Mark to Market Approach and Special Purpose Entities: Lessons from Enron and Walmart's Financial Statement Measurement Methodologies

This article discusses the mark to market approach and special purpose entities through the Enron scandal and Walmart's financial statement measurement methodologies. It emphasizes the importance of choosing the right measurement methods and accounting policies for assets, liabilities, equity, income, and expenses. The article also explains the concept of decision useful information and the techniques used by Walmart to measure its inventory and ROI.

Advanced financial accounting
30 SEPTEMBER 2018

Part A
Answer to question a)
The mark to market approach was one of the chief reasons of the fall of the company Enron
(Markham, 2015). The mark to market approach refers to the measurement of the various
accounts of assets and liabilities at their fair values, which keep on changing as per the
various industry and market conditions. The users of the fair values advocate the reasons of
better transparency and the realistic approach as compared to the book values, to be used in
the accounting principles. The supporters of the fair value believe realistic current market
value of the assets and liabilities display the actual picture of financial position of the
corporation. However, the determination of the fair value is a complicated process. The
Enron company’s main business was the trading of the energy and related commodities. The
company was formed in the year 1985. The company Houston Natural Gas and Inter North
Inc. had merged their energy business to form the company Enron. The top management of
the company had decided to follow the mark to market (MTM) accounting method, instead of
the traditional method based on the historical cost of the assets. As the fair values are
required to be measured at the end of the each reporting period, the management of the
company would compute the outstanding balance of derivatives contracts and other energy
contracts at fair values. Accordingly, the booking of the gains and losses that were unrealised
at the end of the reporting period were charged to the income statements. As the fair value
measurements are based on a number of assumptions and estimates, the directors of the
corporation overstated the earnings of the entity with the aid of overstatement of the fair
values and booking the profits thereon. As the management was required to determine the
market value of the contracts of the gas, some of which were even 20 years old, the
management failed to examine the vitality and the cost of such contracts. The company had
shown the present values of the contracts entered into with the companies, making estimated
profits of $110 million and $ 0.5 billion of the pilot projects and the energy supplies
respectively; without the consideration of vitality of the contracts.
Answer to question b)
Special purpose entities are the means by which the corporations securitize some of their
assets. These are shell vehicles in real, through which the companies hold their own assets,
without showing them the part of their financial statements. These entities are funded by the
aid of the equity investors and through the means of the debt financing. In order to determine
whether a special purpose entity is independent of a corporation, the autonomous investors

must hold an approximate of 3 percent of the total debt and equity possessed by the special
purpose entities (Fischer and Marsh, 2017). The company had created about hundreds of the
special purpose entities, to primarily display the better financial reporting picture of the
entity. The company had violated the rules of the accounting in order to avoid the debt
component from its financial statements. Thus, while on the one hand the company
understated its liability, it overstated its equity and earnings on the other, posing a rosy
picture to the stakeholders. The company Enron had capitalised the special purpose entities it
had created with a number of the assets that were on a consistent fall in the prices, to avoid
the losses in the statement of financial positions at the end of the reporting periods. The
restatement of the accounts in order to correct the acts resulted in the increment in the
liabilities by $628 million and decrement of the earnings by $613 million.
Answer to question c)
According to the application of the agency theory to the corporations, the directors and the
top management of the entity are regarded as the agents, who are required to work and
manage the affairs of the entity in the best interests of the stakeholders. The agency theory is
regarded to be violated when the agents do not act according to the interest of the
corporation, rather put their individuals interest ahead. The top management compensation
also played a significant role in the fall of the entity. The compensation scheme can be linked
to the influencing of the prices of the stocks in the market, by the projections of the optimistic
profits and the growth objectives to the stakeholders in the market. The management of the
Enron used to enjoy a very high compensation, especially that at the executive level. While
the management of the entity used the technique of influencing the short-term profits through
the stock compensation schemes, the same failed to realise any long-term value to the
stakeholders (Kim and Zhang, 2016).
In addition to influencing the stock, the management of the entity also did not pay attention to
its compliance and regulatory responsibilities in terms of the fair trade practices and
transparent accounting policies. This resulted into entity venturing into illegal activities and
irresponsible reporting, keeping the stakeholders away from the real picture of the
corporation’s financial position. Thus, as per the discussions conducted above, it can be
stated that the top management if the entity violated the principles of the agency theory. This
was done by creation of special purpose entities, overstating the profits by the use of the mark
to market accounting approach and providing the huge compensations to the directors and
managers at the top level and executive positions.

