The business environment in much of the world is reeling from the revelation of several financial scandals in the past few years. The optimism of the turn of the century has been replaced by scepticism and distrust. It will be discussed as to how we landed ourselves in this situation, what is being done to correct it, and what the future holds for us. Though Enron has been used as the poster-child for this purpose, breakdowns in accounting and corporate governance in Enron as well as in other companies will be discussed.
Some companies that have encountered financial reporting problems will be discussed along with the role of auditors (including Andersen’s role in Enron), the regulatory environment, some of the causes of the problems, and the current and possible future outcomes.
Ethics and Accounting
Ethics (maintaining true and fair statements) is a key part of financial reporting. For shareholders to trust a company with money, they must feel confident in the company’s financial reporting. Financial reporting presents all data relating to the entity’s current, historical and projected health meaning investors and shareholders rely upon the available financial data for making informed and educated decisions. To help entities comply with business regulations and maintain financial reporting, shareholders can trust the existing organizations designed to watchdog different aspects of the accounting world. Primary among the organizations are the Securities and Exchange Committee (SEC), Financial Accounting Standards Board (FASB) and Public Company Accounting Oversight Board (PCAOB). These three bodies together ensure financial reporting is fair, reliable, and available to all investors.
The specific importance of ethics in business and in financial reporting is to inspire and ensure public and investor confidence in companies. Without a strong code of ethics, and adherence to that code, individuals may not be certain their investments are secure. Accounting professionals must have a strong ethical and moral reasoning as their decisions regarding financial reporting can have major consequences for individuals as well as corporations and entire nations. Ethics in the business environment are more than just issues that relate to accounting; because ethical practices can and will cross boundaries from business practice in to what a company may ask its accounting professionals to do in financial record-keeping and recording. The many recent scandals involving accounting fraud generally began at the CEO and made their way down into the financial records.
Before the Sarbanes-Oxley Act, various financial abuses such as WorldCom, Enron, and Adelphia Communications plagued the American public and affected economic health of the entire nation adversely. Most of these frauds stemmed from unethical accounting practices instituted at the highest levels of the corporations, but carried out in the financial reporting practices of public accounting firms. In December 2001, Enron, which used to be one of the world’s leading energy companies once, filed the largest bankruptcy in the history of the U.S., using the retirement accounts of thousands of American workers, to enrich those at the highest levels of the corporation. Using thousands of off-the-records partnerships to hide nearly $1 billion in debt and to inflate profits, company had defrauded shareholders of billions. Due to these scandals, President Bush and Congress were forced to take tough stance in the form of the Sarbanes-Oxley Act in July of 2002.
When ethics seem to be on the downfall in a society, the common man naturally turns to the government for guidance. Various crises in the history of the United States have led to creation of several regulatory bodies and laws. The three entities in the US, mentioned above, work closely together to ensure financial accounting is honest. The SEC, the FASB, and the PCAOB are each an independent entity, but they often work in cooperation in certain areas such as oversight and reporting. While these three bodies work together, they rely on cooperation from member companies and from participation from “whistle-blowers” in companies and public citizens. As the Enron collapse illustrated, there were systemic failures in the private-sector watchdog-groups. The SEC and the PCAOB must work closely together and include way to fast-track criminal cases.
Enron and other financial reporting scandals Enron was a great symbol of widespread problem in corporate America as its rise was as spectacular as its fall. Enron, formed in 1985 when Internorth purchased Houston Natural Gas was soon being run mainly by Houston Natural Gas executives, with Ken Lay as CEO. In 1990, both Jeffrey Skilling and Andy Fastow were hired. In 1996, Skilling became the President and COO. A meteoric rise in both reputation and stock value came by, with Enron being named as one of Fortunes’ most admired companies in 2001 and its stock price peaking at $90.56 a share as on August 23, 2000. Much of the company’s success was credited to the financial wizardry of Fastow. However, company’s fall was just around the corner, with Skilling resigning in August of 2001. This was followed by a $1.2 billion write-off, and the beginning of an SEC investigation in October. By December, Enron had declared bankruptcy and the share price was $.26 per share.
