Misuse of Mark to Market Accounting
a)
Mark to market accounting is an accounting technique that values assets with regards to the prevailing market condition. According to Bigman and Forbes, the concept behind mark to market approach is found on its capability to make sure that some assets are carried out using their fair value based on the prevailing market condition. The management has to make estimates in order to come up with the fair value of assets (Bigman, Goldfarb and Schechtman, 1983, pp. 330). Mark to market technique is mainly used by companies which release their financial reports yearly. The following are some examples of how Enron’s accountants and management misused this approach.
Enron’s management signed an agreement with Blockbuster for 20 years to introduce entertainments in every year-end. Enron’s accountants estimated a profit of $ 110 million and recorded this profit estimates in their books of account even though the transaction seemed to have questionable figures (Schwarcz, 2002, np.).
Enron used the mark to market technique to wrongly value their entire assets. This was against the mark to market accounting rule, they should have used this method only in instances where the historical cost of the assets fluctuates frequently which was in this case gas (Nelson, Price and Rountree, 2008, pp. 380). Enron used the mark to market accounting to value all items including electricity, profits and losses, paper and other coal ventures.
Enron also signed a contract worth $ 1.3 billion to supply the Indian polis Eli Lilly Company with electricity and this was for a period of 15years. Enron went ahead and recorded the present value of the contract as revenues and recorded the servicing contracts cost as expenses when Indiana had not yet determined the actual costs of servicing the contract.
b). Special purpose entities are legal entities which are formed in order to achieve narrow, tinny and special goals. Special purpose entities are used by companies to assist in debt settlement and removing other liabilities in their books
Enron had a joint venture called JEDI in which it had $ 12 million shares. While reporting in its financial statements, Enron did not consolidate this joint venture and the debt in JEDI was not reported in the balance sheet, (Schwarz, 2002, np). Enron avoided consolidation in order to achieve its financial objectives.
Enron also sold assets to its special purpose entity and did not consolidate it in the financial statements as recommended by the generally accepted accounting principle rules. The special purpose entities were used by Enron’s management in inappropriate profit realization and recognition. Enron moved its assets to the special purpose entities and reported this as sales. This transaction inflated their profits and by so doing they were able to report high profits as they wanted. This Is contrary to the generally accepted accounting principles rules. Enron acquired another special entity called Chewco and a joint venture for a total cost of $383 million; this was supposed to be recorded as a debt in the books. Enron did not record this debt and therefore their profits were inflated.
Special Purpose Entities
c).The main intention of Enron’s management on the issue of stock options was to bring about the alignment of the specific interest of shareholders with those of the management. The other reason was to show the focus of the management of Enron on the creation of anticipation of rapid growth and its effort to push up its reported earnings in order to meet their expectations. Enron’s management acted contrary to the agency theory which says that agents should represent the interest of principals. The management of Enron had conflicting interests. The managers issued the stock options without restricting the number of shares the managers ought to own and hence they ended up having a big portion of ownership. The management bought other short-term stock options and they manipulated the entity’s programs in favor of their interests.
The five main elements of financial statements are; assets, liabilities, revenue, expenses and equity. Assets refer to as resources which are controlled and managed by an entity as a result of the past events of transactions and are expected to produce future monetary benefits. Liabilities can be defined as current obligations that come from past transactions and they are supposed to be settled in future using the company resources.
Equity can be defined as the residual profit after removing liabilities from the total assets. Revenue refers to as increases in profits during a particular accounting period. Expenses can be defined as cash outflows
a).Assets are measured using the historical cost, fair value, present value, current costs and net realizable value. CBA bank of Australia, according to its annual report (2017) measured its asset using the historical cost method and fair value method (Commbank.com.au, 2018).
Liabilities are also measured using the historical cost method, present value, net realizable value, current cost and fair value (Iasplus.com, 2018, np). According to CBA bank of Australia annual report for (2017), the liabilities were measured using the historical cost.
Measurement Methods Used by CBA
Equity is measured as the residual value after subtracting assets from liabilities. According to CBA annual report (2017), the equity was measured using the fair value.
Revenues are measured using fair value. According to the CBA annual report (2017), the revenues of the bank was measured using the current market value and the quoted prices.
