Mark To Market Accounting Approach

Answer :

Part A

a)

Ans- Mark-to-market accounting is an accounting approach in which the firm records its assets & liabilities in its books of accounts at the “fair value” or the “current market price”.

               In case of Enron’s financial reporting, the mark-to-market approach was central to its income recognition. The management of Enron was making forecasts of energy prices and interest rates very soon for the future. Originally, in Enron’s natural gas business, the accounting was simple and straightforward as the company listed actual historical costs of supplying the gas and actual revenues received from selling it in every financial period. 

However, the trading business of Enron doesn’t follow the Historical cost method of accounting. The firm adopted mark-to-market accounting, which meant that once a long-term contract was signed, the present value of the stream of future inflows under the contract was recognized as revenues and the present value of the expected costs of  fulfilling the contract were expensed. Unrealized gains and losses in the market value of long-term contracts (that were not hedged) were then required to be reported later as part of annual earnings when they actually occurred in their respective financial period.

Unfortunately, Enron’s management / accountants misused this approach to portray a rosy picture of its performance / profitability. In case of the agreement with Blockbuster Video to introduce and stream the entertainment over its global broadband network. Enron’s books of accounts recognized and presented an estimated profits of more than $110 million from the Blockbuster deal, even though there were serious questions about technical viability and market demand. Hence, this was a deliberate attempt of the Enron’s management to present a rosy picture of revenue and assets of the company which doesn’t represent the entire actual scenario.

In another example, Enron entered into a $1.3 billion, 15-year contract to supply electricity to the Indianapolis company Eli Lilly. Enron’s financials represented the present value of future assets for more than half a billion dollars, as revenues. Enron then had to report the present value of the costs of servicing the contract as an expense. However, Indiana had 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 the ten years. Hence, this estimate is not based on any logical assumption, rather it is based on just a random guess on when and if the government will deregulate the electricity. If deregulation doesn’t happen, the contract might go for a loss and the company might incur unexpected losses. 

b)

Ans- A special purpose vehicle/entity is a legal entity made to fulfill contract, particular or transitory destinations. They are shell firms created by a sponsor, but funded by independent equity investors and debt financing, ordinarily utilized by companies to disconnect the firm from budgetary hazard. [Special Purpose Vehicle/Entity - SPV/SPE (2011)]

In simpler terms, it can be defined as a company that is hedging its risk or reducing its risks by investing in a subsidiary company with an asset/liability structure and legal status that has lower risks and good profits to fulfill the obligations of the parent company, even if the parent company goes bankrupt. It allows the business to run smaller operations without a fear of a huge financial risk. 

Enron’s management is using its special purpose entities to fund or manage risks associated with some specific assets.

E.g. Enron had used hundreds of special purpose entities by 2001. Many of these were used to fund the purchase of forward contracts with gas producers to supply gas to utilities under long-term fixed contracts.

Case 1: Enron used special purpose entities to fund the acquisition of gas reserves from producers. In return, the investors in the special purpose entity received the stream of revenues from the sale of the reserves.

Case 2: In 1997, Enron wanted to buy out a partner’s stake in one of its many joint ventures without showing any debt borrowed to finance the acquisition in its balance sheet. Chewco, a SPE that was controlled by an Enron executive and raised debt that was guaranteed by Enron, acquired the joint venture stake for $383 million. The transaction was structured in such a way that Enron did not have to consolidate Chewco or the joint venture into its financials, enabling it effectively to acquire the partnership interest without recognizing any additional debt on its books. 

It can be observed that Enron’s management has violated accounting standards that require at least 3 percent of assets to be owned by independent equity investors. By ignoring this requirement, Enron was able to avoid consolidating these special purpose entities. As a result, Enron’s balance sheet understated its liabilities and overstated its equity and its earnings. 

Even though in 2001, Enron restated its financial statements for years 1997 to 2000 to correct these violations. Doing this reduced the Enron’s earnings for the four-year period by $613 million (or 23 percent of reported profits during the period), increase liabilities at the end of 2000 by $628 million (6 percent of reported liabilities and 5.5 percent of reported equity) and reduce equity at the end of 2000 by $1.2 billion (10 percent of reported equity).

c)

Ans- Agency is a relationship of a principal and agent in a business, in which the principal hires an agent to perform a task and gets remuneration in return. Assumptions of agency theory deals with the conflicts that might occur due to unaligned goals between the principal and the agent. [The Assumption of Agency Theory (Apr 2015)]

Some of the major assumptions of the theory are- 

1. Difference in the personal goals of the agent and the business goals of the principal for the organization

2. Difference in risk tolerance ability between the agent and the principal, because the agent is the decision maker of the business but he uses the resources of the principal

3. Principals generally delegate decision-making authority to the agents. As we know, the contracts and decisions are made with third parties by the agent and that affect the principal’s business, a difference in agreement might arise.

