HA 3011: Advanced Financial Accounting - Enron Case Report

This report delves into the financial accounting practices of Enron, examining the company's use of mark-to-market accounting, Special Purpose Entities (SPEs), and stock options. It begins by defining and explaining the mark-to-market approach, providing examples of how Enron's management potentially misused this method to misrepresent the company's financial performance. The report then explores the role of Special Purpose Entities (SPEs) and how Enron employed them to fund contracts and achieve specific financial reporting objectives. Furthermore, it investigates the rationale behind Enron's stock option compensation scheme for top management, analyzing it through the lens of agency theory. The study also includes examples of measurement methodologies from annual reports and elements measured for beneficial decision making. Finally, it analyzes techniques employed by the company through critical analysis and draws conclusions about the impact of these practices on the company's downfall. The report is based on the provided assignment brief, which focuses on understanding Enron's accounting irregularities and their implications.

Running head: ADVANCED FINANCIAL ACCOUNTING
Advanced Financial Accounting
Name of the Student
Name of the University
Authors Note
Course ID
Table of Content

1ADVANCED FINANCIAL ACCOUNTING
s
Introduction................................................................................................................................2
Assessment Task Part A.............................................................................................................2
a) Mark to Market accounting................................................................................................2
Defining SPE and use by the management of Enron to achieve financial reporting
objectives................................................................................................................................3
c) Rationale for stock options compensation scheme............................................................4
Assessment Task Part B.............................................................................................................5
a) Examples of measurement methodologies from the annual report....................................5
b) Elements measured and beneficial decision making.........................................................6
c) Determining the techniques employed by company through a critical analysis................6
Conclusion..................................................................................................................................7
References..................................................................................................................................8

2ADVANCED FINANCIAL ACCOUNTING
Introduction
Enron founded by Kenneth Lay in 1985 was a result of merger of two natural gas
pipeline companies Houston Natural Gas and Internorth. There had been several changes in
regulation for natural gas market in the mid-1980s. This led to deregulation of prices and
allow the arrangements among producers and pipelines thereby increasing the use of is what
market transaction. By 1990s, more than 75% of the gas sales were identified at spot prices
rather than result of long-term contracts. During the 1990s it was evident that Enron’s stock
increased to 311% which is only modestly higher than the growth stated in S&P 500.
However, the stock even increased to 56% in 1999 and 87% in 2000. This is depicted with an
increase of 20% and 10% decrease of index in the same year (Rose & Biles, 2017).
The present study will evaluate the strategies which were incorporated by Enron
pertaining to misleading financial reporting objectives. In addition to this, it could also
consider several measurement methodologies from other company’s financial statements and
referr the same with Enron to critically analyse the rationale for techniques which were
incorporated.
Assessment Task Part A
a) Mark to Market accounting
The concept of MTM relates to the measurement of fair value which can go through
several changes in a particular timeline due to assets and liabilities. This concept is often
implemented in the accounting practice for recording the present value of an asset as per the
current levels of market. For instance, companies associated to financial services industry
may consider making several adjustments in accounting for the assets pertaining to the events
in which there may be defaulters of loan. Therefore, at the time of assessment of financial
statement, the bank film marks such assets as bad debt and at the same time mark down the

3ADVANCED FINANCIAL ACCOUNTING
fair value associated with them. Similarly, a company offering discounts to its customers will
also mark its current assets account to a significantly lower value for fastening of the process
of collecting Accounts Receivable (Nguyen, 2016).
The accounting process for natural gas business in Enron had been fairly reliable in
each financial year and the company was recognised to list its actual cost incurred and
revenue generated from supplying the gas. However, the application of MTM accounting was
particularly evident in the trading business of the company. This meant that at the time of
signing long-term contract the PV of the future cash flows needed to be recognised as
revenues along with expensing the cost of fulfilling the contract. The main challenge faced in
terms of MTM was depicted with estimating the market value of the contracts. This led to
estimation of income as PV of net future cash flows even though there was a serious question
on viability of contracts and the costs associated with the same (Sullivan, 2017).
Defining SPE and use by the management of Enron to achieve financial reporting
objectives
SPEs are often identified as “bankruptcy-remote entity” which is used by a parent
company for securitising or isolating the assets and portray the same in their off-balance-
sheet exposures. These are often stated as “bankruptcy remote entity” and “variable interest
entities”. This is due to the fact that the operations are restricted to acquisition and financing
of certain assets as per the method of isolation of risk. In general, companies may form the
SPV/SPEs by the means of limited partnerships, corporations and trusts from other entities.
Additionally, these may be designed for the independent ownership, management and
protection of project from operational or insolvency issues (Edel Lemus, 2014).
Enron used such entities for funding its perils concerned with certain assets. Enron
mainly took support of SPE in financing the acquisition for the gas reserves pertaining to the

