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

ACCOUNTING ASSIGNMENT 1
Advanced Financial Accounting Assignment
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ACCOUNTING ASSIGNMENT 2
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).

ACCOUNTING ASSIGNMENT 3
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?

ACCOUNTING ASSIGNMENT 4
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