Enron’s Case: Fair Value Accounting

The purpose of this research is to assess potential threats to the fair value accounting system and accounting standards. It uses the case of Enron, which misrepresented the facts and figures that led to bankruptcy. Administrators should exercise extreme caution when using this accounting system.

Article summary of George Benston, “Fair Value Accounting"

Enron's cautionary tale highlighting issues surrounding the use of the fair value system. This text warns business leaders not to use fair value. We use the Enron case as the best example to present the challenges of this valuation method. George believed the use of fair value accounting and substantial contribution to the demise of the company.

The International Accounting Standards Board and Financial Accounting Standards Board in the US wanted to move towards historical-cost with the fair value system of accounting (Benston 466). The shortcomings are evident due to its easy manipulation to the benefit of a firm. Most of the time, the accounting records do not communicate the correct information to the shareholders, investors, government and other stakeholders.

Market and actual price

The major weaknesses of fair value include basing actual price instead of the market price of the stocks. The external reporting (level 3) relies on discounted cash flows managers may produce instead of concentrating on market prices. Consequently, it is easy to manipulate the accounting system and the external auditor cannot identify the errors. The managers need to set the highest and best price prior to determining asset’s fair value. Hypothetical participants in the market need to be identified and should make put the assets into personal use.

Entrance value determination

The firm purchasing an asset must pay the value of the asset in use. In case there are no buyers, the value of the asset on the balance sheet should zero (0) which has a significant impact on the balance sheet in question.

The Enron Case

Enron Company leads in the US energy sector and purchased contracts and acted as a bank for commodities. For instance, it would commit to delivering gas or energy in future but would use the future derivatives to hedge the contract (Benston 471). The approached helped the company maintain a favorable cash and credit liquidity. Conversely, the firm depended on cash loans to maintain liquidity which led to challenges.

The company grew at a very first rate and experienced dynamic shifts from fixed assets to intangible assets, commodities and future contract. The firm transformed from natural gas supplier to trading fund Investment Corporation (Benston 474). However, the company did not have budgetary controls and abandoned such strategies. The managers and auditors did not notice anything wrong with such practices. The main aim was to maintain the cash flow rather than managing natural gas and oil business.

The extensive use of fair value as the financial reporting practice led to inflated profit statements, cash flow, and balance sheets. The external auditors produced the financial statement for the company. These strategies helped the CEO and other managers in maintaining their clients. The mark-to-markets accounting was used in managing long-term contracts where they estimated income from the present value of net cash flows in future (Benston 477). It was a daunting task to judge the contracts’ feasibility as well as relevant costs. There were major discrepancies and mismatch in the financial statements leading to a huge scandal and demise of Enron.

Conclusion

The article used the Enron company case to caution fair value stem users. The level 3 asset reporting is prone to manipulation by the external auditors thus risk stakeholders’ investments. The managers can use the system to overstate project or asset values to give a positive financial report. Several techniques are applied to give unverifiable profits. The practices have detrimental effects on the company and the market.

Work Cited

Benston, George J. "Fair-value Accounting: a Cautionary Tale from Enron." Journal of Accounting and Public Policy. 25.4 (2006): 465-484. Print.