Financial Statements: Their Reliability and Lessons from the Financial Crisis - Research Paper Example

FINANCIAL MENTS: THEIR RELIABILITY & LESSONS FROM THE FINANCIAL CRISIS Introduction The usually elegant, glossy pages of Annual Reports released by big companies can lead one to believe that the financial statements contained therein are accurate and complete and that they fairly reflect the true financial condition of a company. This impression is all the more bolstered by the discovery that the companys financial records had been audited by one of the worlds top accountancy firms. Yet our experience since the early part of this decade has shown this to be an illusion. Massive accounting irregularities and scandals, involving large companies and the worlds top-5 accounting firms, have resulted in lawsuits and bankruptcies, as well as government rescue efforts, to the detriment of many investors and taxpayers. Some of these companies were formerly prestigious financial institutions with huge capital and with global reach such as Citigroup, JP Morgan, and AIG. This paper seeks to study this recent phenomenon with a view to identifying what would perhaps be a good long-term solution. Accounting principles. The generally accepted accounting principles (GAAP) have been tagged as one of the fundamental causes of the recent financial and banking crisis that originated in the United States and sent shock waves throughout the world. According to the Accounting Dictionary, the GAAP consists of “standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements.” There is no central authority that promulgates the rules of GAAP; instead the Securities and Exchange Commission accepts and enforces the compiled issuances from FASB, AICPA, and other sources. The Accounting Principles Board (APB) of AICPA defines GAAP as encompassing “the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time,” and that the principles are derived from “experiences and reason” that have proved useful.(AICPA, 1970, cited in Wolk et al., 1997). Voluminous rules under GAAP have been issued over the years, and the complexity of these rules which have not been consistently organized around fixed and commonly agreed principles have not increased our understanding of financial reports. In fact, they have fostered a lack of clarity and transparency. Although the GAAP are designed for the preparation of financial statements for external users, internal decision makers also use them for various purposes including decisions regarding promotions and year-end bonuses to its executives. Management has some leeways to impact earnings, through the depreciation methods it uses, the determined useful life of an asset, the decision as to whether or when to write off bad debts, and the increase or decrease in the allowance for bad debts. Such earnings management manipulation may be used to smooth out earnings from quarter to the next, or it may be used in order to maintain an expected trend. In 1999 Microsoft was accused by SEC of manipulating financial statements when CEO Bill Gates asked for excess revenue and earnings to be to reported for the ensuing year in order to keep a "steady-state earnings model."(Jackson & Sawyers 2001) Company officers are constantly under pressure to show good or better performance to its stockholders, and they are also concerned that the analysts forecasts may show inferior performance compared to other companies, thus adversely affecting the market price of its stock.. If performance is also tied to compensation and bonuses, accounts would tend to be manipulated or managed. Executives resort to creative accounting - defined by the Accounting Dictionary as “ Managements attempt to "fool around" with its accounting in order to overstate net income, thereby making it appear that the management is doing better than it actually does. (Creative accounting). In addition, the management is likely to paint a bright and positive picture of the companys situation in its Annual Report and to put a spin on anything that looks somewhat neutral or negative. The external auditors may tend to collaborate, by “looking the other way” when accounting manipulation is seen to exist. They will be inclined to be lax for practical selfish reasons: Doing so can mean their retention for the next years audit job. Where they also have non-audit business engagement with the company, it will improve their probability of maintaining the relationship or even expanding it next year or for an indefinite period of time into the future. Because of these factors financial statements can come out distorted and misleading in many respects. But management can always justify its practice by saying that it has not breached the generally accepted accounting principles. The principles of GAAP can be taken advantage of by all companies that do their financial reporting according to its rules. However, at this juncture, it may be useful to focus on the banking industry because of the huge impact of its practices on the investors and the consumers of its services. Bank capital under GAAP A companys capital structure is usually expressed as the ratio of debt to equity. In the case of banks, their huge deposit and other liabilities make for heavy debt in relation to stockholders equity. According to Sinkey (1989), banks are allowed to convert 20 percent of its debt to equity – a practice that violates the principles of finance. At the same time, because assets were booked at acquisition cost, the divergence between this book value and the market value does not give a true picture – nay, a distorted one – of the value these assets, which should have been marked to market. The devalued assets are given unrealistic, inflated values. Also, prior to the savings-and-loan crisis in the late 1980s, the regulatory accounting principles (RAP) allowed banks to recognize the banks reserve for bad debts or its subordinated debt as equity capital. RAP accounting was later phased out by the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which authorized federal funding to pay depositor claims on the failed