Part A: Accounting Approaches
The paper seeks to address the key issues that influence the financial investment market. The paper is divided into two parts. Part A addresses accounting approaches such as mark to market, Special purpose entities, and stock option plan and their impact on real companies. The focus is no the Enron Corporation and how it used the mark to market approach, special purpose entities techniques, and stock option plan to present a falsely financial position to its stakeholders. For example, Enron used the Chewco special purpose entity to hide its debts. Enron used stock option plan to create an impression that its stock was competitive in the market.
The second part addresses the different methodologies used by companies to measure their assets, liabilities, equity, income, and expenses. The common measurement methodologies are historical cost, current value, net realisable value, and present value. To present a true and fair value of an entity, the International FRS conceptual framework prefers the use of fair value and amortisation cost to obtain the real value of financial elements.
Mark to Market (MTM) refers to an accounting approach that is used to measure the fair value of balance sheet items such as assets and liabilities that are likely to change over time (Delaney & Whittington, 2008, p. 321). MTM entails recording the value of an account by reflecting on its current value in the market. MTM seeks to present a realistic position of a company’s financial position. For instance, financial service companies should mark down bad debt to fair value when borrowers default their loans (Epstein, 2009, p. 413).
A problem might arise where the mark to market-based value does not reflect the true value of an asset. Such a situation may occur when a company has to calculate the selling price of its assets during volatile periods like the financial crisis. When investors have lost confidence in a company’s share, such a company would be forced to lower the selling price of its shares. Subsequently, the value of owners’ equity would reduce (Nikolai, et al., 2009, p. 891).
The use of the mark to market accounting approach has been cited as one of the reasons why Enron Corporation failed. The approach was used to recognise expected future inflows and associated future outflows, undersigned long-term contracts, as revenues and expenses respectively. Likewise, the approach also treated unrealised gains and losses under such contracts as annual earnings at their occurrence (Nikolai, et al., 2009, p. 981).
Enron was faced with a challenge of estimating the real market value of long-term contracts. Although income was projected as the present value of the expected future cash flows, the viability of some of the contracts was raised. In 2000 a 20-year contract was signed between Enron and Blockbuster Video. Enron was to stream entertainment on demand product from Blockbuster globally using the formers broadband. Enron recognised the estimated profit of $110 million from the contract even though serious issues were raised about market demand and viability of the contract (Healy & Palepu, 2003, p. 9).
a) Mark to market accounting approach and its implication on Enron’s failure
Enron also entered a 15-year contract with Indianapolis Company with the former supplying the latter with electricity. Enron recognised $ 500 million as revenue and used the present value to report the cost associated with executing the contract. However, Enron did not take into account the cost impact it would face if Indiana decided to deregulate electricity (Thomas, 2002, p. 43).
Special purpose entity (SPE) is defined as a subsidiary company which is used to isolate risks associated with financial operations of a parent company. The entity is also known as bankruptcy remote entity because is used to isolate assets by acquiring and financing special assets (Russakova, 2005, p. 13). Special purpose entity enjoys separate legal obligation and should continue operating even if the parent company is declared bankrupt. Although SPEs are meant for the isolation of financial risks, chief finance officers take advantage of accounting loopholes to hide company debts in these entities. Enron serves as a good example where such a practice was used (Shajan, 2007, p. 193).
Enron used SPEs to either manage or fund financial risks associated with purchasing of gas reserves. Enron had hundreds of SPE sin 2001 which were purposely used to finance the acquisition of gas reserves by entering into long-term contracts with producers. However, some SPEs were meant for debts and poor financial performance (Healy & Palepu, 2003, p. 13). In 1997 Enron formed the Chewco SPE which was owned by its executives. Although Chewco was a joint venture to the Enron, its financial reports and statements were not included in the Enron’s consolidated balance sheet. The SPE accumulated a debt of $383 million which was not disclosed in Enron’s balance sheet as required by accounting standards. Moreover, 3% of Chewco assets were not owned by a third party as required by accounting standards. It was easier for Enron to overstate its earnings and equity while understanding the liabilities (Thomas, 2002, p. 49).
