Advanced Financial Accounting: Analyzing Enron's Downfall Case Study

This case study delves into the financial accounting irregularities that led to the collapse of Enron. It examines the use of mark-to-market accounting, special purpose entities, and stock compensation programs in manipulating financial statements. The analysis highlights how these practices, coupled with weak regulatory oversight, resulted in the misrepresentation of Enron's financial health. The study also discusses the five key elements of financial statements—assets, liabilities, equity, revenue, and expenses—and compares different valuation methods, with a focus on the historical cost method preferred by Lasani Stone Crushing Company for its objectivity and reliability, while also acknowledging its limitations in reflecting current market values. The conclusion emphasizes the need for stricter regulations and penalties to prevent accounting malpractice and ensure transparent financial reporting.

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Advanced Financial Accounting
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Introduction
International accounting and reporting standards are important for ensuring proper
and transparent financial reporting for listed companies. These regulations ensure that the
users of the company financial information are able to understand and interpret company
financial information (Accounting for Management, 2018). This not only helps the investors
in making decisions but also assist the management in identifying areas that need
improvement. This paper will focus on the case of “The Fall of Enron” and identify various
reasons that led to the fall. Moving forward the paper will shed light on the five elements of
financial statements and identify the various methods used in determining the value of assets
(a) The mark to market accounting approach is where a business is at liberty to
revalue all the assets and liabilities in accordance with the fair market value. The resulting
increase or decrease in value is then subtracted or added to the available profit distribution to
shareholders to determine the business profit or loss. This type of accounting helps a
company to record the value of an asset or liability based on current market value rather than
the cost of the asset. The alternative to this method is the historical cost method that records
the historical value of an asset and only uses the market value once an asset is sold(Amiram,
Bozanic and Rouen, 2014).
The mark to market accounting has been witnessed in the case of Enron in that it
signed a contract that would see it provide power to a power plant, which was still under
construction. From such a contract, Enron made declared the profits to be recorded. In such a
case, the estimation of market value was inconvenient as some contracts ran as long as twenty
years. For instance, a contract that was signed in July 2000 by Enron and Blockbuster Video
ran for 20 years. Despite the question of the viability of the idea Enron went ahead to declare
a profit of more than $110 million based on pilot projects(Palepu and Healy, 2013). This
measure avoided the reality and was more of a dream created by Jeff Skilling as there was no
market to mark. In a real sense, the company was losing a lot of many, which eventually
forced the company to resort in manipulating the cash flow and balance sheet. This resulted
in an abuse of fair value or mark-to-mark (Davis and Stone, 2014).
(b) Special purpose entities are organizations that are shaped by sponsors and
funded via unbiased fairness investor and debt financing. In the case of Enron special purpose
entities were used to fund the purchase of gas reserves and the investor who put money inside

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the special purpose entity could earn money through selling reserves (Plosser, 2018). The
special purpose entities assist to manipulate the risks related to the unique assets. Enron in
general used the special purpose entity to acquire ahead contracts with fuel producers and
supply the gasoline under long-time period contracts. The best part that Enron used a special
purpose entity when it intended to acquire an associate’s stake in one of its joint ventures.
The employer fashioned a special purpose entity and named it Chewco, which helped collect
the stake at the same time permitting Enron not to reveal any debt from financing the
purchase. At the same time, Enron did not want to consolidate Chewco (Ahmed, Islam and
Uddin, 2015).
This was a clear indication of how Enron was skirting the accounting rules. Such rule
includes the one that requires independent equity investor to not to own more than 3% of the
asset. By violating this rule, Enron understated it liabilities since it did not consolidate the
special purpose entities. Moreover, the third part owner ought to have 50% financial interest
in the special purpose entity. Enron minimal disclosure regarding special purpose entity,
changed into using the shareholders stocks as the guarantee for funds acquisition in the
special entities leaving the company exposed to downside risk (Basu and Waymire, 2017).
(c) According to Jeff Skilling, the aim of awarding the top management with
stocks was to align the interest of the shareholders with those of the management. The
management acts as an agent of the shareholders and in such a position, the management
ensures that the shareholders’ interests are considered in company decision (Healy and
Palepu, 2012). Another reason as to why the company was compensating the top
management with shares was to ensure that they are always protecting their interest, thereby
doing anything at the expense of the company financial health to ensure that the company
share price favours their interest. By so doing this also ensured that the shareholders were
happy as their shares were priced higher. According to the article, the stock compensation
program was designed to make sure that the managers were motivated in making decisions
that would pump up short-term stock performance rather than create medium and long-term
value. In addition, the stock compensation program was initiated to ensure create an
expectation of rapid growth, which is appealing to the shareholders, and at the same time
exaggerate the reported earnings to meet Wall Street’s expectations (Kim and Im, 2017).