S&Ls (Regulatory accounting principles). Such treatment of bank capital may partly account for the above-average vulnerability of banks when a financial crisis occurs. GAAP general characteristics GAAP has many rules from numerous sources but some of these rules give management considerable latitude to pursue goals that are inconsistent with or contrary to its objective to increase shareholder wealth. Management can misstate financial statements in order to mislead their readers or to avail themselves of incentives and benefits linked to earnings performance. Some of these unscrupulous practices are the following: 1. Improper recognition of revenues 2. Overstating assets 3. Understating liabilities 4. Off-balance sheet liabilities In general, the pressure to engaged in accounting manipulation may be the result of pressure from stockholders to report good operating results because the market value of their shares, not to mention dividend payouts, depends on such results. For the executives themselves, the pressure may come from the desire to receive incentive bonuses that are tied to earnings. At other times, it may just be due to a need to meet sales budgets. With regard to manipulating sales records, an example would be one where the sales manager records sales in the wrong period in order to fulfil sales quotas. For example if a large order is received on January 2, 2010, the records may altered in order to show that the sale occurred in last day of December 2009. Sales or revenues may also be inflated by recording non-existent sales or not recording returned goods (thus overstating accounts receivable). Revenues and earnings can also be overstated in order to maintain or smooth trends. The Banking Crisis: How Banks used the GAAP The major financial institutions - Citigroup, Barclays, Bank of America, AIG, Merrill Lynch, and Goldman Sachs -- inflated the value of their assets, moved losses off the books, and made their accountants ignore these moves. Previously energy company Enron had used the same tactic of inflating its earnings and hiding its liabilities and losses in subsidiaries, and after the fraud got blown wide open, filed for bankruptcy in 2001. Worldcom also manipulated its earnings and cash flows, filing for bankruptcy the following year in what was considered the biggest insolvency case in history at that time. Worldcom had used liberal interpretation of the accounting rules when it prepared financial statements. To make it appear that its profits were increasing, it would write down assets it acquired while including in this charge against earnings the cost of company expenses expected in the future. This meant bigger losses in the current quarter and smaller ones in the future quarters, so that its profit picture would seem to be improving.(Worldcom). Accounting firm Arthur Anderson had reportedly endorsed many of the accounting irregularities. In its court ruling the SEC said that WorldCom had violated anti-fraud and and reporting provisions of federal security laws by creating a scheme intended to manipulate earnings to meet Wall street expectations and to support the companys stock price (Worldcom). In 2005 AIG, the worlds largest insurance and financial services company, came under investigation also for accounting fraud.(See AIG). Concerns about the huge domino-effect impact of its failure caused the U.S. government to financially rescue it. What seems ironic is that these were among the worlds top corporations in their industries at the time and their boards and top executives should have had enough common sense and judgement to avoid financial distress. Scandals like these have spurred debate over the merit of the rules-based GAAP compared to other systems. In the meantime, the U.S. government had to take quick action in order to prevent the further spread and recurrence of the financial crisis. The Sarbanes-Oxley Act The Sarbanes-Oxley Act was signed into law in 2002 in order to tighten financial rules in the United States in the wake of the the major failures of Enron and WorldCom. The legislation has the following main features: 1. It requires companies to set up audit committees made up of independent members. 2. The CEOs and CFOs must attest to the accuracy of its financial reports and internal control system 3. It limits the auditors ability to provide consultancy services that would result in a conflict of interest. 4. The SEC assumed more supervisory powers over corporations 5. The Public Company Accounting Oversight Board was to be established to supervise the auditing of public companies. Section 401 may deserve special mention for it requires that financial statements published by issuers should be accurate and presented in a manner that does not contain incorrect statements or admit to state material information. These financial statements shall also include all material off-balance sheet liabilities, obligations or transactions (Sarbanes-Oxley Act) A provision concerning the rotation of auditors every five years would obviate future collusions that have brought about the downfall of companies such as Enron and WorldCom. Section 203 provides that "it shall be unlawful for a registered public accounting firm to provide audit services to an insurer if the lead (or coordinating) audit partner (having primary responsibility for that audit) or partner responsible for reviewing the audit services for that issuer in each of the 5 fiscal years of that issuer."