The Fall Of Enron Case Study

Assessment Task Part A

On the basis of an article written by Paul M. Healy and Krishna G. Palepu on the fall of Enron Case study, following are the explanation to the issues:

a)      Mark-to-Market Accounting approach pertains to the accounting on the fair value of the assets and liabilities that rsides on the current market price of similar kind of assets and liabilities. In the mark-to-market accounting, as the current market price is taken as the base for the future transactions as well, it becomes highly volatile as the market prices are prone to fluctuations. The company used this accounting method for its long-term contracts as well. According to mark-to-market accounting, the income and expenses for the long-term contracts are estimated depending on the present value of future cash flows (Arnold, 2010). So when the prices fluctuate in future, the same was not adjusted in the books of accounts of the company. The discrepancies in the incomes and profits were very large which resulted in misleading financial reports. The management used to forecast energy rates and interest rates on the basis of the future value of cash flows (Ross et. al, 2014).

The company used to recognise its revenues as the future value of all cash inflows in coming years and the expenses were booked as the future value of all cash outflows in coming years. The unrealised gains and losses were reported in the later years as an when they occurred. Enron did many long-term business contracts in which it depicted the present value of future cash flows as its income and the present value of costs to be incurred during the entire contract as its cost of service (Arnold, 2010). Some of the contracts even failed viability tests in the later years of the contract. This way the management of the company used to show a rosy picture of its financial performance while entering into long-term contracts without taking a cushion for fluctuations in incomes and expenses that could arise in future.

b)      Special Purpose entities are a kind of shell firms or companies which are developed by a sponsor but funding is done by independent equity investors or by debt financing (Vaitilingam, 2014). Special purpose entities are used for many purposes by the businesses such as for help in financing, risk sharing, easy transferring of assets, securitization of loans, etc (Bekaert & Hodrock, 2012).

The company Enron has used numerous Special Purpose Entities to finance its forward contracts and to achieve financial reporting objectives. One such instance which shows the manipulation of financial reports with the help of SPEs is discussed ahead.

Assessment Task Part B

In the year 1997, the Enron company had an intention to purchase its partner’s share in a joint venture contract. But the company did not want to reflect the debts from this transaction of acquisition or from the joint venture in its financial statements. One of the executives of Enron had a controlling power in an SPE named Chewco who raised a debt from Chewco which was guaranteed by Chewco. This debt was utilised by Enron for acquiring the Joint Venture partnership. All this was structured in such a manner that nothing related to this debt financing transaction could be reflected in the financial statements of Enron and thus Enron could acquire the partnership in Joint Venture easily (Healey & Palepu, 2003). The Chewco SPE violated many accounting standards as well and hence Enron had not to consolidate its accounts with Chewco. This way the debts and liabilities got understated in Enron’s Balance Sheet and the Equity and the earnings were overstated.

Apart from this, Enron did minimum disclosures regarding the association with the SPEs and reported downside risk was hedged in its illiquid investments through SPEs. But there was no awareness amongst the investors that Enron has allowed the use of its stocks to SPEs and guaranteed the whole debt transactions as well. Enron had also involved many top-level officers in all these transactions (Healey & Palepu, 2003). In this way, it was successful in funding contracts and obtaining the financial reporting objectives.

c)      Enron’s top management was awarded high compensations including stock options. The main reason for stock option compensation scheme was to bring the management and shareholders in the same interest. The main reason for providing stock options to the management was to influence their decisions and to encourage them to provide an inflated financial position of the company. This can be said as the stock options provided to the management were without any restriction of further resale and unlike stock options provided by other companies, there were no specific requirements from the management for the purchase of such stock options (Healey & Palepu, 2003). This behavioural pattern can be assumed from the agency theory. According to this theory, both the principal and the agent are motivated by self-interest. This theory relies on the assumption that the agents work for self-interest only and to maximise their personal wealth. Hence in order to challenge this assumption, it is required from the agent that either he leaves aside his self-interest or work according to the principal to maximise his wealth along with agent’s own personal wealth. In the case of Enron, the management were the agents who have been provided with high compensations including stock options (Bodie, Kane & Marcus, 2014). It was their duty to maximise principal’s wealth but they have only inflated the financial performance but did not provide any medium or long-term growth to the company.

The five elements of financial statements as per the International FRS Conceptual Framework are – Asset, Liability, Equity, Income and Expense. Usually, there are different methods of measurement of these elements that are used by different organisations- Historical Cost Measurement basis, Current Value measurement basis, Realisable (settlement) Value and Present Value method.

a)      There are different methodologies for the measurement of different elements of financial statements.

For instance, a listed public company in Australia namely Woolworths Group Limited uses the following measurement methods:

The computation of revenue is done at the FV of the consideration that is received or receivable (Woolworths, 2018). The computation of inventories are done at cost or net realisable value whichever is lower and the  cost is calculated on the basis of weighted average cost.

The recognition of Trade and other Receivables are initially done at fair value and are later measured at amortised cost using effective interest method and an allowance is deducted or impairment. Fixed assets such as PPE are measured at cost less depreciation and the depreciation are computed using straight-line method over the useful life that is remaining in terms of the assets.

Borrowings are initially valued at fair value fewer transaction costs and later at amortised costs. The difference between the two costs are shown in Consolidated   

Income Statement over the period of borrowings.

For comparison purposes, we shall take another company which is US based and uses U.S GAAP to prepare its financial statements. The company is Magal Security Systems Limited which uses following measurement methods: This company recognises its revenue and expenses on the basis of percentage of completion method and this method is calculated based on the Input Method (Magalsecurity, 2018).

