Dubious Fair Value Accounting Practices at Enron Ltd - Case Study Example

DUBIOUS FAIR VALUE ACCOUNTING PRACTICES AT ENRON LTD by Student’s name Course code+name Professor’s name University name City, State Date of submission Abstract This papers the meaning of the term fair value, and its effects, when used as a measurement tool. Different levels of fair value, including level 1, 2 and 3 are explained. In particular, the collapse of a giant United States energy manufacturing company, Enron Ltd will be revisited to explain the reason how fair value accounting could be unreliable. The paper explaining different ways in which Enron Ltd could have blundered in its application of fair value. As it was in the case of Enron, Its managers were not cautious and hence continued to use those fair levels that suited them in their optimistic moods, ignoring other forces such as future volatility of the prices and interest rates. As a result, they continued revaluing their assets and consequently the income on their income statements increased due quick recognition of unrealized revenues. These affected both its external and internal reporting. For example, to raise the morale of the employees, they were given off balance sheet cash handouts. Externally, it made them to issue huge chunks of money to acquire a contract after just valuing it by Net Present Value, which seemed promising with high earnings in future. Dubious Fair Value Accounting Practices at Enron Ltd Introduction Fair value measurement in accounting is defined by Graham (2011) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (p, 437). Given that the fair value is the price of selling an asset, it is considered as an exit price rather than an entry price, thus impacting on measurement of the value of the asset that is sold or transferred. Fair value measurement is described to be occurring in a “principal market”, whereby the participants would sell asset or transfer liability at a price that maximizes the amount that would be received for the asset or minimizes the value that would be paid to reduce the liability. Level 1 way of valuing assets and liability is done by determining the market price of the same asset. Level 2 way of value an asset is determined by market price of a similar asset. For level 3, valuation is by way of present value estimation, together with other approximation methods which are generated internally. According to Patel (2000), there have been a lot of esoteric debates on the issues of measurement that have had a far reaching effect on the behavior of financial institutions, which to a large extent determines the efficiency of the price mechanism in real decision. An example of these debates is the controversies surrounding the International Accounting Standards Board (IASB) and the Australian Accounting Standards Board (AASB). In its applicability, I am going to revisit deeper into the past experiences and explain how unreliable the fair value measurement accounting was, which led to the collapse of a giant United States energy manufacturing company, Enron Ltd. International Accounting Standards Board (IASB) IASB is a privately funded and an independent accounting standard based in London. It was founded in 2001, and replaced the previously known as International Accounting Committee (IASC). IASB is the body, which is charged with developing International Financial Reporting Standards (IFRS) such as the ones behind fair value accounting which is discussed in this paper. it is also responsible for application and promotion of such standards. Energy Contracts Enron Ltd and Sithe Energies One of the mistake made by the accountants in their work in Enron Ltd was assuming that the net present value, which does not incorporate risks, and the failure to record the bad debts as a loss. In 1992, Enron entered a contract with a large electric generating plant developer under the name Sithe Energies, which involved supply of natural gas for 20-years. Enron immediately entered the net present value of the proceeds in its current earnings account. Additional gains were recognized in later years. A loss was never recorded on this contract until Enron was declared bankrupt. First and foremost, net present value does not incorporate risks that are inherent due to market volatility of prices (inflation) (Young 2003). That is why during the year 1990s, there were changes in prices and the contract viewed as more costly, which occasioned more revaluations (Benston 2006). Towards the end of 1990s, Sithe Energies owed Enron $1.5 billion as a result of that revaluation. The group estimated that Sithe’s assets could not adequately cater for its liabilities without reducing the fair value; therefore, a loss was incurred. In fact the loss was only recorded when it was declared bankrupt. The accountants, therefore, did not realize that the debts are among the assets, and hence the inability of the debtor to repay rendered them bad debts. The bad debts should be written off by reducing the receivable as noted by Kimmel, Kisoi and Weygandt (2011). Thus, in these two cases, fair value measurement and valuation could not provide an answer. Enron and Institutional Investors The other setback of the fair value is that the accountants can use any other level of valuation that suits their interests. Level 3, for instance, bases most of its procedures on the unseen likes of the assets and liabilities of the firm in question. Highly optimistic managers and accountants can use it to fabricate figures; obtaining window profit with liquidity shortage in the firm as seen in that one of Enron’s case. In this case, when Skilling became the president of Enron in December 2000, he appointed Loi Pai as the CEO in charge of a separate business, which was created and named Enron Energy Services (EES). The new establishment aimed at targeting the retail power dealers. The business assumed that an opportunity could be opened up if the market was deregulated and the existing assets sold at low cost. Enron sold 7% of EES shares to institutional investors - a sale that could be categorized as a level 2 estimates. While the 7% shares were sold for $130 million, the company was worth $1.9 billion, and an estimated profit of $61milllion was earned. Unfortunately, EES’s did not succeed in its efforts, particularly because deregulation of the market did not materialize. The retail losses incurred in the course of doing business were combined with the wholesale operations, rather than being reported separately. The CEO then focused on contract sales, which could provide companies and institutions with long-term energy and cost saving. Usually, customers were offered front cash payments prior to making of the savings. The contracts were valued based on the mark-to-fair value when the contract was signed. Based on those values, managers and sales personnel were paid handsome bonuses (Benston 2006). From the above case, the accountants ignored level 2 model of valuation which could have been suitable for the above case. A valuation which qualifies as a level 2 is the one, according to Miller and Bahnson (2007), can be valued in two ways. The first is concerned with matching assets and liabilities of an active market, and the second results from the liabilities and assets which are owned are matching, but not the same as those traded in the market. The third case may arise where no active market situations exists for such an asset or a liability, then some observable market data can be applicable to estimate the fair value. By the accountants going with different valuation level may imply that some of them could use any level which suits their interests so that they could be fulfilled. According to Guillaume, Haresh, and Shing (2004), the reliabilities of fair value numbers can be put in doubt. They notes that perhaps importance to independence of public accountants, the examples presented show that fair values, other than those taken from quoted prices (level 1), could be readily manipulated by opportunistic and overoptimistic managers. These could be costly to make and very difficult for auditors to verify leading to a demise of the company as witnessed in Enron Ltd. As noted above, after Skilling became president with Lou Pai as its CEO, they were very optimistic. Based on this, they made a sale basing on other levels other than on level 2 hoping that there would be market deregulation. Their company was therefore overvalued making a profit of $ 61 million. However their efforts were not rewarded by time as the retail energy was not generally deregulated, thus suffering losses as a result. Enron and El Lilly One of the cases that led to its demise was dubious accounting methods as witnessed in too quick recognition of unrealized revenues and even paying from the cash available expecting that they would be realized too soon. Enron signed a contract in 2001 with a pharmaceutical company known as El Lilly for over a period of 15 years, discounting the amounts by 8.25%-8.50%. Although they had recorded the contract at $ 1.3 million with a gain of $ 38 million, the contracts were considered worthless after 2 years. As reported by Barboza (2002) in New York Times, dealings of Enron Ltd were often of balance sheet. The fact that transactions were allowed to go off balance sheet meant that the true and fair value of the company could not be established. That is why it eventually became known that the contract was only on paper but in the reality the dealings had occurred and not documented. There was no sufficient liquidity necessary for the company to run despite making profits. Related to that, Markham (2006) also notes that Enron Accountants were too quick to recognize unrealized revenues as though earned without realizing any cash flow. That is why compounding the accruals of unrealized revenue in cash made it possible for them to pay Lilly $50 millions in advance in order to obtain the contract. Because of quick recognizance of outside accruals as revenues and quick dispatch of cash, they experienced cash flow problems, which led to their. Enron and Blockbuster For Enron and Blockbuster Contract, it led to the demise partly because of too early recognition of unrealized revenues and hence unrealized profits without support from tangible cash flows. They also assumed they were the only actors in the markets failing to incorporate other elements of the market. Putting such an interest rate for the project which would take long was also dangerous because it is hard to determine a sufficient rate and realizing when the market would be inactive. In the year 2000, Enron entered into a 20 year contract with Blockbuster to broadcast movies on demand to television viewers as it did not have the technologies and rights to broadcast them. However, Enron allocated a fair value of $125 M to its Braveheart investment. A profit of $53 million was recognized immediately, even though no sales had yet been made, and a further $53 million was recorded in early 2001. In October 2001, Enron had to announce that it reversed the profit made in relation to this project. This led to its poor publicity and the bankrupts that followed. The managers decided to reverse the profits because there was no sufficient reflection of the said “air profits” and the ready cash flow (Benston 2008). The public, including the government and others, would demand their obligation from the company. As reported in NACUBO by Townsley (2012) on unrealized revenues, whether it is capital gain or loss, it is difficult to predict when the unrealized income would be realized. This is because it is