What were the business risks Enron faced

The original business Enron engaged in is natural gas transportation. The accounting Enron adopted is convention accounting that record actual cost and revenue when they generated. During this period, risks that Enron experienced were all normal business risks which could be circumvent and cannot imperil Enron’s exist.

However, abnormal risks came into being in the early 1990s when Enron expanded the natural gas pipeline business to “new economy” business which is making money from the different price between speculative buying and speculative selling energy futures as a middle man. The energy market were so volatile that made Enron gambling on trend of energy price go up or down more difficult. The forecast had to be so accurate; otherwise, money will easily lose when the bets turn out to be wrong. In addition, the risks were escalated when Enron began to offer a wide variety of financial hedges and contract to customers to protect them against risks.

Mark to market accounting adopted on Enron’s business trading is also a big issue that led to Enron fall [1] . The company record revenue based on the stream of future inflows under a long term contract, and record the expense based on the present value of expected cost. The challenge of using this method is to estimate the market price when it could not be objectively determined. It is propitious for Enron to commit accounting fraud. Therefore, in its financial statement, viability of many contracts was overestimated for the purpose of making itself seem more profitable.

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Part 2

In your own words, summarise how Enron used Special Purpose Entities to hide large amounts of company debt.

Enron’s primary accounting purpose of establishing Special Purpose Entities (SPE) is to use off-balance sheet financing to hide of the company debt. If the relationship between Enron and SPE satisfy certain conditions, the consolidated financial statement is not necessary. Under such circumstance, Enron’s desired accounting purpose is made realizable. Funds borrowed from SPE were recorded as revenues on Enron’s balance sheet, while Enron never book the liabilities on the balance sheet. This made Enron look like more profitable and attractively. As a result, the stock price increased remarkably.

Part 3

Explain how “rules-based” accounting standards differ from “principles-based” standards. How might fundamentally changing accounting standards from bright-line rules to principle-based standards help prevent another Enron-like fiasco in the future? Are there dangers in removing bright line rules? What difficulties might be associated with such a change?

Rules-based accounting is basically a list of detailed rules that must be followed when preparing financial statements. Having a set of rules can increase accuracy and reduce the ambiguity that can trigger aggressive reporting decisions by management. The complexity of rules, however, can cause unnecessary complexity in the preparation of financial statements. Principles-based accounting such as generally accepted accounting principles (GAAP) is used as a conceptual basis for accountants. The fundamental advantage of principles-based accounting is that its broad guidelines can be practical for a variety of circumstances. The problem with principles-based guidelines is that lack of guidelines would lead to the difficulty to compare one organization to another due to unreliable and inconsistent information.

Principle-based accounting may be more efficient than the bright- line accounting- especially in response to accounting scandals, such as  Enron (PricewaterhouseCoopers 2003). A principle-based rule encourages and demands individual responsibility and the application of professional judgment, so auditors would find SPE’s which allowed to omit substantial liabilities from balance sheets was hidden off a company’s books and overshadowed professional judgment. However, Auditors in Enron did not inquiry why the “special purpose entities” (SPE’s) are involved in a number of aggressive transaction; they just ignored the SPE’s existed and made it seem correct.

Under a principles regime, accountants would be required to use their judgment to determine if various financial reporting tactics are appropriate or not, which may lead to ambiguous and uncertain to implement the rules. Everyone would have different opinions on the meanings of rules. And most importantly, the auditors, many of whom have been caught behaving badly recently, abuse their trust and fail to apply the principles in “good faith consistent with the intent and spirit of the standards.” Therefore, the industry feels surrounded by the securities plaintiff’s lawyers and has sought refuge behind rules in a bid to find safe harbor from liability.

Part B

What are the limitations of information in company accounts as discussed by the authors? What can a conceptual framework do to overcome these limitations?

It is obvious that three limitations of information are being discussed in this article. Firstly, on the micro level, users cannot predict very well based on the information provided by the company. This kind of limitation arises from the inadequate financial statement that be concealed part of the fact due to decision of the authority who presented the statement. Moreover, accordant with the conventions and accounting standards and only presentation of the monetary terms are another reasons lead to the not all-inclusive information. As a result, an ‘expectation gap’ which is between expectations of users and the reality of what was included in financial statement comes out. Secondly, on the macro level, the limitation is lack of ability of the conventional accounting to account for inflation since the historical cost accounting applied that without regard all value changed. Finally, the influence of accounting convention, opinion and financial policy on the published financial statement is the third inherent limitation that exists in some areas. Apportionment of income and expense is largely depended on management opinions, with which management tends to use to satisfy their own interest, like share based payment. That may mislead the users.

Generally, a conceptual framework focuses on eliminating the ambiguity and inconsistency incorporated within the documents, and becomes a guide to standard setters and practitioners. Meanwhile, a conceptual framework includes two major components, one is to predefine the outcome of standard setting processed, and the other is to build up the basis for financial reporting practice. As the limitations mentioned above, a conceptual framework would overcome these by following,

1. A conceptual framework is explicit expressed by using the certain well – established formulation of accounting doctrines, and provides a comprehensive or complete framework to guide financial reporting practice, which covers financial reporting for all forms of private sector and public sector entities. Moreover, a conceptual framework is consistent with knowledge about commercial practices and the behavior of external users of relevant accounting information for users to prediction.

2. A conceptual framework presents current cost financial statements as a supplement to the conventional statements that show the changes in the purchasing power of the monetary unit in order to overcome distortions in historical accounting data due to the continuous inflation experienced in the world’s major economic nations.

3. A conceptual framework uses terminology in a certain manner which is consistent with usage in related technical literatures in order to provide qualified and reliable financial information for users, which needs to represent faithfully and free from error and bias (AASB Framework¼Œpara.31). Furthermore, apportionment of income and expense is included in accounting information, thus the reliability of accounting information plays an important part in the financial and management decisions since