Fall of Enron Case Study: Issues and Explanations

This article discusses the fall of Enron case study and its issues with mark-to-market accounting, special purpose entities, and stock option compensation. It also provides a critical analysis of IFRS and US GAAP. The article also compares the financial statement preparation methods of two companies, Woolworths Group Limited and Magal Security Systems Limited. The article concludes that IFRS is a better standard to use as compared to US GAAP due to ease of understanding and use of simpler methods in measurement and recognition of the elements of financial statements.

HA 3011 Advanced Financial
Accounting Assessment item 2 —
Assignment

Accounting
Assessment Task Part -A
Answer
On the basis of an article written by Paul M. Healy and Krishna G. Palepu on the fall of
Enron Case study, following are the explanation to the issues:
a) Mark-to-Market Accounting approach pertains to the accounting on the fair value of the
assets and liabilities that rsides on the current market price of similar kind of assets and
liabilities. In the mark-to-market accounting, as the current market price is taken as the base
for the future transactions as well, it becomes highly volatile as the market prices are prone to
fluctuations. The company used this accounting method for its long-term contracts as well.
According to mark-to-market accounting, the income and expenses for the long-term
contracts are estimated depending on the present value of future cash flows (Arnold, 2010).
So when the prices fluctuate in future, the same was not adjusted in the books of accounts of
the company. The discrepancies in the incomes and profits were very large which resulted in
misleading financial reports. The management used to forecast energy rates and interest rates
on the basis of the future value of cash flows (Ross et. al, 2014).
The company used to recognise its revenues as the future value of all cash inflows in coming
years and the expenses were booked as the future value of all cash outflows in coming years.
The unrealised gains and losses were reported in the later years as an when they occurred.
Enron did many long-term business contracts in which it depicted the present value of future
cash flows as its income and the present value of costs to be incurred during the entire
contract as its cost of service (Arnold, 2010). Some of the contracts even failed viability tests
in the later years of the contract. This way the management of the company used to show a
rosy picture of its financial performance while entering into long-term contracts without
taking a cushion for fluctuations in incomes and expenses that could arise in future.
b) Special Purpose entities are a kind of shell firms or companies which are developed by a
sponsor but funding is done by independent equity investors or by debt financing
(Vaitilingam, 2014). Special purpose entities are used for many purposes by the businesses
such as for help in financing, risk sharing, easy transferring of assets, securitization of loans,
etc (Bekaert & Hodrock, 2012).
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The company Enron has used numerous Special Purpose Entities to finance its forward
contracts and to achieve financial reporting objectives. One such instance which shows the
manipulation of financial reports with the help of SPEs is discussed ahead.
In the year 1997, the Enron company had an intention to purchase its partner’s share in a joint
venture contract. But the company did not want to reflect the debts from this transaction of
acquisition or from the joint venture in its financial statements. One of the executives of
Enron had a controlling power in an SPE named Chewco who raised a debt from Chewco
which was guaranteed by Chewco. This debt was utilised by Enron for acquiring the Joint
Venture partnership. All this was structured in such a manner that nothing related to this debt
financing transaction could be reflected in the financial statements of Enron and thus Enron
could acquire the partnership in Joint Venture easily (Healey & Palepu, 2003). The Chewco
SPE violated many accounting standards as well and hence Enron had not to consolidate its
accounts with Chewco. This way the debts and liabilities got understated in Enron’s Balance
Sheet and the Equity and the earnings were overstated.
