TRACKS: Dual Accounting and the Enron Control Crisis

Abstract

At the time of the Enron collapse, the new fair value accounting (FVA) paradigm was progressively incorporated into the framework of Generally Accepted Accounting Principles (GAAP), to serve along with the well-established historical-cost accounting (HCA) paradigm. Naturally, the Enron debacle involved misuses of both paradigms. As a result, the FVA—and in particular the “mark-to-model” valuation procedure—became a target for keen criticism. It was suggested that, apart from its application to a limited number of marketable financial instruments, the time of FVA had not yet come. In this paper, we reject this criticism and discuss the basic conditions that facilitated the abuse of FVA. We argue that despite the obvious advantage of value relevance information offered by the FVA paradigm, the lack of well-designed and effective, adequate control systems produced opportunities for the abuse and manipulation of FVA. We claim that the current control systems, designed for and capable of providing effective safeguards for HCA, are not suitable for FVA, and do not supply adequate safeguards for FVA. Furthermore, these existing accounting control systems turned into gauges for new standards and thus into barriers for FVA-based standards. These, among other reasons, caused the FVA to develop at a slow pace, creating a hybrid accounting system in which HCA and FVA are used simultaneously. We argue that the dual accounting system distorts the coherency of the reporting system, increases potential income management and “window dressing,” and nullifies the effectiveness of the existing control systems. We also stress that a well-designed and carefully implemented control system is indispensable for a properly functioning FVA model. We note that the proposed Statement of Auditing Standards, “Auditing Fair Values,” is an important step in the right direction.

An Examination of the Impact of Control Risk, Negotiation, and Pricing Specialists in the Audit of Fair Value Measurements

“…Internal controls related to FVMs are likely more difficult to audit effectively than traditional transaction-based controls because FVM methods are revised frequently. Controls over FVMs are more difficult to audit because they rely on different mechanisms than controls over traditional accounting information based on historical costs (Barlev & Haddad, 2004;Martin et al, 2006). Financial reporting frameworks often call for neutrality, but accounting estimates are imprecise and can be influenced by management judgment.…”

Accounting Issues: An Essay Series Part VI - Investments In Securities

“…These two classifications (for both debt and equity securities) require different accounting treatment, as described in the following paragraphs. 1 Available for sale (AFS) securities (both debt and equity) are reported on the balance sheet at their market value at that date (referred to as "mark-to-market" accounting). Unlike investments in property, plant, and equipment, there is some likelihood that securities will be sold (are not necessary for a "going concern" to stay in business), and therefore this approach is deemed more relevant than historical cost accounting.…”

“…No doubt, this is due in part to the fact that the accounting is somewhat confusing, but the primary argument revolves around the subjectivity associated with classification of investments. In addition, the use of fair value in accounting provides fodder for a fair amount of debate (See Barlev and Haddad, 2004.) Also earning some press among scholars and accounting professionals is the issue of "gains trading"-selling off "winners" to recognize gains in income, a form of income manipulation.…”