Advanced Financial Accounting in Enron Company Paper Example

Paper Type:  Case study
Pages:  7
Wordcount:  1840 Words
Date:  2022-11-20

Introduction

Enron Company, based in the United States, was one of the largest integrated electricity and natural gas companies in the world until 2001 when it filed for bankruptcy (Healy 2003, pp. 1). It had a market for natural gas liquids globally and controlled one of the highest natural gas transmission systems in the world. Enron's target was to serve both the industrial and emerging markets sufficiently. Enron initiated ground-breaking trade products, considerably modernizing the utility industry. This led to the seventh rank of Enron Company on the Fortune 500. The company crinkled after a merger deal with Dynegy Inc. went wrong. Unfortunately, the failure of Enron Company was the largest bankruptcy in American history. The case study, therefore, seeks to assess the governance and incentive problems which influenced Enron's rise and fall.

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Mark-To-Market Accounting Approach

The understanding behind mark-to-market evaluation is quite simple- that the value of a given asset meant for trade in the market may change depending on market conditions. Therefore, the value of the asset on a Balance sheet should change in conjunction with market conditions. The mark-to-market accounting approach for correctly-traded assets is a reliable and essential practice in many situations. Mark-to-market accounting would not be proper for assets whose values are set by an authority separate from the market, such as a public utility commission. During the process of electricity deregulation, as a result of California's power crisis, mark-to-market accounting approach acquired a lousy name accruing to how Enron Company employed this approach. The case study explicitly describes what went wrong with Enron Company and the role of mark-to-market accounting in concealing many of Enron's corporate losses.

Enron Corporation used long-term contracting and derivatives trading (such as futures and options) extensively to make money; So Enron had to mark those contracts to market in its periodic financial statements, that is every quarter, or so, it had to declare the current market value of all deals and contracts. Enron's abuse of mark-to-market accounting approach primarily comprised of two associated practices. First, Enron would develop incomprehensible numbers for what an energy contract was actually worth (moreover, yet natural gas future prices are only available through the New York Mercantile Exchange (NYMEX) for a period of several years into the future; Enron would develop a value for, say, a 20 year natural gas contract that was passed off as being legitimate but was, in fact, nothing more than pure speculation). Second, Enron would record the total expected lifetime value of a given project or contract on its balance sheet instead of its value in that particular quarter. It is these practices that made Enron appear much more than it actually was. Ultimately, the Enron affair had a positive side effect of improving mark-to-market accounting through the establishment of rules for upscaling the transparency of how long-term contracts and other durable assets were valued.

Examples include the 20-year agreement with Blockbuster Video in the year 2000, to introduce entertainment on demand to multiple cities of the United States by the end of the year. Enron's role was to store the entertainment and encode as well as stream the entertainment over its global broadband network. Pilot projects in Portland, Salt Lake, and Seattle City were developed to stream movies to some apartments from servers established in the basement (Healy 2003, pp. 1). From these Pilot projects, Enron went on and recognized estimated profits of more than 110 million dollars from the Blockbuster deal, even though serious questions about technical viability and market demand existed. In another example is when Enron entered into a 15-year contract to supply electricity to the Indianapolis Company Eli Lilly. Enron projected the present value of the contract for more than half a billion dollars as incomes. Enron also reported the present value of the costs of servicing the contract as an expense. "Nonetheless, Indiana ad not yet deregulated electricity, requiring Enron to predict when Indiana would deregulate and how much impact this would have on the costs of servicing the contract over ten years" (Healy 2003, pp.10).

Special Purpose Entities

Special purpose entities (SPEs) refer to "bankruptcy-remote entities" that a parent company uses to securitize and isolate assets, and it often holds the off-balance sheet. The SPEs involved operations limited to the acquisition and financing of specific assets as a method of isolating risk. Therefore, SPEs can be said to be companies with assets/liability structure and legal status that make their obligations secure, even if the parent company goes bankrupt. These SPEs are sometimes a financially devastating way for Chief Financial Officers to hide debt, as with the Enron bankruptcy case. Enron used SPEs to control risks related to specific assets. An example is when Enron used SPEs to fund the acquirement of gas reserves from producers. In return, investors in the SPE received the stream of incomes from the sale of reserves.

For financial reporting purposes, a chain of rules is used to identify whether an SPE is a separate entity from the parent company. These rules require that an independent third-party owner have a substantive equity stake that is "at risk" in the SPE, which has been inferred as at least three percent of the SPE's total debt and equity. The parent company is required to have a control financial interest in the SPE. In case the rules are not fulfilled, the SPE must be fused with the parent firm's business.