Enron did not provide full disclosure about its relationship with the SPEs to the investors. The investors did not know that the SPEs were operated using Enron’s share and funds which made their investment vulnerable to downside risks. Lastly, some employees were rewarded handsomely for agreeing to be partners in the SPEs at the expense of the investors (Russakova, 2005, p. 29).
Agency theory states that managers (agencies) should run a company in the best interest of the shareholders (principals). The management has a financial objective of maximising the wealth of the shareholders. Failure to act in the interest of the shareholders (wealth maximisation) leads to an agency problem. When there is a divergence of interest between the management and shareholders, conflicts might arise followed by separations (Bebchuk & Fried, 2003, p. 45).
Most companies, like, Enron use managerial competitions to not only retain talented managers but also align the interest of shareholders to those of the managers. Besides the performance shares option, companies also use executive stock option to reward managers. A stock option allows managers to buy shares at a future price and date. As such managers would strive to increase the profitability of a company to earn dividends. By becoming stockholders in a company, the interests of shareholders and managers are aligned: both of them seek increased returns on their investment (Flood, 2014, p. 78).
b) Special purpose entities and its application at Enron
In December 2000, Enron decided that 96 million shares (13% of its outstanding shares) were to be awarded to the executive managers through the stock option plan. The plan was to run for three years and was aimed to align the interests of the managers with those of shareholders. Kenneth Lay, Jeff Skilling, and remaining directors and managers were awarded 5,285,542 shares, 824,038 shares, and 12,611,385 shares respectively (Thomas, 2002, p. 31).
However, besides using stock option plan to align interests of the two parties, Enron wanted to create an impression that its stock was competitive in the market. The management projected that the stock price would increase. Subsequently, the earnings would increase hence the company would meet the expectations of Wall Street. The plan focused on the short-term impact, and there were no restrictions if the managers wanted to hold shares for a long term. The scheme failed because it could not create value for the company in the medium and long-term (Scholtz, 2009, pp. 11-19).
Companies use different methodologies to measure their assets, liabilities, equity, income, and expenses. The common measurement methodologies are historical cost, current value, net realisable value, and present value (Kieso, 2010, p. 431). This section analyses the measurement methodologies used by the Coca-Cola Company to measure financial elements using its 2017 annual report.
- Sales: Coca-Cola measures its sales at fair value after taking sales discounting, promotion and marketing incentives and listing fees into consideration (Coca-Cola, 2018, p. 147).
- Finance Costs: Coca-Cola recognizes its finance costs by using the effective interest rate method (Coca-Cola, 2018, p. 150).
- Taxation: The Company uses the liability method to measure the difference between assets and liabilities’ tax bases and their respective carrying value (Coca-Cola, 2018, p. 150).
- Intangible assets: intangible assets with an indefinite life are measured at their recoverable amount (carried cost less impairment losses). While intangible assets with finite are measured at amortisation over their useful lives (Coca-Cola, 2018, p. 154).
- The property, Plants, and equipment: Coca-Cola measures all its property, plants and equipment at their historical cost less impairment losses and accumulated depreciation (Coca-Cola, 2018, p. 157).
- Associates and Joint Arrangements: The Company measures its associates and joint arrangements using the equity method of accounting (Coca-Cola, 2018, p. 161).
- Inventories: The Company measures its inventories using either net realisable value or lower of cost (Coca-Cola, 2018, p. 163).
- Trade receivables: Coca-Cola measures its trade receivables using their amortisation cost. The effective interest rate method is used to calculate trade receivables.
- Trade Payable: The financial element is initially recognised at its fair value. Afterward, the trade payable is identified at an amortisation cost which calculated using the effective interest rate method (Coca-Cola, 2018, p. 164).
- Net debt: Debts are first recognised at their fair value before recording them at amortised cost. The amortisation cost is calculated using the effective interest rate method (Coca-Cola, 2018, p. 186).
