Enron’s Unethical Practices
- a) Mark to market accounting approach can be described as an accounting technique which values assets according to the existing current market levels(Sapra, 2008, p.380). It simply shows how much an organization will receive if it sells its material goods today. It can also be termed as the fair value accounting technique. This method usually works when organizations release every year financial statements which reveal the fair value of the organizations. Mark to market accounting technique is also used in measuring the financial records fair value in terms of assets and liabilities of an organization. The fair market values of asset and liabilities are released at the end of every fiscal year so as to reflect the current market levels. The following are the example of places where Enron misused the mark to market accounting method.
Enron signed a 20-year agreement with Blockbuster so as to introduce entertainment on demand during the year-end. Enron estimated $110 million profits and recorded in its books of accounts although it was not sure about the market demand for entertainment which was subject to fluctuation.
Enron entered into a$ 1.3 billion contracts with Indiana to supply electricity to Indian polis Eli Lilly company which was supposed to last for 15 years, Enron reported the present value of the contract as revenues and reported the cost of servicing the contract as an expense, even though Indiana had not deregulated in order to determine the actual expense servicing cost (Trinkaus and Giacalone, 2005,p.245).
- b) Special purpose entities can be described as lawfully separate entities (business) that take risks so as to reverse situations for a company or a corporation. Special purpose entities are not usually recorded in the books of accounts by a company. Special entities are always formed to perform specific duties. They can be termed as subsidiary companies of the larger companies because larger companies take less than 20 per cent ownership rights. The special purpose entities are created for distinct and very isolated reasons which majorly entail narrowing the extent of risks to the assets and liabilities of an organization. Special purpose entities can be categorized into three which includes; joint venture companies, off-balance sheet financing companies and asset securitization companies.
Enron sold an asset to one of its special purpose entities and did not consolidate it in the financial statements and hence it did not follow the GAAP rules. Enron also used the special purpose entities for improper revenue realization and recognition. Enron transferred assets to the special purpose entities and recorded them as sales and therefore their revenue was inflated and this would enable Enron to report their desired results contrary to the GAAP rules. Enron also acquired Chewco and a joint venture which cost $ 383 million and did not report in the financial statements as debt hence inflating its financial statement too.
Enron formed several controversial special purpose entities in order to achieve its financial reporting objectives and a good example is in 1997 where Enron wanted to purchase a partner’s stake in one of its numerous joint ventures and it did not want to illustrate any debt on the balance sheet as a consequence of financing the venture. Enron used the special purpose entities to show understated liabilities and overstated equity and earnings in the balance sheet.
Enron used the special purpose entities in funding the risks associated with the specific assets. Enron used the special purpose entities to fund the acquisition of gas reserves from their producers (Schwarcz, 2002, np.). In the case of Enron, the investors of special purpose entities received revenues from the sale of reserves (Jain and Bowman, 2005, p.85).
- c)
The main reason of stock options issuing was to bring into line the interest of shareholders and that of management and to show the focus of Enron management on creating expectations of rapid growth and its effort to blow up reported earnings to meet the Wall Street’s expectations. Trinkausa and Giakalone discussed on the silence of stakeholders of Enron (Trinkausa and Giakalone 2005, p.238). This was contrary to agency theory which stipulates the relationship between the principal and the agent. (Foss and Stea, 2014, p.114) The agent is supposed to represent the principal but the managers of Enron had a conflict of interest. Enron management issued stock options to the managers and directors without restricting the sale of stock to the management. Enron issued short-term stock options to its managers hence they set the stock compensation programs that suit their stock holding. The management of Enron did not represent their principal interest but represented their own interest in the company and this was contrary to agency theory.
Measuring Financial Elements in Listed Companies
The five elements of financial elements include; Assets, liabilities, equity, revenue and expenses (Vakutin and Fedulova, 2018, p.265). Assets can be defined as properties which are controlled by a particular entity as an outcome of past transactions and events and which are anticipated to give the company future benefits or rewards (Chalmers, Clinch and Godfrey, 2008, p. 240). Examples include things like land, furniture among others. They can be categorized into three; current assets, fixed assets and tangible assets.
