Financial Accounting Theories in a Real Life - Assignment Example

Financial Accounting Theories in a Real Life Table of Contents Table of Contents 2 3 Introduction 4 Repo 105 and Its Impact 4 Motives of Firms behind Manipulating Their Earnings 6 Need for Financial Accounting Regulations to Prevent Accounting Scandals 8 Conclusion 10 10 References 11 Abstract The report has discussed about the impact of the current accounting cases to the financial world. It has been observed from the analysis of the report that there should be certain strict regulations in order to reduce cases related to misleading financial accounts which ultimately affect the global financial world. Introduction Accounting is known as the universal language relating to business all over the world. It is used to communicate various aspects of the business. There are diverse kinds of theories that prevail in financial accounting. It has been observed that there prevails no accounting theory which is a universally accepted theory of financial accounting. Different researchers have dissimilar views regarding financial accounting theories (McGraw-Hill, 2006). There are different types of accounting theories that can be implemented in real life scenario. One of them is the Repo 105 theory. This theory is used by many of the companies. Moreover, it needs to be mentioned that the misuse of such theories can result in negative functioning of the companies. There are many such cases where improper use of accounting theories result in complete demise of the companies. Financial regulations can play a major role in reducing such cases (Liu & Schaefer, 2011; Eisinger, 2012). The report intends to discuss the role of Repo 105 scheme in the enhanced performance and subsequent downfall of the Lehman Brothers. The report would further depict the different motives that encourage companies to manipulate their financial accounts with reference to a few well known cases. Moreover, the report also intends to illustrate the importance of financial regulations in reducing such cases. Repo 105 and Its Impact Repo 105 is an accounting trick where a company depicts a short-term loan as a part of the sales of the company. Moreover, this loan would be further used by the company to repay its liabilities. A repo agreement would include temporary transfer of assets from one party to another which would also be accompanied by an agreement of repurchase of the same assets after a particular phase of time. After a certain period of time, the transferee returns the securities to the borrowers, which in turn repays the loan with a considerable interest. It needs to be mentioned that as a part of the exchange process, one party would receive securities as guarantee for the cash loaned, while the other party would receive cash guarantee for the securities loaned. It has been observed that these agreements are widely used as well as recognised as a legal means of providing short-term financing for liquidity needs. It has been further observed that the size of the repo market is quite vast and widespread and is estimated to be around US$12 trillion. It has been noticed that repos are also used by banks to borrow money from different companies that have additional cash reserves. In order to minimise the repayment risk, the banks transfer assets to lenders (i.e. companies) as part of security (Liu & Schaefer, 2011). The fall down of the Lehman Brothers in the year 2008 is amid the most critical moments in the financial world. Lehman Brothers were observed to have utilised Repo 105 scheme to show a better financial health to the outsiders. It has been analysed that Lehman Brothers had got into an agreement of repurchase with banks situated in the Cayman Islands. It has been further noted that within the deal, Lehman Brothers would be entrusted to sell toxic assets to other banks with the understanding that they would buy them after a particular period of time. It is worth mentioning in this context that this agreement or the repo trick depicted the financial health of the company to be much better in paper. It can be analysed that repo agreements are used by most of the banks and they show them as loans of the bank. Apparently, it has been further noticed that Lehman Brothers portrayed the agreement as the sales of the company and strengthened their financial health in front of the people. It has been observed that as a result of the trick, Lehman Brothers demonstrated US$50 billion more in their books of cash and US$50 billion less in mortgage assets. It has been argued by many of the critics that the trick was done by Lehman Brothers with the intention to manipulate the accounts of the company with the objective of misleading the investors (Sharp, 2010). After the study of repo accounting scheme, it has to be mentioned that this theory might be one of the most controversial accounting theories but it cannot be necessarily considered as illegal. It has been observed that the repo theory is legitimate