HA 3011 Advanced Financial Accounting: Enron Case Study Analysis

This report provides a comprehensive analysis of the Enron case study, focusing on the accounting practices that led to its downfall. It examines the use of mark-to-market accounting, special purpose entities, and stock option compensation schemes, highlighting how these methods were misused to misrepresent the company's financial performance. The analysis also contrasts US GAAP and IFRS in measuring financial statement elements, using Apple Inc. and Woolworth as examples. The report concludes that fraudulent accounting practices and a lack of effective corporate governance were the primary causes of Enron's collapse, emphasizing the importance of ethical financial reporting and stakeholder protection. The document is a valuable resource for students studying advanced financial accounting, offering insights into real-world applications and ethical considerations.

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Assessment Part A

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Executive Summary
The report carried out an evaluation of the case stud related to corporate failure of Enron.
It has been identified through the evaluation of the report that the accounting practice of mark-
to-market accounting has facilitated the top managers to overstate its profitability position by
recognizing unrealized gains within its income sheet. Also, the special purpose entities were
created specifically for hiding the debt liabilities and thus disclosing manipulated financial
information to the end-users. In addition to this, the use of employee stock options scheme has
caused the motivation to managers to improve firm performance as stated by the agency theory.

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Contents
Executive Summary.........................................................................................................................2
Introduction......................................................................................................................................4
Case Study Analysis........................................................................................................................4
Conclusion.......................................................................................................................................5
References........................................................................................................................................6

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Introduction
This report has carried out an evaluation of the given case study of ‘the Fall of Enron’.
This has been done to highlight the major accounting issues that lead to the downfall of
corporation. I this context, the report has examined the contribution of accounting methods such
as mark-to-market, special purpose entities and the stock options compensation scheme to cause
the occurrence of unethical accounting practices within the corporation.
Case Study Analysis
A) Mark-to-Market (MTM) accounting can be regarded as the method of conducting valuation of
an asset on the basis of its present market prices. It is also known as fair value method of
accounting and it is introduced for providing a realistic value of an entity on the basis of recent
market conditions. Enron, an American energy company established in the year 1985 and
collapsed in the year 2007 has adopted the use of practice of mark-to-market (MTM) approach
for depicted false information about its profitability position to the end-users. The company
recognizes income of its long-term contracts involved in its trading business with the use of the
approach of MTM (Jennings, 2014). As such, management is required to make forecasts of
future prices of energy commodities and recognizes the income on the basis of future cash flows
to be realized by its long-term contracts that are as long as for 20 years. Thus, the unrealized
gains recognized in the income statement in the case of contracts that are not viable in the future
context resulted in overstatement of its profit position. Thus, the use of such approach of
accounting enabled the company to misinterpret the financial information and presenting a rosy
picture of its performance (Healy & Palepu, 2003).
(b) A special purpose entity is known to be a financial vehicle that is developed by its parent
entity in order to achieve some of its desired objectives. Such entities need to have a legal
existence and also 3 per cent of stake by an independent third-party owners consist of its overall
equity and debt. The meeting of this condition is essential for such entities to have an
independent existence from the owner and thus not consolidating its financial results with that f
its parent entity. It can be analyzed from the case of Enron that it has used such entities to
misrepresent its financial information (Ryder, 2014). The company has created many special

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purpose entities for funding its long-term contracts. Enron has however incorporated their use for
achieving its determined objective of stating higher profits in its financial statements. The
company used its special purpose entities for concealing its debt liabilities arising from its many
joint ventures. It did not consolidate its main financial reports with that of the special purpose
entities and thus facilitating it to acquire the partnership without recognition of any additional
debt. Enron has violated the accounting standards of creating a special purpose entity as these
entities developed by the company does not have stake of 3 per cent of assets owned by
independent equity investors. Thus, it can be said that Enron adopts the use of special purpose
entities in an illegal way for manipulating the general users about its financial information
(Healy & Palepu, 2003).
(c)Agency theory has described the relation present between the business owners and the
managers on the basis of principal-agent relation. As per the theory, agents are the business
managers who act for the sake of maximizing profits for the owners that are the shareholders.
The theory has stated that principal tend to reduce the agency costs by aligning their goals with
those of the agents by developing common goals and objectives. The business owners are
adopting the use of stock options compensation scheme to provide additional incentives to them
on the basis of the firm performance (Stephen, 2006). This helps them to achieve a consensus
between the goals of managers and the owners of maximizing the business profitability.
However, the use of such compensation scheme can often motivate managers to adopt the use of
unethical means for achieving the stated goals as that happened in the case of Enron. The
prevalence of unethical business practices within the company is largely attributed to the
presence of high compensation that managers receive on the basis of the performance of stocks.
This has often motivated them to adopt the fraudulent accounting practices for reporting higher
business profits and thus maximizing their compensation achieved. Thus, business managers
have ignored the interest of the stakeholders and has only emphasized on creating value for the
shareholders that in turn directs their one welfare (Healy & Palepu, 2003).
Conclusion
The case study analysis of Enron has revealed that the main reason for its collapse is due
to the use of fraudulent accounting practices for deliberately higher financial performance for

