Role of Mark to Market Accounting Approach in Enron’s fall

15 September 2018

Part A
Role of Mark to Market Accounting Approach in Enron’s fall
The company Enron was formed in the year 1985, as a result of the merger between Houston
Natural Gas Co. and Omaha-based InterNorth Inc. (Matoussi and Jardak, 2012). One of the
major reasons that formed the base for the fall of the company was the top management’s
decision to lead Enron from a conventional historical cost accounting method to the mark to
market (MTM) accounting method (West, 2018). In order to do the same, the company had
got sanction from the U.S. Securities and Exchange Commission in the year 1992. The
company had incorporated the mark to market accounting approach for the energy trading
business. The mark to market approach is the measurement of the fair values of the various
accounts of an entity, that can change over a time, as in the case of assets and liabilities. The
aim behind using such an approach is to display a more realistic appraisal of the company’s
current financial situation. The company Enron used the approach to manipulate the financial
statements, this is because the fair value determination is a complex process (Kim and Zhang,
2016). This is because of the fact that commodities such as gas do not often have a quoted
price upon which to base the valuations of the fair value.
Under this approach, whenever the company Enron had an outstanding balance in relation to
energy and other derivative contract related asset or the liability balance, the same was
required to be adjusted to the fair value as at the end of a particular quarter (Rimkus, 2017).
The resulting unrealised gains or losses were booked in the income statement for that period.
As there is difficulty in determination of the fair value prices, the companies like Enron are
free to use and develop a range of the discretionary models for the valuation that are based on
their own assumptions and estimates. The company Enron was under a consistent pressure to
get pass the earnings estimate, in response to which the valuation estimates used by the entity
were considerably made to overstate the earnings. As per the reports, the unrealised gains of

the company were a bit more than half of the company’s pre-tax profits of the year 2000 that
were $ 1.41 billion.
Use of the Special Purpose Entity by the management of Enron
A special purpose entity (SPE) or vehicle is often known as the bankruptcy-remote entity that
is being used by the companies to securitize the assets and in turn holding them off the
balance sheet. The operations of these kinds of entities are limited to the acquisition and
financing of specific assets, which is further directed at isolating the capital or hedge risks
(Norwani, Zam and Chek, 2011). The operations of a special purpose entity are explained as
follows.
At first stage companies like Enron contributes the hard assets in relation to the commodities
like real estate or energy and the related debt to a SPE, in exchange for an interest (Fischer
and Marsh, 2017). In the second stage, the original company then borrows huge sums from
the financial institutions in order to purchase the further another assets and the conduct of the
business without the hard assets and the debt being shown on the financial statements.
The company Enron had made the use of the SPEs, and capitalised them with a wide range of
the assets and liabilities, including the derivative financial instruments, restricted stock and
the incidental rights to buy the stock and related liabilities (Li, 2010). It also used the SPE to
get rid of the assets that were consistently falling in value one of them being overseas energy
facilities. This enabled the Enron to keep the losses of such assets out of the actual financial
books of Enron. Thousands of SPEs were reported to be involved in the conduct of the
business of Enron, while two of them were operated by the company’s management itself
namely the LJM Cayman LP and LJM2 Co-Investment LP. This enabled the payment of
whooping $30 million in management fees by these SPEs to the Enron’s management itself.