Enron's Corporate Failure: Issues with Mark-to-Market Accounting, Special Purpose Entities, and Stock Options

HA 3011 Advanced Financial Accounting
1

Contents
Assessment Task Part A...............................................................................................................................3
Executive Summary.................................................................................................................................3
Introduction.............................................................................................................................................4
a)Mark-to-market Accounting Approach & Its use by Enron’s Management..........................................4
(b)Special Purpose Entities & Their Use by Enron’s Management...........................................................4
(c) Stock options compensation scheme & Its use by Enron’s Management...........................................5
Conclusion...............................................................................................................................................5
References...................................................................................................................................................7
Assessment Task Part B...............................................................................................................................8
a. Methods of measurement used to measure the value of elements of financial statements..............8
b. Evaluation of accounting methods to provide the decision usefulness information...........................9
c. Critical analysis of each method of measurement...............................................................................9
References.................................................................................................................................................10
2

Assessment Task Part A
Executive Summary
The report is developed to identify and discuss the issues presented in the case study f
Enron in the academic article given. The report has specifically discussed the contribution if
mark-to-mark accounting, special purpose entities and stock options in the occurrence of
corporate scandal at Enron Corporation.
3

Introduction
The corporate failure of Enron is recognized as biggest accounting scandal in the
financial world whose long-term effects have been faced by the corporate environment across the
globe. This report has been undertaken to gain an insight into the major issues that lead to the
occurrence of corporate failure of Enron. This is carried out by analysis of the article ‘The Fall of
Enron’ written by Healy and Palepu published in the year 2003. In this context, the report
explains and discusses the issues such as mark-to-market accounting, role of special purpose
entities and use of stock options by Enron’s management to manipulate its stock results.
a)Mark-to-market Accounting Approach & Its use by Enron’s Management
Mark-to-market (MTM) can be described as an accounting method that involves the use
of current market price for recording an asset value. The method is regarded to be highly useful
for depicting a realistic image of the financial situation of a corporation. It provides a real
depiction of the amount likely to be received by a company on selling an asset at present. It is
known as fair value accounting and has been a part of the generally accepted accounting
principles. The method is proving to be largely problematic in the situations of fluctuating
market conditions as the value of assets are likely to change continuously with the use of such a
method of accounting. Thus, it is not helpful in providing a true depiction of the value of an asset
when there are irregularities in the market-based measurement mechanism (Benston, 2004).
The accounting fraud of Enron is stated to occur on account of the use of mark-to-market
approach. Enron has adopted the use of accounting approach for manipulating the financial
information and reporting higher profits than actually realized. The company makes use of this
approach for recognizing the income and forecasting the energy prices. The income recognized is
based on estimated future cash flows to be realized from its long-term contracts even when there
is uncertainty in relation to their feasibility and their associated costs. This resulted in depiction
of unrealized gains in its financial statements associated with the market value of long-term
contracts. This results in overstatement of profits and depiction of higher profitability position of
the company among its investors (Healy and Palepu, 2003).
(b)Special Purpose Entities & Their Use by Enron’s Management
Special purpose entities can be regarded as special entity that is created by the foundation
corporation for achieving its specific temporary objectives. The entities have an asset and
liability structure and can be regarded as a subsidiary company and are mainly used to meet the
funding needs of parent company. However, the existence of a special purpose entity requires
some specific accounting requirements to be met such as an independent third-party owner need
to have atleast 3 per cent of assets to be owned for avoiding its consolidation with the parent
company. The independent third-pay owner is also required to have more than 50 per cent of
financial interest in the special purpose entity (Carey and Stulz, 2007).
4