American Accounting Scandals - Essay Example

?Running Head: American Accounting Scandals American Accounting Scandals [Institute’s American Accounting Scandals IntroductionIn the aftermath of the financial recession that rocked United States and the entire world, policymakers, stakeholders, experts and other observers are raising their fingers on various events, policies, and happenings that led the country to this disastrous recession. They include the artificially low interest rates, toxic mortgage backed securities, housing bubble, excessive and risky financial innovation, shadow banking system, trade deficits and others (Cornelius, pp. 29-33, 2003). However, one very important cause or contributing factor to the current recession was the accounting practices and the entire accounting system in the United States (Rittenberg, Johnstone, Gramling & Schweiger, pp. 55, 2009). Interestingly, this is not the first time in the history of United States that its accounting practices, approaches and system has received criticism and strict scrutiny from its stakeholders. After the bankruptcy of Enron and WorldCom in 2001 and 2003, respectively that was also the biggest accounting scandals of their time, the US accounting practices made the headlines all over the world (Ketz, pp. 234, 2003). This paper is an attempt to explore the accounting standards whether they are too flexible or too rigid. The discussion would include looking over the causes of Enron’s bankruptcy rooted in its accounting problem, debate between rules based accounting and principles based accounting and the problems with the possible convergence of accounting standards all over the world. Discussion Enron Accounting Scandal Enron posted revenue of more than 101 billion US dollars in the year 2000, however, in the very next year, the company had to announce its bankruptcy since one of the biggest scandals in the history of corporate world appeared on the scene which is now known as “Enron accounting scandal” (Cherreson, pp. 38-42, 2003). Enron was a giant in the energy industry and its financial ratios along with the fact that it appeared on the “most admired companies list” indicate that observers were optimistic about the future performance of the company (Jeffrey, pp. 30-31, 2011; Golden, Skalak & Clayton, pp. 144, 2006). Non-transparent and unethical accounting was the most important cause attributed to the failure and downfall of Enron. In the year 2004, McLean wrote Enron scandal that, “The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control” (Silverstone & Sheetz, pp. 22, 2007). Furthermore, another writer in an attempt to explain these “habits and values” wrote that, “the primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income and reported cash flow up, asset values inflated, and liabilities off the books. (Duska, Duska, & Ragatz, pp. 74-75, 2011)” Without any doubts, Enron had some of the smartest minds in the company, as its executives and accountants, who were spot on in tweaking and twisting, the accounting laws to their advantages (Rapoport & Dharan, pp. 106, 2004). They used off balance sheet vehicles, complex financial structures and others to hide their debts and inflate their incomes. Furthermore, the mark to market accounting further allowed the company to manipulate its financial figures for deceiving the shareholders, creditors and other stakeholders. More importantly, Enron used the ambiguities and gaps in the mark to market accounting to inflate its income (Rezaee, pp. 175, 176, 2002; Mulford & Comiskey, pp. 44-46, 2005). Mark to Market accounting method requires showing the net present value of the cash flows from any long-term project and adjust the values of market assets according to the current market value. However, the problem with this method is that under certain situations and for certain projects, correct, accurate, and timely predictions about their future values. In fact, at times, it is not possible to determine accurately the market value of certain assets. This allowed Enron to come up with its own complex calculations and formulae to justify its inflated and over optimistic predictions (Barreveld, pp. 85, 2002). When merchants and traders sell goods to their customers, the accounting standards allow them to report the selling price and their revenue and the cost of goods sold as their expenses to be deducted from the revenues to reach their income. However, in case of agents, who serve as the intermediaries in providing services, accounting standards require them to report their brokerage fees or commission as their income minus any expenses incurred in the process of acquiring them (McLean & Elkind, 2003). Enron earned majority of its revenue acting as service agent firm providing trading, risk management and other services along with its primary energy business, the company rather than following the agent model of financial accounting, went to choose the “agent model” where it started recording its revenue as the overall value of the truncation. This explains a part of the 750 percent increase in the revenues of Enron during 1996-2000 (Previts, pp. 55-56, 2008; Rapoport & Dharan, pp. 106, 2004). Poor and reckless corporate governance in Enron also appears as one of the prime reasons behind its demise. The company was focusing too much on its share price and the sole method of getting faster promotions and pay raises was to ensure that one could provide the company with front line deals with better outlook (Norton, Diamond & Pagach, pp. 274-275, 2006). The focus was