Advanced Financial Accounting: The Fall of Enron and Bond Liabilities

This article discusses Enron's misuse of accounting techniques such as mark to market accounting and special purpose entities. It also covers the different methods of reporting bond liabilities, including the straight line and effective interest methods. The article is relevant for students taking Advanced Financial Accounting courses and includes solved assignments, essays, and dissertations available at Desklib.

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ADVANCED FINANCIAL ACCOUNTING
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Advanced Financial Accounting 2
Advanced Financial Accounting
The Fall of Enron
Part A
a) Mark to market accounting approach can be described as an accounting technique
which values assets according to the existing current market levels (Sapra, 2008, p.380). It
simply shows how much an organization will receive if it sells its material goods today. It can
also be termed as the fair value accounting technique. This method usually works when
organizations release every year financial statements which reveal the fair value of the
organizations. Mark to market accounting technique is also used in measuring the financial
records fair value in terms of assets and liabilities of an organization. The fair market values of
asset and liabilities are released at the end of every fiscal year so as to reflect the current market
levels. The following are the example of places where Enron misused the mark to market
accounting method.
Enron signed a 20-year agreement with Blockbuster so as to introduce entertainment on
demand during the year-end. Enron estimated $110 million profits and recorded in its books of
accounts although it was not sure about the market demand for entertainment which was subject
to fluctuation.
Enron entered into a$ 1.3 billion contracts with Indiana to supply electricity to Indian
polis Eli Lilly company which was supposed to last for 15 years, Enron reported the present
value of the contract as revenues and reported the cost of servicing the contract as an expense,
even though Indiana had not deregulated in order to determine the actual expense servicing cost
(Trinkaus and Giacalone, 2005,p.245).

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b) Special purpose entities can be described as lawfully separate entities (business) that
take risks so as to reverse situations for a company or a corporation. Special purpose entities are
not usually recorded in the books of accounts by a company. Special entities are always formed
to perform specific duties. They can be termed as subsidiary companies of the larger companies
because larger companies take less than 20 per cent ownership rights. The special purpose
entities are created for distinct and very isolated reasons which majorly entail narrowing the
extent of risks to the assets and liabilities of an organization. Special purpose entities can be
categorized into three which includes; joint venture companies, off-balance sheet financing
companies and asset securitization companies.
Enron sold an asset to one of its special purpose entities and did not consolidate it in the
financial statements and hence it did not follow the GAAP rules. Enron also used the special
purpose entities for improper revenue realization and recognition. Enron transferred assets to the
special purpose entities and recorded them as sales and therefore their revenue was inflated and
this would enable Enron to report their desired results contrary to the GAAP rules. Enron also
acquired Chewco and a joint venture which cost $ 383 million and did not report in the financial
statements as debt hence inflating its financial statement too.
Enron formed several controversial special purpose entities in order to achieve its
financial reporting objectives and a good example is in 1997 where Enron wanted to purchase a
partner’s stake in one of its numerous joint ventures and it did not want to illustrate any debt on
the balance sheet as a consequence of financing the venture. Enron used the special purpose
entities to show understated liabilities and overstated equity and earnings in the balance sheet.

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Enron used the special purpose entities in funding the risks associated with the specific
assets. Enron used the special purpose entities to fund the acquisition of gas reserves from their
producers (Schwarcz, 2002, np.). In the case of Enron, the investors of special purpose entities
received revenues from the sale of reserves (Jain and Bowman, 2005, p.85).
c)
The main reason of stock options issuing was to bring into line the interest of
shareholders and that of management and to show the focus of Enron management on creating
expectations of rapid growth and its effort to blow up reported earnings to meet the Wall Street’s
expectations. Trinkausa and Giakalone discussed on the silence of stakeholders of Enron
(Trinkausa and Giakalone 2005, p.238). This was contrary to agency theory which stipulates the
relationship between the principal and the agent. (Foss and Stea, 2014, p.114) The agent is
supposed to represent the principal but the managers of Enron had a conflict of interest. Enron
management issued stock options to the managers and directors without restricting the sale of
stock to the management. Enron issued short-term stock options to its managers hence they set
the stock compensation programs that suit their stock holding. The management of Enron did not
represent their principal interest but represented their own interest in the company and this was
contrary to agency theory.
Part B
The five elements of financial elements include; Assets, liabilities, equity, revenue and
expenses (Vakutin and Fedulova, 2018, p.265). Assets can be defined as properties which are
controlled by a particular entity as an outcome of past transactions and events and which are
anticipated to give the company future benefits or rewards (Chalmers, Clinch and Godfrey, 2008,