in the financial system. It has been further observed from the study that repo is an agreement which is used to take a certain amount of loan for a particular period of time. It has further been observed that many of the banks use this theory to take such loans. Furthermore, it is worth mentioning in this regard that these loans would have to be portrayed only as loans in the books of accounts. In the case of the Lehman Brothers, it has been recognised that loans that they were taken in accordance with the repo theory were shown as sales in their books of accounts which strengthened their financial position in paper. Thus, the controversy took place. However, it can be stated that this theory cannot be considered as illegal until and unless its implications are illegal (Merced & Werdigier, 2010). Motives of Firms behind Manipulating Their Earnings In the financial world, the accounts that are presented by companies are quite significant and they depict the current financial health of the companies. However, it has been viewed that there are numerous cases that arise regarding manipulation of accounts. There are several reasons that force or encourage companies to manipulate their accounts. Manipulation of accounts can also be termed as earnings management in certain cases. One of the utmost significant motives of the companies for manipulating the accounts would be to attract the stakeholders of the company. It has been observed that the financial health of a company plays a major role in attracting the stakeholders towards the entity. An example in this regard would be famous the Enron scandal. It has been recognised that the financial accounts of the company (i.e. Enron) were quite complex. It was illuminated from the investigation that the company was using the accounting limitations and modified as well as portrayed financial accounts that indicated encouraging performance of the company. It has been further observed that the main motive of the company behind manipulating the accounts was to show a positive financial structure in order to attract the investors of the company and also enhance the reputation of the company in the global market (Chryssides & Kaler, 1993; Bauer, 2009; Ronen & Yaari, 2007). Another crucial motive regarding the manipulation of financial accounts of companies would be the facet of greed to increase the sales of the company. It has been noted that there have been a number of cases regarding misinterpretation of accounts which led to increase in sales and ultimately the profit of the company. This can also be regarded as earnings management where the manager would intervene in the financial accounting for private gain of the company. An example in this regard would be the case of Peregrine Systems, Inc. It is a software developer company that had received positive responses in its initial years. However, with the advent of the internet, the sellers of the company had decided to switch to a sell of more advances. Thus, in order to convince sellers to sell the product of the company, they manipulated their accounts to portray financial reports that depicted a profitable result of their business in 17 consecutive quarters. As a result of this, the sellers of the company’s software were convinced to sell it further in the global markets (Chryssides & Kaler, 1993; US Securities and Exchange Commission, 2003). Moreover, another motive that encourages the companies to manipulate their accounts is to avoid portraying the losses that occurred in their performance. It has been observed that the companies would always desire to present profitable accounts which would bind the interests of the people associated with the company. An example in this regard would be the case of Worldcom in the year 2002. Worldcom was among the major telecommunication companies in the world. In the year 2002, the auditors of the company discovered that there were certain abnormal accounting entries in the accounts of the company. Further investigation depicted that a huge amount of business of the company had been misstated in the accounts. It has been observed that the amount was entered in the book of accounts as a capitalised investment related cost in place of routine expenses. There were also certain other misleading entries in the accounts which enabled the company to avoid a declaration of its losses. As a result of all this inter-related activities, the company declared bankrupt in the year 2002 (Chryssides & Kaler, 1993; Fernando, 2009). Therefore, it has been ascertained that it is the personal interests of the companies that generally force them to manipulate their accounts. Need for Financial Accounting Regulations to Prevent Accounting Scandals Now-a-days, there are many cases that arise regarding accounting scandals. It has been argued by most people that there is a need for strict regulations in order to avoid or eliminate such scandals. It is believed that owing to certain limitations of accounting regulations, companies