What is Mark-To-Market Accounting?
Mark to Market Definition and Explanation using the Enron’s Case
The mark to market accounting approach is an accounting strategy whereby the value of a particular asset is recorded following the price of such an item in the market. In this case, the value of the assets shifts daily depending on the decision of a large number of sellers and buyers in the market regarding the price of such an item. The fundamental application of the Mark to market strategy is employed when predicting future contracts especially among the investors who are often trading goods and services with margin accounts. Most global authors present pieces of literatures to support the use of Mark to market ideology in financial accounting as it provides the actual value of the assets. However, some authors criticize the method by claiming that forecasting of the asset value is difficult following the fact that this method relies on the asset price that is heavily depended on unpredictable buyers and sellers in the market.
One of the fundamental issues resulting in the fall of Enron is a shift from the previous method of accounting to the mark to market strategy. The change was greatly celebrated within the company in January 1992. The celebration came as a result of the clear announcement from the Securities and Exchange Commission that it won’t oppose the new method of the company. However, the strategy did not turn good as thought before but instead lead to the occurrence of the enormous fraud stated in the United States of America leading to the bankruptcy declaration of the company in 2001. The introduction of the mark to market accounting method as opposed to the historical cost accounting laid down the foundation for accounting abuse and fraud in the company. Unlike the mark to market strategy, the historical cost method acknowledges the cost of the asset while assuming that the price of the asset remains undefined until when sold. Many accounting professionals argue that the mark to market accounting strategy focus on valuations and estimates thus more of imaginations. In this case, the method is subjective and therefore provides gaps that promote accounting abuse.
The mark to market strategy requires constant and periodic adjustments of the asset value following the fluctuations in the market conditions. In this case, the Enron executive took advantage of the situation and recorded an increase in the asset valuations even in situations with a decrease in the actual ideology. Following the facts, the real value of the assets of the company had gone below the cost. Additionally, revenue recognition became another problem resulting from the mark to market strategy. Under the conventional accounting, the revenues are recognized only after a service is delivered, a product contract made and cost incurred. Otherwise, the mark to market strategy provides room for estimations whereby the revenue is recognized before any service is delivered and cost incurred. It is in this area that invited portholes for financial accounting frauds within the company.
Advantages of Mark-To-Market Accounting
A revenue recognition case example is when Enron made a contract off supplying Sithe Energies in 1992. The contract was to take 20 years. Furthermore, the company had to provide a daily gas equivalent to 195M cubic feet. The accountants who claimed to be smartest guys in the room estimated the value of the entire contract to lie between $3.5 to $4billion. Following the opportunity presented by the mark to market strategy, the Enron began premature documentation of the profits before even the company had started working. Following this scenario, Enron would book a revenue amounting to $3.5 in 1992 for a 20-year contract while being declared bankrupt just nine years later. In such a case, the investors, shareholders, and creditors of the organization were misled by the vast value of the revenue assuming that the company was large but in real sense operates on a small scale basis.
Additionally, the company came into a significant problem for recording cash flows only ones regarding the long-term projects. In such a case, the company recognizes large values on the financial statements while failing to present cash at the doors. The company, therefore, runs into a crisis of meeting the cost of the daily operations.
Special Purpose Entities and their Implication to the Progress of Enron’s Accountants
A special entity is a subsidiary company with an asset and liability structure that acts as a security to the parent company in case of a bankruptcy declaration. Enron’s management had a strategic way of maintaining the reputation of the firm through increasing the returns on assets while reducing the hard assets. The executives were also strategically minimizing the company’s debt ratios (creditpulse.com, 2012. The company used limited partnerships with the external parties to raise the ROA and the leverage without presenting the debt on the balance sheet. The Special Financial Entities then borrow large debts from substantial financial entities to purchase assets without reflecting the debt on the balance sheet of the parent country. Additionally, the company used to sell leveraged assets to the special purpose entities while booking profits in the long run.
The company also used the special purpose entities in troubled parking assets that were depreciating in the value. Some of the assets whose value was depreciating included overseas energy facilities, and the stock in the companies whose reputation to the public had been distorted. Transfer of such assets to the special purpose companies was a strategic aim of avoiding the losses associated with such assets in the financial books of the Enron Corporation. Typical examples of the special purpose entities used by the Enrons company include but not limited to LJM2 corporation investment LP and the LJM Cayman LP (Thomas, 2017). It’s vivid that the company executives aimed at meeting the accounting needs rather than operating outcomes (Schwarcz, 2018). The special purpose entities also paid a management fee equivalent to $30M as evidenced in the 1999 case.
Controversies Surrounding Mark-To-Market Accounting
The Role of the Stock Options Compensation Scheme Among Enron’s Top Management
Stock option acted as an incentive for cheating among the management of the firm. In this case, the managers of the company can view the actual price of the firm depending on the vesting period and develop an interest in increasing the stock price over a short period (Chesney and Gibson, 2018). The ideology helps the company to hide the actual financial health of the corporation while furthering the figures that display the financial performance of the firm. Additionally, the ideology ensures that the compensation of the management remains high without questioning.
