Mark to Market Approach and Enron’s Fall
The mark to market approach was one of the chief reasons of the fall of the company Enron (Markham, 2015). The mark to market approach refers to the measurement of the various accounts of assets and liabilities at their fair values, which keep on changing as per the various industry and market conditions. The users of the fair values advocate the reasons of better transparency and the realistic approach as compared to the book values, to be used in the accounting principles. The supporters of the fair value believe realistic current market value of the assets and liabilities display the actual picture of financial position of the corporation. However, the determination of the fair value is a complicated process. The Enron company’s main business was the trading of the energy and related commodities. The company was formed in the year 1985. The company Houston Natural Gas and Inter North Inc. had merged their energy business to form the company Enron. The top management of the company had decided to follow the mark to market (MTM) accounting method, instead of the traditional method based on the historical cost of the assets. As the fair values are required to be measured at the end of the each reporting period, the management of the company would compute the outstanding balance of derivatives contracts and other energy contracts at fair values. Accordingly, the booking of the gains and losses that were unrealised at the end of the reporting period were charged to the income statements. As the fair value measurements are based on a number of assumptions and estimates, the directors of the corporation overstated the earnings of the entity with the aid of overstatement of the fair values and booking the profits thereon. As the management was required to determine the market value of the contracts of the gas, some of which were even 20 years old, the management failed to examine the vitality and the cost of such contracts. The company had shown the present values of the contracts entered into with the companies, making estimated profits of $110 million and $ 0.5 billion of the pilot projects and the energy supplies respectively; without the consideration of vitality of the contracts.
Special purpose entities are the means by which the corporations securitize some of their assets. These are shell vehicles in real, through which the companies hold their own assets, without showing them the part of their financial statements. These entities are funded by the aid of the equity investors and through the means of the debt financing. In order to determine whether a special purpose entity is independent of a corporation, the autonomous investors must hold an approximate of 3 percent of the total debt and equity possessed by the special purpose entities (Fischer and Marsh, 2017). The company had created about hundreds of the special purpose entities, to primarily display the better financial reporting picture of the entity. The company had violated the rules of the accounting in order to avoid the debt component from its financial statements. Thus, while on the one hand the company understated its liability, it overstated its equity and earnings on the other, posing a rosy picture to the stakeholders. The company Enron had capitalised the special purpose entities it had created with a number of the assets that were on a consistent fall in the prices, to avoid the losses in the statement of financial positions at the end of the reporting periods. The restatement of the accounts in order to correct the acts resulted in the increment in the liabilities by $628 million and decrement of the earnings by $613 million.
Special Purpose Entities and Accounting Violations
According to the application of the agency theory to the corporations, the directors and the top management of the entity are regarded as the agents, who are required to work and manage the affairs of the entity in the best interests of the stakeholders. The agency theory is regarded to be violated when the agents do not act according to the interest of the corporation, rather put their individuals interest ahead. The top management compensation also played a significant role in the fall of the entity. The compensation scheme can be linked to the influencing of the prices of the stocks in the market, by the projections of the optimistic profits and the growth objectives to the stakeholders in the market. The management of the Enron used to enjoy a very high compensation, especially that at the executive level. While the management of the entity used the technique of influencing the short-term profits through the stock compensation schemes, the same failed to realise any long-term value to the stakeholders (Kim and Zhang, 2016).
In addition to influencing the stock, the management of the entity also did not pay attention to its compliance and regulatory responsibilities in terms of the fair trade practices and transparent accounting policies. This resulted into entity venturing into illegal activities and irresponsible reporting, keeping the stakeholders away from the real picture of the corporation’s financial position. Thus, as per the discussions conducted above, it can be stated that the top management if the entity violated the principles of the agency theory. This was done by creation of special purpose entities, overstating the profits by the use of the mark to market accounting approach and providing the huge compensations to the directors and managers at the top level and executive positions.
The five main elements of the financial statements of the listed companies as prescribed by the International Financial Reporting Standards conceptual framework are the Assets, Liabilities, Equity, Income, and the Expense. The top management if the entities are entrusted with the responsibility of choosing the measurement methods and the accounting principles as suited for the entity, out of all the available approaches. It is significant to note that while one measurement method or accounting policy may depict the results in a certain manner, the amounts and the nature of reporting as per the other accounting principles and the measurement methods may be different. Thus, management must carefully make the choice between the available methods and policies, in lines of the compliance requirements and the nature and industry of the business. The company chosen to conduct the research on the financial statements and report on the measurement methodologies is Walmart. The same has been listed on the New York stock exchange.
Impact of Compensation on Enron’s Downfall
The various measurement methodologies adopted by the company for different elements of the financial statements have been explained as follows.
