Exploring the Fall of Enron: Misuse of Mark-to-Market Accounting and Special Purpose Entities

In this document we will discuss about Misuse of Mark-to-Market Accounting and Special Purpose Entities and below are the summary points of this document:- Enron used mark-to-market accounting approach in its trading business This approach recognized as revenues the present value of projected income streams and expensed the present value of expected future costs Enron reported unrealized gains as part of annual revenues or earnings upon occurrence Enron faced challenges estimating the market value of its contracts due to their long-term nature and feasibility questions Enron used special purpose entities to fund and manage risks of certain assets Special purpose entities were shell companies funded by debt financing and independent equity investors Enron utilized special purpose entities to achieve financial reporting objectives and avoid consolidation Chewco was used to raise guaranteed debt to acquire a stake in joint ventures without revealing debt on the balance sheet Enron inadequately disclosed its relations with special purpose entities and misled shareholders about hedging downside risk in illiquid investments Key staff members partnered with special purpose entities and benefited significantly.

ADVANCED FINANCIAL ACCOUNTING 1
Advanced Financial Accounting
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ASSESSMENT TASK PART A
Introduction
The purpose of this paper is to explore the fall of Enron case study. The paper explains
the mark-to-market accounting approach and gives examples where the management of Enron
misused the approach, portraying a rosy picture of its performance. It also explains special
purpose entities and highlights how Enron used them to fund contracts or achieve its objectives
of financial reporting. Finally, the paper discusses the high compensation options that Enron’s
management enjoyed.
a. Mark –To-Mark Accounting Approach and How Enron’s Management Misused It
Enron adopted mark-to-mark accounting approach in its trading business. The approach
meant that when the company entered into a long term contract, it recognized as revenues the PV
of the projected income streams of the contract and expensed the PV of the expected future costs
incurred in the fulfillment of the contract. The company then later reported unrealized gains,
which were unhedged, as part of annual revenues or earnings upon occurrence (Kaplan and
Atkinson 2015, pp. 84).
There are two examples where the accountants and the management of Enron misused
the mark-to-market accounting approach to portraying a rosy picture of the company’s
performance and profitability. Enron experienced a significant challenge in its use of the mark-
to-market approach as it was difficult to estimate the market value of its contracts. The contracts
were sometimes very long, extending up to twenty years (Kieso, Weygandt and Warfield 2016,
pp. 116). The company estimated its income regarding the PV of the net future cash flows.
However, in other cases, the contracts and their associated costs posed significant questions

ADVANCED FINANCIAL ACCOUNTING 3
regarding their feasibility (Nobes 2014, pp. 22). The following are the two scenarios where
Enron’s management used the mark-to-market approach to show a rosy image of its performance
(profitability).
i. In July 2000, the company entered into a contract of 20 years with Blockbuster
Video for the introduction of entertainment to the multiple cities America by the
end of the year upon demand. Enron was to keep the entertainment as well as
encode and stream it through its international network of broadband. The
company piloted the projects in Seattle, Salt Lake City and Portland to stream
movies from various apartments using servers which it had established in the
basement. However, the management of Enron proceeded and made recognition
of estimated profits amounting to more than $110 million from the Blockbuster
contract, although the people had various questions about the company’s market
demand and technical viability (Kaplan and Atkinson 2015, pp. 87).
ii. Another scenario where Enron’s management misused this approach is when it
signed a fifteen-year contract of $1.3 billion that entailed supply of electricity to
Eli Lilly, an organization in Indianapolis. Enron reported as revenue, the
contract’s present value, for more than $0.5 billion in its financial records. It then
reported the present value of the contract servicing costs as an expense. Enron’s
management misused the mark-to-market accounting approach in this case since
Indiana had not yet taken a move to deregulate electricity. It was therefore hard
for Enron to make a prediction when Indiana would make the deregulation and its
impact on the contract servicing costs during the ten years (Lewis and Pendrill
2014, pp. 137).

