Financial Reporting in the Face of Accounting Scandals - Essay Example

Financial Reporting in the Face of Accounting Scandals Inserts His/Her Inserts Grade Inserts Tutor's Name 14th March 2009 Financial reporting is an important aspect in modern business. It development has been part and parcel of the growth of business and commerce around the world. As the global economy grows and we see newer and bigger multinational corporations emerging and competing businesses spreading around the world, the need for the development of accurate and transparent financial statements for public limited companies is increasing. This has been highlighted by the numerous financial reporting scandals that have arisen lately that have had national and international repercussions. To understand the importance of this unique field, one needs to understand what financial reporting does. The job of financial reporting is to give an overview of the short and long term financial position of a company. This is done by producing the Balance sheet, which provides a picture of the company at a point in time, the Income Statement which gives an account of the business's performance during the year in terms of revenues and expenses, the Cash flow Statement which presents the cash inflows and outflows fro the company divided into operating, investing and financing activities and finally the statement of changes in equity which basically explains the change in a retained earnings of the company during the financial year (Graham 2005). These four statements are aided in understanding by notes to the financial statements which provide additional and in depth information about specific items mentioned in the four statements. Accurate and transparent financial reporting of a company's accounts is significantly important in this age of massive investments. The four statements listed above provide information to the investors in making important investment decisions and to lenders regarding credit decisions (Piotroski 2000). This is done based on the position of the company presented in the financial statements which allows investors to judge whether the company is profitable and whether they would be able to get a significant return on their investments with this company. Creditors similarly can judge the ability of the company to pay off its debt in the future and whether they will be able to receive their money back with the interest payments. These statements are also utilized for assessing the cash flow prospects of the company as well with the same purpose in mind, to benefit investors and creditors. Cash flow projections are very important for decision making as cash inflows and outflows are ultimately the most important things in terms of a company's ability to payoff investors and creditors. Without this liquidity, there would be little to payoff with (Kaplan 1995). Furthermore, financial reporting gives information about the ownership of assets of the company and its related liabilities which allows users of the statements to assess what the company holds and how it is performing in general. It is also an indicator of the management's performance during a fiscal year, allowing shareholders to judge whether the current crop of management and the Board of Directors is doing a good job handling their investment (Kaplan 1995). As such, the existing shareholders of the company need financial reporting to assess whether their investments are worthwhile. Prospective investors can utilize them to judge whether the company presents a better investment option compared to others in the industry and in general. The all important tax collections that government authorities perform are based on the financial statements of the companies which make them important for the Government (Watts 2003). Even the employees of the company, who are organized in the form of labor unions in many countries, use the financial statements to assess the company's performance and negotiate for compensation and promotion with the management. Financial analysts and those on the media rely heavily on accurate financial reporting to forecast the future of companies and whether they are a good buy for investors. Therefore it is very easy to see the tremendous role financial reporting plays in today's business environment. An indelible part of public limited companies is corporate governance which is linked strongly with financial reporting. This is basically the system employing which the companies are controlled and includes in it the interaction between and the responsibilities of senior management and the company's board of directors. It is also the legal framework for management and monitoring of companies (Turnbull 1997). A lot of the basis of corporate governance hinges around the principle-agency problem and the needs for accountability of those responsible for the management of the company who handle resources that do not primarily belong to them. The importance of good corporate governance can be gauged by the studies by McKinsey which show that many investors are willing to pay a premium for the stocks of companies that illustrate really good corporate governance (Newel 2002). In regards to this, financial reporting assumes greater importance in terms of allowing the corporate governance system to function well. The accountants of the company prepare the financial statements, which the directors have to assume are prepared according t the standards and with due ethical concerns in mind. This is supplemented by review by independent external auditors who vouch for the accuracy of the statements. What the board needs to be wary of is that the principle based IFRS under the IASB leave some room for interpretation in recognizing revenue and other areas which could be used to "dress up" the accounts of the company, giving a rosier picture (Ball 2006). There is also the threat of the external auditor also functioning as the management consultant for the company which brings into question the assurance given by the auditors about the accuracy of the financial statements as they now have a "related party interest". Such measures thwart the ability of the board to make informed decisions and thus lead to bad corporate governance (Turnbull, 1997). It highlights its importance link with accurate and transparent financial reporting. With so many standards and steps in place, the business world is still ripe with scandals and corporate quagmires leading to big bankruptcies of major corporations around the world. Such events have a tendency to have far reaching effects. It also brings into question the reliability of the current standards used for financial reporting and how the companies were able to use loopholes to misrepresent the company's position and show a better condition than it really is. It further questions the reporting of other companies