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

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