QUESTION

ACCT 20054 – ADVANCED CORPORATE ACCOUNTING
Assessment details for ALL students
Assessment item 1 – Individual Written Assignment
Due date:  Friday of Week 7     ASSESSMENT
Weighting:  40%
Length:  2500 – 3000 words      1
Objectives
This is a major assessment item for this course. The main objective of this assignment is to
develop your critical analytical skills and written communication skills to a point that you
have demonstrated your competence in applying your accounting knowledge to a real life
case, critically analysing the issues involved, arguing a case from different perspectives, and
communicating your views on those issues with logical explanations.
Preamble
This assignment is about the controversies surrounding the recent introduction and
application of ‘fair value’ measurement system by the International Accounting Standards
Board (IASB) and the Australian Accounting Standards Board (AASB). More specifically, this
assignment requires you to revisit the dubious accounting practices of the collapsed US
energy giant Enron Ltd and their use (or abuse) of ‘fair value’ accounting. This assignment is
prepared with materials taken from chapter 5 (Fair value measurement) of the prescribed
textbook, Company Accounting, 9
th
(2012) edition by Leo, Hoggett and Sweeting.

Although the Big 4 accounting firms and large multinational companies generally accepted
the fair value proposals, the accounting literature raises many questions about the
application of fair value measurements in practice. This case study raises some of these
questions with reference to Enron’s use of fair value system. Because fair values can be
based on unobservable input data (e.g., Level 1, Level 2, or Level 3), Section 5.8.1 of the
textbook (Page 208) asks the question: How reliable are the fair value numbers? Section
5.8.2 (Page 208) raises another question: Does past experience warn us against the
extensive use of fair values? Benston (2006) discussed the use of fair values by Enron, which
collapsed in 2001 as a result of a number of accounting scandals. Enron extensively used
Level 3 inputs and in some cases Level 2 inputs in measuring fair values. The following
information and analysis concerning Enron’s activities are summarised from Benston’s
(2006) paper:
1

The Enron Cases
Some examples of Enron’s fair value practices are outlined below:
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.

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.

3. Enron signed a contract in 2001 with Eli Lilly to make improvements in energy supply
and use over 15 years, discounting these amounts by 8.25% – 8.50%. Enron valued
the contract at $1.3 billion and recorded a $38 million gain. Within two years, this
contract was considered worthless.

4. In 2000, Enron announced a 20-year project (named Braveheart) with Blockbuster to

broadcast movies on demand to television viewers. Enron did not have the
technology to deliver the movies and Blockbuster did not have the rights to the
movies to be broadcast. However, Enron assigned a fair value of $125 million to its
Braveheart investment. A profit of $53 million was recognised 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 contributed to its loss of public trust and subsequent
bankruptcy.
It was subsequently revealed by the Examiner in Bankruptcy that the auditors,
Arthur Andersen, had assumed the following in the valuation process: the business
will be established in 10 major metro areas within 12 months, eight new areas will
be added per year until 2010 and each would grow at 1% p.a., digital subscriber lines
would be used by 5% of the households increasing to 32% by 2010, and Braveheart
would get 50% of this market. A net cash flow from each of these households was
determined, discounted by 31% – 34%, and a fair value determined.
Does this example provide an illustration of the weakness of using Level 3 inputs?
How can one determine whether or not such assumptions about a first-time project
are reasonable?
2

Required:
1. Read chapter 5 (Fair value measurement) of your textbook thoroughly. Pay
special attention to pages 182-184 (Need for, and definition of fair value) and
pages 195-198 on hierarchy of input variables (Level 1, Level 2 and Level 3
inputs). Prepare a succinct summary of fair value accounting and valuation
techniques related to asset valuation and income measurement as a derivative of
the valuation process.
2. Collect the following journal articles by Benston (2006 and 2008) and summarise
the key points of those articles:

Benston GJ 2006, ‘Fair value accounting: a cautionary tale from Enron’,
Journal of Accounting and Public Policy, Volume 25, number 4, July, pp. 465484.

