Fall of Enron Case Study: Issues and Explanations

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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Accounting
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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