all tied to the volatility of equity markets. He notes again that the firm would be fairly well when the unrealized gains are not recorded. On the same note, Patel (2000) also insists that Recording unrealized profits tend to be very much decorative of our financial statements, without realizing the risks involved in them - it has led closure of very many businesses. And the general public As argued by Microthink Institute (2011), using all level of fair value measurement is still relevant and important. This is because it is needed in order to know the value of their investment. However, in the event of applying level 3 three to qualify the value of an asset or a liability, it cautions that investors and hence the general public expects more transparency in the assumptions used in determining the fair value of an asset or a liability. Financial assumptions need to incorporate the assumptions used for building the model and clear picture on the measurement of liquidity and credit risks incorporated in the measurement of assets and liabilities. Therefore, full disclosures especially on the unseen and unrealized revenues and liabilities need to be made in every financial statement they concern. Lack of disclosure of the above as reported by Graf and Orr (2002) in San Francisco Chronicle reveals that Enron leadership committed a lot of secret transactions without letting the public know about their assumptions, which diminished its trust in them. An average citizens need to know whatever is going on in the firm for them to have confidence with their investments in the company, otherwise they will shy away from it. Impact on auditors The Auditor’s Report Its bankruptcy When the company became bankrupt, it was subsequently put under the examination by the Examiner in Bankruptcy. The then auditors, who were Arthur Andersen, held some assumptions in their valuation process. In its expansion plans, the business was to expand in 10 major metropolises within 12 months and eight new regions were to be added until 2010, each growing at 1% per year, and the Braveheart was to get 50% of this market. A net cash flow from these household was determined, discounted by 31%-34%, and a fair value determined. According to Miller and Bahnson (2007), using level 3 inputs require that measurements of value be done according to level 3, which requires use of internally estimated values, such as the present value - in case level 1 and 2 are absent. The inaccurate tendency of fair value measures is indeed acknowledged by FASB. The board argues that level there is not observable and advises that they should only be sued where observable inputs are not available. Application of fair value accounting As Microthink Institute (2011) puts it, it is hard to determine when the market will become inactive especially level 3 measurement criteria is used. For them, they had used the fair value that gave them a constant growth of their business at 1% in all metropolises. On the same note, they were focusing on their firm only, ignoring all other firms. The other question the institute asks is when and to what extent should liquidity be considered in the valuation of asset. The accountants failed to realize that it led to lack of liquidity while all kept urging the public to continue having trust in them. By stating that digital subscriber lines would be used by 5 percent, while the household would increase to 32 percent by 2010, and that and Braveheart would get 50% of this market, they were simply assuming that they would be alone in the market which could be the case. Suppose other players arrived on the market? It would be difficult for things to go as planned earlier on. They also anticipated an increase in cash flow from the households, which was determined and discounted by 31% - 34%, and a fair value determined. According to Microthink (2011) institute, there are two main weaknesses of the mark-to model that we have observed. First, the market assumptions on the expected future cash flows may not be the same with the assumptions of the management. Second, what is the adequate discount rate to be used in the model? This question is crucial to the extent that it serves to determine the ratio between two components of the risk associated with the fair value determination, for example the liquidity risk that is present in distressed markets and the credit risk that is associated with uncertainty of future cash flows. Determination of the discount rate in determining the fundamental value presents a serious problem. If the current risk rate is used to discount future cash flows, the fundamental value tend to converge the present value. On the other hand, if a lower discount rate is used, level 3 measured fair values may become a tool for “window dressing” in which the real credit risk is hidden. So the above discount rate may not be arrived to as per the expectation of the market, but as per the expectations of the management, which may not been rational but only put there to suit the interests of the optimistic managers. They then suggest that as a consequence of the above weaknesses, the level 3 or mark-to-model is to be used in combination with full disclosure. It ensures users of financial statements are made aware of the assumptions used in establishing the fair value of assets or liabilities. This could have enhanced the public trust needed in any business enterprise and the demise that occurred could have been avoided. Role of auditors Microthink Institute (2011) continues to observe that the other impact of level 3 valuation model is its complexity and the volume of the auditor’s work. The auditors, therefore, need to be aware that by using level 3 valuation models, they should be more cautious when performing audit procedures. This is because level 3 valuation