Advanced Financial Accounting: Analysis of Enron's Financial Practices

This case study provides an in-depth analysis of Enron's advanced financial accounting practices, focusing on the mark-to-market accounting method, the use of special purpose entities (SPEs), and stock option compensation for top management. The analysis explains how Enron exploited accounting regulation gaps by recognizing projected revenues as actual revenues and using SPEs to hide debt. The case study also discusses the implications of using the fair value method versus the historical cost method for measuring financial elements, and how Enron's choices impacted decision usefulness for investors. Furthermore, it contrasts the effective interest method and the straight-line method for amortizing bond liabilities, highlighting their differences and similarities. This document is available on Desklib, a platform offering a variety of study tools and resources for students.

ADVANCED FINANCIAL ACCOUNTING
ADVANCED FINANCIAL ACCOUNTING
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ADVANCED FINANCIAL ACCOUNTING
PART A
(a)
Mark to Market is an accounting approach method that seeks to value assets and liabilities
‘Fair Values’ at the current market level. It shows what a particular company would receive if
they chose to dispose of their assets at that particular time as referenced by Healy, P.M. and
Palepu, K .G (2003.Pg 27.) Enron in his primary oil business, the accounting system was
followed to the core with streams of revenue and expenses being recorded were.
Enron changed this system and adopted the mark to market accounting method once he
managed to sign an agreement whose lapse time is long. The current value of all inflows from
the contract was treated as revenues while the cost of servicing these contracts was treated as
expenses Armstrong, C.S. and Vashishtha, R(2012.Pg. 79.) A good example depicting this; In
July 2000 Enron managed to sign a 20year contract with Blockbuster Video to introduce
entertainment for a charge in various U.S cities under the global broadband network. Enron
continued to recognize the estimated revenue of $110 million dollars from the Blockbuster Video
even before earning the actual revenue.
Another example which shows how Enron used Mark to Market accounting approach is
when Enron signed a business term agreement of dollars-worth one point three billion for the
electricity deal supply of 15 to Eli Lily Indianapolis Company. Enron’s company reported
estimated revenue streams projection of up to $500 billion dollars. Enron went ahead and quoted
the most current cost value that meant to service the contracts as expenses. While still doing this,
Indiana had not yet deregulated electricity.
Therefore Enron had to estimate the time frame in which the deregulation would happen,
to determine the costs of servicing the contracts. These two activities portrayed a picture that the

ADVANCED FINANCIAL ACCOUNTING
company was profitable by recognizing revenue projections as revenue and projected cost as
expenses while in the real sense very little money had been earned.
Due the accounting regulation gaps that existed during this period Enron as the owner the
group of companies took advantage of this shortcoming in regulations.The top management
when reporting their financial statements at the end of the period, reported current assets based
on their fair value. Mark to Market theory was clearly depicted or shown through how they made
their final accounting entries of recording current asset at fair value, in their final books when
reporting at the end of the period. Out of this Enron’s management had to predict potential
revenue stream that the company would earn in the future without being certain that they would
earn the money Caiden (2002.Pg .327.) This showed that the company was doing great
financially in the eyes of the shareholders one being Enron and the shareholder buying stocks at
the New York stocks Exchange.
(b)
A special purpose entity is a company that is established to fulfill a specific and well-
defined objective. The aim is to isolate the parent company from any financial risk. The
company can buy and maintain assets independently away from the parent company’s balance
sheet. The Special purpose entity with its asset or liabilities makes its structures secure even if
the parent company becomes bankrupt or collapses.
Enron used these individual purpose entities with the aim of funding contracts and with the
primary goal of achieving financial reporting objectives Healy and Palepu (2003.Pg 7). This is
clearly shown in 2001 Enron had hundreds of individual purpose entities that were used in the

ADVANCED FINANCIAL ACCOUNTING
purchasing of the forward contract with gas companies to supplies gas to facilities that had
indeed signed long period agreements of service Thiemann (2012.Pg 45).
Although the main agenda of these individual purpose entities were to facilitate
achievement of financial reporting objective. This is clearly shown when Enron showed interest
of buying share portion in most of its investment on the financial position, hence the interest
made Enron fail to disclose any debt that resulted from the take-over of the ventures in the
financial position of that year.
Enron had unique and identified concept which is known as Chewco which had been
managed by the Enron leadership that indeed saw to it that assured debt issued on behalf of
Enron had been managed. This facilitated the acquisition investment interest stake of dollars’
worth three hundred and eighty three million dollars Demere, P., Donohoe, M.P. and Lisowsky,
P (2017.Pg 24). This acquisition was designed and bookwork managed in a manner that ensured
that Enron financial books of accounts are separate for Checo vs. the Joint Venture. This enabled
Enron to acquire partnership interest without reporting any debt in the company’s financials.
As stated earlier due to the lack of strict guidelines or regulations on financial reporting at
the time, Enron used this fault to his full advantage as very little information was available as far
as his special purpose entities were concerned in terms of book keeping. Enron took the
advantage of the company’s investor and shareholder by falsely giving them the wrong
information that he had diverted any risk that may arise on the companies non cash assets by
having the special purpose entities. Enron was diverting this risk by using the company’s
financial guarantees and stock and while doing this ensuring that the investor was kept in the
dark. This made the investors have confidence that Enron’s company assets were risk averse;
however this was contrary to their conclusions.