If Enron had been a lone case, concern would have dissipated quickly and confidence in capital markets would not have plumped. But it was not so. Before Enron, there were companies such as Waste Management and Sunbeam – not significant by themselves, but they should have acted as a warning of what was to come. After Enron the disclosures kept coming. WorldCom was caught capitalizing expenses. While Enron was trying to outsmart the accounting and capital market regulators, WorldCom made accounting errors that even novice accounting students would know were inappropriate. A disturbing aspect of many of these scandals is the collusion among many executives.
An important observation is that all of these scandals can’t be attributed to one factor alone. Each one was different. Hence it can be concluded that the solution is not easy to find. There is no single accounting practice that made these entities vulnerable to executive excesses.
What these scandals had in common was a culture that was pervasive in corporations. A culture had come in that made it permissible to lie to shareholders and the markets. “The ends justify the means” became the corporate mantra. Also, the watchdogs, the auditors had turned a blind eye with their focus just on their consulting businesses. They were not as vigilant as they should have been in audits.
The auditor’s role in ensuring fair play Auditors are supposed to protect the public from the types of abuses that have been seen in the past. Even though financial statements are responsibility of management, the shareholders hire auditors for the protection of their interests and to add credibility to financial information provided by the firms. To be credible, auditors need both expertise and integrity. Expertise assures if there is a financial reporting irregularity, the auditor has the capacity to discover it. Integrity assures that auditors will disclose any irregularity they may find. These two qualities are essential. They are also multiplicative that is if either is missing, other has no value. It has been found that both were missing in many cases. Expertise was missing as audits had come under cost cutting measures of firms. This happened often at the cost of quality. Integrity was gone when auditors forgot that the first allegiance of a professional is to the public. Seldom did auditors betray management for the benefit of the public. Hence, even if they did discover reporting problems, rather than reporting them to the public they often helped management devise ways around the reporting problems.
Auditors fell into this position (probably not because they were incompetent or unethical but) because of the cultures in major accounting firms. Andersen, Enron’s auditor, is a classic example. There were good auditors who got caught up in an economic struggle leading to undue focus on revenue generation. An audit firm having the highest reputation for competence and integrity compromised on its values as that was the only way its partners thought to be economically competitive.
In the more recent Satyam case in India, the fraud started at the top level management and reached the financial records. The role of Pricewaterhouse, Satyam’s auditor, is also controversial in the said scandal.
Causes of financial reporting problems The regulatory environment had not changed suddenly then why did the financial reporting problems surface at the time, is a question to be pondered upon. There are many reasons, not one that dominates.
It was a confluence of circumstances that opened eyes to the problems. The bursting of the bubble economy was a major reason these financial abuses came to light. When everything was seemed bright, nobody questioned companies’ financial reports. In accounting the lack of relevance of historical cost accounting and even the basic traditional accounting framework were being discussed. The “new economy” was not to last forever. And when it did not last, investors began to ask tough questions. For many of the questions, there were no answers – only denials and cover-ups.
In the auditing profession, audits had become loss leaders. The balance sheets and income statements had lost value, so auditing of the statements was not important. Thus, many audits became hasty and more of a formality. No one was willing to pay for quality audits, so many audit firms believed there remained no sense in competing on the basis of quality. Cost drove audit decisions. Lower cost even with lower quality was the norm.
The passivity of corporate boards was also a contributor. This was worsened by the growing number of complex financial transactions, most of which were beyond understanding of board members, who had gained their experience before such instruments came into being. Even a former accounting professor heading Enron’s Audit Committee, a person of utmost integrity, had difficulty understanding the implications of the company’s financial manoeuvring.
