Mark-to-Market Accounting Approach
Going by the matter provided in the article of Paul M. Healy and Krishna G. Palepu regarding the downfall of Enron, the following can be extracted from the article:
Mark-to-market accounting approach can be said to be the accounting on the FV of the assets, as well as liabilities that dwells on market price in the current scenario that links to the assets of similar nature and liabilities. In the accounting of mark-to-market, the current market price is considered as the base for the transactions, it is infused with high volatility because the market price is exposed to fluctuations. This method is used by the company when it comes to long-term contracts. when it comes to mark-to-market accounting, the income, as well as expenses for the long-term contract, are considered residing on the PV of the future cash flow. Hence, when the price tends to increase or decrease, the same cannot be adjusted in the books of the company. The faults in the income, as well as profit, was huge that resulted in misleading of the financial report. When there is a discrepancy in the income and expenses either it exaggerate or lower the figures.
The company used to ascertain the revenue as the FV of all cash inflow in coming years, as well as expenses, were booked. The gains, as well as losses, were unrealized in the later years when that happened. Enron engaged into many long-term contracts of business that depicted the PV of future cash flow as the income, as well as PV of costs to be incurred during the entire contract as the cost of service (Healy & Palepu, 2003). There were many contracts that failed the test of viability in the later year of the contract. In this manner, the management of the company depicted a false picture of the financial performance while considering the long-term contract without enabling a cushion for the alterations in income, as well as expenses that arise in future (Ross et. al, 2014).
Special purpose entities can be said to be the shell firms that are developed by the sponsor but the funding happens through independent equity investor or through debt financing. Special purpose entities are utilized for different purposes by the businesses like support in financing, sharing of risk, assets transfer, loan securitization, etc. When it comes to Enron, it has made various Special Purpose entities so that the finance can be done to forward contracts and to attain the objectives of financial reporting (Healy &Palepu, 2003). An apt example of financial report manipulation is done with the help of SPE is being discussed in the following. In 1997, the Enron contained an intention to purchase the partner share in a contract of a joint venture. However, the company had no intention to disclose the debts from the transaction of acquisition or from the JV in the financial statements. The controlling power in an SPE was held by an executive of Enron that was named as Chewco that raised a debt guaranteed by Chewco. Enron utilized the debt for the acquisition of the JV relationship. The structure was framed in a fashion that nothing linked to the transaction of debt financing was highlighted in the financial statements of Enron and hence Enron was at ease in the acquisition of the partnership in Joint Venture (Vaitilingam, 2014). The Chewco SPE led to the violation of various accounting standards and therefore, Enron did not consolidate the accounts with Chewco. In this fashion, debt, as well as liabilities was understated in the balance sheet of Enron and on the contrary, earnings, as well a equity was overstated.
Revenue Recognition and Special Purpose Entities
In contrast to this, Enron led to minimum disclosures in terms of link with the SPE and a downside risk was observed in the illiquid investment through SPE. However, no awareness was seen among the investor that Enron allowed the usage of the stocks to SPE and the overall debt transaction was guaranteed. Enron even involved various top officers in the transactions and therefore was successful in funding of contracts and obtained the aims of financial objectives (Deegan, 2012).
The top management of Enron was awarded high compensation that contained stock options. The main reason for the compensation scheme of the stock option was to lure the management, as well as a shareholder in the same interest. The main need for providing the stock option to the employees was to bring a change in the decision making capacity and to influence them to provide an inflated position of the company. The major noteworthy point that can be seen is that the stock options provided were without any restriction of further resale and was indifferent as per the other companies (Davies & Crawford, 2012). When the stock options are provided without any restriction it leads to a massive problem as there is no bar in terms of the transfer. Moreover, there were no particular needs for the management of the stock option purchase. This pattern can be highlighted with the help of the agency theory. As per the theory, both the principal, as well as the agent is driven by self-interest. The theory dwells on the assumption that the agent works for self-interest only and to enhance personal wealth. Therefore, to challenge the assumption it is needed from the agent that either the work is left aside for self-interest or work in tune with the principle to maximize the wealth together with the personal wealth (Choi & Meek, 2011). When it comes to Enron, the management can be defined as the agents that are provided with compensation of high stature that includes stock options. It was the need to enhance the wealth of the public however, only the financial performance was inflated without providing any sort of growth for the company.
Assessment Task Part-B
As per the International IFRS Conceptual framework, the five elements of financial statements are asset, liability, equity, income and expense. Different organization has different level of measurement of such level like historical cost measurement basis, current value measurement basis, realisable value and present value method.
There are various mechanism that can be used to ascertain the various element of financial statements. An apt example of such a framework is that of Wesfarmer Group Limited that uses the method prescribed below. The revenue computation is done at the consideration fair value that is received or receivable (Wesfarmer, 2014). The inventories computation are done at cost or net realisable value that is lower and the computation of cost is done on the basis of weighted average cost (Melville, 2013).