The five elements of the financial statements as per the IFRS include the assets, liabilities, revenue, expenses and the equity. This section of the report provides definitions of the five elements under the IFRS, measurement methodologies employed by example companies, critical analysis of the measurement techniques and the importance of the method as opposed to others.
Assets
An asset refers to a resource that is controlled by an entity due to a historical event and from which economic reimbursements are predictable to stream to the entity (accounting-simplified.com, 2018). Assets are measured through the summation of the investment capital, nun-current assets and the current asset less the depreciation value. Following the information in the 2017 annual report, the figure 51,216,462 (total assets) is obtained from 18,504,632 (total current assets) + 47,374,942 (total Investment capital and non-current assets) – 14,036,690 (total accumulated depreciation). The method employed by Toyota company is important for it acknowledges all the aspects that impact the economic benefits within the company, unlike other methods that may exclude the accumulated depreciation.
Liabilities
As per the IFRS, liabilities refer to the present obligations that arise from historical events within the organization (BOD, 2018). Usually, liabilities are measured by summing the long-term obligations to the short-term liabilities. In the case of the Toyota company, the figure 31, 046,071 (total liabilities) is obtained from the addition of 17,792,506 (current liabilities) to 13,253,565 (long-term liabilities). The strategic methodology used by the company is very fundamental for it expresses all the debts of the company to be used in decision making among the investors. Following the comparison of the asset value and the liability value, we realize that Toyota company as per 31st December 2017 is capable of paying off all the debts generating a positive owner’s equity.
Equity
The Role of Mark-To-Market Accounting in Enron’s Downfall
Equity refers to any contract that executes an enduring interest in the assets of an entity after all debts have been deducted (Goetz, 2018). Equity is calculated by subtracting liabilities from the total assets of the company. In the case of the Toyota company, equity is provided by 51,216,462 (total assets) – 31, 046,071 (total liabilities). In this case, the value generated is positive implying that the company is excellent for investment for its capable of paying off all the depts. Without venturing into the owner’s income.
Income
Income refers to any economic benefit of the company that results into an increase in the owners’ equity either by decreasing the liability side or increasing the total assets of the company (iasplus.com, 2018). Usually, incomes are recorded on the income statement. Income is generated from the total revenues less the taxation expenses. In the case of the Toyota company, the company has a higher revenue which is an implication that the company is a large company. Additionally, the company has illustrated an increase in the net income from 1,496,830 to 2,083655 which attracts investment.
Expenses
Expenses, on the other hand, refers to the declines in the economic benefits of the firm in such a way that the total equity is decreased through the reduction of the total assets or an increase in the liability side. Total costs and expenses are calculated by summation of all the expenses. In the case of the Toyota company, the total expenses have increased from 18,599,269 to 20,026,788 (TMC, 2017, p.7). This method of calculating the total expenses are important for they acknowledge all the aspects that affect the net profit of the firm. In this case, one can tell the profitability of the firm and decide whether to invest or not
References
accounting-simplified.com (2018). Recognition Criteria of Assets. Retrieved from: https://accounting-simplified.com/assets-recognition.html [Accessed 26, September 2018].
BOD (2018). ASSURANCE AND ACCOUNTING. ASPE-IFRS: A Comparison. Retrieved from: https://www.bdo.ca/getattachment/6601167c-7f37-49f1-a7eb-9b50e607ce63/attachment.aspx/ [Accessed 26, September 2018].
Chesney M. and Gibson R. (2018). Stock Options and Managers’ Incentive to Cheat. Retrieved from: https://www.cairn.info/revue-finance-et-bien-commun-2005-2-page-11.htm [Accessed 26, September 2018].
creditpulse.com (2012). Lessons of Enron. Retrieved from https://www.creditpulse.com/accountingfinance/lessons-enron/enron-lesson-no-1-mark-market-fair-value-accounting [Accessed on 26, September 2018].
Goetz M. (2018). IFRS 9: Classifying financial assets as equity instruments. Retrieved from: https://blog.kpmg.lu/ifrs-9-classifying-financial-assets-as-equity-instruments/ [Accessed 26, September 2018].
iasplus.com (2018). A conceptual framework of financial reporting 2018. Retrieved from: https://www.iasplus.com/en/standards/other/framework [Accessed 26, September 2018].
Schwarcz S. (2018). ENRON AND THE USE AND ABUSE OF SPECIAL PURPOSE ENTITIES IN CORPORATE STRUCTURES. Retrieved from: https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=2308&context=faculty_scholarship [Accessed on 26, September 2018].
Thomas W. (2017). The rise and fall of Enron. Retrieved from: https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html [Accessed on 26, September 2018].
TMC (2017). Unaudited Consolidated Financial Statements for the periods ended December 31, 2017. Retrieved from: https://www.rns-pdf.londonstockexchange.com/rns/1899G_-2018-2-28.pdf [Accessed 26, September 2018].
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