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b. Special Purpose Entities and How Enron Used them to Fund Contracts or Achieve
Financial Reporting Objectives
Enron made use of special purpose entities in funding and managing risks that
accompany certain assets. Special purpose entities refer to shell companies developed by
sponsors. The owners, however, fund the entities using debt financing as well as equity investors
who are independent. One way through which Enron made use of special purpose entities is to
finance its gas reserve acquisition from various producers. The special purpose entity investors
received revenue streams from the reserve sales in return. Enron had acquired multiple special
purpose entities by the year 2001. T used most of the entities in funding its purchase of the gas
producers’ forward contracts to supply gas to the various utilities under its contracts which were
long-term.
Additionally, Enron utilized the special purpose entities to achieve its financial reporting
objectives. For instance, Enron in 1993, used Chewco to raise a guaranteed debt by Enron to
acquire a stake of its partners in its various joint ventures, without revealing any debt on its
balance sheet as a result of the joint venture or the acquisition. Besides, alongside other special
purpose entities, Chewco violated specific accounting rules and standards to enable Enron to
avoid consolidation of the special purpose entities (Phillips, Libby, Libby and Mackintosh 2011,
pp. 65). Consequentially, the balance sheet of Enron led to a material understatement of the
company’s liabilities while overstating its retained earnings and equity. Furthermore, Enron
inadequately disclosed its relations of business with the various special purpose entities that it
used in achieving its financial objectives. Enron presented lied to its shareholders that it hedged

ADVANCED FINANCIAL ACCOUNTING 5
downside risk in its illiquid investments by transacting with the special purpose entities. It also
allowed its key staff members to partner with the special purpose entities, and they benefited
significantly (Lewis and Pendrill 2014, pp. 148).
c. The Main Purpose of The Stock Options Compensation Scheme
The top management of Enron enjoyed significant remuneration which included stock
options. The primary purpose of the top management’s stock option compensation scheme was
to focus on developing rapid growth expectations and puffing up the reported profits intending to
achieve the expectations of the Wall Street. Therefore, the primary purpose of the stock options
compensation scheme was to align the top management’s interests to those of the shareholders,
by the agency theory (Walton, Haller and Raffournier 2013, pp. 23). There are few or no
requirements for the top executives to acquire stock bought via long-term programs of stock
options since they receive sizeable option grants based upon their short-term performance. The
stock options act as a motivating tool to managers in making decisions which aim to boost the
short-term performance of the company stock but do not offer long-term or a medium value
(Elliott and Elliott 2017, pp. 96).
ASSESSMENT TASK PART B
Introduction
The main aim of financial statements is to give financial information to users to help
them make viable economic decisions. Financial statements must, therefore, present financial
information to users in an understandable and useable manner. The IFRS groups business
transactions in various classes depending on their commercial properties to improve the quality
of financial statements information. Financial statement elements are the term that refers to these

ADVANCED FINANCIAL ACCOUNTING 6
classes (Elliott and Elliott 2017, pp. 26). According to the conceptual framework of the IFRS, the
five elements of financial statements include assets, liabilities, equity, income, and expenses.
This paper aims to describe and evaluate the various ways through which listed
companies measure the five elements of financial statements, as defined in the conceptual
framework of the IFRS. For this assignment, I select ADX Energy Ltd (ADX). In making the
discussion and analysis, the paper gives examples of measurement methodologies from the
annual reports of the company. It also explains how the company has measured an element, how
the method of measurement offered decision-useful information and the meaning of decision-
useful information. It also gives a critical analysis of the techniques that the company has used
and why a particular technique deployed may be more practical or useful than another method.
Brief Background of the Company
ADX Energy Ltd is a multinational company dealing in exploration and appraisal of gas
and oil. The company trades its securities on the Australian Stock Exchange (ASX). It carries out
its operations through four permits of oil and gas in Europe and North Africa, as well as gold and
base metal interests in Australia. The headquarters of the company are in Perth, west of
Australia.
a. Examples of Measurement Methodologies From the Company’s Annual Reports
ADX energy limited uses various methodologies of measurement such as fair value and
carrying value or amount as discussed below.
i. Fair Value

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The company measures the cost of its equity-settled transactions by reference to the fair
value of its instruments of equity at the date it received them. The company determines the value
of its shares by share price. Besides, it determines the fair value of options using the model of
Black Scholes.
Furthermore, ADX Energy Limited initially recognizes its receivables at fair value and
subsequently measures them at amortized cost, less provision for bad debts. The company also
measures its listed securities at fair value, by referring to published quotations of prices.
Additionally, ADX Energy Limited carries its account payables at amortized costs and represents
liabilities for products offered to the whole Group before the financial period end which remains
unpaid and arises as the company obliges to settle the future liabilities regarding the purchase of
the products (Scott 2009, pp. 58).
ii. Carrying Value (Book Value)
The company also uses the carrying amount method to review its assets of deferred
income tax at each date of the balance sheet. It then reduces the assets to the extent to which it is
no longer probable that it will have sufficient taxable profit to let it utilise part or all of the
deferred income tax assets. ADX Energy limited reassesses its deferred income tax assets at each
date of the balance sheet and recognises them up to the extent at which it becomes probable that
future taxable profits would allow the company recovers the deferred tax assets (Elliott and
Elliott 2017, pp. 49). Furthermore, the company measures its deferred income tax assets and
liabilities at a rate of taxes have the likelihood of being applied to the year of the asset’s
realisation or the liabilities settlement, based upon the applicable rates of taxes (Meigs, Meigs
and Ferrara 2017, pp. 54).

