Mark to Market Accounting Approach and its role in the fall of Enron

This article discusses the Mark to Market Accounting Approach and its role in the fall of Enron. It also explains the role of Special Purpose Entity and Stock Compensation Scheme in Enron's business. The second part of the article evaluates the financial statements of Walmart and reports on the measurement methodologies used by the management of the entity. It also discusses the decision useful information and techniques used by Walmart.

Part A
Mark to Market Accounting Approach and its role in the fall of Enron
The company Enron’s business was established in the year 1985. The business was a result of a
successful merger between Omaha-based InterNorth Inc. and the Houston Natural Gas Co. The
top management of the company Enron had decided to shift the company from the conservative
historical cost accounting method to the mark to market accounting method, popularly known as
the MTM approach. The decision is said to be one of the most significant reasons because of
which the company Enron had failed. An explanation of the same has been provided as follows.
In the year 1992, the senior management of the entity had decided to make the said shift and got
the decision sanctioned from the U.S. Securities and Exchange Commission as well. The entity
had decided to carry out the mark to market accounting approach in the energy trading sector of
its business operations. The approach refers to the measurement of far values that can change
over a time. These fair values are measured for various accounts of the enterprise, majorly the
assets and liabilities. The reason the approach is favoured by the section of experts is that it is
said that the approach best depicts the current and real financial position of a company, in terms
of appraisal in the values. It must be significantly noted that the determination of the fair values
of the components of the balance sheet is a complex procedure (Kim and Zhang, 2016). Thus,
the same aided the management if Enron to manipulate the accounts and the financial statements.
For instance, it must be noted that while the gas was one of the chief commodities in the energy
trading business, the valuation of the same was complex because of the unavailability of the
quoted price, which is necessary for valuation.
Following the mark to market approach, the management of the entity would adjust the fair
values of the energy and other derivative contract related asset or the liability at the end of each

quarters. The outstanding balance of the same was adjusted as the unrealised gains or losses.
These unrealised gains and losses were carried in the income statement for the particular
reporting period. The fact that the determination of fair values was a complex set of procedure
was abused by the management of the company (Li, 2010). This was done with the help of use of
various estimates, assumptions combined with a series of the discretionary models, for the
working out the fair value prices. Thus, the company used the valuation models to overstate the
earnings, in response of the mounting pressure to maintain the earnings by the stakeholders. This
is evident by the fact that in the year 2000, the company’s combined company’s pre-tax profits
of $ 1.41 billion were less than the unrealised gains of the company.
Special Purpose Entity and their role in the Enron business
The chief role of the special purpose entity (SPE) or vehicle is to hold the certain assets off the
balance sheet by the management of the entity, thereby using the same as means of bankruptcy
(Fischer and Marsh, 2017). This is done by the aid of securitization of the assets. The mode of
operations of these entities is limited to acquisition and financing of specific assets, thereby
leading to the hedging of the risks or isolation of the capital. The company Enron would make
use of the SPE by firstly contributing the assets relating to the real estate or energy commodities,
and getting an amount of interest in the exchange (Markham, 2015). These assets are known as
the hard assets. This was followed by large sum of borrowings from the banks and the financial
institutions, and using the said amount to finance the purchase of the further assets and continue
conducting the business. Thus, while the hard assets were put off the balance sheet, the debt was
shown in the financial statements. In the case of the company Enron, the SPE were financed by a
variety of the assets and liabilities which included the restricted stock, derivative financial
instruments, incidental rights to purchase the stock and most importantly to remove the

consistently falling assets from the balance sheet. Thus, the management was successful in
keeping the losses of the balance sheet, and making the financial statements attractive to the
stakeholders of the company (Norwani, Zam and Chek, 2011). As per the reports it is stated that
a thousands of special purpose entities were used by the company for the conduct of its business.
The two main such entities were the LJM Cayman LP and LJM2 Co-Investment LP. Thus, the
management made use of the special purpose vehicles to manipulate the picture of the financial
statements.
Role of the Stock Compensation Scheme
It must be noted that as per the agency theory, the directors and the top management of the
company are entrusted to manage the affairs of the company in the capacity of the agents (Bosse
and Phillips, 2016). Such agent should comply with their responsibilities in the best interest of
the stakeholders and the company. It must be noted that the directors and the top management of
the company Enron had plunged into various set of illegal activities, did not pay the adequate
attention to their responsibilities and thus, barred the agency theory by acting in opposition to the
general interest and benefit of the stakeholders (West, 2018).
In the case of the company Enron, the company had annual options awards which were equal to
the 5 percent of the salaries of the employees. Around 60 percent of the total employees were
said to be benefitted by the said scheme. In addition to the employees, the executives and the top
managers were also stated to be the part of the beneficiaries of the said scheme. The options were
lucrative because of the huge rewards being attached to the same. This is evident by the fact that
while the average strike price of the stock options was about $30 at Enron, the average trading
price in the market for the same options was about $83, by the end of the year 2000. In order to
yield the maximum benefits of the said option and hype the same, the management of the Enron

even manipulate the same, by projecting optimistic but unrealistic profits for the future years.
Thus, the management of the entity overstated the profits and prejudiced the annual stock
options, leading to the abuse of the accounting principles (Deutsch, Keil and Laamanen, 2011).
Hence, while the management influenced the short-term profits through the stock compensation
schemes, there was lack of any long-term value to the stakeholders. Not only a huge conflict of
interest was created among that of stakeholders and personal interest, but the same was abused as
well, in light of the breach and oppression of the agency theory.
Part B
Answer a)
The principles of International FRS conceptual framework state the five elements of the financial
statements to be significant in the case of the listed corporations. These are the Assets,
Liabilities, the Income, the Expense and the Equity. It is significant to note that the different
companies are free to adopt the most suitable accounting principles and the range of the
measurement methodologies. These are done for the appropriate measurement at the end of the
reporting period of the said five elements of the financial statements. The change in the
measurement methods can result in a significant change in the overall picture of the financial
statements of the entity, as described by the case study and analysis of the mark to market
accounting approach of the Enron company. The said significant changes must be clearly
provided in the financial statements, together with the support of evidences that the said changes
are aimed at providing the better picture of the financial statements to the stakeholders. Thus it is
the responsibility of the management of an entity makes a careful choice between the available
methods and policies. Each of the methods must be evaluated on lines of the nature and industry
of the business , together with the applicable compliance requirements.