on short-term returns, publicity, and its immediate impact on the share price of the company. The employees and even the executives had little concern whatsoever for the quality of the cash flows and the long-term impact of those deals (Rapoport & Dharan, pp. 106, 2004). The insiders in the company reported that the company’s board meetings were focused on specific stock price targets and the rest of the discussion was aimed at deciding the income that needs to be earned in order to reach that stock price. More importantly, the company will go on to use all ethical and unethical means to achieve those targets. One of the accountants of Enron himself admitted, “We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness”. Quite understandably, the GAAP had and even as of today, it has many weaknesses and loopholes which companies, its executives, auditors and accountants try to use to their advantage, manipulating the financial results of the company (Barreveld, pp. 85, 2002; Duska, Duska, & Ragatz, pp. 74-75, 2011). WorldCom Accounting Scandal The Accounting scandal of WorldCom holds many similarities with that of Enron; however, the major difference involved here is that the company used its reserve funds in order to cheat the auditors. Furthermore, the accountants were smart enough to label its operating expenses as its capital investments thus allowing it to not only inflate its profits but also at the same time improve its outlook (Rapoport & Dharan, pp. 106, 2004). The investors found out in the year 2002 that the 3.3 billion US dollars in profits that were shown during 1999-2002 will have to be written off due to the accounting mishaps. Moreover, the company will also settle the 3.8 billion US dollars of expenses that it showed as capital expenses. It total it had to write off more than 50 billion US dollars that pushed the company to the brink of bankruptcy (Jeter, pp. 25-29, 2004). Rules based vs principle based accounting As the name suggests, under rules based accounting, companies get a list of detailed rules to follow while preparing their financial accounts. There are lesser ambiguities in the standards and in case of any deviations; accountants know that they could be easily tried in the court (Torre, pp. 30-31, 2009). Therefore, the possibility of deviations decreases, however, at the same time, excessive, rigid, and stubborn rules increase the complexity in financial reporting. In fact, its opponents believe that presence of too many rules forces accountants and their masterminds to spend time in order to come up with complex financial transactions in order to beat the system (Revsine, Collins & Johnson, pp. 49-50, 2002). On the other hand, principles based accounting, as the Generally Accepted Accounting Principles (GAAP) in the United States, refrains from setting any comprehensive rules but provides basic and limited guidelines to accounting. There are some rules, which cannot be avoided by the accountants; however, it provides great deal of flexibility and room for accountants to vary their approaches for different situations (Jones, pp. 354, 2011). Proponents of principles based accounting believe by forcing companies to follow specific guidelines, the policy makers are providing them with reasons to deviate from the law by manipulating the statement to fit what is necessary and acceptable (Rezaee, pp. 175, 176, 2002). However, these people fail to understand that by having too few rules in order to boost financial innovation, desperate times will force these companies and their accountants to not only take advantage of the flexibility but also to engage in all unethical accounting practices. The results flowing from principles based accounting are not reliable and consistent thus raising various questions regarding the same (Zyla, pp. 413, 2009). The United States Securities and Exchange Commission decided in the year 2008 that the all United States companies would have shifted from the GAAP to IFRS for its accounting needs by year 2016. Some of the largest companies started the process in the year 2010 (Epstein, & Saafir, pp. 21-23, 2010). However, as the paper argues, the policymakers are missing a very important point here that a principles-based IFRS system will not solve but compound the problem faced by the country’s financial system. The reason why Enron, WorldCom and other scandals appeared on the scene and one of the most important reasons of the financial crunch and recession of 2008 was that accountants got too much freedom (courtesy their own financial innovations and creativities) to tweak and twist the law and make use of the exceptions. However, with a principle based accounting system, these accountant would get even more freedom for the same (Norton, Diamond & Pagach, pp. 274-275, 2006). The solution to this freedom is to curb the freedom and not to increase it. Therefore, the solution lies in strengthening the rules based accounting system, decrease the number of expectations, include provisions in the law to put a lid on past wrongdoings and proactively sense the possible loopholes present in the system before the companies and their accountants do the same (Mulford & Comiskey, pp. 44-46, 2005). Asking for the replacement of rules based accounting system by principles based accounting system is similar to asking for more dose of the medicine, which previously had disastrous impact on your health (Bragg, pp. 10, 2011). The policymakers and other observes have already seen the misuse of any possible freedom that accountants and company can do