Advanced financial accounting is a highly advanced branch of accounting which includes major concepts related to consolidation, partnerships, and foreign currency transactions. However it also includes accounting approaches, Generally accepted accounting policies, Translation and Consolidation of Foreign Operations, Accounting for Not-for-Profit and Public Sector Organizations etc (Renz, D. O., 2016). This report exhibits Mark-to-Market accounting approach and its misuse, Special purpose entities, Purpose of the stock options compensation scheme provided to top management in the context of Enron. This report also describes Measurement methodologies in relation to annual report, Measurement of an element and Critical analysis of techniques used by Wa
(a) Mark-to-Market accounting approach and misuse of it by Enron:
Mark to market is a significant accounting approach in which asset is valued while considering asset's current market value. It simply implies amount that organisation will receive if asset is sold today. This is because it is also called as fair value accounting or market value accounting. Under this approach asset's value is recorded in books at its original cost (Brigham and Houston, 2012). Mark to market provides actual portray of asset's current value which is helpful for investors.
Enron's management or accountants misused this approach to portray a rosy picture of its performance and profitability, for example NYMEX provides Natural gas futures prices for a period of several years, therefore Enron in order to develop a favourable price has created a fake natural gas contract of 20 years with the help Mark To Market Approach. Enron has recorded expected lifetime value of any given contract or project on its Balance Sheet rather than its value in that particular quarter. These acts of Enron created a fake growth for company in order to buil the trust of investors.
(b) Special purpose entities and how Enron’s management used them to fund contracts or achieve financial reporting objectives:
SPEs are organisations incorporated to achieve sensitive and unique objectives, to comply with specific requirements. Special purpose entity is a lawfully created separate business that helps to eliminate risk for a business organisation. Special purpose entity is formed to avoid adverse situation for example assets that SPE holds are safe even if concerned business organisation facing bankruptcy. SPE holds its own assets and has its own investors, separate from concerned organisation (Taipaleenmäki and Ikäheimo, 2013). This composition provides assistance to business organisation in order to switch inappropriate operations and risk away from its annual report. Special purpose entities attracts many legal complications, but can be misused to present a company risk free and more profitable to misguide investors.
Enron has used SPEs by transferring huge amount of assets and liabilities, extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities in these entities. Sometimes Enron's financial operations or decisions turned out to be progressively confused, organisation in smart manner additionally utilized SPEs to transfer disputed resources and assets, hold them until these are converted into profit assets. Enron conducted business through various special purpose entities and most considerable entity among them JEDI, a joint venture (Krakhmal, 2012). In JEDI, approx $250 million was invested by Enron. Enron incorrectly included in income from JEDI the appreciation in the value of Enron stock owned by JEDI, which JEDI marked to market value. One misuse of such joint venture is made by Enron, that company included in income transferred from JEDI the enhancement in the value of Enron stock owned by JEDI, which JEDI marked to market value. But due to this Enron’s stock price started to decline, Enron expressly excluded its share of the unrealized losses from equity income. Approx. $250m was invested by Enron in JEDI. The income of JEDI earned from the stock owned by JEDI was incorrectly included in the appreciation of market value. But it did not impact in the way it was thought to, in fact, Enron's share price started to decline and it excluded its shares from the unrealized losses of equity income.
(c) Main purpose of the stock options compensation scheme provided to top management in the context of Enron:
Compensation schemes are framed for upper-level management in case of huge companies like Enron and top level management get a huge amount of their compensation as bonuses and incentives according to their contributions in company's performance and profitability (Ward, 2012). Compensation in form of stock and securities are provided to top managers with special benefits to promote them to increase efforts towards enhancing company's performance. In Enron compensation scheme provided to top managers gives a legal right to buy a certain number of shares at a fixed price in future. Normally exercise price or strike price of a management stock option is equal to or higher than market value of the stock shares at the time of grant therefore providing manager a stock option does not guarantee profit at time of issue. Some time these stock option shares are sold by top managers to other in order to gain extreme profits.
There are many theories related with compensation one of major theory is agency under which both employer and employee are stakeholders of the company, and remuneration paid to employee is considered as agency cost (Banerjee, 2012). In this theory Employee tries to get an increased agency cost but on other hand employer will try to reduce it therefore remuneration is determined in such a way that satisfaction of both employer or employee can be matched. But in Enron heavy one time compensation and stock option benefits are provides to top managers which leads the way to Enron's bankruptcy.
