QUESTION

Dear Students

I believe, the following additional information will help you to organise the answers to the assignment:

1. Students have to study a total of 8 articles. That means, given 2 plus another 6.

2. The marks allocated for each requirements are as follows:

Requirement 1: 12 marks

Requirement 2: 12 marks

Requirement 3: 10 marks

Requirement 4: 6 marks

Total              40 marks.

4. Requirement 1 is mostly cognitive and descriptive

5. Requirement 2 is analytical and critical

6. Requirement 3 is more investigative, analytical and critical

7. Requirement 4 is fairly descriptive

I hope this helps.

Have a good Easter break and take care of yourselves.

SOLUTION

1. Introduction

The main aim of the paper is to evaluate the fair value system. The paper critically examines the fair value system and the potential threats it poses to financial reporting. The study also highlights the Enron case as the case financial misreporting and poses certain cautionary moves to both the users and makers of the fair value system.

2. Definition of Fair Value System

The main aim of the fair value accounting system is to evaluate the maximum possible value of their assets when the asset would change hands under the current financial circumstances. The fair value system determines the value and profitability of a project or an asset based on the discounted cash flow method to predict future cash flows. The main rationale behind the system is that fair values reflect market prices from the publically available information on the cash flows of the firm. When the fair values are estimated including the market prices it is called market-market values and when the valuation is done on the basis of valuation models it is called mark-to-model values (Ryan,2008).

The main issue associated with the fair value system is to estimate the value of the assets at a current time position for this purpose the assets can been classified into 3 level inputs.

1. Level 1 represents quoted prices (unadjusted) in active markets for equal assets or liabilities examples include US government and agencies, foreign government debt and several money market securities.

2. Level 2 are the  inputs other than quoted prices included within level 1,that is visible for the asset or liability, either directly (i.e.as prices) or indirectly (i.e., derived from prices), some of the examples are level 2 inputs are corporate bonds , mortgage securities, OTC derivative securities.

3. Level 3 inputs for the asset or liability that are not based on evident market data, some of the examples of such securities are private equity, exotic or non-standard derivatives.

(PWC-2004)

The fair value is focused on the inputs in valuation rather than the techniques, thus the determination of the valuation technique depends upon several factors like judgements and specific characteristic nature of the security.

The only problem associated with the fair value system that the system can easily be manipulated to disclose information that can mislead stakeholders is this particularly true for the level 3 inputs and asset class. The fair value may fail to identify losses and risks in the future and therefore have a detrimental effect as evident from the Enron Case Thus, there are many considerations for using the fair value system.

3. Articles Summary

The articles under consideration ‘the shortcomings of fair-value accounting described in SFAS 157 by George J. Benston and’ Fair-value accounting: A cautionary tale from Enron by George J. Benston highlights some of the problems associated with the fair value system. Both the articles caution against the use of the fair value system and the problems associated with the new system initiated. The articles also highlight the Enron’s case and some of the problems in valuation that were encountered after using the fair value system.

3.1 Summary of The shortcomings of fair-value accounting described in SFAS 157 by George J. Benston

The US FASB and the IASB have been fast moving to replace the historical cost system with the fair value system. The article highlights the shortcomings of the fair value system and the affect that it has had on the system of accounting. The theorists believe that the fair value system can be easily manipulated to the benefit of the company and often communicate misleading information to the stakeholders.

3.1.1 Fair value based on actual price and not Market price

Some of the main weaknesses that have been identified with the fair value system are. The proposed fair value system proposes that the ‘The Third Level’ (external reporting) is based on the discounted cash flows and other methods produced by managers rather than accounting the market prices. This creates a clear situation under which the accounting system manipulation based upon the external auditors and the managerial decision making.  Therefore managers must determine the highest and the highest and the best price before determining the fair value price of the asset. The managers should also be able to determine hypothetical market participants and the use of the assets for their own operations and such that the price can be perfectly estimated. Other fair value measures, for example entrance (replacement) value and value-in-use are also costly to make and verify.

