Enron's Misuse of Market-to-Market Accounting, Special Purpose Entities, and Stock Options Compensation Scheme

This article discusses Enron's misuse of market-to-market accounting, special purpose entities, and stock options compensation scheme. It explores the weaknesses of market-to-market accounting, how Enron's management used special purpose entities to fund contracts, and the primary purpose of the stock options compensation scheme. The article also examines Amazon's measurement methods for financial statements.

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Advanced Financial Accounting Assignment
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Advanced Financial Accounting Assignment
Assessment Task Part A
a) Define and explain mark-to-market accounting approach and give examples where
Enron's management/accountants perhaps misused this approach to portraying a rosy
picture of its performance/profitability?
Market-to-market is an accounting method that evaluates the value an asset of a firm to its
present market value (Kolakowski, 2018). Market to market approach illustrates how much
the owner of the asset would receive if the asset were to be sold today. Consequently, the
method is also known as fair value or market value accounting method (Kolakowski, 2018).
According to The Economic Times Website, market-to-market accounting method became
part of generally accepted accounting principles (GAAP) in 1990 (2018). The technique
offers a realistic forecast of a financial scenario. This is because the method indicates the
value of assets in relation to its present price in the market. The technique was widely
accepted in the last century (The Economic Times, 2018).
At the end of every financial year, every firm must declare the value of its assets in its books
of accounts (Amadeo, 2018). It is generally easier to forecast the market value of the assets if
traders purchase and sell that type of asset often. A classic example is 10-year Treasury note.
The note is re-priced based on the quoted market rate. Consequently, if the yield rate of the
Treasury rose in the course of the year, the value of the treasury notes. Since the Treasury
note that the bank holds at the time does not pay interest as new ones, selling of such bond
results into a loss (Amadeo, 2018).

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Market to Market (MTM) is a legitimate accounting and is widely accepted. However,
because MTM is not based on the actual costs of a firm but fair value, the method is
susceptible to manipulation. This is the weakness that Enron’s management manipulated to
display unrealistic performance. The company thrived on MTM in several ways (Healy &
Palepu, 2003). Because MTM allows constant adjustments of the value of assets, Enron’s
management exploited these adjustments to stay ahead of the Wall Street estimates by
reporting increased asset values; whether there was an actual increment or not. Besides,
under MTM, unlike most accounting methods where revenue is realized from a sales contract
when the goods are delivered, or service is undertaken, the whole forecasted value of a sales
contract can be recognized as revenue on the very day the deal is struck (Healy & Palepu,
2003).
Enron utilized these loopholes to perpetrate fraud. A perfect example is the 1992 deal
between Enron and Sithe Energies. Enron entered the agreement to supply 195 million cubic
feet of gas per day for twenty years. The forecasted value of the deal was about $4 billion
(Connell, 2017). Using MTM, Enron’s management recognized the revenue before the
operation began.
Additionally, Enron’s investment in Mariner Energy misused MTM guidelines. The firm
acquired a private-equity buyout valued at $185 million. Using the fair market value, the
investment in Mariner, as reported by Enron, stood at $367.4 million in the second quarter of
2001 (Connell, 2017).
b) What are individual purpose entities and how Enron's management used them to fund
contracts or achieve financial reporting objectives?

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Special-purpose entities are financing techniques that allow a firm to reduce its exposure
to risk by developing separate partnerships as opposed to subsidiaries (Central Bank of
Ireland, 2017). The firm then seeks outside investors to assume the risk. By 2001,
Enron’s management had used several special purpose entities. Most of these entities
were used to finance the purchase of forwarding contracts with producers of gas to
facilitate the supply of has to various firms using long-term fixed contracts (Healy &
Palepu, 2003). Enron’s management used most of these Special Purpose Entities were
created mainly to achieve financial reporting objectives. For instance, in 1997, Enron
wanted to buy out the stake of a partner in one of its joint ventures. However, Enron was
not willing to report any debt from funding the acquisition or the joint venture on the
balance sheet (Healy & Palepu, 2003). Besides, Chewco, a special purpose entity,
acquired a joint venture stake for $383 million. The entity was being managed by one of
the Enron’s executives and raised a debt that was guaranteed by Enron (Healy & Palepu,
2003). During the process, Enron did not recognize any additional obligations in its
financial statements. The transaction was carried out in a way that exempted Enron from
consolidating Chewco or the joint venture into its books (Healy & Palepu, 2003).
Additionally, in October 2001, Enron disclosed that it violated accounting principles that
demands that independent equity investors own at least 3 percent of its assets. That is, by
breaking the accounting standard, Enron avoided consolidating special purpose entities.
Consequently, liabilities were understated while equity and earning overstated (Healy &
Palepu, 2003).
c) Enron's top management enjoyed high compensation/ remuneration including stock
options, what was the primary purpose of the stock options compensation scheme