The receivables of the entity are measured at the carrying values of the same and the same are netted with the amount of the reserve created for the doubtful accounts (Walmart, 2018).
The inventory of the entity is measured at either the cost, or the market value, whichever is lower of them. The measurement of the cost of the inventory of US segment of the Walmart is done using the Last in, first-out (“LIFO”) method. The inventory of the international segments is valued at the first-in, first-out (“FIFO”) method. Thus, the company follows the retail inventory method of accounting (Walmart, 2018).
The property, plant, and equipment of Walmart are initially recoded at the costs (Walmart, 2018).
The long lived assets are also recorded at the cost, and the same are evaluated on the lines of the impairment loss, if any. The impairment loss is stated to be occurred when the carrying amount of the assets may not be recoverable in the market. Hence, the entity Walmart measures the potential impairment loss at the fair value of the related asset or the group of such assets.
Goodwill of the corporation is measured computing the excess of the purchase price of the net assets, over their fair values in the market. The fair values is further determined by computation of the discounted cash flows and the other approaches on the basis of the industry and market practices.
The decision useful information is the information that aids an investor, regulator, or the other stakeholders of the concerned entity, to make the decisions about the financial viability of the enterprise. The evaluation of the financial statements cannot be alone done by the numerical figures stated therein. The stakeholder can gain a decision useful information by looking at the various incidental factors to the numerical figures stated in the financial statements. Some of the examples are such as the choice of the method of the accounting, the choice of method of depreciation, the choice of inventory and other asset valuation, information post the preparation of the financials, related party disclosures and much more. Thus, the same should not be overlooked while assessing the financial statements.
For instance, the entity regards the assets held for sale as the ones that meet the requirements as pronounces by the IFRS framework to be held for sale (Walmart, 2018). The entity presents the same as the single amount of the asset or the liability with a respective amount for the valuation allowance. The net carrying amounts are measured at the fair value or the cost, whichever is lower. Further, the amount of the sales, if any is deducted thereon. In order to represent the true values of the assets held for the sale, the yearly review is conducted to assess the vitality of the recoverable amounts of the carrying values in respect to the sales.
Measurement Methodologies of Walmart’s Financial Statements
The company further stated that it has included the immaterial amounts of the assets and liabilities held for sale, as part of the prepaid expenses and other and accrued liabilities, while making disclosures in the Consolidated Balance Sheets for the year ended on January 31, 2018 and 2017 (Walmart, 2018).
Thus, in order to first understand the amounts represented by the assets held for sale of the entity, the stakeholders must first understand the nature of these elements, together with how the same are measured in balance sheet, and if the impairment is charged, on what basis the same has been charged.
Some of the techniques used by the corporation have been stated as follows.
Firstly, the company measures the inventory using the retail inventory method of accounting (Walmart, 2018). This enables the valuation of the inventory at the lower of the costs of the market value. The technique of the retail inventory method of accounting is best suited for the company, because of the kind of industry it is part of. In addition, it record the permanent markdowns in the value of the inventory immediately, together with the reduction of the retail value of inventory in the market.
Another technique that has been used by the company is for the measurement of the ROI. While the numerator includes the sum of the operating income, interest income, depreciation and amortization, together with the rent received. The denominator includes the sum of the average total assets, the sum of accumulated depreciation, rent, and the average of liabilities and payables are deducted thereon. The numerator figure is referred to as the adjusted operating income, and the denominator figure is referred to as the average invested capital.
Thus, the ROI as per the stated techniques for the company is shown as follows.
For the year ended on January 31, 2018:
Adjusted operating income = $ 34,050 (in millions)
Average invested capital = $ 239,974 (in millions)
Thus, the ROI amounts to 14.2 %
In order to compare the ROI of a different firm, with that of the Walmart Inc., the stakeholder must first compare the method and respective items included.
Hence, it can be said that different entities adopt different techniques for various components of the financial statements. Stakeholders’ must carefully assess the same to judge the information.
References
Fischer, M. and Marsh, T. (2017) Special Business Entity Reporting: One Plugged Hole is better than none. ASBBS Proceedings, 24(1), p. 188.
Kim, J. B. and Zhang, L. (2016) Accounting conservatism and stock price crash risk: Firm?level evidence. Contemporary Accounting Research, 33(1), pp. 412-441.
Li, Y. (2010) The case analysis of the scandal of Enron. International Journal of Business and Management, 5(10), p. 37.
Markham, J. W. (2015) A financial history of the United States: From Enron-era scandals to the subprime crisis (2004-2006); From the subprime crisis to the Great Recession (2006-2009). Oxon: Routledge.
Walmart. (2018) 2018 Annual Report. [online] Available from: https://s2.q4cdn.com/056532643/files/doc_financials/2018/annual/WMT-2018_Annual-Report.pdf [Accessed on 30/09/2018].
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