Mark-to-Market Accounting
The confidence of users of financial statements hit the rock bottom on accounting and financial reporting post the publication of Enron Scandal in October, 2001 that led to the dissolution of the company, Enron Corporation. The accounting scandal of Enron highlighted the number of shortcomings of different accounting concepts and auditing failure to such a large extent. A brief discussion on the different aspects of accounting shall be made in this document by keeping in mind the accounting scandal at Enron Corporation.
- Mark to market accounting:
Mark to market accounting better known as Fair Value Accounting is the accounting method that measures the amount of assets and liabilities on the basis of current market price. Since 1990 the concept of mark to market accounting has been an integral part of Generally Accepted Accounting Principles (GAAP). Though the concept is now often regarded as the gold standard to disclose the true and fair picture of an organization via financial statements however, the management of Enron used it for their personal benefits and gains at the expenses of the company (Chen, Shroff & Zhang, 2017).
The accounting in Enron’s natural gas business was fairly simple. Actual revenues received from selling the natural gas used to be recorded in the profit and loss account and the actual cost of supplying such natural gas was charged against such revenue to disclose the amount of profit or loss from business operations. However, the accounting method was changed to mark-to-market accounting subsequent to the demand made by Skilling after joining the company (Terando, Cataldi & Mennecke, 2017). According to Skilling mark-to-market accounting would reflect the true economic value of company’s natural gas business and its performance. In an out of the box decision, at the time of the decision at least it seemed that way, the company became the first non-financial company to use the method for reporting its long term contracts. As per the method of accounting the accountants required to record estimated amount of income from long term contracts immediately subsequent to the signing of such contracts. Such income was estimated at the present value of net cash flows in the future (Welch, 2017). The management recorded high amount of expected earnings even from long term contracts whose viability related to costs and future cash flows were difficult to estimate. The management kept on recording income from projects without even verifying the ability of the company to recover such income in the future. As a result the investors were provided with false and misleading information. The management failed to match the profits and cash due to recording income from long term contracts that never generated any income in reality. The large discrepancies between cash and income were compensated by providing false and misleading financial reports to the shareholders and investors of the company. As a result the future earnings of the company as per the books of accounts kept on increasing without any realistic possibility for the company to generate such income in the future. With no profits could be included in future years from number of projects the management manipulated the accounts by including income from fictitious projects (Magnan, Menini & Parbonetti, 2015).
Special Purpose Entities
Thus, a rosy picture of the company was portrayed by using mark-to-market accounting to appease the investors of the company with the objective of keeping the share prices of the company as high as possible.
- Use of special purpose entity concept by Enron:
In order to fulfil specific and temporary objectives special purpose entities are created by companies. Special purpose entities (SPEs) are legal entities and generally formed as limited companies and mainly used by companies for isolation of a firm from financial risks of different types. However, Enron has used more than hundreds of such SPEs to hide its debts. In case of Enron, the SPEs were used not only for circumventing accounting conventions but also to circumvent number of provisions of corporate regulations of the country. The liabilities of Enron were understated and the equity of the company was overstated by use of SPEs. The equity was overstated by overstating the earnings of the company to mislead the investors of the company (Demerjian, Donovan & Larson, 2016). The use of SPEs were supposed to be made only to achieve specific and temporary objectives by an organisation but in this case Enron has used to circumvent accounting conventions and flouting the rules and regulations of corporate reporting.
- Main purpose of stock compensation scheme provided to the top management:
The most integral part of executive compensation scheme of Enron was the stock option scheme. The executives in addition to high remuneration enjoyed extensive stock options. The management knowing the huge stock options available used misleading and false financial information to fuel the rapid growth expectations. As a result the share prices used to soar and the management with significant amount of stock options available can make profit from selling stock options (Yao, Percy & Hu, 015). In fact in budget meetings the executives used to discuss the target profits that would keep the stock price high instead of discussing on the operations of the company to improve its financial performance and subsequently position in the future. At one point almost 13% of the outstanding stock of the company was attributable to stock option plans. In January, 2001 two of the top executive of the company, Lay, had a beneficial ownership in the company of $659 million and Skilling’s beneficial ownership of $174 million (Singh, 2015).