Finally, the biggest culprit is the corporate culture. Focus was laid on short-term gains forgetting about all long-run considerations. Also the executive scorecard became focused on salary. Many players had become greedy – executives, investors, and attorney, among others – but more than that was the need to compete on the basis of compensation.
Implications for accounting educators The perpetrators of most of financial reporting scandals are former students, graduates of accounting or MBA programs. So educators must ask themselves: What are they doing wrong and what must they do to fix the problems?
The first obvious reaction is to emphasize ethics in business and accounting curricula. This is important. Educators in a business ethics class can not dissuade someone who is inclined to commit a fraud from doing so. But it is also true that most perpetrators did not at the onset set out to commit a fraud. They simply got ended up on a slippery zone.
Also, the most disappointing aspect about most of the scandals is the number of people who, (though not personally involved) knew what was happening and still did nothing. Exceptions to the rule are some courageous whistle blowers, many of whom were products of university accounting programs. Thus, the focus of ethics classes should be to recognize and analyse the situations that can lead to compromise on one’s ideals and values, and to promote the reporting of inappropriate behaviour. This can be best done in context because ethics issues come up in context, with you imagining yourself in the real situation. It is easy to go into an ethics class and give the answer that the instructor wants. It is an altogether different thing to put one’s self in a case situation with conflicting pressures, and determine the appropriate action when ethics is only one of the many factors impacting your decision.
Conclusion The accounting profession is in the middle of a challenging time. A reputation gained over years and decades can be lost in a day. Accountants were thought of as persons of high integrity working at an uninteresting job. In the current scenario the job has gotten more interesting, but at the cost of their reputation for integrity. It is essential to win back the trust of the public and maintain their belief in the importance of accounting. The road to restoring integrity of accountants today is a long one. The job will neither be quick nor easy, with the new series of financial reporting scandals that have come up.
Accounting standards Setting Approach: principles-based vs rules based
Rules-based accounting is generally a list of detailed rules that must be followed when preparing financial statements. Principle based standards derive from a conceptual framework that provides for broad ‘principles’ to be adopted within standards and also requires professional and managerial judgment in relevance to particular transactions and events. US secretary Heary Paulson had once said “We must rise above the rule based mindset that asks Is it legal?, and adopt a more principle based approach that asks Is this right?”. This essay discusses the principle based approach and rules based approach for accounting and critically examine the more appropriate standard of accounting.
According to Bennet et al (2006) the difference between rules-based and principles-based standards is not clear and is subject to a variety of interpretations. But there is a generally held outlook that the FASB’s standards are rules-based and the IASB’s standards are principles-based. The commencement for the current principles versus rules debate is sited in section 108 of the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act was a result to the failure of Enron and the blow to the capital market system that Enron induced. Sarbanes-Oxley Act of 2002 instructed SEC (The Securities and Exchange Commission) to carry out an investigation into the implementation by the United States financial reporting system of a Principles-based Accounting System. The preliminary effect of Enron was primarily that things have to change (ICAS 2006). Immediately prior to the fall down of Enron the Chairman of FASB was not sure that accounting principles or rules were achieving the required goals. Schipper (2003) points out that the U.S. rules are frequently based on principles. The standard setters use principles in order to create the rules for the preparers of financial statements. According to Nelson (2003) cited in Nobes (2005) said that a particular standard should be seen as rules-based standard. He also add that rules can increase the correctness with which standard setters communicate their requirements and can reduce the sort of vagueness that leads to forceful reporting choices by management.
According to Schipper (2003) and Nelson (2003) cited in Nobes (2005) say that rules standards has some potential advantages. Those identified by them include:
· increased comparability,
· increased verifiability for auditors and regulators
· reduced opportunities for earnings management through judgements, and
· improved communication of standard setters’ intentions.