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(a) The five main elements of the financial statements are expense, revenues, equity liabilities
and assets. These elements build up the financial statements, such as the balance sheet, which
contain equity assets and liabilities, while the income statement contains revenues and
expense(Ebarry, 2018).
Listed companies use different measurement methodologies used to analyse the five
elements of the financial statement.
One of the methods is the historical cost method, which involves recording assets
based on the amount of cash or cash equivalent for a fair price when acquiring the asset. For
the case of liabilities, they are recorded in accordance with the proceeds received in exchange
for the loan, or cash to be paid for instances such as tax. A good example of such a method in
practice is the Lasani Stone Crushing Company when valuing its machines (Davis and Stone,
2014).
Another method is the current cost, which is conducted depending on the amount of
cash, or cash equivalent that would have otherwise been paid for an asset acquired currently.
In the case of liabilities, they are recorded at the undiscounted amount of cash or cash
equivalents that is needed to honour the obligation.
Realizable or settlement value is another method, which requires that assets be carried
at the value of cash or cash equivalent that an asset would fetch once sold or disposed.
Liabilities are recorded as a cash settlement or cash equivalent value that is undiscounted and
expected to be paid to settle the liability (Halíř, 2014).
The present value method specializes in present discounted value, whereby the asset
is carried at gift discounted price of the anticipated cash flow the asset is anticipated to
generate inside the ordinary path of business. Liabilities are discounted on the price of the
future net cash outflows so that it will be sufficient to settle the liabilities in a regular
operation of enterprise (Nash, 2017).
The most common methodology used by companies in preparation of financial
statements is the historical cost. However, the measurement is coupled with other
measurement basis, such as market value for marketable securities and lower cost and net
realizable value for inventories.
(b) The Lasani Stone Crushing Company mostly prefers the historical costing method
while valuing its assets and liabilities during financial statement preparation. The main reason

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as to why the company opts for this method is due to its objectivity and reliability of
accounting information. This is to mean that the amount of financial statements is not
overwhelmed by subjective increase and decrease of values. This provides limitations in data
manipulation, as there is an objective basis of recording business transactions, which ensures
the reliability of the accounting information.
Another reason as to why the company has used the historical cost method is due to
its simplicity; this is that transactions are recorded at their original amounts. Therefore, no
changes are made to reflect inflation. This helps the user of the information to easily
understand the financial position of the company as well as make decisions easily(Brown,
2018).
Finally, the historical cost method ensures consistency and comparability of the
financial statements. The Lasani Stone Crushing Company prefers the method as it enhances
intra and inter comparability of financial statements. This means that it is possible to compare
the performance of the company from one year to another while at the same time manage to
compare with other entities. This is very useful to the financial information users as they are
able to determine whether the company is making progress or whether their competitors are
catching up(Staff, 2018).
(c) Critical analysis
The historical method has proved to be objective and reliable, simple and convenient
as well as consistent and comparable. However, the method has a downside in that when it
comes to accuracy, the method fails to represent the current market value of assets on the
financial statement. Another disadvantage is the overstatement of figures in that profits are
dependent on measuring capital on different dates. This fails to represent shareholders
purchasing power since it is a comparison of two meaningless figures (Brown, 2018).
Finally, the historical method gives a misleading impression that the company can
continue operating at a given level, as the assets are undervalued.
On the other and the historical method is the most preferable compared to the other
methods as it minimizes the room for manipulation in comparison to the other methods.

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Conclusion
In light of the analysis conducted in the paper, it evident that a slight change in the
accounting standards can lead to misrepresentation of items in the financial reports of a
company. Enron turned out to be an exaggeration of financial information and manipulation
of accounts yet the company lived of Jeff Skilling dreams. Despite the craftiness of Enron top
management, the analysis has determined that the accounting regulations are not airtight and
can be manipulated by those with malicious intent. Therefore, apart from the regulations it is
useful to back the regulations with proper and hefty punishment that would deter individuals
from engaging in accounting malpractice.

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List of References
Accounting for Management (2018). Historical cost concept - explanation, examples,
importance, exceptions, advantages | Accounting for Management. [online] Accounting for
Management. Available at: https://www.accountingformanagement.org/historical-cost-
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Ahmed, A., Islam, M. and Uddin, M. (2015). ENRON: Fall of a Creative Accountant. SSRN
Electronic Journal.
Amiram, D., Bozanic, Z. and Rouen, E. (2014). Financial Statement Irregularities: Evidence
from the Distributional Properties of Financial Statement Numbers. SSRN Electronic Journal.
Basu, S. and Waymire, G. (2017). Historical Cost and Conservatism Are Joint Adaptations
That Help Identify Opportunity Cost. Accounting, Economics, and Law: A Convivium, 0(0).
Davis, E. and Stone, M. (2014). Corporate financial structure and financial stability. Journal
of Financial Stability, 1(1), pp.65-91.
Ebarry (2018). Conceptual Framework for Financial Reporting 2018. [online] Iasplus.com.
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Fox, L. (2013). Enron. Hoboken, N.J.: Wiley.
Healy, P. and Palepu, K. (2012). Governance and Intermediation Problems in Capital
Markets:Evidence from the Fall of Enron. SSRN Electronic Journal.
Halíř, Z. (2014). Accounting System and Financial Performance Measurements. European
Financial and Accounting Journal, 2011(3), pp.38-65.
Healy, P. and Palepu, K. (2012). Governance and Intermediation Problems in Capital
Markets:Evidence from the Fall of Enron. SSRN Electronic Journal.
Kim, J. and Im, C. (2017). Reported Profits And Effective Tax Rate Following Accounting
Standards Changes Analysis Of Consolidated Financial Statements And Separate Financial
Statements. Journal of Applied Business Research (JABR), 33(6), p.1171.
Palepu, K. and Healy, P. (2013). The Fall of Enron. SSRN Electronic Journal.
Parker, L. (2015). The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall
of Enron. Research in Accounting Regulation, 18, pp.353-356.

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Plosser, C. (2018). Financial Econometrics, Financial Innovation, and Financial
Stability. Journal of Financial Econometrics, 7(1), pp.3-11.
Staff, I. (2018). Current Rate Method. [online] Investopedia. Available at:
https://www.investopedia.com/terms/c/currentratemethod.asp [Accessed 26 Sep. 2018].