are able to manipulate their accounts for personal interests, which further lead to scandals. The accounting scandals of the companies such as Enron, Lehman Brothers and worldcom disrupted the financial world and eroded the trusts of the investors towards the companies. These scandals could have been avoided through various financial regulations. One of them is the Sarbanes-Oxley Act (SOX) which had been introduced to avoid such cases in the future. It has been observed that SOX is designed with the capability of financial tracking which would ensure that the financial reporting of the companies would be accurate and there is no fraud or manipulation taking place. It has been observed that once SOX is enacted, the companies would require meeting certain specific financial reporting guidelines (Harkins, 2012). It has been observed that after the emergence of SOX, accounting disagreements generally finish before they actually start. An example in this regard would be the accounting scandal of the Groupon Company which got resolved in a matter of a few weeks. However, it requires to be mentioned that like many regulations SOX also cannot be considered as perfect. There are flaws which are to be corrected in course of time. Also, after the emergence of the SOX regulation, the accounting industry has also improved. It has also been the accountants of most of the companies who have done a great job after the emergence of the regulation. It is worth mentioning in this regard that the previous scandals that took place related to accounting have also forced the companies to operate legally. Overall, it can be said that the financial regulations would be quite effective in reducing the scandals that arise from manipulation of accounts. However, there is also further scope of expanding the regulations in the future. The government needs to implement more use of Information Technology (IT) in the enacted regulations to make them more effective (Eisinger, 2012). Conclusion From the overall analysis of the report, it can be summarised that financial accounting theories are quite vital in real life. It been observed through the report that there are certain theories that could be used by companies for illegal as well as unethical practices. An important case discussed in this aspect is the scandal of the Lehman Brothers, where the company misused the theory of Repo 105 to depict a misleading financial performance of the company. Furthermore, it has also been observed that there are various motives that encourage or force the companies to manipulate their accounts. It has been noted that all these manipulations are done primarily due to personal gains of the companies. A few of the well known example of the scandals are also discussed in this report. Moreover, it has been observed that strict financial regulations would be effective in reducing such cases of misinterpretation of financial accounts. However, there is a scope for further improvement in the financial regulations which should not be ignored. Consequently, it can be concluded that accounting frauds is one of the major concerns in the financial world and strict measures should be adopted to reduce such cases. References Bauer, A., 2009. The Enron Scandal and the Sarbanes-Oxley-Act. GRIN Verlag. Chryssides, G. D. & Kaler, J. H., 1993. An Introduction to Business Ethics. Cengage Learning EMEA. Eisinger, J., 2012. The SOX Win: How Financial Regulation Can Work. Publica: Journalism in Public Interest. [Online] Available at: http://www.propublica.org/thetrade/item/the-sox-win-how-financial-regulation-can-work [Assessed March 27, 2013]. Fernando, A. C., 2009. Corporate Governance: Principles, Policies and Practices. Pearson Education India. Harkins, M., 2012. Managing Risk and Information Security: Protect to Enable (Google eBook). Apress. Liu, C-S & Schaefer, T. F., 2011. Asset Sales or Loans: The Case of Lehman Brothers’ Repo 105s. The Accounting Educators Journal, Vol. 21, pp. 79-88. McGraw-Hill, 2006. Introduction to Financial Accounting Theory. Home. [Online] Available at: http://highered.mcgraw-hill.com/sites/dl/free/0074716719/363734/sample_ch01.pdf [Assessed March 27, 2013]. Merced, M.J. D. L & Werdigier, J., 2010. The Origins of Lehman’s ‘Repo 105’. The New York Times Company. [Online] Available at: http://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/ [Assessed March 27, 2013]. Ronen, J. & Yaari, V., 2007. Earnings Management: Emerging Insights in Theory, Practice, and Research. Springer. Sharp, A., 2010. Lehman Brothers Repo 105 Accounting Scandal Accounting Gimmicks or Outright Fraud? Wealth Daily. [Online] Available at: http://www.wealthdaily.com/articles/lehman-brothers-enron-accounting-gimmicks/2375 [Assessed March 27, 2013]. US Securities and Exchange Commission, 2003. United States District Court For the Southern District Of California. Home. [Online] Available at: http://www.sec.gov/litigation/complaints/comp18205.htm [Assessed March 27, 2013]. Read More