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The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability. The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability.
SFAS identifies three approaches for estimating exit prices: SFAS then establishes a hierarchy of fair value measurements for financial disclosure. The hierarchy is intended to convey information about the nature of the inputs the assumptions, not the valuation techniques used in creating the reported fair values.
The principal complaint about historical cost accounting is that it often understates the value of corporate assets, as well as of equity and income. Convervatism, a long-standing and pervasive property of financial reporting, has always placed greater focus on the concern of financial performance being overstated. Careful, conservative investors hereafter, including creditors as well must be advised of the potential risks when the new accounting theory is applied by aggressive corporate managers.
When the company announced massive write-offs and restatements in October and November , it seemed that fraud must have been involved. It could even be argued that Enron resembled an organized crime syndicate; efforts to mislead investors required the coordinated efforts of many people. Prosecutors may have judged that favorable plea arrangements could be justified by the ultimate convictions of the two really big targets: Lay and Skilling had a unique strategy in preparing for their criminal trial.
Emshwiller, January 20, It is important to emphasize that Lay and Skilling did not plan to claim that: Effectively, Lay and Skilling were willing to admit that they fully understood the accounting rules, they understood the picture of Enron that these rules presented to investors, and they and their subordinates intentionally applied the accounting rules to their logical conclusion.
The risk of default is a central focus for most creditors and many equity investors. For example, bond ratings carry implications for the probability of default.
Long-term credit ratings generally depend on financial statement information such as the relationship of debt to equity, liquidity, and profitability. Because bond ratings also incorporate subjective information e. This suggests that an adjusting entry could be used to recast the financial statements.
The mechanical credit rating can first be calculated using the original financial statement data and then re-estimated after posting the hypothetical adjusting entry.
Any change in rating would serve as an estimate of the impact that changes in financial information might have had on bond ratings. This can be accomplished using the well-documented proprietary Zeta credit risk model, which combines variables that measure traditional credit-rating concepts of capital structure, liquidity, profitability, debt service capacity, and predictability of income flow.
Series 3 in Exhibit 2 shows the historical record of Zeta credit ratings. Series 3 provides a base of comparison for proposed adjustments to the financial statements. It certainly does not reflect the very-high risk profile that Enron in retrospect demonstrated.
These assets alone would appear to be worth more than the amount creditors will realize although security analysts frequently discount the value of goodwill. Skilling and Enron persuaded the SEC in January that Enron should be able to use mark-to-market accounting to value long-term gas contracts and derivatives McLean and Elkind. Thus, the SEC handed Enron the tools to abandon traditional principles and introduce the bookkeeping analogue of financial engineering into nonfinancial companies.
Enron eagerly applied the tools and soon began discounting to present value as much as 29 years of income from customer contracts. The result, after considerable manipulation, was instantaneous increases in assets and offsetting equity and, of course, income. From through , these adjustments resulted in an average rating reduction of about one notch. In light of the fact that virtually all of the recovery to creditors will come from the sale of electric and gas-transmission utility assets, it is tempting to speculate that these were the only Enron businesses that had any value.
Obviously, shrinkage of asset values is a common problem in bankruptcy, but it looks as though Enron was never much more than a simple utility company. The additional step of removing the highly questionable PRMA would have lowered the rating an additional three notches. Batson, the bankruptcy examiner, concurred: If they had been more realistic about their claims regarding the financial statements, they might have been able to deflect much of the responsibility through the following argument: What really misled investors was the far more material accounting for fair value assets that was approved by the SEC.
A few investors who consciously avoided Enron may have done so because they understood what the company was doing. The value to investors of forward-looking fair value accounting is questionable. While investors will always be vitally interested in what is likely to occur in the future, more than anything else they need an accurate record of what has happened in the past. At its best, fair value accounting does not provide this. Benston was writing about rules-based GAAP, but it is clear that his comment is also applicable to fair value accounting.
Consequently, the authorities have required fair values, at least for financial assets, even when they are not based on reliable market values. The traditional model for dissemination of financial information follows a certain path: Companies generate financial statement data. Independent accountants verify financial statement data. Independent security analysts use data to assess value.
Portfolio managers use value assessments to allocate capital. A critical element of this process is the presentation of independently verified financial statements to security analysts.