Part B
The five main elements of the financial statements of the listed companies as prescribed by
the International Financial Reporting Standards conceptual framework are the Assets,
Liabilities, Equity, Income, and the Expense. The top management if the entities are entrusted
with the responsibility of choosing the measurement methods and the accounting principles
as suited for the entity, out of all the available approaches. It is significant to note that while
one measurement method or accounting policy may depict the results in a certain manner, the
amounts and the nature of reporting as per the other accounting principles and the
measurement methods may be different. Thus, management must carefully make the choice
between the available methods and policies, in lines of the compliance requirements and the
nature and industry of the business. The company chosen to conduct the research on the
financial statements and report on the measurement methodologies is Walmart. The same has
been listed on the New York stock exchange.
Answer to question a)
The various measurement methodologies adopted by the company for different elements of
the financial statements have been explained as follows.
The receivables of the entity are measured at the carrying values of the same and the same are
netted with the amount of the reserve created for the doubtful accounts (Walmart, 2018).
The inventory of the entity is measured at either the cost, or the market value, whichever is
lower of them. The measurement of the cost of the inventory of US segment of the Walmart
is done using the Last in, first-out ("LIFO") method. The inventory of the international
segments is valued at the first-in, first-out ("FIFO") method. Thus, the company follows the
retail inventory method of accounting (Walmart, 2018).
The property, plant, and equipment of Walmart are initially recoded at the costs (Walmart,
2018).
The long lived assets are also recorded at the cost, and the same are evaluated on the lines of
the impairment loss, if any. The impairment loss is stated to be occurred when the carrying
amount of the assets may not be recoverable in the market. Hence, the entity Walmart
measures the potential impairment loss at the fair value of the related asset or the group of
such assets.

Goodwill of the corporation is measured computing the excess of the purchase price of the
net assets, over their fair values in the market. The fair values is further determined by
computation of the discounted cash flows and the other approaches on the basis of the
industry and market practices.
Answer to question b)
The decision useful information is the information that aids an investor, regulator, or the
other stakeholders of the concerned entity, to make the decisions about the financial viability
of the enterprise. The evaluation of the financial statements cannot be alone done by the
numerical figures stated therein. The stakeholder can gain a decision useful information by
looking at the various incidental factors to the numerical figures stated in the financial
statements. Some of the examples are such as the choice of the method of the accounting, the
choice of method of depreciation, the choice of inventory and other asset valuation,
information post the preparation of the financials, related party disclosures and much more.
Thus, the same should not be overlooked while assessing the financial statements.
For instance, the entity regards the assets held for sale as the ones that meet the requirements
as pronounces by the IFRS framework to be held for sale (Walmart, 2018). The entity
presents the same as the single amount of the asset or the liability with a respective amount
for the valuation allowance. The net carrying amounts are measured at the fair value or the
cost, whichever is lower. Further, the amount of the sales, if any is deducted thereon. In order
to represent the true values of the assets held for the sale, the yearly review is conducted to
assess the vitality of the recoverable amounts of the carrying values in respect to the sales.
The company further stated that it has included the immaterial amounts of the assets and
liabilities held for sale, as part of the prepaid expenses and other and accrued liabilities, while
making disclosures in the Consolidated Balance Sheets for the year ended on January 31,
2018 and 2017 (Walmart, 2018).
Thus, in order to first understand the amounts represented by the assets held for sale of the
entity, the stakeholders must first understand the nature of these elements, together with how
the same are measured in balance sheet, and if the impairment is charged, on what basis the
same has been charged.
Answer to question c)
Some of the techniques used by the corporation have been stated as follows.

Firstly, the company measures the inventory using the retail inventory method of accounting
(Walmart, 2018). This enables the valuation of the inventory at the lower of the costs of the
market value. The technique of the retail inventory method of accounting is best suited for the
company, because of the kind of industry it is part of. In addition, it record the permanent
markdowns in the value of the inventory immediately, together with the reduction of the
retail value of inventory in the market.
Another technique that has been used by the company is for the measurement of the ROI.
While the numerator includes the sum of the operating income, interest income, depreciation
and amortization, together with the rent received. The denominator includes the sum of the
average total assets, the sum of accumulated depreciation, rent, and the average of liabilities
and payables are deducted thereon. The numerator figure is referred to as the adjusted
operating income, and the denominator figure is referred to as the average invested capital.
Thus, the ROI as per the stated techniques for the company is shown as follows.
For the year ended on January 31, 2018:
Adjusted operating income = $ 34,050 (in millions)
Average invested capital = $ 239,974 (in millions)
Thus, the ROI amounts to 14.2 %
In order to compare the ROI of a different firm, with that of the Walmart Inc., the stakeholder
must first compare the method and respective items included.
Hence, it can be said that different entities adopt different techniques for various components
of the financial statements. Stakeholders’ must carefully assess the same to judge the
information stated in the figurative terms.

References
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), p. 37.
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.
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 30/09/2018].