Enron - Adherence of Managerial Accounting System - Essay Example

Name] [Professor’s Name] [Subject] [Date] Table of Contents 1. Executive Summary 2 2. Enron: Adherence of Managerial Accounting System 2 3. Managerial Accounts 4 4. Managerial Account Philosophy 5 5. Managerial Accounting and Collapse of Enron 6 6. References 9 Executive Summary The collapse of the Enron Corporation and the revelation of accounting misappropriation at Enron and other chief corporations have led to a reassessment of the adequacy of accounting, auditing. According to analysts, “the corporate malfeasance as a widespread crisis, but the accounting problems that inundated Enron and other failed corporations do not appear to be systemic in this country” (Christian, 2003). In the light of the given statement, the major danger related to the equity markets post-Enron has been the political interference in a market. The deception was supported by the “rules-based scheme that directs U.S. generally established accounting doctrine, which have conditioned public to look at whether financial statements conform by the rules; however observance with the rules, cannot and does not by itself promise bona fide and positive financial consequences” (Richard, 2003). The statements of account is expected to provide precise and accurate revelation of the past performance of the company, however such assessment do not reveal much about the performance of the company in the coming years, and it becomes difficult for the investor to estimate the worth and value of the company. Enron: Adherence of Managerial Accounting System In general, “economists frequently employ discounted cash flow analysis that is; they approximate the worth of a business by obtaining the current value of expected cash flows discounted at a suitable rate” (Richard, 2003). The dissimilarity between the “backward-looking accounting approach and the forward-looking venture or monetary mindset helps clarify why, while Enron executives were announcing amplified earnings in 2001, Enron’s stock price was declining stridently” (Richard, 2003). The behavior of stock prices on Enron has recommended that “investors saw through Enron’s accounting machinations months before regulators initiated a formal inquiry into Enron’s illegal operating and accounting practices” (Richard, 2003). Consequently, the Sarbanes-Oxley Act, and other political procedures fabricated to reinstate the lost confidence in U.S. corporations, “will likely have the effect of harming investors by penalizing risk taking on the part of corporate management and increasing the quantity but not necessarily the quality of financial reports” (Christian, 2003). The fall down of Enron in December 2001 in the middle of an outbreak of accusations of ambiguous accounting, undependable financial disclosures, and possible criminal behavior has shaken the “wholesale energy markets and contributed to a downturn in worldwide equity markets” (Richard, 2003). The Enron scandal was based upon the accounting and disclosure issues. It has been argued by the management that “earnings can never be more than opinion and that cash flows are the real basis for corporate valuations”, keeping the stated view in mind, some frequently deceptive accounting were observed, which “aggregated and explored the central role played by cash flows in modern corporate finance” (Richard, 2003). Managerial Accountants In an accounting structure this could be represented as an accomplishment at a definite point in time, generally at the conclusion of an accounting phase. However, in a financial, or cash flow, structure, that transaction would be value annihilating. Although the specific category of people debilitated by this “fiction are the Enron shareholders, not the overall market, behavior that rewards people for accounting fiction instead of economic value creation would send a signal to others at Enron to create further transactions with similar value-destroying characteristics” (Christian, 2003). According to the investigation conducted by the Powers Report, which was commissioned by the Enron Board of Directors to check upon the activities and financial transaction of former chief financial officer of Enron Andrew Fastow, described that the accounting-driven behavior at Enron as follows, most of the important deals were actually designed to achieve constructive “financial statement results, not to achieve bona fide economic objectives or to transfer risk” (Richard, 2003), some contacts were planned so that, “had they followed applicable accounting rules, Enron could have kept assets and liabilities especially debt off its balance sheet; but the transactions did not follow those rules”. According to the investigation reports, the remaining contracts were executed improperly, the accounting advisors proposed the offset of losses. The analysts allowed Enron to wrap up from the market collapse resulting from “Enron’s merchant investments by creating an appearance that those investments were hedged that is, that a third party was obliged to pay Enron the amount of the losses when in fact, that third party was simply an entity in which only Enron had a substantial economic stake” (Richard, 2003). According to the investigation report, which discussed the previous financial policies of the management, “Enron sold assets to LJM which is special purpose entity controlled by Andrew Fastow that it wanted to remove from its books, these transactions were ported at the end of the reporting period, Enron bought back five of the seven assets after the close of the financial reporting period, in some cases within a matter of months; the LJM partnerships were able to secure fortune on every financial activity, irrespective of the fact that the worth of the purchased asset declined sharply. Managerial Accounting Philosophy Initially, the special purpose entity is regarded as the integral part of Enron. As per the given variables, "Enron must not be consolidating the financial statements of the SPE into its own balance sheet; otherwise, the $20 million gain for Enron would just wash with the $20 million loss the special purpose entity takes. If no one else was actively trading seven-year weather derivatives, Enron’s internal or external auditor or internal risk managers might well have accepted that this was a reasonable market price. But if a liquid market quote had revealed the true value of an otherwise identical trade to be $100 million, then the $120 million valuation likely would have been questioned. The next step would be for Enron to extrapolate from this single trade to revalue its whole book of seven-year weather derivatives. The book or portfolio of Enron was worth $1billion; therefore the entire book will be marked at price of $ 1.2billion to the market. This would create a notional profit of $200 million for Enron". The transaction is expected to create deficit for the Enron, because in reality the cash flow has remained negative for the company, "Enron or others would normally incur a minimum of two cash costs to achieve that notional profit a bonus to the people involved in creating the notional profit and the transaction costs of the deal itself" (Christian, 2003). The report stated that, “some transactions were designed