Advanced Financial Accounting

TASK A

(a) Mark-to-Market accounting approach and misuse of it by Enron:

Mark-to-market is a significant accounting approach in which an asset is valued while considering the asset's current market value. It simply implies the amount that the organization will receive if the asset is sold today. This is because it is also called 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 an actual portrayal of an 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 favorable price created a fake natural gas contract of 20 years with the help Mark To Market Approach. Enron has recorded the 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 fake growth for the company in order to build 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 organizations incorporated to achieve sensitive and unique objectives, to comply with specific requirements. A special purpose entity is a lawfully created separate business that helps to eliminate risk for a business organization. A special purpose entity is formed to avoid adverse situations for example assets that SPE holds are safe even if a concerned business organization facing bankruptcy. SPE holds its own assets and has its own investors, separate from concerned organizations (Taipaleenmäki and Ikäheimo, 2013). This composition provides assistance to business organizations in order to switch inappropriate operations and risks away from their annual reports. Special purpose entities attract many legal complications but can be misused to present a company risk-free and more profitable to misguide investors.

Enron used SPEs by transferring huge amounts of assets and liabilities, extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock, and related liabilities to these entities. Sometimes Enron's financial operations or decisions turned out to be progressively confused, an organization in a smart manner additionally utilized SPEs to transfer disputed resources and assets, holding them until these were converted into profit assets. Enron conducted business through various special purpose entities and most considerable entity among them being 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 was 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, and 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 the case of huge companies like Enron and top-level management gets a huge amount of their compensation as bonuses and incentives according to their contributions to the company's performance and profitability (Ward, 2012). Compensation in the form of stock and securities is provided to top managers with special benefits to promote them to increase efforts toward enhancing the company's performance. In Enron compensation scheme provided to top managers gave a legal right to buy a certain number of shares at a fixed price in the future. Normally exercise price or strike price of a management stock option is equal to or higher than the market value of the stock shares at the time of grant therefore providing the manager a stock option does not guarantee profit at the time of issue. Sometimes these stock option shares are sold by top managers to others in order to gain extreme profits.

There are many theories related to compensation one of the major theories is agency under which both employer and employee are stakeholders of the company, and remuneration paid to the employee is considered as agency cost (Banerjee, 2012). In this theory Employee tries to get an increased agency cost but on the other hand employer will try to reduce it therefore remuneration is determined in such a way that the satisfaction of both employer and employee can be matched. But in Enron, heavy one-time compensation and stock option benefits are provided to top managers which leads the way to Enron's bankruptcy.

TASK B

(a) Measurement methodologies from the company's annual report

Measurement methodologies act as a basis for the process of measurement of monetary amounts in annual reports. There are various measurements for elements of the annual report. Following are the major methodologies used by companies in annual reports along with the example of Walmart, a US-based company preparing its annual report based on GAAP, as follows:

• Historical cost: In this methodology of measurement items in annual reports like assets described in financial statements are recorded at the amount paid or consideration given to acquire them at the time of purchase of such assets and Liabilities are recorded at the actual amount received in exchange for obligation (Blankespoor, 2013). In this context, Walmart follows this methodology to record some assets and liabilities due to the complex valuation of such assets.
• Current cost: Under this methodology measurement assets are recorded at a possible amount that would have to be paid if such asset has been acquired today and Liabilities are recorded at an amount that would be required to pay obligations today. In Walmart for the current valuation of its resources such methodology is used.
• Realizable value: In this methodology, Assets are recorded at an amount that could be realized by selling the assets in the 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, this method is preferred for cost report preparation (Khan, 2015).

(b) how the company has measured an element:

Elements in the annual report are mainly concerned with financial statements and income statements. These elements are classified as assets and liabilities. Assets include items that have expected future benefits and liabilities are possible obligations that may arise in the future. Every organization uses some measurement methodologies as discussed above in order to make a proper presentation of financial statements and to achieve some objectives or targeted performance (Sharma and Panigrahi, 2013). In this context, Walmart being the largest company in the supermarket industry has a huge responsibility to follow standard measurements as per generally accepted accounting policies. Walmart mainly uses historical cost to record its fixed assets whereas inventory is valued at cost or net realizable value whichever is lower. But for special purposes, valuation of assets and liabilities is required such as for obtaining huge amounts of loans. Then assets and liabilities are recorded at Current cost, Realisable value, and Present value as per different requirements.

The measurement method used by an organization enhances the credibility and reliability of accounting information used in reporting through the annual report, which shows a clear picture of the organization and provides decision-useful information. Decision-useful information refers to information which has high compatibility related to decision-making activities and is preferred by decision-makers.

(c) Critical analysis of techniques used by Walmart and usefulness of techniques deployed:

For reporting an item in an annual report different entity uses different techniques based on suitability and usefulness. Generally, IFRS and GAAP determine 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 the US segment's inventory last-in, first-out ("LIFO") method is used by Walmart. Whereas for an inventory of Walmart's International segment first-in, first-out ("FIFO") is used by the company (Budding, Grossi, and Tagesson, 2014). The retail inventory method of accounting shows inventory at the lower of cost or market because permanent decreases in values are recorded hand in hand with the reduction of the retail value of inventory.
• Receivables are stated at their carrying values after deducting provisions for doubtful accounts as per GAAP. It creates equality in the accounting process and helps to disclose provisions created or used by the entity (Lambert and Sponem, 2012).
• Property and equipment are recorded at cost. Profit or loss on sale or disposal of assets is adjusted from capital reserves. Costs related to major improvements that have future probable profits are capitalized whereas costs of normal repairs and maintenance are treated as expenses. This technique is very useful as compared to other methods because it reduces the complexity and provides a framework for the classification of capital and revenue assets.
• In Walmart, Income tax expenses are ascertained through the 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).

CONCLUSION

From the above report, it has been concluded that an understanding of advanced financial accounting is required in order to solve some critical issues and to identify major threats of fraud in the company. Accounting approaches are farmed to short out issues related to the reporting of financial statements but misuse of these approaches leads to significant irregularities and sometimes even bankruptcy. Measurement of elements in annual reports is a vital aspect of reporting so companies should use these measures in accordance with IFRS and GAAP.

REFERENCES

• Renz, D. O., 2016. The Jossey-Bass handbook of nonprofit leadership and management. John Wiley & Sons.
• Brigham, E. F. and Houston, J. F., 2012. Fundamentals of financial management. Cengage Learning.
• Taipaleenmäki, J. and Ikäheimo, S., 2013. On the convergence of management accounting and financial accounting-the role of information technology in accounting change. International Journal of Accounting Information Systems. 14(4). pp.321-348.
• Krakhmal, V., 2012. Customer profitability accounting. Accounting and financial management, p.188.
• Ward, K., 2012. Strategic management accounting. Routledge.
• Banerjee, B., 2012. Financial policy and management accounting. PHI Learning Pvt. Ltd..
• Blankespoor, E. and et.al., 2013. Fair value accounting for financial instruments: Does it improve the association between bank leverage and credit risk? The Accounting Review. 88(4). pp.1143-1177.

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