Thus, from the above it seems that the stock option compensation scheme of the company was mainly to maximize the wealth of the top executives of the company at the expense of the company. The false and misleading information to fuel the fictitious growth of the company was to appease the investors to keep the share prices of the company as high as possible to maximize the wealth of the executives of the company (Barth, 2015).
Telstra Corporation is the leading service provider in telecommunication industry in Australia. The practical reference from the annual report of the company has been taken to describe five elements of financial elements in this part of the document.
- Five elements of financial elements:
As per the conceptual framework of International Financial Reporting Standards the five elements of financial elements are assets, liabilities, revenue, expenses and equity. These are the five elements that measured and valued in financial reports of an organization to correctly disclose the financial information of an organization in its financial statements (de Jager, 2014).
Executive Compensation
As per the annual report of Telstra the five elements of financial elements have been measured and disclosed using the following methodology.
Assets: The assets are the resources held by an entity to be used by the entity to earn economic benefits in the future. The assets are valued either using historical costing method or by using fair value accounting methodology. Telstra has clearly mentioned in its annual report that the assets of the company have been valued using historical costing method except for financial assets such as equity instruments and debt instruments (Tissot, 2016).
Liabilities: The liabilities are the amount of future obligation of an entity that the entity expects to pay in the future to discharge such obligation. Again Telstra has valued the liabilities of the company using historical costing method except for financial liabilities that were subjected to the methodology of fair value accounting (Rassier, 2014).
Revenue: It is the monetary value of benefits that an organization earns from business operations. The benefits may have been received or receivable thus, both elements are recorded. Telstra while recording revenue in the books of accounts have followed the applicable IFRS to record revenue in the books of accounts. The amount of revenue has only been received once the services have been provided and the amount has either been received or there is significant doubt regarding the recoverability of the amount of revenue (Chang, Fu, Low & Zhang, 2015).
Expenses: It is the ordinary expenditures incurred by an organization to earn revenue from business. For an organization selling goods it is the cost of goods and other associated costs incurred in selling the goods to the customers. Telstra has followed the matching concept while recording expenditures in the books of accounts. Thus, all expenditures that have been incurred to earn the revenue in a particular period has been recorded against the revenue of the company to ascertain the amount of profit earned or loss incurred during the period (Poole, 2017).
Equity: Equity or owners’ equity is the portion of capital invested in the business by the owners of the business. In case of companies having share capital such as Telstra, it is the aggregate amount of share capital, reserves, balance in retained earnings and accumulated profit or losses. Telstra has disclosed amount of share capital, reserves, retained earnings and accumulated profit to disclose the owners’ equity (Robinson, Henry, Pirie, Broihahn & Cope, 2015).
- Measurement method and its usefulness:
Measurement method used by an organization to a certain extent determine the financial performance and position of an organization to be reported in its financial statements.
In case of Telstra Corporation, as mentioned earlier the company has used historical cost method to measure assets and liabilities of the company except for financial assets, debt and equity instruments. The use of measurement method to a certain extent affects the amounts to be recorded in the books of accounts. For example use of fair value accounting considers the current market price while measuring the value of assets and liabilities whereas historical costing uses actual cost incurred on the date of acquisition to measure assets (Prentice, 2016).
Financial Elements
The decision useful information is the information that helps the stakeholders of an organization by providing important financial and nonfinancial information of about the organization. Based on such information the stakeholders find it easier to take important decisions affecting their interests in an organization. Financial reports contain information about five elements of financial statements, assets, liabilities, revenue, expenses and equity (Camilleri & Camilleri, 2017). The measurement methodologies used by an organization affects the value of these elements in financial reports. Thus, most effective methodologies should be used to correctly disclose the value of all these elements of financial statements in the financial reports of an organization. The users of financial statements will find such financial information very useful to take important decision affecting their interests in an organization.