Many accountants favour the outlook of using rules-based standards, because if there are no rules then the accountants could be brought to court of law if their judgments of the financial statements were wrong. But when there are strict rules that have to be followed, then the possibility of lawsuits is reduced. Rules-based standards include important and specific rules to meet as many potential contingencies as possible. Principles-based accounting such as generally accepted accounting principles (GAAP) is used as a theoretical or conceptual basis for the accountants. A simple set of key objectives are set out to enable the companies to build a good report. The following section includes the discussion on the rules based standards and principle standards.
Professional judgment, Enforceability, Comparability, Complexity, Creative accounting and Economic reality are used as the indicators of the discussion (ICAS, 2006).
Views on professional judgement are separated into those who consider that rules strangle judgement and those who believe that rules act as a check on creative judgment. Professionals themselves prefer the defensive comfort of a rules-based system and are uncomfortable with the probable exposure from exercising judgement based on principles.
Enforceability is an argument which has been set forward to support rules-based standards. It is said that rules offer a clear statement for regulators and for those who focus on regulation. The criticism is that rules-based standards do not prevent dishonest practice. Manipulated fulfilment with rules makes auditing more complicated because mangers can justify their manipulation as fulfilment.
Comparability is a difficult notion because it covers a range of different meanings. Those supporting rules-based standards argue that they do provide comparability but in some other cases this comparability gets equated with uniformity. Those who oppose rules based standard argue that they detract from true comparability because they force dissimilar situations into similar treatments.
One of the strong arguments against rules-based standards is that they cause complexity and overload and which causes delay in the process of responding to changing situations. Supporters argue that rules-based standards respond to difficulties by setting a obvious pathway for dealing with complex dealings. According to Kivi et al. (2004) cited in ICAS (2006) if investors find it difficult to know the financial information in the financial statements this is not due to the complexity of rules-based standards but to the complexity of the business models which operating in the market.
The presence of creative accounting has been raised to indicate the limitations of rules-based standards because instances can be cited of professionals using the wording of the rules to produce a required solution. The ‘roadmap to avoidance’ is seen as a outcome of rules-based accounting but well-written rules can reduce the opportunities for flexible explanation of principles that could lead to creative accounting with the help of earnings management. According to Benston et al (2006) this happened in the case of Enron and as a result of the misleading accounting procedures exposed in the investigations of Enron’s failure, the Sarbanes-Oxley Act of 2002 included a provision, Section 108(d).
Representing economic reality is seen as a advantageous aim of financial reporting but there are divisions of outlook. It could be argued that principles allow demonstration of the ‘bigger picture’ but it could also be argued that in many cases the existing rules based standards have led to loyal demonstration of economic reality in a reliable approach. International Federation of Accountants (IFAC) felt that rules-based standards were too long and complex.
Other critics of rules-based standards have pointed out that rules can turn out to be ineffective and, worse yet, dysfunctional when the economic environment changes or as managers produce new transactions around them (Kershaw, 2005 cited in Benston et al (2006)).
Principle based accounting standard is better than rules based approach as:
It is simpler than rules-based standards
Supply broad guidelines that can be useful for many situations
Broad guidelines may get enhance the representational truthfulness of financial statements
Allow accountants to use professional judgments
Principles make structuring transactions in a particular manner more difficult to justify
After the debacle of Enron using rules based standards the enthusiasm of principle based standard approach emerged from different quarters. In 2002, FASB gave a report that “in accounting standards developed under a principles-based approach, the principles reflecting the fundamental recognition, measurement and reporting requirements of the standards would continue to be developed using the conceptual framework. The main differences between accounting standards developed under a principles-based approach and existing accounting standards are (1) the principles would apply more broadly than under existing standards, thereby providing few, if any, exceptions to the principles and (2) there would be less interpretive and implementation guidance (from all sources, not just the FASB) for applying the standards”. According to SEC Chief Accountant Herdman an ideal accounting standard is one that is principle-based and requires financial reporting to replicate the economic essence and not the form of the matter. The European Commission has strongly promoted the use of strategy based on a principles-based approach to financial reporting which is designed to reflect economic reality and therefore giving a true and fair view of the financial position and performance of a company. Principle based approach will help protect the long term interests of the investors and other stakeholders and will help the director of the companies to make a professional judgement in selecting and applying the most suitable accounting policies.