that employ the same standards and this investor and creditor confidence is shattered, not to mention the effect in terms of bad corporate governance. One such incident was the case of Enron. The biggest bankruptcy in US history sparked debate about the adequacy of the current standards in place, especially the treatment of the items that Enron was able to use to bolster its profitability outlook (Lorinc 2002). The first of these relates to the treatment of special purpose entities which were at the core of the problem at Enron. These off balance sheet arrangements, in theory, served to isolate financial risk and provide less expensive financing. Such entities may be created by a business for the purpose of pursuing specific transactions for the sponsor. The money available to the special purpose entity thus and the debt acquired by it using the sponsor and the assets of the SPE as collateral may then be kept off the balance sheet of the sponsor (Lorinc 2002). This benefits the sponsor in terms of taking debt off its balance sheet which serves to improve some of the ratios it is evaluated upon and furthermore shields the company in terms of putting it at risk only for the amount of money invested in the SPE if the venture for which it is created fails and it is not able to service its debt. The downside is that the assets controlled by the SPE also remain off the balance sheet of the sponsor. This device was used extensively by Enron to create such off-balance sheet arrangements. The problem thus was that the amount of transactions involved in these SPEs can not be really represented in the financial statements which leave users guessing as to the extent of these transactions. This was supplemented by the clause that does not require the sponsor to consolidate the assets and liabilities of the SPE as long as a third and independent party held three percent of the share of the SPE. This led to the financial statements of Enron not giving a completely accurate picture of the relationship between the company and its special purpose entities where Enron was siphoning off huge quantities of its debt (Lorinc 2002). When finally things started surfacing, it emerged that Enron was massively in debt and hence its stock started dropping amidst the news of misreporting. The auditors of the company, Arthur Anderson, were deemed complicit in this fraud perpetrated by the company, including obstruction of justice by shredding its documents relating to the audit of Enron. A similar case arose in the case of WorldCom (Sidak 2003). The company which once used to be extremely profitable with soaring stock prices and a burgeoning business was faced with trouble when its fortunes reversed. With stock price falling, the banks were issuing margin calls on the company's CEO which required him to get immediate cash. This he managed through corporate loans and guarantees from the board which again backfired, leading to the dismissal of the CEO. Since the company now found itself in dire straits with earnings steadily decreasing, it started manipulating segments of its accounts. This it did via efforts to increase the earnings of the company in hopes that it would give a more profitable outlook for WorldCom to investors and increase its declining stock price (Sidak 2003). This was managed through the underreporting of interconnection expenses with regards to other telecommunication companies. In standard reporting, this was required to be expensed out in the income statement but it was actually capitalized on the balance sheet. On the revenue side, the company started including bogus entries which made the revenue appear higher than it really was. Eventually the internal auditors of the company were able to uncover the fraud perpetrated by the company and exposed it to the audit committee which took swift action. Outside the US, the financial scandal surrounding the Italian food giant Parmalat was another case of financial misreporting on a big scale. The company was the eight largest industrial empire in Italy and boasted a range of world famous food products. The company started emerging on the financial headlines as it went through a range of acquisitions in Europe which were financed predominantly by debt. However, many of the new divisions being created started getting losses and the company's financing strategy shifted to derivatives which was seen as a ploy to camouflage its rising losses accompanied by debt. This was followed by firing of the company CFO and the new one found himself without complete access to the company's accounts, leading to suspicions of possible fraud. Eventually the workings within Parmalat started opening up as it became clear that it had been involved in shady dealings. One of these was the Enron like case of opening up "shell companies" that could disguise the company's losses and generate fictitious profits for it. Another was the remarkable case of forgery surrounding a document that falsified the presence of nearly $3.9 billion dollars in the bank account of the company. This was released by The Bank of America as it discovered that the banks' letterhead had been scanned and made to go through fax machine numerous times before finally being attached to a verification of the deposit account that allegedly contained this enormous sum. This therefore was able to slip through the auditor's eyes. This was coupled with incorrect sales figures in the company accounts. All this questioned the independence of the company's auditors and whether they were able to review well the financial statements of the company. The Royal Dutch/Shell group was similarly involved in a global financial scandal, though with relatively less consequence. The company's financial statements are released with an estimation of the oil reserves it claims to have control over in the fields it operates in. There estimates were reported to be grossly overestimated by Shell. Some reports suggested the company had over reported the oil reserves in Oman by nearly 40 percent (Crowther 2007). This was based on the optimistic view surrounding the technological advances in drilling which were reported to gives greater output, thus increasing the value of the oil reserves controlled by Shell and the rapid rate in which it could access it. Such overestimation would have had to come under the scrutiny of the company auditors who failed in this regard and allowed the company's asset part of the balance sheet to be increased to a great extent (Crowther 2007). The examples of the financial reporting scandals mentioned above had a deep impact of national and international markets. Investor confidence was shattered and the trust placed on the methods of financial reporting was also shaken. The device used to give guarantees about the accuracy of the reporting, namely the external auditor, was also proving to be problematic