so that, had they followed applicable accounting rules, Enron could have kept the assets and liabilities especially debt off its balance sheet; but the transactions did not follow those rules” (Christian, 2003). It can be concluded from the given text that, this dishonesty was applicable if Enron had adopted the fundamentals and rules of accounting. The application of the rules was expected not to rescue the economic deterioration of the company, the application of the rules would have been beneficial in terms of economic results, “the company would still have achieved only an accounting result” (Andersen, 2003), and this is analytical of the rules and regulations that channels U.S. generally accepted accounting principles “has conditioned people to look not at whether the information presented to the market is a true and fair characterization of the condition of the company, but at whether it complied with the rules”. The critics have revealed that, if the overruling direction had been ideology based, similar to the procedures adopted in other countries like England, “it is more likely that manager and professionals would simply have seen Enron’s behavior for what it was, a deceptive and fraudulent practice” (Christian, 2003). Managerial Accounting & Collapse of Enron The current row over the adequacy of accounting and disclosure in the United States has “crossed both industry lines and company types and traces not just to Enron but to the collapse of WorldCom, Global Crossing, and Tyco as well as several other recent public disasters” (Christian, 2003). According to reports, “Enron was the first and, arguably, far and away the most important and complex”, the fraudulent practices envisaged and transpired by Enron has “created now hangs over all U.S. corporations, but there is little doubt that energy companies have borne the greatest part of the brunt through the impact on their equity value, debt ratings, costs of funding, and liquidity issues” (Andersen, 2003). According to investigations, “the senior management of Enron and others engaged in a systematic attempt to use various accounting and reporting techniques to mislead investors, the primary areas in which Enron misled investors can be separated into four categories, most of which pertain to the company’s energy market activities”. According to the audits reports, some transactions which have been categorized as Wash and Roundtrip Trades were recorded, “these are transactions in which there is no real counterparty; mainly in electricity markets”, Enron have been essentially been trading with itself in different occasions, apparently to increase its revenues and probably its asset values without generating any concrete economic remuneration. The other practices of the management have been categorized as Mark-to-Market Accounting, in some of the cases; Enron inappropriately applied the “functional and well-accepted principle of marking certain open energy transactions to their current market values to create false accounting results”. The related practices have been categorized as Revenue Recognition; Enron actually registered the trading revenues on several energy contacts when the contracts were “first consummated instead of waiting for the actual economic profits to be earned over the life of the transaction” (Andersen, 2003). The management of the company practiced Special Purpose Entities; the company adopted and applied special purpose entities incongruously to assist “improper wash trades and mark-to-market accounting”. In parallel, Enron used “these types of structures outside its energy activities to hide its total indebtedness and to inflate certain asset values”. The application and significance of the discussed policies can be understood through the analysis of the given situation, “Enron enters into a seven-year weather derivatives transaction with a firm at an agreed price of $120 million when the true value of the same transaction is $100 million. The counterparty firm is a special purpose entity owned by Enron and established solely for the purpose of conducting transactions with Enron. According to critics, “the transaction is a wash trade, the total cash flows and risks to Enron when considered across the company and the special purpose entity are unaffected by the transaction” (Andersen, 2003). Enron, however, could book a profit of $20 million to reflect the immediate realization of the increase in the contract’s value above its fair value. It is important to observe that the $120 million is an authentic transaction price, “this profit would be based on the market worth of the transaction and not just on its mark-to-market revaluation” (Andersen, 2003). According to critics, “if the measure of success is not adherence to accounting rules and government regulation but adherence to investor concerns, we would measure success in terms of delivering the highest sustainable risk-adjusted returns, not merely in terms of a pure compliance standard”. Generally, the accounting is not considered to be science, the accounting standards practiced at Enron were the amalgamation of descriptive rules and guidelines, “a great deal of the complexity inherent in current accounting practice is the result of legislation at the state, federal, and international levels concerning taxes, the regulation of capital markets, corporate governance, social programs, health and safety, and environmental and pension issues, among many others”, which were bluntly ignored and avoided by the Enron. The basic accounting standards which stress upon the incorporation of “all variables inherent in this constantly changing landscape while still providing a framework that can fulfill its original role of reporting historical information to investors is difficult” (Andersen, 2003). The investigators revealed that "there were bad cosmetics related to the company's special purpose entities, LJM and Raptors that could give rise to litigation down the road if market conditions turned sour" (Amato, 2003). The report revealed that the accounting practices and activities at Enron were aggressive and technically inappropriate. According to reports, "the company imploded in a wave of accounting scandals, for this purpose the services of the independent auditors and attorneys was important, to address the matter and was shocked to learn that Enron relied on Arthur Andersen and Vinson & Elkins to investigate their own work" (Amato, 2003). The critics have condemned the short-term accounting targets and annual bonuses procedure of adopted by Enron, the policy in this context was drafted by the Enron executives which debilitated the wholesale energy markets, dented the integrity of the derivatives markets, and handed the friends of directive a powerful political tool i.e. corporate sleaze. References 1. Richard Bassett & Mark Storrie. Accounting at Energy Firms after Enron: Is the Sure Worse Than the Disease. Policy Analysis Vol 469. Feb, 2003. 2. Amato, Jeffery, Eli Remolona. 2003. The Credit Spread Puzzle. BIS Quarterly Review Vol. 51. 3. Andersen, Leif, Jakob Sidenius, Susanta Basu. 2003. All Your Hedges in One Basket vol. 67. 4. Christian Bluhm, Ludger Overbeck, Christoph Wagner. 2003. An Introduction to Credit Risk Modeling. CRC Press. Read More