Benston
GJ
2008,
‘The
shortcomings
of
fair
value
accounting
described
in

SFAS
157’,
Journal
of
Accounting
and
Public
Policy,
Volume
27,
number
2,

March-April,
pp.
101-114.

3. Critically examine the four accounting practices used by Enron as described in
(1-4) above and explain why and how fair value measurement system allegedly
may have contributed to each of the four accounting scandals by Enron.

4. What are the Level 1, Level 2 and Level 3 inputs used in the valuation techniques
under fair value measurement system? How realistic are they?
Important points:
i. Your submission should be a blend of analysis, findings, views, and opinions from
existing writings as well as your own analysis on the relevant issues. Bear in mind
that your answers must address the relevant issues/questions. Your personal
opinion in your own language is essential. Please do not copy entire
paragraph/section from other resources. Concentrate more on your own analysis
and arguments.
ii. Your submission should include the following sections:
A title page
An introduction showing that you understood the questions and present
a roadmap of your submission
Evidence of a thorough review/research of relevant literature (a
minimum of 8 articles)
Addressing each part/subpart of the requirements (1-4) listed above.
Clearly identifying  and critically analysing the core issues in each question
A conclusion.

SOLUTION

Question 2: The two articles “Fair-value accounting: A cautionary tale from Enron” (Benston, 2006) and “The shortcomings of fair-value accounting described in SFAS 157” (Benston, 2008) from the Journal of Accounting and Public Policy, Volume 25, number 4 and Volume 27, number 2 can be summarized as follows:

• The companies are determined with the fair valued as per the references to the prices of the market on the same assets, different asset and similar assets.
•  These are the levels where the prices of the company are not available or right, existing value and other estimated values that are generated internally.
• These prices need to know about what hypothetical companies are expected to pay for the assets, which is an expensive procedure at best.
• The present values of these assets such as work-in-progress, furniture, and some machines for special-purpose, that are often zero or negative..
• Majorly, these assets and liabilities that are include in the balance sheets of the company were mentioned again at the current prices yield balance sheets and statements of income that are of less value to investors in the continuing companies, , if any.
• In the case, when these fair values are not limited to actual market costs, the values should be dependent on arbitrary prices that are expected to be provided by hypothetical independent buyers of its assets and liabilities. These assets and liabilities took part in the markets that are not current. The managers are expected to find out the maximum and best use to which an asset or the unit of assets that are expected to be kept as a introduction to forecasting fair value. The auditors are expected to verify these assets.
•  The issues of regulation of accounting became an issue of concern and discussion, specifically following the economic crisis and crash of the year 1920-30s that headed to for the accounting theory and principles defined.
• All the departments of the government must have a rigid, declining, regulatory budget – measured both by quantum and pressure of regulation. Any organization, which goes over the budget of the government, is likely to be banned from launching new regulations until they find old regulations to remove.
• The regulation of accounting is seen as relating to “sustained and focused control exercised by a public agency over activities valued by a community” (Watts, 2003), there are other outlooks.
• This policy is not normally understood to be a part of the common law, and so a law continues in force, until canceled by parliament, although long the time may have been since it was known to have been actually imposed.
• The economic method to manage is constant with the theory of public choice that focuses on the limit to which the behavior of government is meant by imagining all performers as balanced entity maximizers of their own welfare.
• In each time period, the company listed the real cost of supplying the gas and real revenues obtained from real expenses of supplying the gas and real revenues obtained from offloading it.
• Any administration is rapidly confined by special-interest units such as the receivers of the regulation, the minister and their staff who are keen to keep that portfolio and make it influential; the departmental employees, who run the regulation and wish to make it “better” and non beneficiaries who do not want to be excluded.

Question 3: In all the four points, the US-based energy, commodities and services corporation, Enron used fairly straight forward accounting principles. In each time period, the company listed the real cost of supplying the gas and real revenues obtained from real expenses of supplying the gas and real revenues obtained from offloading it. The company became the first non-financial entity to use measures to be responsible for its difficult long-term agreements and the relative expense was complex. This accounting need the one time agreement to be signed, the estimation of income for the non-financial company is needed to see the present and net future value of cash flows.