(a) Measurement methodologies from company’s annual report
Measurement methodologies act as a basis for process of measurement of monetary amount in annual report. There are various measurements for elements of annual report. Following are the major methodologies used by companies in annual reports along with example of Walmart, an US based company and preparing its annual report based on GAAP, as follows:
- Historical cost: In this methodologies of measurement items in annual report like assets described in financial statements are recorded at amount paid or consideration given to acquire them at the time of purchase of such assets and Liabilities are recorded at actual amount received in exchange of obligation (Blankespoor, 2013). In this context Walmart follows this methodology to record some assets and liabilities due to complex valuation of such assets.
- Current cost: Under this methodology measurement assets are recorded at possible amount that would have to be paid if such asset has acquired today and Liabilities are recorded at amount that would be required to pay obligations today. In Walmart for current valuation of its resources such methodology is used.
- Realisable value: In this methodology Assets are recorded at amount that could be realised by selling the assets in ordinary course of business and Liabilities are recorded at their present settlement value. In Walmart measurement is used for specific valuation purposes.
- Present value: In this methodology Assets are recorded at the present discounted value of future net expected cash inflows and Liabilities are recorded at the present discounted value of the future expected net cash outflows. In Walmart to this method is preferred for cost report preparation (Khan, 2015).
(b) how company has measured an element:
Elements in annual report are mainly concerned with financial statements and income statements. These elements are classified as assets and liabilities. Assets includes items that have expected future benefits and liabilities are possible obligation that may arise in future. Every organisation uses some measurement methodologies as discussed above in order to make a proper presentation of financial statement and to achieve some objectives or targeted performance (Sharma and Panigrahi, 2013). In this context Walmart being a largest company in supermarket industry have a huge responsibilities to follow standard measurement as per generally accepted accounting policies. Walmart mainly uses historical cost to record its fixed assets whereas inventory is valued at cost or net realisable value which ever is lower. But for special purpose valuation of assets and liabilities are required such as for obtaining huge amount of loan. Then assets and liabilities are recorded at Current cost, Realisable value and Present value as per different requirements.
Measurement method method used by an organisation enhance the credibility and reliability of accounting information used in reporting through annual report, which shows a clear picture about organisation and provides a decision-useful information. A decision-useful information refers to information which have high compatibility related to decision making activities and preferred by decision makers.
(c) Critical analysis of techniques used by Walmart and usefulness of techniques deployed:
For reporting an item in annual report different entity uses different techniques based on suitability and their usefulness. Generally IFRS and GAAP determines the specific techniques to be followed by particular entities. Following are the major techniques used by Walmart and their usefulness, as follows:
- Walmart values inventories at the lower of cost or market by the retail inventory method of accounting and for US segment's inventory last-in, first-out ("LIFO") method is used by Walmart. Whereas for inventory of Walmart's International segment first-in, first-out ("FIFO") is used by company (Budding,Grossi and Tagesson, 2014). The retail inventory method of accounting shows inventory at the lower of cost or market because permanent decease in values are recorded hand to hand with reduction of the retail value of inventory.
- Receivables are stated at their carrying values after deducting provision for doubtful accounts as per GAAP. It creates equality in accounting process and helps to disclose provisions created or used by entity (Lambert and Sponem, 2012).
- Property and equipment are recorded at cost. Profit or loss on sale or disposal of assets are adjusted from capital reserves. Costs related major improvements that have future probable profits are capitalized where as costs of normal repairs and maintenance are treated as expenses. This techniques is very useful as compared to other method because it reduces the complexity and provides a frameworks for classification of capital and revenue assets.
- In Walmart Income tax expenses are ascertained through balance sheet method and Deferred tax assets and liabilities are recorded as per estimated tax liability as per US GAAP and IFRS as per their respective segments (Ramanna, 2013).
From above report it has been concluded that understanding of advanced financials accounting is required in order to solve some critical issues and to identify major threats of fraud in company. Accounting approaches are farmed to short out issues related with reporting of financials statements but misuse of these approaches leads to significant irregularities and some time even bankruptcy. Measurement of element in annual report is vital aspect of reporting so companies should use these measure in accordances with IFRS and GAAP.
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