi, L. and Sundgren, S. (2012) Are modified audit opinions related to the availability of
credit? Evidence from Finnish SMEs. European Accounting Review. [online]. 21(4), p. 767-
796. Available from: https://doi.org/10.1080/09638180.2012.671465 [Accessed 21 April
2018]
Rezaee, Z & Kedia, B. L. (2012) Role of Corporate Governance Participants in Preventing
and Detecting Financial Statement Fraud. Journal of Forensic & Investigative Accounting.
[online]. 4(2), pp. 176-205. Available from: doi: 10.1016/j.sbspro.2014.06.041 [Accessed 26
September 2018]
Ross, S., Christensen, M., Drew, M., Bianchi, R., Westerfield, R. an Jordan, B.(2014)
Fundamentals of Corporate Finance, 7th ed. North Ryde: McGraw-Hill Australia Pty Ltd.
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