Liabilities are future obligations of a company which occur from the past transactions and which will be settled by the assets of the company. They can be divided into long-term and short-term borrowing. Liabilities usually correspond to the future claims in the business by investors and outsiders. Short-term borrowings are usually paid in a period of less than a year while the long-term borrowings can take a long period before they are settled (Assaad Khalil, 2010, np.)
Equity can be defined as the residual resources when you subtract total liabilities from the total assets, for example, ordinary shares.
Revenues can be defined as increases in economic proceeds during a bookkeeping period in terms of cash inflows an example is the sales revenue.
Expenses can be defined as costs that arise due to the daily operations of a business entity for example salary expenses.
a) Assets=liability + shareholders’ equity
Assets are usually measured by adding the liabilities with shareholder’s equity. Some assets are difficult to measure for example patents. Assets may be measured using the historical costs, measured using the current replacement value or amortized cost. Assets can be measured using the following bases, the historical cost, market value, the replacement costs, the net selling price and value in use. The total assets of Barclays bank in the year 2017 was 1133248 million (Home.barclays, 2018).
Liabilities are measured using bases, for example, using the historical cost base, market value base, the cost of release, the assumption price and the cost of fulfilment. The total liability for Barclays bank in the year 2017 was 1067232 million Euros. (Barclays home liabilities report 2018).
Revenue is gotten using the profitability ratios and that is by dividing the net income by sells. The total revenue for Barclays bank in the year 2017 was 21076 million Euros. (Barclays home revenue report 2017)
Expenses are measured by valuing goods or services that are consumed. It is measured by cost. The total expenses for Barclays bank in the year 2017 was16713 million Euros (Barclays home 2017)
Assets
Equity is measured by subtracting liabilities from assets. The total equity in the year 2017 for Barclays banks is 66016 million Euros (Barclays home 2017)
b) Assets of Barclays have been measured using the fair value. This measure postulates that assets should be measured using the current market value. This means that it should be measured using the current market value or prices by which the asset can be sold currently in the market. This method helps the information to be useful because it makes the information relevant to decision making.
Liabilities of Barclays have been measured using the revenue realization concept and the market value. This is because they are realized when they occur using the current market prices. This method is used to make the information reliable. This helps the financial statement users to make meaningful decisions.
Revenue is measured using the profitability ratios in Barclays using the fair value method. The profitability ratios make the information to be comparable as an investor gets the same results using different approaches hence useful in decision making. Ratios help make the information to be useful.
Expenses are measured also using the fair market value as they are consumed or of an activity. This helps the businesses to cater for the effect of inflation as assets exist in the business. This is useful as it increases the relevance of information.
Equity has been measured by subtracting liabilities from the assets also by using the fair market values. This has been arrived at using the double entry concept. This is useful as it helps increase the accuracy of information.
c) Barclays bank has majorly used the fair market value in measuring assets and liabilities financial statements. The fair market value of Barclays company is arrived at in reference to the quoted market value rates. In some cases, it has used the historical cost method. This method may be more useful than the other methods because it increases the reliability of the financial statements as to when it is compared with other companies it gives the same results. It also increases relevance as it helps in making important decisions about the company. This method also increases understandability of the financial statements by making it simple for the users such as decision-makers, investors, lenders among others
Bonds are reported as long-term debts. Bonds are given to borrowers inform of money by investors and this makes the investors appear like lenders. The bond requires the borrowers to pay interest in every stipulated period and the face value to be paid when the bond matures. The bond interest is normally paid semiannually and that is every six months. The interest payments of the bonds are usually arrived at using the following formula, the face value of the bond multiplied by the stated annual interest multiplied by half a year.
Liabilities
The principal amount of the bond must be paid to the bond issuer when the bond matures and this is more often than not due in a single date.
When a business decides to trade bonds at an interest rate which is lower than the fixed interest rate percentage then it is said to have sold at a premium. Using the straight-line method, the balance of the bond premium must be reduced to zero. For example, assume our bond premium was 4000. This amount must be reduced to 0 over the life of the bond. By so doing the book value of the bond will be decreasing from 104000 to 100000 and this method is known as amortization. The amortization of bonds, in this case, involves the use of interest expense. Every end year the bonds payable is debited and the interest expense is credited and this is done during the life of the bond.
Straight line method is the simplest method to report for bond discounts. In this method, the premium or discount offered on bonds are amortized over the life of bonds in equal amounts.