The issues of regulation of accounting became an issue of concern and discussion, specifically following the economic crisis and crash of the year 1920-30s that headed to for the accounting theory and principles defined. The main aim of accounting is to offer details and detail to the involved parties, who might not have contact to full or partial, but required economic decision. Due to their information disadvantage, they are irregularity in the working and use of information.  However, the regulation of accounting is seen as relating to “sustained and focused control exercised by a public agency over activities valued by a community” (Watts, 2003), there are other outlooks. Accounting policy in Australia a requirement, but it is over-rated and the main reason of this over-rate is that government is the ultimate monopoly (Wu, 1998). The impact of this governmental monopoly on the law-making procedure is to manage that what is produced and the ways of distribution of consequential production within the societies. The governments driven environments that are not checked properly are ever an expanding perpetual-motion machine. Any administration is rapidly confined by special-interest units such as the receivers of the regulation, the minister and their staff who are keen to keep that portfolio and make it influential; the departmental employees, who run the regulation and wish to make it “better” and non beneficiaries who do not want to be excluded.

All the departments of the government must have a rigid, declining, regulatory budget – measured both by quantum and pressure of regulation. Any organization (Xin, Huang, 1951), which goes over the budget of the government, is likely to be banned from launching new regulations until they find old regulations to remove. The yearly budget for each section would lead to a decline in the overall regulatory burden each year (R v London County Council).

This policy is not normally understood to be a part of the common law, and so a law continues in force, until canceled by parliament, although long the time may have been since it was known to have been actually imposed.  There is though some model for the principle, and at times the Latin maxim “jus incognitum” or “unknown rule” has been used to change down unclear and outdated rules by the courts. Developing the principle of desuetude would give the prosecutors the methods to strike down old, the legislation that is not used as no longer law – of course, the regulations for this must be a bit restricted, so that objector moderators cannot use the approaches to hit down legislation only as they do not like it. There is complete awareness of the irony that with a motive of enabling this policy to be launched, a new rule of Parliament would have to be issued.  Regulation Impact Statements must be a necessary procedure, which allows a real method of the expenses and advantages of regulation. Regulations that do not able to clear the test must be submitted back to Parliament or the related Minister.

The economic method to manage is constant with the theory of public choice that focuses on the limit to which the behavior of government is meant by imagining all performers as balanced entity maximizers of their own welfare. Analysis is led to the challenging methods (Zhang, Song, Wang, 1996) of the entities included– how they get across the regulatory that aims for adding their own aims. As a result, private interests are served in spite of the the common interest. Public selection theory settles the questions related to politics and economics (Wang, 1980). It depends on the neo-classical monetary expectations of rational selection, which is also known as self interest to guess the behavior of politicians, who are also called as the regulators (Von, 1969). These politicians only pass those regulations that allow their scope of reelection which, as discussed in the section above, will head the politicians to those that have the methods to add this goal.

REFERENCES

Watts, R. L., 2003, “Conservatism in accounting – Part I&II”, Accounting Horizons

Wu, J., 1998, “Contemporary Chinese economic reform: Strategies and implementation. Shanghai”, Far East Press.

Xin, Z., & S. Huang, 1951, “How to construct new China’s theoretical accounting basis”, New Accounting, pp. 12– 16

Zhang, W., G. Song & L. Wang, 1996, “Great Chinese economic debates”, Beijing: Economic , Management Press, pp. 83–84

Wang, W. B., 1980, “Is accounting of class nature? Accounting Newsletter”

Von, L, Mises, 1969, “Economic calculation in socialism”, Homewood, IL: Irwin, pp. 61–68

Benston, G J, 2008, “The shortcomings of fair value accounting described in SFAS 157”, Journal of Accounting and Public Policy, Volume 27, number 2, pp. 101-114

Benston, G J, 2006, “Fair value accounting: a cautionary tale from Enron”, Journal of Accounting and Public Policy, Volume 25, pp. 465-484

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