Hundreds, perhaps thousands, of security analysts in turn use their best efforts to model or value a company. Market efficiency results from the collective efforts of many analysts assessing a relatively objective set of financial statements. Broad implementation of fair value accounting will change the dissemination of financial information, which will proceed along the following path: Independent accountants verify financial statement data and value companies.
Portfolio managers use value assessments of public accountants to allocate capital. FASB, knowingly or not, is pushing to change the role of the independent accountant from objective reviewer of financial information to subjective valuation specialist.
Accountants will become both judge and jury regarding financial valuation. Even if independent accountants have no intentional bias, the capital allocation formula will transform from a review by many analysts to a review by a single analyst.
Benston proposes a solution: After that, markets, not independent accountants, would determine the meaning of the additional data. The committee emphasized that accounting methods are subjective and, consequently, accountants must be shielded from liability when required to provide subjective analyses.
The accounting profession increases its own vulnerability as its standards progress toward the increased application of Level 3 fair value accounting. It drives itself toward ever greater subjectivity! Perhaps he should have called it the most stunning recommendation. Is no one going to be held responsible for the next Enron?
On the other hand, no standards setter, regulator, or academic body has offered to accept responsibility for materially flawed accounting standards. In the end, increasingly subjective financial statements, combined with insulation from liability, will make it nearly impossible to hold anyone accountable for the inevitable opportunistic bookkeeping.
Earlier in these pages, Walter P. By his reckoning, outside experts would have corrected i. Testimony of Walter P. He argues that historical cost accounting and the current impairment standard are not adequate for this purpose, citing several examples where specific assets should have been marked down using mark-to-market valuations. Conceptually, I have no quarrel with these examples, but they are relatively straightforward valuations where market Level 1 or near market Level 2 prices exist.
Enron invented whole businesses—including trading desks, fixed assets, and capitalized software—in order to create and maintain Level 3 PRMA. These businesses never had any real business purpose, and never created tangible cash benefits for shareholders. Their purpose was to manipulate into current years as much speculative future income as they could, so that management could profit from their incentive compensation agreements.
It would have been nearly impossible for any outsider to call these businesses, employing thousands of workers, worthless, especially because the SEC said it was all legal. How could a valuation consulting firm have had more leverage over Enron than its independent auditor?
Until now, the accountants could blame only management, and vice versa. This final question may be the most important.
Enormous effort has gone into re-evaluating every aspect of accounting, but this may be overthinking the problem. Accounting changes are expensive to implement and audit, but all accounting standards share the same problem: No one knows if they have made a difference in the utility of financial statements for investors. There is usually vigorous argument about a new standard before it is made effective.
Yet there is no effort, before an accounting release or after, to collect verifiable evidence that the new standard allows investors to better invest their capital, or creditors to better quantify default risk. A more important goal for accounting than a conceptual framework is developing a way to collect evidence that shows whether changes in accounting standards allow investors to make better judgments about future performance.
This author is not sure what the measure of effectiveness for new accounting rules should be, but FASB should be trying to solve that problem. In renowned accounting professor and researcher William Beaver proposed that prediction of business failure i. Without any evidence of usefulness, Flegm may be correct: Measuring the Value of Accounting Standards.
Accounting theory is undergoing a major conceptual change, and the most recent manifestation—the application of Level 3 fair value accounting under SFAS —has the potential for widespread deception of investors. Issuers of corporate securities ask investors to trust them with their money. Financial statements provide the vehicle through which companies communicate to investors what has been done with that money.
This is no theoretical exercise and should not be treated as one. I believe that until FASB can produce evidence of its value, the fair value accounting project should be limited to footnote or schedule disclosures. Otherwise, investors must become even more skeptical of accounting information than they now are, and questions about the quality of earnings will possess greater urgency.
Even recent accounting scandals are viewed as an aberration that will be addressed by changes in law, oversight, and penalties.
This benign, conservative view of accountants may change as the real meaning of Enron becomes clearer with time. The last odd years have produced a paradigm shift in corporate accounting theory.
Implementation of economic valuation techniques requires that accountants abandon traditional accounting principles historical cost accounting, conservatism, and matching of costs and revenues.