In Enron’s case, several key employees, including its CFO Andrew Fastow, were allowed to become partners of the SPE. These employees profited handsomely, raising questions about whether they had fulfilled their fiduciary responsibility to Enron’s stockholders.

The partners had an agency relationship with the company, and their role was to fulfill the organizational goals first and not personal benefit. It is evident that all the above mentioned assumptions were neglected in the case.

Part- B

a)

Ans- As per International FRS conceptual framework, the elements of financial statement are as follows [Conceptual Framework for Financial Reporting [2018]] -

1. Balance sheet – 
2. Assets;
3. Liabilities; and 
4. Equity
5. income statement
6. Income; and
7. Expenses

In the Enron’s Annual report [Anthony H. Catanach Jr. & Shelley Rhoades-Catanach  [2003]], the problems with the measurement of financial elements are-

1. Undervaluation or hiding liabilities/debts

e.g. Hiding the collateral borrowing amount. 

Hiding the stock yet to be issued as company’s obligation

1. Lack of full disclosure in company’s footnotes or notes to accounts

e.g. In spite of the awareness of company’s possible losses in future, it wasn’t shown in the “Contingent liabilities” section of the company’s financials

1. Miscalculation of current value of long-term contracts - "mark-to-market" accounting

e.g. Valuation of assets and stock a decade early and presenting wrong figures in the balance Sheet, and giving “Price-to-risk” as an excuse for that.

1. Not disclosing the transactions related to SPEs properly and using them as a tool for fraud.

The American Institute of Certified Public Accountants [Section No. 51 (ARB 51)] provides general rules for combining the financial results of related entities. It states that consolidated financial statements are "usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies." 

b)

Ans- The company measured all the incomes and assets to be earned in future through its  contracts on a wrong basis. They manipulated the books to show more incomes and lesser liabilities to portray a rosy picture of its performance / profitability. [Houston Chronicle (2002)]

The mark to market accounting technique didn’t take into concern the major market factors that might affect the contact vastly and incur losses. In some cases, they randomly formed an assumption without any solid basis. 

e.g. In case of the agreement with Blockbuster Video, Enron’s books of accounts recognized and presented an estimated profit of more than $110 million from the Blockbuster deal, even though there were serious questions about technical viability and market demand. Hence, this was a deliberate attempt of the Enron’s management to present a rosy picture of revenue and assets of the company which doesn’t represent the entire actual scenario. [Anthony H. Catanach Jr. & Shelley Rhoades-Catanach  [2003]]

In another case of a 15-year contract to supply electricity to the Indianapolis company Eli Lilly. Enron’s financials represented the present value of future assets for more than half a billion dollars, as revenues. Enron’s management assumed the electricity will be regularized by the government at such and such date. Hence, this estimate is not based on any logical assumption; rather it is based on just a random guess on when and if the government will deregulate the electricity. If deregulation doesn’t happen, the contract might go for a loss and the company might incur unexpected losses.

c)

Ans- The company has used mark to market acconting approach, which is an accounting approach in which the firm records its assets & liabilities in its books of accounts at the “fair value” or the “current market price”. The mark-to-market approach was central to Enron’s income recognition. The management of Enron was making forecasts of energy prices and interest rates very soon for the future. Originally, in Enron’s natural gas business, the accounting was simple and straightforward as the company listed actual historical costs of supplying the gas and actual revenues received from selling it in every financial period.

The company should have-

1. Made logical estimates, and should have based the calculation of the assets and incomes on those estimates
2. Made full disclosures in the balance sheet for its existing liabilities and borrowings
3. Made full disclosures in the balance sheet for its possible losses in expenses in future, under “Contingent liabilities”, either in footnotes on in the notes to accounts
4. Kept a check on its key executives and stop them from exploiting their positions to earn personal gains through stock options
5. Should have followed the guidelines of IFRS or GAAP to account for and disclose all the transactions, assets and liabilities related to the SPEs.