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provided to senior management. Your explanation, discussion, and argument should
principally be based on the assumption of the agency theory.
The management of Enron was heavily compensated using stock options. Heavy and
deliberate use of stock option remunerations linked to short-term stock price can be
attributed to the intention of the management of Enron to steer rapid growth and
development, and inflate earnings in the report as a way of meeting Wall Street’s
requirements (O'brien, 2018). Enron’s personal statement indicated that the awards were
possibly going to be exercised in three years. Additionally, there were no restrictions
mentioned in the sale of stock owned (Healy & Palepu, 2003).
The primary purpose of the stock options was to align the interests of shareholders, and
that of the management of the company. Evaluating Enron’s case, and several other
firms, it can be argued that compensation through stock options are designed to motivate
managers to promote decisions that encourage the short-term performance of the stock of
the organization. However, the strategy fails to support medium and long-term value
(Wayman, 2018).
Assessment Task Part B
According to International Financial Reporting Standards (IFRS), there are five elements of
financial statements. These are assets, liabilities, equities, revenues, and expenses (Clark, 2017).
The measurement of these elements of financial statements is diverse and varied from one
organization to another. The following is an exploration of some of the methodologies that
Amazon uses to recognize and measure elements of financial elements.
Amazon prepares its financial statements in line with the generally accepted accounting
principles of the United States. GAAP guidelines demand that all the estimates and assumptions

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that impact reported amounts of assets, liabilities, revenue, and expenses be declared. However,
due to the complexity of the Amazon’s business model, not all declaration follows GAAP.
Amazon accounts for inventories (current asset) using the first-in-first-out (FIFO) method. The
inventory is measured using the lower of cost or market value method (Amazon, 2016).
Lower of Cost or Market rule demands critical judgments be made based on the currently
available information on inventories, and the method of disposition that is most likely. Lower of
Cost or Market value method requires that the value of the inventories be recorded on the
balance sheet at the fair market value or at a historical cost (Bragg, 2017). Lower of Cost or
Market value method allows any loss incurred as a result of a fall in the value of the inventory to
be accounted for as Cost of Goods Sold (COGS) (Lumen, 2018). Consequently, making
decisions concerning a reduction in the value of the inventory is made easier. Understanding the
cost structure of a business is very important in managing a firm's profits. However, inasmuch as
the method is seemingly simple, and makes a useful decision regarding the inventory to be easy,
the method is relatively expensive. The method calls for double valuation of the inventory to
come with the lower cost value. Additionally, cash valuation of the inventory does not indicate
the amount of revenue that the inventory could bring in the current market condition (Johnston,
2017).
According to Amazon’s 2016 report, Amazon “revenue from product sales or services rendered
when the following four criteria are met: persuasive evidence of an arrangement exists, delivery
has occurred, or service has been rendered, the selling price is fixed or determinable, and
collectability is reasonably assured…and and revenue is allocated using estimated selling prices
if we do not have vendor-specific objective evidence or third-party evidence of the selling prices
of the deliverables” (Amazon, 2016). Evidently, Amazon measures its revenue based on the

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IFRS guidelines. According to IFRS 15-New Requirements regarding Recognition and timing of
revenue, revenue is measured at a fair value of consideration (Financial Accounting Advisory
Services, 2018).
In addition to complying with generally accepted accounting principles, the use of fair market
estimates provides useful information on the value of the revenue. If not manipulated, fair market
value provides accurate information on the value of the business. Besides, the use of fair value to
measure income ensures that Amazon registers true income. This is because the method limits
the business to its reported income (Way, 2018). However, the former is true if only the business
follows the principles of fair market value to avoid a scandal like in the case of Enron (Applied
CG, 2016). Fair market value is particularly suitable to Amazon because of the volatility of retail
industry. Besides, since Amazon has several products and services, the method ensures that
every asset's specific benefits are calculated and assessed (Vitez, 2017).
Similarly, Amazon values liabilities, equity, expenses using fair market value. “For our cash,
cash equivalents, or marketable securities, we measure the fair value of money market funds and
equity securities based on quoted prices in active markets for identical assets or liabilities”
(Amazon, 2016). The 2016 annual report further indicates that the remaining financial securities
were measured based on recent trades of instruments in the inactive market or based on the price
that of similar securities that have been quoted in the market (Amazon, 2016).
International Valuation Standard (IVS) recognizes there significant approaches to valuing
liabilities. These are the market approach, income approach, and cost approach. The fair value or
market-to-market valuation provides a demonstration of value by relating the subject liability
with related or identical liabilities which are being traded in the market, and whose price