The effective interest method is used in discounting of bonds in accounting. It is usually used in bonds that are given on discounts. In this method, the discount amount is usually amortized to interest expense during the period in which the bond is sold (Brayton and Tinsley, 1996). This is usually the most preferred method in amortizing a bond. This is a more complex method than the straight-line method. The cash interest in this method is arrived at by multiplying the coupon rate with the bond value. The discount amortization is calculated by subtracting the cash interest from the interest expense and the results would be discount amortization for a year.
Every end of the year, amortization is added to the carrying value and this procedure is usually repeated in order to come up with the interest expenses and discount amortizations for the following years. In this method, the company’s amortization amounts and the interest expenses are therefore subject to change yearly. Also, premiums under the effective interest method are amortized in the same technique as discounts. The carrying amount of value of the bonds multiplied by the rate of return required by investors and this results to interest expense which is the same as premium amortization. At the end of the year, the premium amortized is subtracted from the carrying amount and the remaining carrying amount used in the calculation of the following years’ amortization and interest expense.
Equity
We can, therefore, say that the straight line method is simpler than the effective interest method. This is because of the same interest expense, the amortization premiums and cash interest results to the bond discounts. Contrary the effective interest results differ yearly because the amortization and interest expense are different in every year, only the cash interest paid on bonds remains the same (Cornaggia, Franzen and Simin, 2011, np.).
The straight line method during the early stages of the life of the bond results to more premiums compared to the effective interest method and the effective interest method results to more premiums towards the end of the life of the bond (Abdelkafi, Ghorbel and Khoufi, 2018, p.371). During the maturity of the bond, the two methods should give the same results in terms of the total amount of the cash interest, the totals of the interest expense and that of amortization. Both the two techniques provide the same useful information and whether one decides to use either of the techniques it would give the same results. Bonds should therefore not be reported using the market value in the balance sheet but reported using either the straight-line method or the effective interest rates. The effective interest method gives slightly a more accurate figure than the straight-line method but the two methods are effective.
References
Abdelkafi, S., Ghorbel, A. and Khoufi, W. (2018). Energy portfolio risk management using time-varying copula methods: application to bonds, interest rate and VIX. American J. of Finance and Accounting, 5(4), p.371.
Assaad Khalil, K. (2010). Financial Statements as Sole Predictors of Financial Distress: The Need for New Financial Ratios. SSRN Electronic Journal.
Brayton, F. and Tinsley, P. (1996). Effective interest rate policies for price stability. Economic Modelling, 13(2), pp.289-314.
Chalmers, K., Clinch, G. and Godfrey, J. (2008). Adoption of International Financial Reporting Standards: Impact on the Value Relevance of Intangible Assets. Australian Accounting Review, 18(3), pp.237-247.
Cornaggia, K., Franzen, L. and Simin, T. (2011). Manipulating the Balance Sheet? Implications of Off-Balance-Sheet Lease Financing. SSRN Electronic Journal.
Foss, N. and Stea, D. (2014). Putting a Realistic Theory of Mind into Agency Theory: Implications for Reward Design and Management in Principal-Agent Relations. European Management Review, 11(1), pp.101-116.
Home.barclays. (2018). Annual Reports | Barclays. [online] Available at: https://www.home.barclays/barclays-investor-relations/results-and-reports/annual-reports.html [Accessed 18 Sep. 2018].
Jain, S. and Bowman, H. (2005). Measuring the gain attributable to revenue management. Journal of Revenue and Pricing Management, 4(1), pp.83-94.
Schwarcz, S. (2002). Enron, and the Use and Abuse of Special Purpose Entities in Corporate Structures. SSRN Electronic Journal.
Sapra, H. (2008). Do accounting measurement regimes matter? A discussion of mark-to-market accounting and liquidity pricing. Journal of Accounting and Economics, 45(2-3), pp.379-387.
Trinkaus, J. and Giacalone, J. (2005). The Silence of the Stakeholders: Zero Decibel Level at Enron. Journal of Business Ethics, 58(1-3), pp.237-248.
Vakutin, N. and Fedulova, E. (2018). Developing the Accounting Policy Elements, Providing the Conditions for Leaseback as a Tool of Corporate Finance Management. International Accounting, 21(3), pp.254-270.
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