Expenses are evaluated using the operational costs. In the case of CBA bank, the expenses were measured using operational costs.
Stock Options
b).The assets, liabilities, revenues and equity of CBA bank of Australia were measured using fair value. This method of measurement helps to make information more meaningful and gives the true picture of an organization. Expenses were measured using operational cost and this brought about consistency. Decision useful information means the information provided is understandable by the user, is reliable, has timeliness and is comparable.
c).CBA bank measured its assets, liabilities, revenues and equity using fair value. This method is important because, it shows consistency, materiality and impartiality. Expenses were measured using the operational cost; this method is significant because it brings about understandability.
Bond Liabilities and Interest Expense
Bond issuers act as lenders because bonds are issued in form of money. After a period of every six months, the bond borrowers are required to pay interest on the bonds which known as the interest expense. The face value of the bond is paid during the maturity of the bond. Face value payment is completed in a single date when the bond is fully matured.
Businesses trade their bonds at premium or at discounts. In the straight-line method, if the bond is sold on premium, the bond premium ought to be discounted to zero. Example if a business sells a bond at a premium of $ 8000, the premium amount has to be discounted back to zero during the lifetime of the bond and in this case, it may be 6 years. While discounting, the bond value which was, for example, $ 108000 will reduce yearly to $ 100000 and this termed as amortization. At the end of every financial year, the payable bonds are debited and the interest expense credited, this activity is repeated in the lifetime of the bond. This method is the easiest way of reporting for bond discount and premiums.
This is another method of discounting bonds. This technique is majorly used to discount bonds which are issued on discounts, (Prosic, 2014, pp.35). Under the effective interest method, the amount of discount of the bond is amortized in order to come up with interest expense (Bizfluent, 2018, np.). The effective interest method is most ideal in amortization than the straight-line method although it is a bit more complex. To arrive at the interest expense, the coupon rate is multiplied by the actual bond value. The cash interest is subtracted from the interest expense and the residual value becomes the discount amortization for that period.
At the end of every year, the amortized value is added to the carrying value in order to come up with the interest expense and discount for years that follow. Premiums under this method are amortized in this way. Under this method, discounts and amortized amounts fluctuates yearly (Kimmel, Weygandt and Kieso, 2011, np.).
Conclusion
To sum up, it is evident that the effective interest method is more complex than the straight-line method and it, therefore, gives a more accurate value compared to the straight-line method. When bonds mature the two techniques produce the same results with regards to the amortized amount, cash interest and the interest expense. Both the two techniques should be used in the calculation of bond interest because they give almost the same results. In circumstances where more accurate amounts are required then the effective interest method should be used. Since the two approaches are useful, bond liability should not be reported using fair values in the balance sheet.
References
Bigman, D., Goldfarb, D. and Schechtman, E. (1983). Futures market efficiency and the time content of the information sets. Journal of Futures Markets, 3(3), pp.321-334.
Bizfluent. (2018). FASB Depreciation Method. [online] Available at: https://bizfluent.com/info-8032557-fasb-depreciation-method.html [Accessed 21 Sep. 2018].
Commbank.com.au. (2018). [online] Available at: https://www.commbank.com.au/content/dam/commbank/about-us/shareholders/pdfs/annual-reports/annual_report_2017_14_aug_2017.pdf [Accessed 21 Sep. 2018].
Iasplus.com. (2018). IAS 39 — Financial Instruments: Recognition and Measurement. [online] Available at: https://www.iasplus.com/en/standards/ias/ias39 [Accessed 21 Sep. 2018].
Kimmel, P., Weygandt, J. and Kieso, D. (2011). Accounting. Hoboken, N.J.: Wiley.
Nelson, K., Price, R. and Rountree, B. (2008). The market reaction to Arthur Andersen’s role in the Enron scandal: Loss of reputation or confounding effects?. Journal of Accounting and Economics, 46(2-3), pp.279-293.
Prosic, D. (2014). Interest and hidden traps in the interest rate calculation methods. Bankarstvo, 43(3), pp.38-81.
Schwarcz, S. (2002). Enron, and the Use and Abuse of Special Purpose Entities in Corporate Structures. SSRN Electronic Journal.
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