From the annual report it is observed that the trade and other receivables are done at FV and later ascertained at amortised cost utilizing the method of effective interest and in tune to this a deduction happens for the part of an allowance. When it comes to fixed assets like PPE, the measurement is done at cost deducting the depreciation and the computation of depreciation happens at straight line method over the useful life for the rest of the time span of the assets (Wesfarmer, 2014). Moreover, the valuation of the borrowings are done at FV with lesser transaction cost and later on amortised (Merchant, 2012). The difference between the two are reflected in the consolidated statement.
Stock Options and Agency Theory
Income Statement (ahead of the borrowings)
For the purpose of comparison, another company is considered from US that implements and make use of the GAAP for the preparation of the financial statements. Mackay Golf club is selected for the purpose of the study. In this company, the recognition of the revenue, as well as expenses is done in regard to the percentage of method of completion and this method is computed as per the Input method (Mackay Golf Club, 2017).
The measurement of inventories is done at cost or market price and the one with the lowest is considered. Further, the determination of the cost happens in two steps that is Raw materials on FIFO and WIP and Finished Goods in terms of proportionate direct and indirect manufacturing costs (Mersland & Urgeghe, 2013). Moreover, the long term trade receivables and other receivables is done as per their present values that is estimated. Furthermore, fixed assets like PPE are measured at cost deducting the depreciation and the depreciation is computed utilizing the straight line method over the left over useful life of the asset (Brigham & Ehrhardt, 2012). The Annual report of the company projects vital information in different areas of the annual report.
(b) The above mentioned companies in the report uses two different approaches for the preparation of the financial statements. It cannot be commented with overall accuracy that which method ranks over another. It can be said that the measurement recognition of one element ranks higher in the case of IFRS and another element ranks higher in U.S GAAP. For this purpose various examples are taken into consideration that projects different method of recognition (Brigham & Ehrhardt, 2012). If the measurement of revenue is done considering the IFRS then it becomes easy to ascertain, as well as recognize the Income Statement instead of the U.S GAAP because the IFRS utilizes the most common method of Revenue Recognition (Brigham & Daves, 2012). Going by the U.S GAAP it can be seen that the classification of the expenses are done by function while in the case of IFRS the classification of expenses are done in two parts that is the nature of expense and function that makes it easier in terms of understanding of the expenses feature in the Income Statement. When it comes to the presentation of Financial statements under GAAP there are stern requirements as compared to IFRS. Therefore, it is effective in terms of IFRS presentation. On providing the remaining examples, the measurements, as well as recognition under the IFRS are easier in terms of understanding in comparison to GAAP thereby ensuring a better decision making. When the financial statements are effective then it becomes easier for the users to understand the financial statement and leads to funding (Mackay Golf Club, 2017).
- IFRS and US GAAP:
If both the companies are considered for the critical evaluation considering the effectiveness of method employed then it can be commented that proper comparability is not ensured. One of the major reason is that both the companies have their operations in different segment thereby, a analysis on a general perspective will deem perfect (Needles & Powers, 2013).
|
Comparison |
IFRS technique |
U.S GAAP technique |
|
Income statement rules |
No fixed format has been prescribed by the IFRS |
In GAAP there has to be either multiple step format or single step |
|
Expenses Recognition and classification |
As per IFRS, there are dual alternatives that is by nature, as well as classification |
When it comes to the US GAAP only classification by function is allowable. |
|
Utilization of historical costs or FV/ revalued costs |
Both are permissible under IFRS |
Only historical cost basis is allowable when it comes to GAAP |
|
Inventory Valuation |
Under IFRS is not allowed. Either FIFO or Weighted Average cost method is used. |
IN GAAP, LIFO is used. |
|
Extraordinary items disclosure |
When it comes to IFRS, the disclosure pertaining to non-recurring expenses, income, as well as extraordinary items is not allowed. It is projected in the notes to the financial statements (Parrino et. al, 2012). |
When it comes to GAAP the extraordinary items are presented in the income statement or in the notes. |
The above comparison pertains to the examples that derives from the financial statements and are selective in nature. As seen from the table of comparison that the methods, as well as techniques utilized under IFRS are easier in terms of understanding, as well as implementation. Further, the valuation, as well as measurement of financial statements can be done in an in-depth manner when the restrictions or limitations are less (Parrino et. al, 2012). Therefore, it can be commented that the IFRS is a better standard when it comes to the usage of US GAAP as the understanding is easier and measuring in simpler in nature thereby the recognition of the elements portrayed in the financial statements are easier in nature. The overall discussion sheds light on the benefit provided by the IFRS and hence ranks above the GAAP.
References
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.
Choi, R.D. and Meek, G.K. (2011) International accounting. Pearson .
Davies, T. and Crawford, I. (2012) Financial accounting. Harlow, England: Pearson.
Deegan, C. M. (2011) In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill
Mackay Golf Club. (2017) Mackay Golf Club 2017 annual report & accounts. Available from: https://mackaygolf.com.au/beta/wp-content/uploads/2017/11/Annual-Report-2017-Final-.pdf [Accessed 22 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
Wesfarmer. (2017) Wesfarmer annual report and accounts 2017 [online]. Available from: https://www.wesfarmers.com.au/docs/default-source/default-document-library/2017-annual-report.pdf?sfvrsn=0 [Accessed 23 September 2018]
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