ADVANCED FINANCIAL ACCOUNTING 8
b. Explanation of Decision-Useful Information and How the Measurement
Methods Used Provided Decision-Useful Information
The primary interest of investors in financial statements of a company is to get
information that is useful for their decision-making process. Decision-useful information is that
which provides investors and other users of financial statements with decision-making relevant
financial information. Decision-useful information emphasises primarily on inferring the specific
needs of investors and creditors as well as other financial statements users. Financial accounting
and reporting is a measurement activity which offers decision-useful financial information to
support the decision makers in making viable business and financial decisions. As such,
companies must provide relevant information to its users of financial statements for purposes of
making profitable economic decisions such as investment and credit decisions (Hoyle, Schaefer
and Doupnik 2015, pp. 79).
ADX Energy limited uses measurement tools which provide the users of its financial
reports with decision-useful financial information. When making financial decisions, investors
focus their key concern on assessing the ability of the company to generate cash inflows and the
ability of its management to safeguard and promote the company’s capital as well as the
investments of the investors. For instance, ADX Energy limited includes its cash flows in the
cash flow statements based on the gross sales and GST cash flow component that arises from
financing and investing activities. The investors, therefore, can ascertain the ability of the
company to generate cash flows from the activities (Elliott and Elliott 2017, pp. 46).
Furthermore, the financial reports of ADX Energy Limited help its investors assess the
timing, amounts, and uncertainty of the prospective inflows of cash from interest or dividends, as

ADVANCED FINANCIAL ACCOUNTING 9
well as the sale proceeds, loan proceeds and redemption proceeds. For instance, the company
uses fair value valuation method to initially recognise the amount of its net expected receivables
and subsequently measures them at amortised costs, less the doubtful debts provision. As such,
investors can ascertain the probable amount of future cash inflows that the company expects to
receive from sales (Beaver 2015, pp. 78). Additionally, reporting trade payables and other
payables at amortised costs helps investors establish indeed the number of future liabilities that
the company has to pay in its future economic periods.
c. Critical Analysis of the Techniques of the Selected Companies and Why a
Technique Deployed is More Useful than Another Method
ADX Energy Limited uses two techniques to report and measure its various assets and
liabilities. The techniques are fair value and carrying value.
i. Fair Value
Although ADX Energy limited has used the two methods to evaluate the worth of its
balance sheet assets and liabilities, fair value is more useful than the carrying value (book value).
Fair value gives the actual selling value of the asset ((Epstein and Jermakowicz 2010, pp. 102).
ii. Carrying Value (Book Value)
Carrying value or book value provides the net value of an asset, less the accumulated
depreciation. The company charges depreciation to the initial cost of the asset in order to arrive
at the net book value or carrying amount.
iii. Critical Analysis of the Two Methods

ADVANCED FINANCIAL ACCOUNTING 10
While the carrying value gives the depreciated value of the company’s fixed assets, the
fair value provides a logical and rational value for the assets (Nobes, Parker and Parker 2008, pp.
72). It offers a solution to valuation difficulties of some balance sheet assets, which are much
difficult to quantify. Therefore, the fair value method is more useful than the carrying value
method as it gives the assets’ actual selling value (Epstein and Jermakowicz 2010, pp. 117).
Conclusion
Financial statements are to give financial information to users to help them make viable
economic decisions. Financial statements must, therefore, present financial information to users
in an understandable and useable manner. ADX Energy Limited has used fair value and carrying
value methods to measure the financial statement element. The two measurement methods
offered decision-useful information to financial statement users. However, the fair value
technique is more useful than the book value since it reports and measures the company’s assets
at their actual value of selling.

ADVANCED FINANCIAL ACCOUNTING 11
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