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

ADVANCED FINANCIAL ACCOUNTING 1
Advanced Financial Accounting
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ADVANCED FINANCIAL ACCOUNTING 2
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