3.1.2 Determination of Entrance Values

The firm which is the purchaser of an asset should be able to pay the value of the asset to the firm and the value of the asset in use. Thus in the case of sale or purchase of the asset in case there are no buyers for the asset then value of the asset would be determined as 0 on the balance sheet , this would greatly affect the balance sheet of the firm in question. This is particularly applicable in the case of stock inventory which have entrance and exit values for both the firms.

3.1.3 The use of Transaction Costs

The other problem associated with the fair value system is that it considers transaction costs in the sale and purchase of the assets. It has been proven in several cases that often the price of the asset at the ‘market quoted prices’ are determined by the market or the cost approach and often include the transactions cost these costs are actually the replacement values and the exit values of the assets.

Thus the article clearly summarizes the researchers concern with the fair value system of financial reporting. One of the major concerns of the fair value system of financial reporting is the easy manipulation it offers the users of the system. And more often than the system has been manipulated to inflate asset values and maintain a positive financial statement and balance sheet performance. This is clearly visible from the fair value practice adopted by Enron’s and the detrimental impact it had on the organization and the market. There are certain implementation issues associated with the fair value system as well as problems have been encountered in the accounting treatments of various asset classes. Therefore it is important for the makers of the system to analyse the system to ensure fair implementation.

(Benston , 2004)

3.2 Case of Enron

The rise and the success of Enron have been determined by the adoption of the fair value system and later the accounting scandals which followed were also the result of the manipulation of the fair value system. Enron a leading energy commodity provider in the US would often purchase energy contracts and act as a bank for commodities. For example if Enron would commit to sell energy or gas at a future date, it would hedge the contract using the futures derivatives. Through this Enron maintained both cash and credit liquidity in the organization. On the other hand Enron relied heavily upon the borrowed cash to maintain the liquidity and this was what caused the problem in the future for Enron.

Thus as Enron grew at fast pace there was a dynamic shift in the assets of Enron from fixed assets to commodities, future contracts and other intangible assets. Thus practice of Enron transformed Enron from a natural gas provider corporation into a trading fund investment company. The main problem for Enron was that all budgetary controls and strategies were abandoned. Enron’s management and auditors failed to recognise the risks associated with such practices. The main aim of Enron in this case was not to manage their oil and natural gas but maintain cash flows management as financial balance sheet performance.

Enron made extensive use of the fair value system to practice financial reporting. On the other hand inflated balance sheets and the cash flows and profit statements have raised questions on the fair value accounting system itself. It seems that Anderson the CEO of Enron made extensive use the external auditors to produce the financial reports of Enron. The main incentive for the management to adopt such a strategy was to ensure that Enron maintained their clients. Enron practiced Mark-to-market accounting that when long-term contract is signed, income was estimated as the present value of net future cash flows. The feasibility of these contracts and relevant costs were difficult to judge. Due to the large discrepancies and the mismatch in the reporting caused the huge financial scandal and eventually bankruptcy for Enron.

Thus the Enron case has cautioned the users and the makers of the fair value system especially when Enron started using the fair value for energy contracts. Enron’s case clearly determines that the level 3 asset class reporting under the fair value system can be easily manipulated by external auditors and poses serious threats for all the stakeholders. The use of the system was the cause of the downfall for Enron, the fair value reporting caused the employees and the management to overstate the value of the projects as well as the compensation associated with them. The Enron example clears spells a cause of concern for the use of the fair value system reporting.

(Benston, 2006, Haldeman, 2009)

4. Critical Analysis of Enron

1. In 1992, Enron signed a 20-year contract to supply natural gas to the developer of a large electric generating plant under construction by the name of Sithe Energies. Enron immediately recorded the net present value of that contract as current earnings. Additional gains were recognised in later years. A loss was never recorded on this contract until after Enron declared bankruptcy. This a clear statement of the overstating of the gains by Enron calculated on the basis of the net present value, in this case the only the discounted net present value was calculated and stated in the balance sheet , the real value or the real contract was never realised by Enron. This clearly reflects the reporting on the basis of market value and not the historical value of the contract which resulted in the over statement of the profits and the non-recognition of the real value or the costs of the contract. This is an example of the market to market accounting followed by Enron. This is an example of the level 3 asset class manipulation undertaken by the auditors to produce inflated profits and manipulate the high prices of the assets.