Most of the sections of my essay are based on the survey reported by Mike Ng a senior accountant with Enron Credit Corporation. In 2004 he reported that evidence did not support the adoption of principle based standards but the evidence that was presented shows the problems of collecting opinions by using survey methods. The responses were sometimes fully dependent on the nature of the question asked. When asked whether companies could apply and interpret rules-based accounting standards in a way that does not properly reflect the economic substance of the transaction, 93% of respondents agreed to it. However when they were asked whether general principles would produce better results in forcing companies to report the economic substance of a transaction, 80% disagreed. Only 13% of the companies believed that principles would achieve a better result than rules. The critics of a principles-based approach argue that financial statements would likely lose their comparability and steadiness across industries and issues regarding income measurement and recognition would always remain divisive. Nobes (2005) argues that rules are based on the principles. Rules exists because the standards are based on the lack of principle because of which the rules are needed and if the principle were more appropriate than the need of rules would be less. Benston et al (2006) consider two shortcomings of the SEC proposed principles-based (objectives-based) standards. The standards are dependent on the contents of what the standards regulate. The more judgement an accounting principle requires, the more difficult it is to draw up a standard without direction. A true and fair is a necessary requirement for any type of standard that is more than ‘principles-only’ to tackle with the inconsistencies between principles and regulation in order to sustain the main objectives of financial statement.
CONVERGENCE, COMPARABILITY, CONSISTENCY AND CULTURE: This section covers convergence, comparability, consistency and culture as four issues that infuse any debate on ‘principles versus rules’ (ICAS 2006). Convergence, consistency and comparability all lay on different ranges of meaning. The focus on convergence has its implications for establishing adequate principles as a source for setting converged accounting standards. According to Andrew Bailey, the deputy chief accountant of SEC said that Principles based standards will only work if everyone is loyal to understand the objectives of the principle standards, rather than using the language of the standards themselves to structure around the requirement. This change will require a cultural shift. According to the Commissioner Cynthia Glassman of SEC the principles are not so broad that they fail to provide enough direction to those who prepare and audit financial statements. He said that the principles must be suitably well defined so that they can be applied in a manner that will allow a sense of comparability across companies. FASB emphasizes that a principles-based approach to standard setting would need changes in the processes and behaviours of all participants in the US financial accounting and reporting process, if adopted by them and not just by the FASB and other standard-setting bodies. Thus, in order for that principle standard approach to work, all participants must be equally committed to make the necessary changes.
The purpose of this review of is to provide background which is relevant to the work of the ICAS Principles versus Rules standard approach. The debate mainly started after the failure of Enron Credit Corporation when Sarbanes-Oxley Act section (108) cited this problem of rules based standards versus the principle based standards. The review does not provide a definitive conclusion to the question. I agree with the analysis and support the move towards principles-based standards suggested by the SEC that principle based standards are appropriate than the rules based standards. Principle based standards are simple than the rules based standards and allows professional judgement for the accountants. But Benston et al (2006) believes that the more judgement an accounting principle requires, the more difficult it is to draw up a standard without direction. According to Bennet et al(2006) rules are based on principles. Schipper (2003) and Nelson (2003) also points out the advantages of the rules based standard accounting. In ICAS (2006) it states that convergence, comparability, consistency and culture are the four issues that infuse the debate of rules based and principle based standards. SEC and FASB also agree to the four issues and state that all participants must be committed to work in the same direction. Both rules and principle based accounting standards have their own advantages and disadvantages but principle based standards are clearly more appropriate and have the backing of the boards from different countries than the rules based accounting standards.