Apart from this, Enron did minimum disclosures regarding the association with the SPEs and
reported downside risk was hedged in its illiquid investments through SPEs. But there was no
awareness amongst the investors that Enron has allowed the use of its stocks to SPEs and
guaranteed the whole debt transactions as well. Enron had also involved many top-level
officers in all these transactions (Healey & Palepu, 2003). In this way, it was successful in
funding contracts and obtaining the financial reporting objectives.
c) Enron’s top management was awarded high compensations including stock options. The
main reason for stock option compensation scheme was to bring the management and
shareholders in the same interest. The main reason for providing stock options to the
management was to influence their decisions and to encourage them to provide an inflated
financial position of the company. This can be said as the stock options provided to the
management were without any restriction of further resale and unlike stock options provided
by other companies, there were no specific requirements from the management for the
purchase of such stock options (Healey & Palepu, 2003). This behavioural pattern can be
assumed from the agency theory. According to this theory, both the principal and the agent
are motivated by self-interest. This theory relies on the assumption that the agents work for
self-interest only and to maximise their personal wealth. Hence in order to challenge this
assumption, it is required from the agent that either he leaves aside his self-interest or work
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according to the principal to maximise his wealth along with agent’s own personal wealth. In
the case of Enron, the management were the agents who have been provided with high
compensations including stock options (Bodie, Kane & Marcus, 2014). It was their duty to
maximise principal’s wealth but they have only inflated the financial performance but did not
provide any medium or long-term growth to the company.
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Assessment Task Part-B
Answer
The five elements of financial statements as per the International FRS Conceptual Framework
are – Asset, Liability, Equity, Income and Expense. Usually, there are different methods of
measurement of these elements that are used by different organisations- Historical Cost
Measurement basis, Current Value measurement basis, Realisable (settlement) Value and
Present Value method.
a) There are different methodologies for the measurement of different elements of financial
statements.
For instance, a listed public company in Australia namely Woolworths Group Limited uses
the following measurement methods:
The computation of revenue is done at the FV of the consideration that is received or
receivable (Woolworths, 2018). The computation of inventories are done at cost or net
realisable value whichever is lower and the cost is calculated on the basis of weighted
average cost.
The recognition of Trade and other Receivables are initially done at fair value and are later
measured at amortised cost using effective interest method and an allowance is deducted or
impairment. Fixed assets such as PPE are measured at cost less depreciation and the
depreciation are computed using straight-line method over the useful life that is remaining in
terms of the assets.
Borrowings are initially valued at fair value fewer transaction costs and later at amortised
costs. The difference between the two costs are shown in Consolidated
Income Statement over the period of borrowings.
For comparison purposes, we shall take another company which is US based and uses U.S
GAAP to prepare its financial statements. The company is Magal Security Systems Limited
which uses following measurement methods: This company recognises its revenue and
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expenses on the basis of percentage of completion method and this method is calculated
based on the Input Method (Magalsecurity, 2018).
The inventories are measured at cost or market price whichever is lower and the cost is
determined in two parts- Raw Materials on FIFO basis and the WIP & Finished Goods on the
basis of proportionate direct and indirect manufacturing costs. Further, the long-term trade
receivables and other receivables are recorded at their estimated present values (Brigham &
Daves, 2012).
Fixed assets such as Property, Plant & Equipment are measured at cost less depreciation and
the depreciation is calculated using the straight-line method over the remaining useful life of
the assets. Above are only few examples as the elements have been spread in many different
parts in the Annual reports of the companies (Magalsecurity, 2018).
a) Both of the above-mentioned companies use two different methods of preparing financial
statements. It cannot be said with complete accuracy that which method is better over the
other one. It might be possible that the measurement recognition of one element is better in
IFRS and of other elements is better in U.S GAAP (Brigham & Ehrhardt, 2011). We have
taken a few examples above which show different methods of recognition for different kinds
of elements of financial statements.
If revenue is measured as per IFRS, it is easy to measure and recognise in the Income
Statement rather than as per U.S GAAP as the IFRS uses the most common method of
Revenue Recognition.
As per U.S GAAP, the expenses are classified by function, whereas under IFRS the expenses
are classified under two parts- nature of expense and function, which makes it's better to
understand the nature of expenses in the Income Statement.