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p. 240). Examples include things like land, furniture among others. They can be categorized into
three; current assets, fixed assets and tangible assets.
Liabilities are future obligations of a company which occur from the past transactions and
which will be settled by the assets of the company. They can be divided into long-term and short-
term borrowing. Liabilities usually correspond to the future claims in the business by investors
and outsiders. Short-term borrowings are usually paid in a period of less than a year while the
long-term borrowings can take a long period before they are settled (Assaad Khalil, 2010, np.)
Equity can be defined as the residual resources when you subtract total liabilities from
the total assets, for example, ordinary shares.
Revenues can be defined as increases in economic proceeds during a bookkeeping
period in terms of cash inflows an example is the sales revenue.
Expenses can be defined as costs that arise due to the daily operations of a business
entity for example salary expenses.
a)
Assets=liability + shareholders’ equity
Assets are usually measured by adding the liabilities with shareholder’s equity. Some
assets are difficult to measure for example patents. Assets may be measured using the historical
costs, measured using the current replacement value or amortized cost. Assets can be measured
using the following bases, the historical cost, market value, the replacement costs, the net selling
price and value in use. The total assets of Barclays bank in the year 2017 was 1133248 million
(Home.barclays, 2018).

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Liabilities are measured using bases, for example, using the historical cost base, market
value base, the cost of release, the assumption price and the cost of fulfilment. The total liability
for Barclays bank in the year 2017 was 1067232 million Euros. (Barclays home liabilities report
2018).
Revenue is gotten using the profitability ratios and that is by dividing the net income by
sells. The total revenue for Barclays bank in the year 2017 was 21076 million Euros. (Barclays
home revenue report 2017)
Expenses are measured by valuing goods or services that are consumed. It is measured by
cost. The total expenses for Barclays bank in the year 2017 was16713 million Euros (Barclays
home 2017)
Equity is measured by subtracting liabilities from assets. The total equity in the year 2017
for Barclays banks is 66016 million Euros (Barclays home 2017)
b)
Assets of Barclays have been measured using the fair value. This measure postulates that
assets should be measured using the current market value. This means that it should be measured
using the current market value or prices by which the asset can be sold currently in the market.
This method helps the information to be useful because it makes the information relevant to
decision making.
Liabilities of Barclays have been measured using the revenue realization concept and the
market value. This is because they are realized when they occur using the current market prices.

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This method is used to make the information reliable. This helps the financial statement users to
make meaningful decisions.
Revenue is measured using the profitability ratios in Barclays using the fair value
method. The profitability ratios make the information to be comparable as an investor gets the
same results using different approaches hence useful in decision making. Ratios help make the
information to be useful.
Expenses are measured also using the fair market value as they are consumed or of an
activity. This helps the businesses to cater for the effect of inflation as assets exist in the
business. This is useful as it increases the relevance of information.
Equity has been measured by subtracting liabilities from the assets also by using the fair
market values. This has been arrived at using the double entry concept. This is useful as it helps
increase the accuracy of information.
c)
Barclays bank has majorly used the fair market value in measuring assets and liabilities
financial statements. The fair market value of Barclays company is arrived at in reference to the
quoted market value rates. In some cases, it has used the historical cost method. This method
may be more useful than the other methods because it increases the reliability of the financial
statements as to when it is compared with other companies it gives the same results. It also
increases relevance as it helps in making important decisions about the company. This method
also increases understandability of the financial statements by making it simple for the users such
as decision-makers, investors, lenders among others