models are based on the unobservable inputs which demand a lot of judgments and assumptions. Moreover, auditors should pay more attention to the information disclosed on the notes to financial statements as they contain all the judgments, assumptions and data used by the management on determining fair value of the assets. As a consequence, auditors will be spending more time on notes to financial statements and will try to test the reasonability behind the assumptions used by the management. Fair value debate The debate of whether fair value method of valuation has contributed to the financial problems of many firms leading to their demise in years continues. When used objectively and cautiously, it can generate the values the firm wants, thus, I feel that it should not be done away with. Where it is hard to determine the fair value like in the inactive markets (when using level 3), we should consider the additional requirements for full disclosure and presentation of the assumptions used in the model when determining the fair value and their effect in financial statement, requirement for explicit quantification of risk components used in mark-to-model measurement such as liquidity vs. credit in order to ensure full transparency for financial statements users and considering suspension of application of the OTTI for a limited period of time (in our opinion one reporting period) for liabilities and assets calculated at fair value due to uncertainties in market. For instance, there is no possibility to estimate the liquidity risk and credit risk and use level 3 measurements in order to protect the companies from having to book OTTI that may be caused by illiquidity. This measure has to be implemented carefully, accompanied with full disclosure by issuers and has to be closely monitored by SEC for compliance to avoid any “window dressing” tendency. It is also that FAS 157 be revised and incorporate two additional disclosure requirements which will increase the quality of information to the public regarding level 3 measurements. Disclosure of controls regarding fair value measurements should be mandatory for all firms holding assets and liabilities at fair value, which are significant to the financial statements. Lastly, disclosure of the effect of alternative assumptions used in valuation models for unobservable inputs should be encouraged. In other words, issuers should disclose the results of the sensitivity analysis, which currently are mandatory for companies following IFRS 7.5 (MicroThink Innstitute 2011). Therefore, fair value measurement has not caused the current crisis and has no pro-cyclical effect. It only reflects the substance of the economic events and transactions in the financial statements. Blaming the fair value measurement for reflecting the bad news is not correct. Calls for suspension of the standards requiring use of fair value would only deepen the crisis and temporarily hide losses. Even though this temporary relief would help some market participants, it would diminish the transparency, which in long-run would discourage the investors. However, when fair value valuation is not used objectively or used with no cautions and disclosures, it can be harmful to any business enterprise as witnessed in the Enron. Such subjective, incautious and undisclosed valuation of assets or liabilities in one firm can trigger the market swings in the prices of the same or related assets or liabilities. These would cause a very adverse effect. This starts when an asset is revalued downwards because of drop in current market prices (Miller and Bahnson, 2007). Conclusion Due to the difficulties I have analyzed above regarding its applicability, fair value measurement proved to be very complex and too demanding on the side of the auditor (Way 2007). Overoptimistic, optimistic and dishonest managers can misuse it to overstate revenues and assets and understate the liabilities in order to have a higher income composed of, in larger part unrealized or window incomes. The Enron example provides some evidence that this concern may not be misplaced or overstated. From the Enron’s case, there is a growing sensation that the financial crunch which begun to affect many firms from 2007 up to now could have undergone the same dubious accounting procedures. References Barboza, D 2002, ‘Enron’s Many Strands: Financial Deals; Enron Offered Management Aid To Companies’, New York Times, April 10. Benston, GJ 2006, ‘Fair-value accounting: A cautionary tale from Enron’, Journal of Accounting and Public Policy, Vol. 25, pp. 465–484. Benston, GJ 2008, ‘The shortcomings of fair value accounting described in SFAS 157’, Journal of Accounting and Public Policy, Volume 27, no. 2, pp. 101-114. Graham, L 2011, Accountant’s Handbook, John Wiley and Sons Inc, Hoboken. Guillaume, P, Haresh S, and Shing, HS 2004, Fair Value Reporting Standards and Market Volatility, London School of Economics, London.. Kimmel, PD, Kisoi, DE, and Weygandt, J 2011, Intermediate Accounting, SAGE, New York. Markham, JW 2006, Financial History of Modern United States Corporate Scandals, Shape Inc, New York. Microthink Institute 2011, ‘Credit Crisis with focus on level three valuations and FAS 157: Analysis and Recommendations for Change’, International Journal of Accounting and Financial Reporting, Vol.1, no.1, pp.1-9. Miller, PB, and Bahnson, P 2007, ‘Refining Fair Value Measurement’, Journal of Accountancy, Vol. 5, no. 2, pp. 5-6. Patel, J 2000, Profit from prices. Patel CFA, Washington. Townsley, MK 2012, Recognizing the Unrealised National Association of College and Business Officer, FALL, New York. Way, J 2007, Advantages or Disadvantages of Fair Value Accounting, Chron.com, New York. Young, D 2003, Management accounting in health care organizations, Jossey Bass, San Francisco. Read More