Week 3 Discussion

TOpic 1.
The Enron scandal was not only the fall of one of the biggest corporations in US, it was also the
fall of Arthur Anderson, one of the largest accountancy firms. The case brings to light many
causes that inflated the earnings of Enron in the eyes of creditors and investors, such as :
Time of recording revenue
Inflation of income by the use of unsustainable activities
By doing so, the company avoided the requisite level of full and transparent information
provided to the users of its financial statements.
Mark to market Accounting (MTM): Enron started to value assets and liabilities at market value.
Even the outstanding futures contracts were booked to balance sheet at market value.
Consequently, there were unrealized gains. It treated its future energy contracts (which are very
subjective) as financial contracts which allowed it to report the presumed benefits from future
transaction in the present Income Statement - thus inflating the income. Revenue was recored
too soon. The reason is that there are no quoted prices for these complex and subjective energy
contracts, which makes it very difficult to calculate the valuation of these contracts using real
market prices. MTM thus used in an aggressive fashion for energy contracts can allow
companies to use assumptions and discretionary methods to record future unrealized profits.
On the other hand it can also allow them to hide future losses, or understate future unrealized
losses. Consequently, it allowed Enron to use the present value of future cash flows rather than
reporting on the basis of conservative revenue recognition - recording the revenue when the
service has been provided, or when the cash has been collected.
Use of Merchant model by Enron: Secondly, the Merchant Model allowed Enron to report
revenue for its trading activities which allowed it to report the entire value of each trade as its
revenue, though it was just a counter-party in that agreement. This allowed it report bogus
revenue in income statement, thus inflating the Net Income. A merchant such as Walmart which
buys products from manufacturers, accept the risk of possession, risk of selling it to customers
can report the entire selling price of product as revenues. However, an agent who is a service
provider has to report only the trading fee as revenue. Reporting entire value of transaction as
revenue definitely aggrandized the revenue of Enron and hence it profits.

In addition, Xerox also increased the residual value on its leased equipment. This allowed it to
curb and record less expenses each period, thus massaging residual value of its equipment to
aggrandize the profits.
While SEC got concerned and singled Xerox out in 2000 for aggressive revenue recognition
practice on its leases when this practice of immediately recording a lease contract as a sale came
in the limelight, Xeroxs ratio of cash flow to earnings showed a declining trend and became
negative earlier than its revenue recognition practices were revealed. One lesson for investors
and shareholders is that earnings growth for a company that exceeds the growth in OCF
(operating cash flow) cant sustain for longer periods. It should normally raise red flags.
A public company such as Xerox was not allowed to sell stocks because it could not file its
reports because of this improper accounting for its leases - for Xerox leasing was the crucial
factor which brought in most its income. Hence it had to change its accounting practices
according to SEC wishes.

Topic 2:
After reading this chapter, and particularly, sections 4-1 and 4-3 of the text, I believe that it is
better and beneficial from the point of view of law, to have a broader definition of Gross Income.
As such it uses such terms as from whatever source derived and not limited to. It envisages
the spirit of times and contextual needs of the nation. It further reinforces the concept of check
and balances in the country, in which Congress has the Judiciary and the Administration
explaining and highlighting the concept of Gross Income. The Judicial branch prefers that only
realized income be taxed. US Code 61 has listed Cross References that are meant for the
individual taxpayer and all concerned interpreters, which lay direction and leads. I also believe
the concept of broader definition of gross income has to encompass many different ways an
individual can earn his or her bread and butter - and as such it has prudent use of words such as
from whatever source derived and not limited to. The vagueness addresses and reflects the
similar vagueness inherent in the broad nature an income can be earned. The clarification that
later follows from the usage and classification of specific examples, cases, rulings and notes
provides guidance and direction.
Response Paul:
Paul, you bring a point of review and feedback in the system. In my opinion its healthy. Clearly,
the system of checks and balances is what contributes to its health. The US Supreme Court
established this power of judicial review which is exercised by both federal and state courts. For
example, a judges function is not to make laws. That is clearly the function of the legislative
branch of the government. The judge reads, interpret and apply it. Take for example gross
income code here, from a practical point of view, however, the court plays a significant role in
defining what the gross income is. Part of the reason is that laws enacted by legislative bodies
tend to be broad and general (and not rigid). Judges come from various school of jurisprudential
thought that represent society, and in time these school of legal thoughts also evolve.
Additionally, the generality and broadness of law afford them the flexibility in interpreting and
applying it.

Response Victoria Tan:

Wolrdcom- a classic dot-com era case. Investors should have raised their concerns as to why the
capital expenditure increased so drastically, and as such the free cash flow slumped. Cash flow
from operations showed a big decline, while profits kept improving. It is a very interesting case
from financial analysts point of view. In fact, most accounting textbooks usually mention
WorldCom as a case study. In Security Analysis, it becomes a case of reading and analyzing
financial statements of companies, and detecting sources of potential problems, if any. At
WolrdCom, they ignored the accounting rules altogether in order to portray positive financial
results, as most tech companies of those times were yearning to please investors.

Q29, Q41, Q53, Q55

Response Alan:
In my opinion no law just reads itself. The IRSs manner to deal with the definition of
gross income as a standard shows that. Applying the Code requires interpretation. You
can base the interpretation of section 61 in legislative history, its language, or cases
related to that law. Additionally, many instances use purpose and context to reach
conclusions in disputes. I think IRS aptly allows the definition of income to evolve. The
approach taken by IRS to the definition of income facilitates its evolution and has
facilitated it to address new scenarios like bitcoin. Predictability of unexpected form of
income and need for code interpreters to be sensitive to changing social and political
conditions (and values) implies that it is crucial for the definition of the income to be left
broad. The fact that Section 61 defines gross income by setting out a list of examples,
preceded by the words including (but not limited to) the following items gives the
courts an incentive to give the meaning of the term on the basis of cases through
analogy. This is how it is it allowed to expand.