2.In 2000, Enron sold 7% of Enron Energy Services to institutional investors for $130 million. Based on this sale – which might have qualified as a level 2 input – Enron valued the company at $1.9 billion, which allowed it to record a $61 million profit. However the efforts on Enron Energy went waste because the retail energy sector was not de regulated. Even though the losses on the retail energy were reported but they were recorded as whole sale losses. Thus yet another case of financial statement manipulation, the loss was clearly a loss on transaction of the firm but were no reported as loses but recorded wholesale losses therefore is the manipulation of tier 2 .

3. Enron signed a contract in 2001 with Eli Lilly to make improve the energy supply and use over 15 years, it discounted these amounts by 8.25% – 8.50%. Enron prised the contract at $1.3 billion and recorded a $38 million gain. In a span of  two years, this contract was considered worthless. This is because of the fact that the gain was calculated on the basis of the net present value and was marked on the fair value basis. The main problem associated with the contracts was large sums of cash were paid upfront alongside the paying large sums of compensation to sales personnel. This led to another problem of bad contracts for Enron, and because Enron did not appropriately account for the losses associated with the contract the contract was considered worthless by the end(Benston ,2006)

4. In the year 2000, Enron signed a 20year deal with blockbuster to broad cast movies on demand to television viewers. Enron did not possess the technical expertise to fulfil such a contract but however signed the deal for $125 million at fair value and estimated a profit of $53 million.  This was an example of an unverifiable tangible which in today is difficult to audit owning to the large scale technological changes in the business. It makes it hard how to present a fair and true view to the general public. The value of such deals and intangible cannot be overestimated. To estimate the profit of such deals is the role of the management of the company with the inclusion of some private information by the management.

Under the circumstances the managements’ expositions will not be true as the detailed standards do not stop the unverifiable intangibles from being projected in the financial statements. Thus in the case of Enron in particular the fair value projections based on the informed insider information were clearly unethical and evil. However if the FSI is adopted then the auditor would adopt the view of the insurer and investor and would therefore adopt fairer disclosures in the financial statements.

(Ronen, 2005)

5. The IFRS fair Value Hierarchy

The IFRS requires the classification of the financial instruments at fair value under categories, the asset classes can be classified as follows

1. Level 1 represents quoted prices (unadjusted) in active markets for equal assets or liabilities examples include US government and agencies, foreign government debt and several money market securities.

2. Level 2 are the  inputs other than quoted prices included within level 1,that is visible for the asset or liability, either directly (i.e.as prices) or indirectly (i.e., derived from prices), some of the examples are level 2 inputs are corporate bonds , mortgage securities, OTC derivative securities.

3. Level 3 inputs for the asset or liability that are not based on evident market data, some of the examples of such securities are private equity, exotic or non-standard derivatives.

The fair value is focused on the inputs in valuation rather than the techniques, thus the determination of the valuation technique depends upon several factors like judgements and specific characteristic nature of the security.

Thus in the case of level 2 security more than one input is required to determine the fair value of the asset and is dependent upon several factors. Considering an example of an option, an option is traded at a particular price the following market based inputs need to be considered before evaluating the price of the option market volatility, Expected dividend yield, The risk-free rate of interest. In this case the risk free rate is clearly a level 2 input which is observable from the market.

It should however be noted that in certain cases of level 1 inputs the quoted prices may not be the representative of the fair value. In such a situation adjustments need to made to the quoted price in order to measure the fair value of the instrument. It should however be noted that if the adjustment is made to the quoted value, the fair value cannot be justified as a level 1 input.