ADVANCED FINANCIAL ACCOUNTING
(c)
Many companies choose to compensate their top management with stock options. This
involves giving the senior managers options to buy the company’s shares at a predetermined
price for a certain period. The main aim for this is to align the goals of the shareholders and those
of the executives Atchinson (2005.Pg .12.) The shareholder's primary goal is to see that the stock
prices increase and by awarding the executive with stocks incentives them to work with the goal
of improving the stock price.
This becomes a ‘win-win’ situation for both the shareholder and the executive. Enron’s
management was heavily compensated using the stock options. The main aim for this was to
create a short-term stock price increase with the control creating the expectation of rapid growth
to meet Wall Street expectations. Enron aimed to motivate his top management to make the
sensible decision that would create shorter stick performance as the majority shareholder Liu, L.,
Liu, H. and Yin, J (2014.Pg 668). But in the real sense, this would not create medium or long-
term value in the long run.
Part B
One example of measurement methodology is the historical cost of measuring a
company’s financial elements of listed companies according to GAAP guidelines. Historical cost
is a measure of value that is used in accounting, where the price of an asset in the balance sheet
is recognized based on its original cost when it was acquired by the company. This principle is
mainly used in the United States of America Liang, L. and Riedl, E.J (2013.Pg 1167). The rule
provides that all assets are to be recorded in the balance sheet based on their historical cost

ADVANCED FINANCIAL ACCOUNTING
despite the significant change in value over-time. For example, the Vodafone group company
form Europe used this method to measure their financial elements because the regulation is
clearly stated under GAAP to get listed under the New York stock exchange.
The next method is the fair value method. This is the sale price agreed upon by a willing
buyer or seller assuming that both parties agree to buy and sell freely and with full information.
Fair value also represents a company’s profit for assets and liabilities when subsidiary company
financial statements are consolidated with those of the parent company.
In the balance sheet, these two measurement concepts are used against each other in the
measurement of financial elements.Historical cost used in the size of assets and liabilities at
purchase price cost incurred during purchase and the fair value based on the market prices. In
Enron financial report 2000, he took advantage of the accounting limitations in managing his
financial books that is the company’s income statement and the balance sheet.
The use of fair value system to record transactions being that all current accounts were based on
their fair value Nobes (2013.Pg 98.)
(b)
Decision usefulness is a financial reporting approach that emphasizes the theory of investor
decision making. This is mainly to provide the conclusion on the nature type of information that
the investor requires. It is a take that is exercised to meet the sole needs of the financial
information or reports for example investors, creditors and other stakeholders to the firm. In
Enron financial report in 2000.
The management of his group of companies used the fair value method to measure
economic elements this is also known as the Mark to Market approach. In using this system once
the Enron secured an agreement whose terms were long with appended signatures with the

ADVANCED FINANCIAL ACCOUNTING
current value of all earning or inflows of cash within the agreed terms of doing business which
were actualized as revenue Ettredge, M.L., Xu, Y. and Yi, H.S(2014.Pg 48.)While all the cost
that were to be incurred in servicing the contract were treated as expenses. This led to the
management to make decisions based on the measuring method used in reporting. The
Management opted forecast for future earnings since they recognized revenue way before it was
even earned.
(c)
The company selected the fair value method to measure their financial elements. Current
assets and liabilities were recorded using fair value because they reflected the current value as
compared to their historical cost Millman (2002.Pg 17.)This technique was adopted because it
made the accounting information more relevant to Enron and the potential shareholders wanting
to buy Enron’s company shares at the time. This decision to value assets and liabilities using fair
value brought about a short-term increase in price on the shares trading at the New York Stock
Exchange.
There two ways of measuring bond liabilities the first one being The Effective Interest
method. This method is mainly used for bonds that have been sold at a discount. The amount of
the bond is amortized against the interest expense over the bonds holding period Silverstein
(2013.Pg. 10.) The other method is the Straight line method which computes depreciation or
amortization by dividing the interest of cost of an asset and its salvage value by the number of
the asset’s useful life. It’s the simplest depreciation or amortization method Jackson, S.B.,
Rodgers, T.C. and Tuttle, B (2010.Pg 4179). This method is mainly used to reflect the
underlying consumption pattern of an asset and is used where there is no particular pattern to be
followed when using the asset.

ADVANCED FINANCIAL ACCOUNTING
When one is amortizing the bond liabilities using the two methods, there two differences
that are noted especially where interest expense is concerned. Effective Interest method occurs
when the bond reported book value decreases as a result of increase in the expense incurred in
that financial year. Amortization method through the straight-line concept sees into it that
interest incurred remains constant whether the reported book value of the bond reduces. The
straight line amortization method has the advantage of being simpler and more straightforward
without any complications. This method best suited for smaller companies that are Companies
with small accounts or financial departments Del Giudice, V., Manganelli, B. and De Paola, P
(2016.Pg 220). This allows the accountants to calculate amortization more quickly.
The two methods that is Effective interest rate method and the Straight line method
possess some similarities, in that they both recognize interest as amortization when calculating
the bond premiums. The interest calculated during amortization reduces the net income of the
bond if the result is a premium while the net income of the bond increases if the interest
calculated results in a discount Berenbeim (2002.Pg 6.) Both methods result remain the same
with the face value of the bond being exactly the same as the book value of the bond;
The Effective interest rate method gains the advantage of calculating the bond premiums
or discounts in small amounts over the period given. This results in arriving at the same results
but showing a more realistic result or picture of the bond value to the company at different points
throughout the period Collins (2012.Pg.13.) The Accounting field reporting considers the
effective interest method to straight-line method due to the reason of showing a more realistic
picture of the bond value, although the straight-line method can be used when the bond premium
is not significant.

ADVANCED FINANCIAL ACCOUNTING
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