The inventories are measured at cost or market price whichever is lower and the cost is determined in two parts- Raw Materials on FIFO basis and the WIP & Finished Goods on the basis of proportionate direct and indirect manufacturing costs. Further, the long-term trade receivables and other receivables are recorded at their estimated present values (Brigham & Daves, 2012).

Fixed assets such as Property, Plant & Equipment are measured at cost less depreciation and the depreciation is calculated using the straight-line method over the  remaining useful life of the assets. Above are only few examples as the elements have been spread in many different parts in the Annual reports of the companies (Magalsecurity, 2018).

b)      Both of the above-mentioned companies use two different methods of preparing financial statements. It cannot be said with complete accuracy that which method is better over the other one. It might be possible that the measurement recognition of one element is better in IFRS and of other elements is better in U.S GAAP (Brigham & Ehrhardt, 2011). We have taken a few examples above which show different methods of recognition for different kinds of elements of financial statements.

If revenue is measured as per IFRS, it is easy to measure and recognise in the Income Statement rather than as per U.S GAAP as the IFRS uses the most common method of Revenue Recognition.

As per U.S GAAP, the expenses are classified by function, whereas under IFRS the expenses are classified under two parts- nature of expense and function, which makes it’s better to understand the nature of expenses in the Income Statement.

There are strict requirements on the presentation of Financial Statements under U.S GAAP as compared to IFRS. Hence it is better to use IFRS presentation. On considering the remaining examples given in former part, the measurement and recognition methods under IFRS are much easier to understand as compared to U.S GAAP, hence making the decision making comparatively easier. The more understandable the financial statements are, easier it becomes for the users of financial statements to understand the same and take their decisions thereafter. For example- investors and financial institutions can decide whether to invest and provide funding to the company or not.

Critical analysis of IFRS and US GAAP:

If we consider the above two companies only for the critical analysis of the two techniques, it would not ensure proper comparability. The reason being that both the companies operate in different sectors and different nature of business is there. Hence, a general analysis of both the techniques would be better.

Basis of comparison	Under IFRS	Under U.S GAAP
Format of Income Statement	There is no fixed format under IFRS	There has to be either multiple step format or single step format under US GAAP
Recognition and classification of expenses	Under IFRS, there are two alternatives- by nature and by function classification (Deegan, 2011)	Under US GAAP, only classification by function is allowed (Parrino, Kidwell & Bates, 2012)
Use of historical costs or fair value/ revalued costs	IFRS permits the use of both	US GAAP allows only historical cost basis (few exceptions are there)
Valuation of Inventory	LIFO method is not permitted. It uses either FIFO or Weighted Average Cost Method (Melville, 2013).	LIFO is allowed to be used.

Disclosure of Extraordinary Items

Under IFRS, the disclosure of non-recurring expenses, income and extraordinary items is not allowed in the financial statements. It is shown outside in the notes to accounts (Mersland & Urgeghe, 2013).

Under IFRS, the disclosure of non-recurring expenses, income and extraordinary items is allowed in the financial statements in limited circumstances (Needles & Powers, 2013).

These are comparison examples for only major heads from the financial statements. As we can see from the above comparison table, the methods and techniques used under IFRS are easier to understand and implement. Also, the valuations and measurements of elements of financial statements can be done in depth when there are lesser restrictions (Merchant, 2012). Hence, IFRS is a better standard to use as compared to US GAAP due to ease of understanding and use of simpler methods in measurement and recognition of the elements of financial statements.

References

Arnold, G. (2010)  The Financial Times Guide to Investing. Prentice Hall.

Bekaert, G., & Hodrock, R. (2012). International financial management (2^nd ed). Prentice Hall

Bodie, Z., Kane, A., &  Marcus, A. J. (2014) Investments. McGraw Hill

Brigham, E., & Daves, P. (2012).  Intermediate Financial Management.  USA: Cengage Learning.

Brigham, E.F. & Ehrhardt, M.C. (2011) Financial Management: Theory and Practice, USA: Cengage Learning.

Deegan, C. M. (2011)  In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill

Magalsecurity. (2018) Magal security 2018 annual report & accounts. Available from: https://magalsecurity.com/sites/default/files/resource/file/20-F%20-%202017%20-%20final.pdf [Accessed 14 September 2018]

Melville, A. (2013) International Financial Reporting – A Practical Guide. 4th edition. Pearson, Education Limited, UK

Merchant, K. A. (2012) Making Management Accounting Research More Useful. Pacific Accounting  Review. [online]. 24(3), 1-34. Available from https://pdfs.semanticscholar.org/6ccf/f78a452763f17ed5e4f4ddc6b96703801403.pdf 

Mersland, R., & Urgeghe, L. (2013) International Debt Financing and Performance of Microfinance Institutions. Strategic Change. [online]. 22. Doi:10.1002/jsc.1919.

Needles, B.E. & Powers, M. (2013) Principles of Financial Accounting. Financial Accounting Series: Cengage Learning.

Parrino, R, Kidwell, D. & Bates, T. (2012) Fundamentals of corporate finance. Hoboken Healy, P.M &  Palepu, K.G. (2003) The Fall of Enron. Journal of Economic Perspectives. 17(2), 3-26. Available from: https://www.aeaweb.org/articles?id=10.1257/089533003765888403

Ross, S., Christensen, M., Drew, M., Bianchi, R., Westerfield, R. an Jordan, B.(2014) Fundamentals of Corporate Finance, 7th ed. North Ryde: McGraw-Hill Australia Pty Ltd.

Vaitilingam, R. (2014) The Financial Times Guide to Using the Financial Pages. London: FT Prentice Hall

Woolworths. (2018) Woolworths 2018 annual report and accounts 2018. Available from:  https://www.woolworthsgroup.com.au/icms_docs/195396_annual-report-2018.pdf [Accessed 14 September 2018]