- Equity: Coca-Cola only has ordinary shares which are recorded at par value (Coca-Cola, 2018, p. 190).
The analysis clearly shows Coca-Cola uses measurement methodologies such as fair value, effective interest rate method, liability method, historical cost less depreciation and impairment losses, and the equity method to measure its respective financial elements.
FASB and IASB define decision-useful information as the objective of financial measurement and reporting. A measurement method is deemed to have decision usefulness when it has achieved its intended purpose. Accounting research has not established a universally accepted decision of usefulness measure that can be used to rank competing measurement concepts like historical cost and fair value (Gassen & Schwedler, 2010, p. 496).
Coca-Cola uses fair value as an initial measure of trade receivables. Subsequently, the trade receivable are recognised at their amortised cost calculated using the effective interest rate method.
The effective interest rate method is an accounting approach used to discount trade receivables such as bonds during their life. The method is used to amortise the cost of a trade receivable to ensure the accumulated interest expenses at the end of the accounting period correlates with the items book value at the start of the accounting period (Beattie, et al., 2004, p. 209).
Under the effective interest rate method, Coca-Cola uses objective evidence based on the original terms to declare doubtful debts. Financial difficulties facing a debtor, debtor’s bankruptcy and a probability of delinquency in payments are mostly considered when measuring doubtful debts. Doubtful debts are written off when they become uncollectible and subsequently credited as an operating expense. Coca-Cola estimates its loans at their fair value before recognising them at their amortised cost after considering discounts, transaction and premium costs (Stickney, et al., 2009, p. 176).
Coca-Cola uses the effective interest rate method to determine the accurate value of its trade receivables. The company wants to know the actual interest received from an investment and financial instrument by taking care of the associated discounts, transaction or premium costs. In other words, Coca Cola’s objective is to avoid a situation where a trade receivable account is either understated or overstated. Based on the company’s 2017 annual report, the effective interest rate method achieved the decision usefulness because all metrics for measuring the accurate value of trade receivables were considered (FASAB, 2011, p. 13).
c) Purpose of stock option compensation scheme for Enron’s top management
Besides, the effective interest rate method, the straight-line method can also be used to measure an amortisation cost of trade receivables. Straight line method is used to charge cost and interest on trade receivables at a constant rate.
The effective interest rate methods are preferred compared to the straight-line method. First, the effective interest rate method is a more accurate measure interest rate to be earned from a financial investment or interest to be paid on a mortgage or loan. The actual book value of a trade receivable item is used to obtain the actual interest rate to be earned. That way, when the book value reduces, the real interest also realised declines (Beattie, et al., 2004, p. 231).
Financial analysts and investors rely more on the effective interest rate method because it provides accurate interest statement from the beginning to the end of an accounting period. Moreover, the effective interest rate method emphasizes on recalculating interest rate every month for accuracy basis. In the real market, interest earned is likely to change from one month to another because of unforeseen factors. When the straight-line method is used, the interest earned remains unchanged every month; this is more of an assumption than a real interest. Therefore the effective interest rate measure is a more accurate measure of trade receivables and other financial instruments (Stickney, et al., 2009, p. 465).
Conclusion
The study is based on two Corporations: Enron and Coca-Cola. The first part addresses the rise and fall of Enron Corporation and how the management used several accounting approaches to deceive stakeholders. In 2000 Enron recognised the estimated profit of $110 million from a contract between them and Blockbuster Video even though serious issues were raised about market demand and viability of the contract. Likewise, Enron used the Chewco special purpose entity to hide its debts. Lastly, Enron used stock option plan to create an impression that its stock was competitive in the market.
Coca-Cola Corporation uses different methodologies to measure its assets, liabilities, equity, income, and expenses. The common measurement methodologies are historical cost, current value, net realisable value, and present value. The International FRS conceptual framework prefers the use of fair value and amortisation cost to obtain the real value of a financial element. The paper established that the effective interest rate method is preferred when it comes to calculating amortization cost a financial instrument compared to the straight-line method.
References List
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