4ADVANCED FINANCIAL ACCOUNTING
producers. As a result of this the investors in the SPE received a certain revenue for sale of
the reserves. Enron engaged in designing several controversial SPE for achieving financial
reporting objectives. For instance, in 1997 the company tried to buy out a certain percentage
of partners stake in one of the many JVs (Betta, 2016). However, in the process of this
acquisition it did not wanted to portray any debt in their balance sheet due to financing of the
JV. It used Chewco as its main SPE raised the debt which was confirmed by Enron after
investment of $ 383m in the JV. The structuring of transaction was done in such a way that
Enron didn’t have to consolidate the SPE or the JV in their financial statement thereby
allowing it to effectively acquired the partnership interest without the need of recognising any
additional liability in the balance sheet (Edel Lemus & Orta, 2015).
c) Rationale for stock options compensation scheme
It is discerned that agency theory and enumerates the Association of principles and
agents in a business. This theory is mainly identified with resolution of the problems which
may exist in the relationship of agency with an alignment of the goals. This theory for the
addresses the issues pertaining to desires and goals between the principal and agent.
To be seen that the main reliance of Enron was depicted with its reliance on stock
options. Therefore, the high usage of search tools was concerned with short-term stock price
evaluation focused with management expectations and growth factors at Enron. Moreover,
the application of agency theory was concerned with the main intention of company for
aligning the welfare is of the agents and principles. In this case, the agents are the
management of Enron and principles are the shareholders. Despite of this, in a number of
programs suffered from problems associated to short-term accounting performance.
Additionally, the experience of Enron pertaining to other firms they’re concerned with
several issues, such as including the possibility for stock compensation program to motivate

5ADVANCED FINANCIAL ACCOUNTING
executives and stimulate the short-term stock performance and enhancing the long-term value
(Connell, 2017).
Assessment Task Part B
a) Examples of measurement methodologies from the annual report
The new accounting pronouncements published by the company in 1998 very seen to
be in accordance with “Statement of Financial Accounting Standards (SFAS)” in terms of
recording derivative instruments and hedging activities in the balance sheet in form of either
a liability or asset. This is required for fair value measurement for qualifying to the hedges.
Enron was depicted to adopt SFAS number 113 for recognition of its ATNL worth $ 5m (Wu
& Olson, 2015). There are several evaluations of measures in terms of managing the
marketing risk pertaining to investments on a daily basis. The process of quantifying the
market risk is used with consistently measuring the risk pertaining to diverse markets and
products. The notable amounts for accurately measuring the risk of exposure of Enron’s is
further depicted with credit risks (Reiche et al., 2016).
The US companies such as Broadcom Inc is identified with the preparation of
financial statements by using GAAP framework which is similar to the application of SFAS
113. However, Broadcom Inc has estimated their assumptions based on current facts and
there is no historical experience of other factors which are hampering the decision-making of
the organisation. Moreover, the estimates pertaining to revenue recognition is based on
revenue from the sales for the products to distributors based on delivery. Moreover, there is
an alliance for distributor credit which is seen to cover the price adjustments pertaining to the
estimates of historical experience rates and economic conditions as per contractual terms. Till
date, the company’s actual claims form a trilogy concerned and historical estimates is seen to

6ADVANCED FINANCIAL ACCOUNTING
be significantly based on the differences between the actual amounts and the estimates.
Moreover, the recording of reductions pertaining to revenue and rebate is also recorded in the
same financial period (Tansey, Neal & Carroll, 2018).
b) Elements measured and beneficial decision making
The measurement factors can be immediately considered with identifying the
shareholders’ value associated with offering of services pertaining to contract value and
providing other services. Moreover, the company is also involved in measuring of diagnostic
measurements which has been beneficial for real-time monitoring of unusual changes in the
demand (Micklethwait & Dimond, 2017). It is also addressed to several problems prior to
running out of energy costs. The measurement of network control is identified with
broadband operating system which is based on Enron BOS measure pertaining to real-time
monitoring of each layer of network and ensuring that service and quality is delivered on
time. The measurement of scalability component is implemented with “The Enron
Intelligent Network (EIN)” which is identified with an extensive reach across the United
States thereby connecting both Europe and Asia. The application of “SFAS No. 137” and
“SFAS No. 138” had proved to be substantially useful in determining the use of derivative
instrument on its liability measurements (Yu, Xin, Chen & Kim, 2018).
c) Determining the techniques employed by company through a critical analysis
The trading business of Enron were often based on complex business models
associated with long-term contracts. The application of current accounting procedures with
the use of PV framework was evident in regarding the transactions related to future earnings.
The main techniques applied by the company can be identified with MTM approach which
was central to its recognition of income and forecast of energy prices along with interest rates
in the future. Secondly, there was an extensive reliance on financial transactions which
considered of the using SPE. Such transactions included the shared ownership for certain