- Critical analysis of techniques used by an organization:
In United States of America, both effective interest method and straight line method are allowed to disclose bond liabilities and interest expenses. However, Australia allows only effective interest method to measure the value of bond liabilities and interest expense. Thus, entities operating in Australia including Telstra must use effective interest method to measure bond liabilities and interest expenses (Weygandt, Kimmel & Kieso, 2015).
The annual report of Telstra issued for the year 2018 disclosed the measurement technique that the company has used to value its bond liabilities and interest expenses. The borrowings of the company for the year ending on June 30, 2018 is amounting to $16,951 million as per carrying value with $17,805 million is the value of total borrowings under fair value. Borrowings have been recognized on trade dates initially and has been derecognized immediately after the obligations in relation to such borrowings have been discharged. For subsequent measurements the company has stated in its annual report that it has used effective interest method to measure borrowings in financial statements (Warren & Jones, 2018).
Total amount of interest expenses on borrowings during financial year 2017-18 is amounted to $784 million as per the effective interest method. Net gain or losses at the time of subsequent measurements of borrowings have been recorded in the income statement of the company to reflect the impact of measurement on financial performance of the company.
Conclusion:
The utility of financial information is an important qualitative characteristic of financial reporting. In order to be useful to the stakeholders of an organization financial reports must disclose the true and fair values assets, liabilities, revenue, expenditures and equity of an organization. Proper measurement methodologies and valuation techniques must be used to ensure that financial elements are correctly valued and disclosed in financial statements.
References:
Barth, M. E. (2015). Financial accounting research, practice, and financial accountability. Abacus, 51(4), 499-510.
Camilleri, E., & Camilleri, R. (2017). Accounting for Financial Instruments: A Guide to Valuation and Risk Management. Routledge.
Chang, X., Fu, K., Low, A., & Zhang, W. (2015). Non-executive employee stock options and corporate innovation. Journal of financial economics, 115(1), 168-188.
Chen, W., Shroff, P. K., & Zhang, I. (2017). Fair value accounting: Consequences of booking market-driven goodwill impairment.
de Jager, P. (2014). Fair value accounting, fragile bank balance sheets and crisis: A model. Accounting, Organizations and Society, 39(2), 97-116.
Demerjian, P. R., Donovan, J., & Larson, C. R. (2016). Fair value accounting and debt contracting: Evidence from adoption of SFAS 159. Journal of Accounting Research, 54(4), 1041-1076.
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Robinson, T. R., Henry, E., Pirie, W. L., Broihahn, M. A., & Cope, A. T. (2015). International Financial Statement Analysis, (CFA Institute Investment Series). John Wiley & Sons.
Singh, J. P. (2015). Fair Value Accounting: A Practitioner’s Perspective. IUP Journal of Accounting Research & Audit Practices, 14(2).
Terando, W. D., Cataldi, B., & Mennecke, B. E. (2017). Impact of the IRC Section 475 Mark-to-Market Election on Bitcoin Taxation. The ATA Journal of Legal Tax Research, 15(1), 66-76.
Tissot, B. (2016). Globalisation and financial stability risks: is the residency-based approach of the national accounts old-fashioned?.
Warren, C., & Jones, J. (2018). Corporate financial accounting. Cengage Learning.
Welch, K. (2017). Private Equity’s Diversification Illusion: Evidence From Fair Value Accounting.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Financial & managerial accounting. John Wiley & Sons.
Yao, D. F. T., Percy, M., & Hu, F. (2015). Fair value accounting for non-current assets and audit fees: Evidence from Australian companies. Journal of Contemporary Accounting & Economics, 11(1), 31-45.
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