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driving company’s growth. As such, it can be said that the company lacks effective corporate
governance practices for identifying and reporting these frauds in advance and protecting the
interest of the stakeholders.
References
Healy, P.M. & Palepu, K.G. (2003). The fall of Enron. Journal of Economic Perspectives 17(2),
pp. 3-26.
Jennings, M.M. (2014). Business Ethics: Case Studies and Selected Readings. Cengage
Learning.
Ryder, N. (2014). The Financial Crisis and White Collar Crime: The Perfect Storm. Edward
Elgar Publishing.
Stephen, J. (2006). Changing Ethical Attitudes: The Case of the Enron and ImClone Scandals.
Social Science Quarterly 87 (2), pp.395-410.

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Assessment Task B:
The purpose of this assessment task is to analysis the different methods under US GAAP
and IFRS to measure the value of five elements of the financial statements. The five elements of
the financial statements are income, expenses, assets, liabilities and equity. In order to better
understand the different methods of measurement under IFRS and US GAAP, it has been
decided to take one listed company that applies US GAAP and other company that applies IFRS.
For this purpose, Apple Inc. has been selected that applies US GAAP and Woolworth has been
selected that applies IFRS as their basis of preparation of financial statements.
Income: There is difference in measurement method of income under US GAAP and IFRS.
From the annual report of Woolworth it has been found that income is measured as fair amount
received and receivable under IFRS (Annual Report: Woolworth, 2017). From the annual report
of Apple Inc. it has been found that income is measured through the exchange value assets or
liabilities implied in the transaction under US GAAP (Annual Report: Apple Inc, 2017). In my
opinion the method given under US GAAP provides more meaningful information as compared
method described under IFRS. As per the method used in the US GAAP, there separate method
for specific transaction that gives more meaningful estimation of income. Among the two
methods of income measurement, exchange value method is practical and provides decision
usefulness information. The main reason of this difference is that fair value method has no
practical capability in certain specific transactions (PriceWaterCoppers, 2017).
Expenses: On the basis of differences of treatment of expenses by both the companies it has
been found that Apple applies fair value accounting approach (Annual Report: Apple Inc, 2017)
and Woolworth applies variable accounting approach to measure the value of transactions of
cash with employees (Annual Report: Woolworth, 2017). Both the method provides decision
useful information but when it comes to practical application, fair value accounting seems to
provide more decision useful information as compared to variable accounting approach. Fair
value method allows re-measuring the value of expenses at end of period which is better
estimation in case of any expenses that will arises in future period (PriceWaterCoppers, 2017).
Assets: There are no such differences in measuring the value of assets but the value of
investment in instruments (Equity) is measured differently under both the methods. Under US

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GAAP these assets are measured at cost price less any impairment value (Annual Report: Apple
Inc, 2017) but in IFRS there is no concept to consider the impairment (Annual Report:
Woolworth, 2017). As it is important to consider the recoverable value of assets while measuring
it, that signifies that method cost less any impairment must be valid and provides decision useful
information (PriceWaterCoppers, 2017).
Liabilities: There are very few differences in measuring the value of liabilities under both US
GAAP and IFRS. It has been found that there is difference in method to measure the value of
convertible debt. Under US GAAP convertible debt are measured through using the debt method
where total value of debt is recognised as long term liabilities and no equity part of separated
from that (Annual Report: Apple Inc, 2017). On the other under IFRS, convertible debt is
measured through using the split accounting method (Annual Report: Woolworth, 2017). Split
accounting method allows differentiating the value of debt and equity from the convertible debt
and disclosing them separately. So it can be said that split method of measuring the value of
convertible debt is more sensible and provides meaningful information as compared to debt
method (PriceWaterCoppers, 2017).
Equity: Under both US GAAP and IFRS effective interest method is used to value the equity
(Annual Report: Woolworth, 2017). So there is no difference in method to measure the value of
different equity instruments (Annual Report: Apple Inc, 2017). It can be said that effective
interest method is useful in measuring the value of equity as it consider effect time value of
money while measuring the value (PriceWaterCoppers, 2017).

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References
Annual Report: Apple Inc. (2017). Retrieved October 6, 2018 from
http://www.annualreports.com/HostedData/AnnualReports/PDF/NASDAQ_AAPL_2017.
pdf
Annual Report: Woolworth. (2017). Retrieved October 6, 2018 from
https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf
PriceWaterCoppers. (2017). IFRS and US GAAP: similarities and differences. Retrieved
October 6, 2018 from https://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-
guides/pwc-ifrs-us-gaap-similarities-and-differences-2017.pdf