The level 2 securities are generally those securities which have a broker cost and a transaction cost attached to them, therefore these costs need to be appropriately be accounted before determining the fair value of the asset. A third party may also be used to determine the price of the asset but however it does not undermine the duty of the management to appropriately determine the price of the asset.

(PWC-2004, Ernst and Young 2009)

The level 3 inputs are the unobservable inputs and are used in situations where the active markets are non-existent. May researchers and theorists also believe that the financial crisis have also been caused by the fair value reporting to some extent. This is particularly the case with the level 3 input reporting which is unverifiable to some extent. Applicable accounting information is able to make decisions that the stakeholders difference in the decision making in the future at the daily quoted market prices, and which to some extent confirms the actions of the firm. However reliability requires that accounting information remains to be questioned and therefore needs to be to be independently verifiable and unbiased then real portray of reality and events. If the fair values are based on unbiased market prices then then the fair value valuation is also valid. (Fahnestock, 2009).

The level 3 input reporting is the tier which can be manipulated the most easily and the Enron case is also the clear case of misleading reporting of the level 3 securities. The level 3 asset class reporting under the fair value system can be easily manipulated by external auditors and poses serious threats for all the stakeholders. The use of the system was the cause of the downfall for Enron, the fair value reporting caused the employees and the management to overstate the value of the projects as well as the compensation associated with them. The Enron example clears spells a cause of concern for the use of the fair value system reporting.

6. Conclusion

The manipulation of financial statements and disclosures is clearly possible under the fair value system; this factor is particularly applicable in the level 3 inputs which measure unverifiable profits through a wide variety of techniques. The searchers and analysts have also concluded that the financial crises are also a cause of the reporting under the fair value system.  Empirical evidence has proven that that there was clear overstatements of the value of the bank assets which have been written off post the 2008 another example of misleading fair value reporting. The misuse of the fair value system is also evident from the Enron case (Laux et al ,2009).

The IFRS and the IASB needs to reconcile and reconsider the accounting standards related to fair value valuation. These standards need to become strict such that financial disclosures made by the corporations do not mislead the shareholders.

7. References

• Ryan, Stephen G. “FAIR VALUE ACCOUNTING: UNDERSTANDING THE ISSUES RAISED BY THE CREDIT CRUNCH.” SIB.WA.GOV 1.1 (2008): 1-18. Print.

• J Benston, George . “Fair-value accounting: A cautionary tale from Enron.” Journal of Accounting and Public Policy 25.1 (2006): 465–484. Print.
• J Benston, George . “. The shortcomings of fair-value accounting described in SFAS 157” Journal of Accounting and Public Policy 25.1 (2008): 101-114. Print.
• G. Haldeman, Robert. “Fact, Fiction, and Fair Value Accounting at Enron.” Fisher edu 1.1 (2009): 1-10. Print.
• Ronen, Joshua. “Post-Enron Reform: Financial Statement Insurance and GAAP Re-visited.” Stanford Papers 1.1 (2009): 1-30. Print.
• Ernst, Young . “Classification of financial instruments within the IFRS 7 fair value hierarchy.” Ernst and Young 1.1 (2009): 1-6 . Print.
• PWC. “Statement of Financial Accounting Standards No. 157 – Fair Value Measurements FAS 157.” Price Water House Coopers 1.1 (2008): 1-5. pwc.com. Web. 22 Apr. 2012.
• Fahnestock, Robert T, and Eric Bostswick. “An analysis of the fair value controversy.” Journal of Finance and Accountancy 1.1 (2009): 1-12. Print.
• Christian and Leuz, Christian, Did Fair-Value Accounting Contribute to the Financial Crisis? (October 12, 2009). Chicago Booth Research Paper 09-38; ECGI – Finance Working Paper No. 266/2009; Journal of Economic Perspectives, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1487905 or http://dx.doi.org/10.2139/ssrn.1487905

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