The company Walmart has been chosen to evaluate the financial statements and report on the
measurement methodologies used by the management of the entity. The company’s shares are
listed on the New York stock exchange, and the company is required to abide by the US GAAP
for the preparation and the presentation of the financial statements.
The company has adopted different set of measurement methodologies different elements of the
financial statements. The company measures the receivables at the carrying amounts. The
carrying amounts are presented after the deduction of the amount for the doubtful accounts, in
the form of the reserve created for the same (Walmart, 2018). The property, plant, and equipment
of Walmart are initially recoded at their respective costs (Walmart, 2018).
In addition to the above, the entity measures it inventory at either the market value or the cost,
whichever is lower of them, as required by the US GAAP. The first-in, first-out ("FIFO") method
for the valuation of inventory is employed in the case of the international segments (Walmart,
2018). The Last in, first-out ("LIFO") method is being used by the management of the entity
Walmart to measure the inventory of US segment. Thus, as stated in the reports, the retail
inventory method of accounting is being followed by the company Walmart. The long lived
assets of the company Walmart are also recorded at the cost. The evaluations for the impairment
loss are done at the end of the reporting period. The impairment loss occurs when the carrying
amount of the long lived assets becomes irrecoverable in the market. Thus, it can be stated that
the potential impairment loss of the company Walmart are valued at the fair value of the asset or
the such group of assets. For the purpose of the valuation of the goodwill, the fair values is
computed by the discounted cash flows method or based on the industry and market practices.
These fair values are then further compared with the purchase price of the net assets, to compute
the excess over the said fair values.

Answer b)
The decision useful information refers to the information that are useful for the various range of
the stakeholders that are the investors, customers, regulators, suppliers and the others. It must be
noted that only the numbers cannot be used to evaluate the real picture of the financial position
of the entity, thus, varied range of the decision useful information must be utilised to support and
aid the research of the financial information. The decision useful information that can yield
various information in various scenarios and when changed are the choice of method of valuation
of the inventory, the choice of the management of the method of the accounting, the choice of
method of depreciation. These are in addition to the other asset valuation models, related party
disclosures and the information gained post the preparation of the financial statements. The same
must be examined while analysing the financial statements.
It must be noted that there have been prescribed two separate techniques for the measurement of
the bond liabilities and the interest expense, respectively in Australia and the USA. These
techniques are called as the effective interest method and straight line method. Therefore while
drawing the comparisons in the financial statements; the evaluators must know the differences in
the above mentioned techniques. While the interest method is permissible to be used in both
IFRS and the GAAP, the straight line method is only permissible under the US GAAP.
For instance, the assets held for sale for the company Walmart are as the ones that meet the
requirements as pronounces by the IFRS framework to be held for sale. Therefore the
stakeholders must first gain the knowledge of the amounts represented by the assets held for sale
of the company. Further, the nature of these elements must be analysed, together with how the
same are measured in balance sheet to gain the bigger picture of the financial statements.

Answer c)
The following segment describe the some of the techniques used by the company Walmart.
The measurement of ROI is done as follows. The figure in the numerator is the sum combined of
the interest income, depreciation, operating income, amount of the amortization, and the rent
received. This is together called as the adjusted operating income. The denominator represents
the sum of the average total assets, in addition to the accumulated depreciation, rent. Further, the
average of payables and the liabilities are deducted from the same. This is referred to as the
average invested capital. Thus, the ROI for the year ended on January 31, 2018 is 14.2 % ($
34,050/ $ 239,974).

References
Bosse, D. A. and Phillips, R. A. (2016) Agency theory and bounded self-interest. Academy of
Management Review, 41(2), pp. 276-297.
Deutsch, Y., Keil, T. and Laamanen, T. (2011) A dual agency view of board compensation: The
joint effects of outside director and CEO stock options on firm risk. Strategic Management
Journal, 32(2), pp. 212-227.
Fischer, M. and Marsh, T. (2017) Special Business Entity Reporting: One Plugged Hole is better
than none. ASBBS Proceedings, 24(1), p. 188.
Kim, J. B. and Zhang, L. (2016) Accounting conservatism and stock price crash risk: Firm‐level
evidence. Contemporary Accounting Research, 33(1), pp. 412-441.
Li, Y. (2010) The case analysis of the scandal of Enron. International Journal of Business and
Management, 5(10).
Markham, J. W. (2015) A financial history of the United States: From Enron-era scandals to the
subprime crisis (2004-2006); From the subprime crisis to the Great Recession (2006-2009).
Oxon: Routledge.
Norwani, N.M., Zam, Z.M. and Chek, I. T. (2011) Corporate governance failure and its impact
on financial reporting within chosen companies. International Journal of Business and Social
Science, 2(21).
Walmart (2018) 2018 Annual Report. [online] Available from:
https://s2.q4cdn.com/056532643/files/doc_financials/2018/annual/WMT-2018_Annual-
Report.pdf [Accessed on 30/01/2019].

West, A. (2018) After virtue and accounting ethics. Journal of Business Ethics, 148 (1), pp. 21-
36.