Accounting Scandals - Case Study Example

Accounting Scandals The Refco Scandal: Refco or Ray E Friedman and Co was a New York based financial services firm that was one of the world's largest and most powerful commodities dealers, specializing in derivative brokerage services (Teather 2005). Prior to the scandal that broke out in 2005, the company employed 2400 people in 14 countries and was the biggest trader on the Chicago Mercantile Exchange. Refco became a public company on August 11, 2005 when a large number of shares were floated to the public to raise 583 million dollars. In October, the Company's financial crisis was made public through an announcement that the CEO, Philip R Bennett had concealed as much as 545 million dollars in bed debts from the Company's investors and auditors by keeping them off the account books, in order to artificially inflate earnings and boost up the Company's stock price.(White and O'Hara 2005:D01). This anomaly in the accounts was discovered during a process of internal review which was carried out over the preceding weekend. Refco's stock prices plunged immediately once the announcement was made, resulting in losses of more than $1 billion in shareholder value, with its bonds also plummeting to insolvency levels.(White and O'Hara 2005:D01). The Company reportedly engaged in a series of circular transactions, whereby an unnamed business entity owned by Mr. Bennett was buying off Refco's bad debts at every quarter, so that they did not show up on Refco's books. The unidentified company owned by Mr. Bennett assumed those debts of third parties which were likely to be difficult or impossible to collect (Teather, 2005). The Chairman arranged for a Refco subsidiary, Refco Capital Markets to lend money to a hedge fund company named Liberty Corner Capital, which in turn lent the money to Refco Group Holdings, which paid off the debt to Refco Inc.(White and O'Hara 2005:D01). In this way, at the end of every quarter when accounting statements became due, debt was temporarily moved off Refco's books and onto Liberty's account. Such accounting scandals generate fears of a liquidity squeeze and market contagion, highlighting the need for tighter regulation and higher levels of disclosure and transparency in hedge funds (The Herald 2005). Accountants and banks are being sued as a part of the shareholder class action suits against Refco, because the circular pattern of transactions which occurred regularly at the end of every fiscal quarter and then unwound after the quarters ended were themselves a warning alarm bell which should have sounded in the minds of auditors and accountants (White and O'Hara 2005:D01). Goldman Sachs, CSFB and other leading investment banks are being sued for negligence in underwriting and advising on Refco's float issue and on its bond issues, which led to the perpetration of accounting fraud.(Walsh, 2005). Refco Capital Markets is at the centre of the regulatory investigations, because this was the corporate entity through which Bennett was able to receive loan funds, which were hidden from Company auditors and officers. A commodity funds Company is suing Refco for diverting its assets to an insolvent entity like Refco Capital markets, while senior executives at an Australian bank, Bawag, are also being scrutinized for their role in the scandal, because the bank approved a loan of 420 million dollars which was just prior to the accounting manipulation that was taking place.(Fortune, 2006:5) The Polly Peck Scandal: Polly Peck was initially a small clothing company on the London stock exchange which did not demonstrate any remarkable profits, but its fortunes began to change when it came under the management of Asil Nadir, a Turkish businessman, in 1980. Over the next ten years, the Company experienced an unprecedented level of growth. In 1980, it also moved into the fruit packing business through a public share funded acquisition of Uni-Pac, which was a company already owned by Nadir.(Wearing, 2005: 41). The move away from clothing into fruit packing represented a risk for the Company and this was followed by the acquisition of several other small companies, both in the UK and on the Turkish mainland. However, while Polly Peck's activities in the stock market generally reflected a positive trend over a ten year period till 1990, perhaps linked to Nadir's reputation as a good businessman, revenues generated from the Turkish activities of the Company yielded only 30% of the revenues of the group. Nadir decided to take the Company private, but five days after the announcement, he abruptly changed his mind - a course of action which reflected negatively in the share market, with share prices for Polly Peck falling from 393 pence to 307 pence, which resulted in a wiping off of 600 million pounds of the equity value of the Polly Peck group. (Wearing, 2005: 45). Investigations by the London Stock Exchange revealed that the Chairman Nadir was guilty of financial improprieties and had benefited from insider trading. The question of availability of finance by Nadir to carry out the purported buy out of the stocks of other shareholders was also in question, leading to the suspicion that the inside knowledge of the backtracking on the move to privatize the Company could have allowed some individuals to profit from the fluctuations in share prices (Wearing, 2005:4-46). The