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

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.