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Bond Liabilities
Bonds are reported as long-term debts. Bonds are given to borrowers inform of money by
investors and this makes the investors appear like lenders. The bond requires the borrowers to
pay interest in every stipulated period and the face value to be paid when the bond matures. The
bond interest is normally paid semiannually and that is every six months. The interest payments
of the bonds are usually arrived at using the following formula, the face value of the bond
multiplied by the stated annual interest multiplied by half a year.
The principal amount of the bond must be paid to the bond issuer when the bond matures
and this is more often than not due in a single date.
Straight line Amortization Method
When a business decides to trade bonds at an interest rate which is lower than the fixed
interest rate percentage then it is said to have sold at a premium. Using the straight-line method,
the balance of the bond premium must be reduced to zero. For example, assume our bond
premium was 4000. This amount must be reduced to 0 over the life of the bond. By so doing the
book value of the bond will be decreasing from 104000 to 100000 and this method is known as
amortization. The amortization of bonds, in this case, involves the use of interest expense. Every
end year the bonds payable is debited and the interest expense is credited and this is done during
the life of the bond.
Straight line method is the simplest method to report for bond discounts. In this method,
the premium or discount offered on bonds are amortized over the life of bonds in equal amounts.

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The effective Interest Method
The effective interest method is used in discounting of bonds in accounting. It is
usually used in bonds that are given on discounts. In this method, the discount amount is usually
amortized to interest expense during the period in which the bond is sold (Brayton and Tinsley,
1996). This is usually the most preferred method in amortizing a bond. This is a more complex
method than the straight-line method. The cash interest in this method is arrived at by
multiplying the coupon rate with the bond value. The discount amortization is calculated by
subtracting the cash interest from the interest expense and the results would be discount
amortization for a year.
Every end of the year, amortization is added to the carrying value and this procedure is
usually repeated in order to come up with the interest expenses and discount amortizations for
the following years. In this method, the company's amortization amounts and the interest
expenses are therefore subject to change yearly. Also, premiums under the effective interest
method are amortized in the same technique as discounts. The carrying amount of value of the
bonds multiplied by the rate of return required by investors and this results to interest expense
which is the same as premium amortization. At the end of the year, the premium amortized is
subtracted from the carrying amount and the remaining carrying amount used in the calculation
of the following years' amortization and interest expense.
We can, therefore, say that the straight line method is simpler than the effective interest
method. This is because of the same interest expense, the amortization premiums and cash
interest results to the bond discounts. Contrary the effective interest results differ yearly because

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the amortization and interest expense are different in every year, only the cash interest paid on
bonds remains the same (Cornaggia, Franzen and Simin, 2011, np.).
The straight line method during the early stages of the life of the bond results to more
premiums compared to the effective interest method and the effective interest method results to
more premiums towards the end of the life of the bond (Abdelkafi, Ghorbel and Khoufi, 2018,
p.371). During the maturity of the bond, the two methods should give the same results in terms
of the total amount of the cash interest, the totals of the interest expense and that of amortization.
Both the two techniques provide the same useful information and whether one decides to use
either of the techniques it would give the same results. Bonds should therefore not be reported
using the market value in the balance sheet but reported using either the straight-line method or
the effective interest rates. The effective interest method gives slightly a more accurate figure
than the straight-line method but the two methods are effective.

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References
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Finance and Accounting, 5(4), p.371.
Assaad Khalil, K. (2010). Financial Statements as Sole Predictors of Financial Distress: The
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Brayton, F. and Tinsley, P. (1996). Effective interest rate policies for price stability. Economic
Modelling, 13(2), pp.289-314.
Chalmers, K., Clinch, G. and Godfrey, J. (2008). Adoption of International Financial Reporting
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Cornaggia, K., Franzen, L. and Simin, T. (2011). Manipulating the Balance Sheet? Implications
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Jain, S. and Bowman, H. (2005). Measuring the gain attributable to revenue
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Schwarcz, S. (2002). Enron, and the Use and Abuse of Special Purpose Entities in Corporate
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Sapra, H. (2008). Do accounting measurement regimes matter? A discussion of mark-to-market
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