Company was found to be in violation of section 8.3 of the Takeover code because, because all deals by any shareholder controlling more than 1% of the company were to be disclosed, however Nadir and his brokers had acquired several shares through letterbox companies over the preceding months and sold large chunks when the prices were at their zenith at 410 pence in the days immediately following Nadir's announcement to take over the Company (Wearing, 2005: 4-47). Comparison of the two cases: The case of Polly Peck differs from Refco in that it was a case of insider trading, where the Chairman sought to benefit from his inside knowledge of events that were to transpire, which would affect the value of the shares in the market. The Refco case on the other hand, involved the manipulation of financial accounts in such a manner as to hide debts and bad loans during audit periods, especially in the wake of a large flotation of shares in the market. While the Polly Peck case dealt with a manipulation of shares, the Refco case dealt with the manipulation of accounting statements. The similarity in both cases is that fraud has been perpetrated by the principal officers of the respective corporations. Both the firms have shown strong growth in the market prior to the scandals. Polly Peck enjoyed a strong presence in the market due to the favorable shareholder perception about the managerial abilities of Nadir, while Refco was the largest trader on the Chicago Mercantile Exchange. In both cases, the CEO's resorted to tactics designed to hide fraudulent activity from others of the corporation. In the case of Polly Peck, it was through letter box companies that were used to acquire shares in the Company before their rise in value. These companies served to conceal the fact that the CEO who controlled more than 1% of the Company, was buying shares, although this aspect had to be revealed according to the Takeover Code. In a similar way, Bennett, the CEO of Refco, diverted bad loans to his company, Refco Capital, which served to conceal these non collectable debts from auditors because they were rotated off the Refco statements onto other entities like Liberty Mutual during each successive quarter. Both these cases demonstrate a deficiency in regulation and monitoring of corporate activity. The manner in which accounts were maintained and scrutinized was irregular in both companies, thereby resulting in a failure by auditors and banks to detect the anomalies which ultimately led to the collapse and near liquidity state of both companies. Both instances therefore reveal a failure in corporate governance. Corporate Governance and regulation in the UK: In the wake of the Polly Peck Scandal, Mr. Nadir was further able to escape charges by flying back to his home state. This case accentuated the difficulties that were being faced by the Serious Fraud office in the UK, in terms of resources and legal muscle required to tackle cases of corporate fraud and theft.(Baker, 1993). In effect, corporate powers have aggregated such that they are "creatures of money"(Korten 1995:16) due to the legal status of a person accorded to them under the law and action against them becomes difficult and obscure. For example, under UK law, the only recourse for a shareholder who has a dispute is to try and invoke an order from the Court under Section 459 of the Companies Act of 1985 to declare that the company's affairs are being conducted in a manner prejudicial to shareholder interests, which is a time consuming, expensive option. Government regulation does not play a significant role in undermining fund raising activity through exchange of securities, although most Stock Exchanges have the power to delist a publicly traded Company. But in most cases, the behavior of corporations is not dictated in the belief that shareholders will themselves press for action against a Company that is in breach of the norms (Finch 1992:581-595). In a report prepared by the Institute of Chartered Accountants of England and Wales, the ultimate profit objective of corporations has been clearly identified: Since profits are, in part, the reward for successful risk-taking in business, the purpose of internal control is to help manage and control risk appropriately rather than to eliminate it.(Institute of Chartered Accountants, 1999:5). The Turnbull Report seeks to introduce a system of internal controls and risk assessment within an organization in order to bring about sound business practices and prevent financial mismanagement, such as that which occurred in the cases of Enron and Refco mentioned above. The Report requires that the Board maintain a "sound system of internal control to safeguard shareholders' investments and the Company's assets." (Turnbull Report:4). The Turnbull also introduces a conceptual framework for corporate risk disclosure, to protect the interests of shareholders. For instance, the Company must have clear objectives, which should include measurable targets. Furthermore, internal and external, operational and financial risks should periodically be assessed and identified in the Operating and Financial review (Turnbull Report:13). Additionally, the Revised Combined Code 2003 also requires companies to benchmark their corporate governance, thereby making the requirements of internal monitoring within corporations a more rigorous process.