7ADVANCED FINANCIAL ACCOUNTING
cash flows which went outside the domain of lenders and investors (Saleuddin, 2016).
Therefore, the traditional accounting implemented by the company often involve several
arm’s-length transactions among the independent entities suffering from several issues in the
transactions. The accounting rule makers at Enron are also debated for using inappropriate
accounting tools for several years. On the other hand, the company use mechanical
conventions to record the transaction which resulted in a divergence among the accounting
numbers and economic reality (Khdir, 2016).
Conclusion
The discourse of the study has identified that accounting process for natural gas
business in Enron had been fairly reliable in the initial years. However, as the business
progressed, the company used several malpractices such as MTM approach. MTM was
depicted with estimating the market value of the contracts. This led to estimation of income
as PV of net future cash flows even though there was a serious question on viability of
contracts and the costs associated with the same. Enron used SPE to mitigate the risk
associated with certain assets. Enron mainly took support of SPE in financing the acquisition
for the gas reserves pertaining to the producers. It used Chewco as its main SPE raised the
debt which was confirmed by Enron after investment of $ 383m in the JV. However, it was
later revealed that the company violated the accounting standards which required at least 3%
of the assets to be returned in ownership of the equity investors. Moreover, the investors we
are unaware of the fact that Enron was using its own financial guarantees and stocks to carry
out the process of hedging. So, there was no real protection provided by Enron to its
shareholders.

8ADVANCED FINANCIAL ACCOUNTING
References
Betta, M. (2016). Three Case Studies: Australian HIH, American Enron, and Global Lehman
Brothers. In Ethicmentality-Ethics in Capitalist Economy, Business, and Society (pp.
79-97). Springer, Dordrecht.
Connell, M. (2017). The Fall of Enron and the Creation of the Sarbanes-Oxley Act of 2002.
Edel Lemus, M. I. B. A. (2014). The Financial Collapse of the Enron Corporation and its
Impact in the United States Capital Market. Global Journal of Management And
Business Research.
Edel Lemus, M. I. B. A., & Orta, M. A. (2015). The Unprecedented Business Ethical
Dilemma in the World Financial Markets. Global Journal of Management And
Business Research.
Khdir, S. H. (2016). Contemporary Financial Crimes of Employee Embezzlement and Insider
Trading. International Journal of Social Sciences & Educational Studies, 140.
Micklethwait, A., & Dimond, P. (2017). Enron: Launch to Boom and Bust, 1985–2001.
In Driven to the Brink (pp. 15-38). Palgrave Macmillan, London.
Nguyen, T. N. (2016). Insights from Science into Business and Economics: Roadmap to a
Fiasco Prevention Theory.
Reiche, B. S., Stahl, G. K., Mendenhall, M. E., & Oddou, G. R. (Eds.). (2016). Readings and
cases in international human resource management. Taylor & Francis.
Rose, M. H., & Biles, R. (2017). The President and American Capitalism Since 1945.
University Press of Florida.

9ADVANCED FINANCIAL ACCOUNTING
Saleuddin, R. (2016). Should credit risks be marked to market in crisis? Re-examining
subprime securities ‘irrationality’2008-2010.
Sullivan, C. (2017). OIL INDUSTRY FRAUD: BLACK GOLD FLOWING INTO THE
WRONG PIPELINES. Journal of Business and Accounting, 10(1), 111-117.
Tansey, R., Neal, M., & Carroll, R. (2018). Patent Aggression: High Risk Intellectual
Property Strategies in the Semiconductor Industries.
Wu, D. D., & Olson, D. L. (2015). Financial risk management. In Enterprise Risk
Management in Finance (pp. 15-22). Palgrave Macmillan, London.
Yu, X., Xin, X., Chen, L., & Kim, H. S. (2018). Predicting Market Reactions to Bad News.