considering their desperateness to post good financial results comparative to their competition (Rezaee, pp. 175, 176, 2002). Despite all the theory, conferences, and seminars and on-paper efforts, ethics always take the backseat while making decisions due to cutthroat competition. Companies know that their very survival is at stake if they fail to beat the competition and threat is so intense that there is no room for mistakes. Again, the point here is that a principle based accounting system would lead to more scandals, mistakes and tweaking of the law by companies (Rittenberg, Johnstone, Gramling & Schweiger, pp. 55, 2009). There are certain aspects in the rules based financial accounting system, which need consideration or may be possible abolition. An example would be the mark to market accounting system, which allows too much freedom to the accountants and their companies to manipulate or inflate the results (Golden, Skalak & Clayton, pp. 144, 2006). Furthermore, many financial institutions had to announce their bankruptcies because of the fact that the mark to market accounting system forced their financial institutions to report the market value of their toxic mortgage based securities, thus leading to their demise. As the market price of these MBSs decreased, the firms had to show losses on their balance sheet thus forcing them to bankruptcies. On the other side, during the economic boom during the mid 2000s, these institutions posted great profits and increasing income only because the market value of these assets was increasing (Jones, pp. 354, 2011). Important here to note is that market price of any asset of security is not only the manifestation of its current and present performance but it greatly depends upon the expectations of investors about its future performance. Therefore, these financial institutions were able to benefit from the positive expectations of the investors and the same led them to their collapse as well, courtesy mark to market accounting (Fortin, pp. 20-31, 2010). Therefore, the point here is that these controversial and problematic aspects of the GAAP need consideration, alteration or may be abolition but blaming the entire rules based accounting system for the shortcomings of a few portions is not justified (Zack, pp. 10, 2009; Langendijk, Swagerman & Verhoog, pp. 241, 2003). Convergence of Accounting Standards Another aspect, which is also being termed as revolution in the financial world, is the fact that lately, many countries have come closer towards adopting a single financial accounting system. A couple of decades back when these debates first surfaced, observers predicted that the same is never going to be possible. How can we expect the countries to follow a universal accounting system, a sector where the stake of many countries and their influential countries lie, when we cannot convince all countries to drive on a specific side of the world? However, there has been great deal of progress in this regard (Olagbemi, pp. 35-38, 2011). The United States has shown great deal of flexibility towards moving from the US GAAP to IFRS (Revsine, Collins & Johnson, pp. 49-50, 2002). However, the policymakers will have to forgo a lot in order to meet the criteria for this convergence. Furthermore, observers are raising questions over the sustainability of such a model. They believe that this would arrangement may as well collapse or will face great deal of problems just like the Euro countries are facing. Consider of the example of Japan and Germany where a significant portion of the lending and investing takes place with a handful of the big banks. These big banks are powerful enough to obtain all the information about their borrowers and do not need that information in their financial books which is the case in United States and some of the other European countries (Singleton, Singleton & Bologna, pp. 66, 2006). Conclusion Despite the fact that there are some problems and loopholes in the current financial accounting system of the United States, principles based accounting system is not the answer to the problems of United States. Repeatedly, accountants all over the world have expressed their desire to have rules based accounting system so that there are lesser chances for them falling in the trap of litigation (Pounder, pp. 142-143, 2009). With a principle based accounting system and all the flexibility accompanying the system, the accountants will have more chances to employ their creative techniques for manipulating the results and creating fake bubbles. This would mean that in the near future, we would witness more and more accounting scandals due to the unchecked freedom (Rezaee, pp. 168-169, 2007). Furthermore, it appears that the stakeholders will also not be able to achieve the consistency, uniformity and reliability that they wish to achieve in the financial reporting system. It does not take the experience in rocket science to see that with the freedom and flexibility of principle-based system, different companies, and sectors will go on to report their results in their own ways and make all possible use of the room available to deviate from the norms. Furthermore, the policymakers and authorities will have to engage in great deal of homework if they want to ensure true convergence of accounting practices all over the world (Walton, pp. 61, 2009; Pounder, pp. 142-143, 2009). References Barreveld, Dirk J. 2002. The Enron collapse: creative accounting, wrong economics, or criminal acts? 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