and in some instances faced "related party" problems as they also acted as management and financial consultants for the same companies. This prompted newer regulation and some change with regards to the standards of reporting to shore up investor confidence once again. The Sarbanes-Oxley Act in 2002 was one such piece of legislation in the US (Romano 2005). It directly tackled some of the problems encountered in the cases of Enron and WorldCom. More accurate disclosure was encouraged by requiring the senior officers such as CFO to certify that they are responsible for the financial statements. This takes away the argument many presented about not knowing what was being done with the accounts of the company. It further put pressure on the companies in terms of the stock-option form of compensation to its higher management that pushed it to shore up the company stock price to get higher compensation (Romano 2005). Greater emphasis was not put on expensing this form of compensation, making it less attractive for the company. In the same vein, the Combined Code on Corporate Governance in 2006 was issued in response to the challenges faced with financial scandals and their adverse effects on corporate governance (Romano 2005). As such, a number of policies were changed with regards to disclosure and to increase the independence of auditors world wide so that financial shenanigans can be rooted out. One has been the obvious pressure to expense out stock option compensation which even Warren Buffet questioned in its previous form. There are problems in determining the value of stock options however since the underlying asset that is the company stock keeps on moving. However, it is a step in the right direction. Another has been the much better policy in terms of dealing with special purpose entities. Now, sponsors are required to consolidate their financial statements with these entities if they hold a controlling interest in them which amounts to owning 50 percent of the controlling stock (Lorinc 2002). This limits their power to siphon off debt and losses to off balance sheet arrangements and results in better representation of their transactions in the financial statements. This has been supplemented by the attempt to give greater independence to auditors. The fees for external auditors were already said to be low leading to them frequently cutting corners in the auditing process. It further required a reliance on the consultancy areas of the company which sported clients from the same base that the companies were auditing. This sometimes created issues concerned with how much to trust the stamp of an external auditor. Now greater action is being taken towards that, particularly in the Sarbanes-Oxley Act, which calls for a set limit of partner rotation, stringent policies towards financial ties between the members of an audit team and the client. Another change in US rules involves dealing with the conflict of interest when a senior officer related with the issuance of the financial statements had been employed by the audit firm less than a year before its financial statements were issued. Italy similarly required a nine year auditor rotation after the Parmalat case (Lorinc 2002). Another significant problem tackled from the reporting side has been advocacy of fuller disclosure of guarantees, including in interim financial statements and also support for regulators to have tough disclosure requirements for management discussion and analysis reports. Professional oversight has further been stressed at national and provincial level so as to allow improvements in corporate governance related with financial reporting. The problems mentioned and the steps taken to rectify them have been seen widely as influential in terms of getting back investor confidence in the financial statements of corporations and making sure that more accurate representation is made available to the users of these statements. This has been augmented in the improvement of corporate governance by reports such as the Cadbury report (Boyd 1996). This was significant in terms of requiring compliance to be part of the listing requirements for public limited companies which puts the responsibility squarely on the management for taking care of the compliance. Another hallmark was the emphasis on sub committees such as those for executive remuneration and audit. This put the decision making of crucial areas such as the compensation management enjoyed in a specific block, allowing it to be monitored. It further made audit committees separate, allowing an internal avenue for reporting of fraud and money laundering. The other measures brought about by new legislation such as that for SPEs allowed the users to get better image of the company's performance, for the shareholders to evaluate the benefit of their investments and for creditors to judge the liquidity of the company (Hartgraves 2002). The other steps relating to auditor independence can not be rules out either as with less of a related party relationship with the client, the auditors could now more accurately report incidents of misrepresentation in the statements. Not all of the measures taken can be said to have taken care of the problems however. There is still the problem of quantifying the value of stock options to expense them out and report accurately on the financial statements. Furthermore, auditor fees is still a problem which if persists, may lead to them cutting corners again in new cases. The current financial crisis has revealed that the fair value method which allowed companies to value some assets based on complicated models which could be manipulated to drive up value still present an ever present threat. Thus we can see that some problems are still abounding in the business world today with regards to financial reporting. However, the stern steps taken can be seen as improving investor confidence as it shows that if and where loopholes do arise, they will be dealt with harshly. This was further augmented by the strict punishments in relation to misreporting contained in the Sarbanes-Oxley Act. Thus taking a look back at the history of financial reporting in recent years, we see that it is an important field for business that has been marred by many scandals. It has seen ups and downs in terms of confidence from the investors and shareholders and events around the world have shaped how much trust users have put into the financial statements. However, some of the retaliatory steps taken such as tougher legislation can be said to have revitalized trust in the accounts of a company and acted as a good deterrent to elements of fraud. This has been shown by the burgeoning industry and jump in the financial sector as of 2007. We can therefore conclude that the various methods employed have been successful. 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