There are strict requirements on the presentation of Financial Statements under U.S GAAP as
compared to IFRS. Hence it is better to use IFRS presentation. On considering the remaining
examples given in former part, the measurement and recognition methods under IFRS are
much easier to understand as compared to U.S GAAP, hence making the decision making
comparatively easier. The more understandable the financial statements are, easier it becomes
for the users of financial statements to understand the same and take their decisions
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thereafter. For example- investors and financial institutions can decide whether to invest and
provide funding to the company or not.
a) Critical analysis of IFRS and US GAAP:
If we consider the above two companies only for the critical analysis of the two
techniques, it would not ensure proper comparability. The reason being that both the
companies operate in different sectors and different nature of business is there. Hence,
a general analysis of both the techniques would be better.
Basis of comparison Under IFRS Under U.S GAAP
Format of Income
Statement
There is no fixed format
under IFRS
There has to be either
multiple step format or
single step format under
US GAAP
Recognition and
classification of expenses
Under IFRS, there are two
alternatives- by nature and
by function classification
(Deegan, 2011)
Under US GAAP, only
classification by function
is allowed (Parrino,
Kidwell & Bates, 2012)
Use of historical costs or
fair value/ revalued costs
IFRS permits the use of
both
US GAAP allows only
historical cost basis (few
exceptions are there)
Valuation of Inventory LIFO method is not
permitted. It uses either
FIFO or Weighted
Average Cost Method
(Melville, 2013).
LIFO is allowed to be
used.
Disclosure of
Extraordinary Items
Under IFRS, the disclosure
of non-recurring expenses,
income and extraordinary
items is not allowed in the
financial statements. It is
Under IFRS, the disclosure
of non-recurring expenses,
income and extraordinary
items is allowed in the
financial statements in
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shown outside in the notes
to accounts (Mersland &
Urgeghe, 2013).
limited circumstances
(Needles & Powers, 2013).
These are comparison examples for only major heads from the financial statements.
As we can see from the above comparison table, the methods and techniques used
under IFRS are easier to understand and implement. Also, the valuations and
measurements of elements of financial statements can be done in depth when there are
lesser restrictions (Merchant, 2012). Hence, IFRS is a better standard to use as
compared to US GAAP due to ease of understanding and use of simpler methods in
measurement and recognition of the elements of financial statements.
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References
Arnold, G. (2010) The Financial Times Guide to Investing. Prentice Hall.
Bekaert, G., & Hodrock, R. (2012). International financial management (2nd ed). Prentice
Hall
Bodie, Z., Kane, A., & Marcus, A. J. (2014) Investments. McGraw Hill
Brigham, E., & Daves, P. (2012). Intermediate Financial Management. USA: Cengage
Learning.
Brigham, E.F. & Ehrhardt, M.C. (2011) Financial Management: Theory and Practice, USA:
Cengage Learning.
Deegan, C. M. (2011) In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill
Magalsecurity. (2018) Magal security 2018 annual report & accounts. Available from:
https://magalsecurity.com/sites/default/files/resource/file/20-F%20-%202017%20-
%20final.pdf [Accessed 14 September 2018]
Melville, A. (2013) International Financial Reporting – A Practical Guide. 4th edition.
Pearson, Education Limited, UK
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Mersland, R., & Urgeghe, L. (2013) International Debt Financing and Performance of
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Needles, B.E. & Powers, M. (2013) Principles of Financial Accounting. Financial
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Parrino, R, Kidwell, D. & Bates, T. (2012) Fundamentals of corporate finance. Hoboken
Healy, P.M & Palepu, K.G. (2003) The Fall of Enron. Journal of Economic Perspectives.
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Ross, S., Christensen, M., Drew, M., Bianchi, R., Westerfield, R. an Jordan, B.(2014)
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Vaitilingam, R. (2014) The Financial Times Guide to Using the Financial Pages. London: FT
Prentice Hall
Woolworths. (2018) Woolworths 2018 annual report and accounts 2018. Available from:
https://www.woolworthsgroup.com.au/icms_docs/195396_annual-report-2018.pdf [Accessed
14 September 2018]
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