(O'Shea 2007). Companies in the UK are required to provide a report on corporate governance as a part of their annual report. Regulation in the USA: In the United States, the issue of corporate governance came to the forefront in the wake of financial scandals such as those which occurred at Enron and WorldCom, due to the accounting frauds which resulted in earnings restatements and manipulation of earnings. (Klein 2003). This resulted in the enactment of several corporate governance reforms, the most notable of which is the Sarbanes Oxley Act. (U.S. House of Representatives, 2002). This Act introduced some changes into auditing institutions, transforming them from self regulating entities overseen by the U.S. Securities and Exchange Commission to a separate industry in itself, which is now controlled by the Public Company Account Oversight Board.(U.S. House of Representatives, 2002). This act requires a mandatory rotation of audit partners and bans the performance of non audit services by auditors. It also sets out a minimum waiting period of one year before an auditor can accept an executive position with a client. The Act also requires that firm ensure that there is a financial expert present on their audit committee. However, the Act has been widely perceived as being too strict and seeking to regulate the behavior of a firm and its auditors rather than the disclosures required of public registrants, which in turn undermines its efficacy. (Romano, 2005). Carcello and Neal (2003) have concluded in their study that there is no association between good corporate governance outcomes and the financial expertise of the audit committee, as required in the Sarbanes Oxley Act. The time when the Enron and WorldCom scandals erupted was prior to the mid term Congressional elections, which created a sense of urgency around the formulation of the Sarbanes Oxley Act and Romano (2005) argues that this sense of urgency could have led to provisions that are not necessarily well reasoned, with an unfair amount of pressure being placed on the auditing profession. Rajan and Zingales (2003) contend that globalization has resulted in U.S. capital and product markets in the U.S. becoming more oriented towards the free market, as a result of which boom bust cycles are likely to increase, with increased scrutiny on the auditing profession, which may not be the best way to ensure corporate governance. Conclusions: The significance of the Refco scandal is that it appears to have occurred despite the existence of the Sarbanes Oxley Act and the strict requirements on flotation of shares. The passage of the Sarbanes Oxley Act was supposed to regulate the issue of shares. Under the Securities and Exchange Act of 1933 as amended, all prospective issues of stock must first register with the Securities and Exchange Commission by filing out Form S-1 and providing a prospectus. The prospectus is supposed to provide a full and fair disclosure to investors of all material facts, and the Commission is supposed to prohibit any securities sales where the prospectus and/or registration have omissions. However, it must be noted that in the Refco case, the flotation of shares occurred despite the existence of anomalies and irregularities in the accounting systems. This indicates that in practice, the provisions of the Act may be perceived as too stringent to implement effectively and comprehensively, so that some provisions are simply ignored in practice. In an analysis of corporation law after the scandal of Enron, Westbrook (2003) points out that shareholder value in a given economy is not defined by the actual success of a Company, but rather by the perception of the company's likelihood of success. Therefore, financial markets are not the same as the real markets. Corporate governance seeks service as the public end for the corporation; however this rises in conflict with the shareholder's purpose for the corporation, which is profit. In regulating corporate activity therefore, it is necessary that the distinctions between reality and perception be clarified; the distinctions between financial and real markets be taken into consideration and confusion between the two must be avoided. Corporate governance in the UK is still largely self regulated with a focus on internal risk assessments, while the Sarbanes Oxley Act in the United States has largely focused on auditor function in terms of regulation of corporate activity and has sought to regulate corporate behavior. In the Refco case for example, it would appear that a more stringent requirement for internal controls and risk assessment, as mandated in the UK, would have been able to discern the accounting anomalies earlier. But the too-stringent provisions of the Sarbanes Oxley Act have resulted in their being ignored in practice by regulators, banks, etc, which may have contributed to the scandal. Bibliography: * Baker, Martin, 1993. "Indicted Polly Peck Chief finds no place like home", International herald Tribune, May 6, 1993. Retrieved December 10, 2007 from: http://www.iht.com/articles/1993/05/06/poll_0.php * Carcello, J. V., and T. L. Neal. 2000. "Audit committee composition and auditor reporting", The Accounting Review, 75 (October): 453-467. * Finch, V., (1992), "Board Performance and Cadbury on Corporate Governance", The Journal of Business Law, Nov., pp. 581-595 * Fortune, 2006. "The Sixth Annual Excellence