( Sarbanes-Oxley in force today) The U.K. Companies (Audit, Investigations and Community Enterprise) Act of 2004 In the United Kingdom, the governments response to same challenge was the Companies (Audit, Investigations and Community Enterprise) Act of 2004, which tightens auditing controls for UK companies. It requires corporate directors to provide correct information to auditors and allows the government to investigate suspected violations. In addition, accuracy and integrity of company records were to be ensured. It also requires directors to create an audit trail "to prove that they have carried out due diligence on the required information. (Company law) Corporate governance These enactments by two countries on both sides of the Atlantic emphasize the importance of good corporate governance, which may be described as principles that ensure accountability, fairness and responsibility to shareholders through transparency that would earn their trust and confidence (Compliance and corporate governance, Europe, Comparison. . . .). In the U.S. corporate governance is determined by the SOXs detailed regulations necessary for its implementation, with concomitant fines and imprisonment to give it legal force. The U.K. model uses the "comply or explain" approach with respect to whether a company has a code of ethics or if it has a financial expert. A more thorough comparison of the governance elements applied by both countries is beyond the scope of this paper. Post-SOX: What to do with GAAP? Because the generally accepted accounting principles (GAAP) lie at the heart of many accounting irregularities that distort and misrepresent the true financial situation of a company, there has been a recent awakening within the accountancy industry to shift from GAAP to another system, in particular, the International Financial Reporting Standards (IFRS), formerly known as the International Accounting Standards, which is now used by about a hundred countries worldwide. In 2008, the Securities and Exchange Commission held round-table discussions concerning the question of shifting to the UK-based standards. The European Union is known to have already initiated a three-year transition to IFRS. Big U.S. accounting firms are reported to be willing to shift to IFRS. The IFRS is based in London, and has been the system of choice in U.K. the for many years. It is principles-based rather than rules-based as is the case with GAAP. Reference to rules results in great complexity, while the use of principles gives room for interpretation and professional judgement. The U.S. Securities and Exchange Commission has already formulated a "road map" laying out a proposal on how to shift from GAAP to the IFRS by 2014. (Schafiro says. . . ). This global system is considered capable of preventing the anomalies that occurred under GAAP, and, except for the inevitable initial pains associated with the transition, should be go full swing after 2014 in the United States and adopted by other countries soon after. Conclusion Although analysis enumerate many causes of the financial and banking crisis that began with the subprime mortgage crisis, the lack of appropriate disclosure and transparency of financial statements may have contributed considerably to the speed, scope and gravity of the disaster that followed. The generally accepted accounted principles (GAAP) were used by many companies -- banks and accounting firms among them -- to manipulate accounting information and hide their deeds from regulators and the investing public, as well as the great number of employees and retired persons who saw their retirement funds vanish. The U.S. and U.K. governments also took action by instituting legislation that would prevent the recurrence of the accounting irregularities and the consequent damage to the investors and taxpayers alike. Another good response was the decision of the U.S. government to pursue the shift from GAAP to IFRS in order to bring about better comparability of financial information, resulting in better decision making for investors. At the same time, the system is supposedly able to prevent off-balance sheet transactions that vastly accounted for disclosure problems under GAAP. It is also quite surprising that no one early on at the start of the present age of globalization had taken the initiative to unify and harmonize the principles of accounting worldwide -- an initiative similar to what we see in other issue areas such as climate change. Such an initiative would have prevented to a significant extent the many fraudulent activities associated with accounting practice under the inadequate GAAP. BIBLIOGRAPHY AIG, Actuarial Accounting: A Cautionary Report. Viewed December 01, 2009, http://www.casact.org/education/spring/2009/handouts/young.pdf Company law:Companies (audit, investigations and community enterprise) act 2004 a guide . . . . Viewed December 01, 2009, at http://www.berr.gov.uk/files/file13421.pdf Compliance and corporate governance, Europe, Comparison. . . . Viewed November 30, 2009 at http://www.metrocorpcounsel.com/current.php?artType=view&artMonth=December&artYear=2005&EntryNo=3957 Creative accounting. Dictionary of Accounting Terms. Barrons Educational Series, Inc, 2005. Answers.com. Viewed November 30, 2009 at http://www.answers.com/topic/creative-accounting GAAP. (n.d.). Dictionary of Accounting Terms. Retrieved November 30, 2009, from Answers.com Web site: http://www.answers.com/topic/generally-accepted-accounting-principles-gaap Jackson, S & Sawyers, R 2001, Managerial accounting: A focus on decision making. Harcourt Brace, Orlando, FL Meigs, R.F., Williams, J.R., Haka, S.F. & Bettner, M.S. (1999). Accounting: The basis for business decisions (11th ed). New York: Irwin/McGraw-Hill Sarbanes-Oxley Act. Viewed December 01, 2009, at http://www.yourdictionary.com/finance/sarbanes-oxley-act Sarbanes-Oxley Act . Viewed December 01, 2009, at http://duhaime.org/LegalDictionary/S/SarbanesOxleyAct.aspx Sarbanes-Oxley in force today. Viewed December 01, 2009, at http://www.out-law.com/page-5505 Regulatory Accounting Principles (RAP). (n.d.). Dictionary of Banking Terms. Viewed December 01, 2009, at Answers.com Web site: http://www.answers.com/topic/regulatory-accounting-principles-rap Wolk, HI, Tearney, MG, & Dodd, JL 2001, Accounting theory: A conceptual and institutional approach. 5th edn., South Western College Publishing, Cincinnati, OH Worldcom, Santa Clara University. Viewed December 01, 2009, at (http://scu.edu/ethics/dialogue/candc/cases/worldcom.html) Schafiro says. . . . Viewed November 30, 2009 at http://www.nasdaq.com/aspx/stock-market-news-story.aspx?storyid=200909181521dowjonesdjonline000 570&title=schapiro-says-sec-will-discuss-transition-to-ifrs-this-fall Read More