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information is available. Fair market value is one of the generally accepted accounting principles
(John, 2016). In addition to that, the applicability of the method to Amazon is because fair value
operates recent current information of the liabilities, is a consistent measure of assets and
liabilities, and provides useful information for equity analysis. Because of the consistency in
which assets and liabilities are valued, the market-to-market method improves comparability of
performance over the years, and between different companies (John, 2016).
However, the market value method may not be the best for Amazon. There is a possibility of fair
value creating huge swings of value due to changes in prices in the marketing in the course of the
year. If the assets and liabilities fluctuate in value in large amounts, the true value of the assets
will be derailed in the long run. Furthermore, there is a likelihood of a fair value approach
discouraging investors.
In conclusion, there are two distinct valuation methods that Amazon employed in the 2016
financial year. These are fair value, and Lower cost or market value method. Arguably, the
motivating factor behind Amazon’s measurement methods is in compliance with the generally
accepted accounting principle, and suitability to the business model.

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References
Amadeo, K., 2018. Mark to Market Accounting, How It Works, and Its Pros and Cons. [Online]
Available at: https://www.thebalance.com/mark-to-market-accounting-how-it-works-3305942
[Accessed 19 September 2018].
Amazon, 2016. Amazon 2016 Annual Report. [Online] Available at:
http://annualreports.com/HostedData/AnnualReportArchive/a/NASDAQ_AMZN_2016.pdf
[Accessed 20 September 2018].
Applied CG, 2016. Home Case study Enron Case study. [Online] Available at:
https://www.applied-corporate-governance.com/case-study/enron-case-study/ [Accessed 20
September 2018].
Bragg, S., 2017. Lower of cost or market (LCM). [Online] Available at:
https://www.accountingtools.com/articles/2017/5/13/lower-of-cost-or-market-lcm [Accessed 20
September 2018].
Central Bank of Ireland, 2017. Special Purpose Entities (SPEs) - Central Bank of Ireland.
[Online] Available at: https://www.centralbank.ie/docs/default-source/statistics/statistical-
reporting-requirements/special-purpose-vehicles/spes-worked-examples---dec-2017.pdf?
sfvrsn=4 [Accessed 19 September 2018].
Clark, W., 2017. The Five Elements of a Financial Statement. [Online] Available at:
https://bizfluent.com/info-7924055-five-elements-financial-statement.html [Accessed 19
September 2018].

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Connell, M., 2017. The Fall of Enron and the Creation of the Sarbanes-Oxley Act of 2002.
[Online] Available at: https://digitalcommons.lasalle.edu/cgi/viewcontent.cgi?
article=1029&context=honors_projects [Accessed 19 September 2018].
Financial Accounting Advisory Services, 2018. IFRS 15: The new revenue recognition standard.
[Online] Available at:
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d/%24FILE/IFRS15_low.pdf [Accessed 20 September 2018].
Healy, P. & Palepu, K., 2003. The Fall of Enron. Journal of Economic Perspectives, 17(2), pp.3–
26.
John, L., 2016. Advantages and disadvantages of fair value accounting. [Online] Available at:
https://siteeconomics.blogspot.com/2016/09/advantages-and-disadvantages-of-fair.html
[Accessed 20 September 2018].
Johnston, K., 2017. What Are the Disadvantages of Using the Lower of Cost or Market to Value
Inventory? [Online] Available at: https://bizfluent.com/info-8511215-disadvantages-cost-market-
value-inventory.html [Accessed 20 September 2018].
Kolakowski, M., 2018. Mark to Market Accounting. [Online] Available at:
https://www.thebalancecareers.com/mark-to-market-accounting-1286951 [Accessed 19
September 2018].
Lumen, 2018. Lower of Cost or Market. [Online] Available at:
https://courses.lumenlearning.com/boundless-accounting/chapter/additional-topics-in-inventory-
valuation/ [Accessed 20 September 2018].

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O'Brien, S., 2018. Don't overlook the risk that comes with your employee stock options. [Online]
Available at: https://www.cnbc.com/2018/02/27/employee-stock-options-can-come-with-
expensive-risks.html [Accessed 19 September 2018].
The Economic Times, 2018. Definition of 'Mark To Market.' [Online] Available at
https://economictimes.indiatimes.com/definition/mark-to-market? [Accessed 19 September
2018].
Vitez, O., 2017. The Advantages of Fair Market Value. [Online] Available at:
https://smallbusiness.chron.com/advantages-fair-market-value-4123.html [Accessed 20
September 2018].
Way, J., 2018. Advantages or Disadvantages of Fair Value Accounting. [Online] Available at:
https://smallbusiness.chron.com/advantages-disadvantages-fair-value-accounting-20577.html
[Accessed 20 September 2018].
Wayman, R., 2018. Should Employees Be Compensated With Stock Options?. [Online] Available
at: https://www.investopedia.com/articles/analyst/091202.asp [Accessed 19 September 2018].