in Absolute Returns", "Global Fund Analysis", Retrieved December 10, 2007 from: http://www.fortune.co.uk/reports/November1.pdf * Institute of Chartered Accountants in England & Wales, (1999), "Internal Control : Guidance for Directors on the Combined Code", London : Accountancy Books * Klein, A. 2003. "Likely effects of stock exchange governance proposals and Sarbanes-Oxley on corporate boards and financial reporting", Accounting Horizons, (December): 343-355. * Korten, D, 1995 ."When Corporations rule the world", San Francisco: Kumarain Press * O'Shea, Niall, No Date. "How we've got where we are and what's next", Accountancy Ireland, 39(6), Retrieved December 10, 2007 from: http://www.accountancyireland.ie/dsp_articles.cfm/goto/1164/page/Corporate_Governance_-_How_weve_got_where_we_are_and_whats_next.htm * Rajan, R. G., and L. Zingales, 2003. "The great reversals: The politics of financial development in the 20th century", Journal of Financial Economics, 69 (1): 5-50. * Romano, R, 2005. "The Sarbanes-Oxley Act and the making of quack corporate governance", Yale Law Journal, 114: 1521-1611. * Teather, David, 2005. "Scandal rocks New York brokerage firm", The Guardian, October 1, 2005. Retrieved December 9, 2007 from: http://www.guardian.co.uk/business/2005/oct/11/futures.corporatefraud * Turnbull report [online] available at: http://www.frc.org.uk/corporate/internalcontrol.cfm * The Herald, 2005. "Refco scandal exposes fragility of stock markets", Sunday herald, October 16, 2005. Retrieved December 9, 2007 from: http://findarticles.com/p/articles/mi_qn4156/is_20051016/ai_n15710287 * U.S. House of Representatives, Committee on Financial Services, 2002. "Sarbanes-Oxley Act of 2002. Public Law No. 107-204". Washington, D.C.: Government Printing Office. * Wearing, Robert, 2005. "Cases in corporate governance", Sage Publications. * Walsh, Conal, 2005. "Banks hit by Refco backlash", The Observer, Sunday, October 16, 1005. Retrieved October 9, 2007 from: http://www.guardian.co.uk/business/2005/oct/16/futures.accounts * Westbrook, David A, 2003. "Corporation law after Enron: The possibility of a capitalist reimagination", Georgetown Law Journal, 92(1): 6 * White, Ben and O'Hara, Terence, 2005. "Crisis at Refco raises questions about accounting", Washington Post, October 15, 2005: D01. Retrieved December 9, 2007 from: http://www.washingtonpost.com/wp-dyn/content/article/2005/10/14/AR2005101402043.html Bibliography: * Baker, Martin, 1993. "Indicted Polly Peck Chief finds no place like home", International herald Tribune, May 6, 1993. Retrieved December 10, 2007 from: http://www.iht.com/articles/1993/05/06/poll_0.php * Carcello, J. V., and T. L. Neal. 2000. "Audit committee composition and auditor reporting", The Accounting Review, 75 (October): 453-467. * Finch, V., (1992), "Board Performance and Cadbury on Corporate Governance", The Journal of Business Law, Nov., pp. 581-595 * Fortune, 2006. "The Sixth Annual Excellence in Absolute Returns", "Global Fund Analysis", Retrieved December 10, 2007 from: http://www.fortune.co.uk/reports/November1.pdf * Institute of Chartered Accountants in England & Wales, (1999), "Internal Control : Guidance for Directors on the Combined Code", London : Accountancy Books * Klein, A. 2003. "Likely effects of stock exchange governance proposals and Sarbanes-Oxley on corporate boards and financial reporting", Accounting Horizons, (December): 343-355. * Korten, D, 1995 ."When Corporations rule the world", San Francisco: Kumarain Press * O'Shea, Niall, No Date. "How we've got where we are and what's next", Accountancy Ireland, 39(6), Retrieved December 10, 2007 from: http://www.accountancyireland.ie/dsp_articles.cfm/goto/1164/page/Corporate_Governance_-_How_weve_got_where_we_are_and_whats_next.htm * Rajan, R. G., and L. Zingales, 2003. "The great reversals: The politics of financial development in the 20th century", Journal of Financial Economics, 69 (1): 5-50. * Romano, R, 2005. "The Sarbanes-Oxley Act and the making of quack corporate governance", Yale Law Journal, 114: 1521-1611. * Teather, David, 2005. "Scandal rocks New York brokerage firm", The Guardian, October 1, 2005. Retrieved December 9, 2007 from: http://www.guardian.co.uk/business/2005/oct/11/futures.corporatefraud * Turnbull report [online] available at: http://www.frc.org.uk/corporate/internalcontrol.cfm * The Herald, 2005. "Refco scandal exposes fragility of stock markets", Sunday herald, October 16, 2005. Retrieved December 9, 2007 from: http://findarticles.com/p/articles/mi_qn4156/is_20051016/ai_n15710287 * U.S. House of Representatives, Committee on Financial Services, 2002. "Sarbanes-Oxley Act of 2002. Public Law No. 107-204". Washington, D.C.: Government Printing Office. * Wearing, Robert, 2005. "Cases in corporate governance", Sage Publications. * Walsh, Conal, 2005. "Banks hit by Refco backlash", The Observer, Sunday, October 16, 1005. Retrieved October 9, 2007 from: http://www.guardian.co.uk/business/2005/oct/16/futures.accounts * Westbrook, David A, 2003. "Corporation law after Enron: The possibility of a capitalist reimagination", Georgetown Law Journal, 92(1): 6 * White, Ben and O'Hara, Terence, 2005. "Crisis at Refco raises questions about accounting", Washington Post, October 15, 2005: D01. Retrieved December 9, 2007 from: http://www.washingtonpost.com/wp-dyn/content/article/2005/10/14/AR2005101402043.html Read More