Enron had managed hundreds of SPEs by 2001. Several of these were used to sponsor the purchase of forwarding contracts with gas producers to supply gas to utilities under long-term fixed contracts. However, most of these SPEs were controversial, and they were designed mainly to attain financial reporting objectives. In 1997, Enron desired to buy out a partner's stake in one of the many joint ventures. Enron did not, however, want to show any debt from financing the acquisition on its balance sheet. Chewco was one of the SPEs managed by Enron, and it raised debt which was warranted by Enron. The transaction was planned in a manner that Enron did not have to consolidate Chewco, enabling it to effectively obtain the partnership interest with no further debts on its books.

Chewco and several other SPEs did more than just by-pass the accounting rules, and as exposed in October 2001, they breached accounting standards which demand at least three percent of assets be owned by sovereign equity investors. Enron ignored this requirement, and by doing so, it evaded the consequence of consolidating these SPEs. As a result, Enron's balance sheet devalued its liabilities and exaggerated its earnings and its equity. In addition to accounting flops, Enron provided only minimal disclosure on its relations with SPEs. Investors were unaware that the SPEs were expending Enron's stock and financial guarantees to carry out hedges so that Enron is not covered from downside risk. Furthermore, Enron allowed several key employees to become partners of the SPEs, and in the transactions that followed, these employees profited substantially. These actions raised questions about whether they had satisfied their fiduciary responsibility to Enron's stockholders.

Top Management Compensation

As in most other companies in the United States, Enron's top management was heavily compensated using stock options. It can be noted that heavy use of stock options "linked to short-term stock price may explain the focus of Enron's management on creating expectations of rapid growth and its efforts to puff up reported earnings to meet Wall Street's expectations" (Healy 2003, pp.13). Besides, it can be said that the main purpose of stock options is to align the interests of management with shareholders. From Enron's experience, there is the possibility that stock compensation programs are often designed to motivate managers into effective decision making specifically to pump up short-term stock performance instead of creating medium or long-term value. Cite.

In an understanding, the stock option is never a problem of its own. High stock and high compensation give corporate executives much more incentives to maneuver the financial reports as well as the company's stock price. Whenever enormous cash or options bonuses are dependent upon the accomplishment of some hardly-defined profits/growth goals, the desire to bias the numbers will be immense. Excessive compensation given to top management in the United States compared to the incomes of the regular employees of the company is the real deal. The ratio should condense to a value close to that of the Japanese companies.

International Financial Reporting Standards (IFRS) Conceptual framework

"IFRS is a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements" (Hogdgon 2011, pp.415). The main impetus for the standard setting programme was to reduce the wide variety of accounting practices companies employed. It was believed that Principles' destroyed comparability between the accounts of one business and another and that the standard setters are to carry out a careful investigation of existing practices and to identify best practices and try to help those companies employing minor procedures to improve their published reports. This would allow some flexibility and attempt to justify the favored procedure with the argument that it is better to have second rate figures that are comparable than to allow choices to be made. Compliance with accounting standards has also been shown to be a valid defense for auditors faced with accusations of misconduct based on alleged failure to ensure that accounts show an accurate and fair view. It is acknowledged that standards fulfill a valuable role in the short run by ensuring that all companies adopt the best procedures currently used, but it is believed in some quarters that they may prove detrimental in 6 the long run. For a reasonable period, significant developments have been made in the form and content of published accounts and much of this has occurred as the result of free market experiment and innovation.

Elements of financial statements in Aquafin Company

The company of focus in this paper is the Aquafin Company, which provides clean water in Flemish. Usually, transactions in companies are grouped into two broad classes, and in this manner, their financial results are presented in the financial statements. Financial statements tend to give an accurate and fair view of the consolidated financial position and net equity. The classes, as aforementioned, constitute the elements of financial statements. IFRS use the titles "statement of financial position" and "statement of profit or loss and other comprehensive income." In practice, the statement of financial position is at times known as the balance sheet (see Appendix A), and the statement of profit/loss and other comprehensive income may also be termed as profit and loss account, the income statement, or the statement of comprehensive income (See Appendix B). Under financial position, the following three elements can be listed:

  • Asset. Refers to an entity's managed resource due to the past events out of which the economic benefits for the future are supposed to flow to the entity.
  • Liability. Indicates a present obligation of the entity accruing from past events, the settlement expected to cause an outflow from the resources' entity embodying the benefits of...

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Advanced Financial Accounting in Enron Company Paper Example. (2022, Nov 20). Retrieved from https://proessays.net/essays/advanced-financial-accounting-in-enron-company-paper-example

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