The Application of Financial Accounting Theories in a Real-Life - Case Study Example

The Application of Financial Accounting Theories in a real-life case of Introduction Part 1 of this paper seeks to critically discuss the motives for listed companies to engage in creative accounting practices to meet analysts’ expectation, using relevant literature and real life examples. Discussion starts with defining creative accounting is defined first, followed by possible motives to engage in creative accounting and then by the companies which practiced creative accounting. Part 2 of this paper critically evaluate the role of regulations and ethics in preventing accounting frauds, supporting the same with appropriate theories. This part will expound on the role, purpose and the need to have financial reporting regulation as part of corporate governance and the related arguments against financial reporting regulation. The paper will conclude by combining the two parts of this paper with the choice to have regulation while making some valid qualification. Part 1 2. Critically discuss the motive for listed companies to engage in creative accounting practices to meet analysts’ expectation. 2.1. Creative Accounting defined Creative accounting, sometimes called earnings management, can be defined as any attempt by management of a company to manipulate reported earnings to accomplish their personal rather than the organizational interests and purposes. Thus, using specific accounting method over another method gives management the opportunity defer or accelerate expense or revenue transactions or to recognize one-time non-recurring items (Pagach, et al, 2006). Deferring expense or revenue would actually try to accomplish accounting standards in form but substance to suit the particular purpose of management. Based on said definition, the issue of recognition and measurement of an accounting element becomes the very foundation of accounting information as contained in accounting standards which may be called generally accepted accounting principles (GAAP) in the United States or international financial reporting standards (IFRS) in Europe. The guidelines essentially prescribe what should be and what should not be part in the financial statements to arrive at reliable and accounting information to guide users to make responsible decisions. Creative accounting, in effect, is less candid than accounting standards requires and failure to follow therefore the requirements of standards (Lee, 2007). 2.2 What could be the motives behind earnings management? It can be deciphered from the definition that the purpose of the creative accounting is to influence short-term earning , virtually telling the decision makers, who are principally the investors of that company that profits are meant to be kept unbroken more or less for the near future. In this way, investors or buyers of a company‘s stock could be hoodwinked to purchase or invest. There is greater chance that decision makers are less informed of what is fair in the absence of rules or accounting standards to guide or restrict companies ‘management in the preparation financial statements of the practice of creative accounting. Managers are motivated to do earnings management due to perceived advantages for their interests. This finds explanation under the agency theory. The agency theory assumes a conflict of interest between principals as represented by stockholders and agents are represented by the directors chosen by the stockholders to be their agency. Within the agency framework, it may be assumed that directors will have their self-serving interest or the tendency to protect their above the shareholders although the same is illegal and unethical (Dietrich and Krafft, 2012). Thus creative accounting can happen as bloating income may increase executive compensation of directors at the disadvantage of shareholders. Moreover, managers want to bring their wealth maximization objective to reality (Brigham and Houston, 2011). Various pressures come from both external and internal environments that could be telling the managers to produce results or they get fired. Having stable earnings in the short-term, stock prices of concerned companies could be expected to go up or at least maintained (Brigham and Houston, 2011). Occasionally if not most of the times, stock prices are forecasted by analysts with the linkage to management, who may not want to lose face if profits will eventually get down. With the implied expectation to grow and be profitable, they must have to adjust their profitability, liquidity and solvency profile that could be extracted only from financial reports. This would therefore mean possibly making the financial reports to look attractive to investors and to the public. The behaviour of the analysts could in effect tempt the company‘s to manage their earnings, which happens in reality (Brown, 1999.) Analyst can unethically earn in return for the validation of their forecasts. This may be an unfair behaviour among analysts of companies but the actualities must be met since people in the business entities tend to move for their own interest. 2.3 Companies which practiced creative accounting The case of Enron is creative accounting in its company practice in its revenue recognition. The company used the mark-to-market accounting allegedly to reflect the true economic value of transaction in its complex long-term contracts (Epstein and Lee, 2008). This allowed the company to recognize income while being based on estimated present value of net future cash flow although the viability of these contracts and their related cost could not be easy to estimate (Rapoport and Dharan, 2004). From this action, one could see the bias as investors were typically misled due to the discrepancy of profits and cash which they could no longer match. The case of WorldCom is on booking interconnection expenses as capital expenditure instead of expenses and inflating revenues with bogus entries from corporate unallocated revenue accounts (Kranacher, Riley and Wells, 2010). The case of HealthSouth Corporation as the main case study (Chaubey, 2006) is another form of creative accounting where proper earnings are not reflected because of the need to have income smoothing or avoidance of negative earnings to sustain the value of its stocks. The officers of the corporation, under the direction of its CEO Richard Scrushy, were making false reports of overstated earnings because of the capital market pressures as forecasted by analyst. In other words, analysts who were supposed to be independent minded professionals were made to appear correct in their forecast by the manipulative officers of the corporation (Chaubey, 2006). Part 2 3. Critically evaluate the role of regulations and ethics in preventing accounting frauds, supporting the same with appropriate theories. The role of regulation and ethics in preventing accounting frauds is very important. The issue of accountability is as important in business as in real life. Regulation comes in the form of the use of the standards in financial reporting. The requirement for companies to adhere to the requirements of good corporate governance is indeed very important. Financial reporting regulation becomes a necessity in corporate governance as required by Sarbanes-Oxley Act (SOX) in 2002. Regulation aims to provide solutions to problems for imperfect market causing serious market failures. These externalities cannot be solved the law of supply and demand or free market forces in the economy. The SOX of 2002 came into being to prevent repetition of scandals by fraud committed by companies particularly that of Enron and World.com. Externality that can only be addressed by regulation in the same way that police action is needed in rowdy and violent crowds. Financial reporting regulation is made to protect investors through improvement in the accuracy and reliability of disclosures by corporation on securities (DeVay, 2006). Allowing companies to make false financial reports due to absence of standards, is leaving governance to the greediest pigs. The clear need for regulation is the realistic solution when scandals and corporate collapses happen that could render the government helpless. However, overregulation, not just under or lack regulation, is also a possibility, as it could cause problems rather than solutions. The same could also mislead rather than properly inform investors as decision makers. However, there should be moderation in everything as the tendency to overregulate may happen. This brings this paper into discussing arguments against regulation. Opponents argued that cost of regulation could be prohibitive (Stice and Stice, 2011; Kieso, et al , 2007). It cannot be denied that direct costs and indirect costs go with regulation as an activity. Financial reporting requirements are inevitably creating more costs to business entities. It is not difficult to imagine that more requirements would mean more preparation activities for companies as they comply with regulators. It would also mean more certification and dissemination of accounting reports. More of these activities simply mean substantial costs (Ribstein, 2005) as there are also costs involved for those who are making disclosures to the public. While companies need to advertise by telling about their products and their plans to the buying and investing public, as a necessary part of marketing in their efforts to reach their customers and investors, they could actually do by voluntary disclosure. These companies could not expect to raise good prices for their shares of stock if they would not at least inform about the benefits of their goods or services to customers. However, the issue in financial reporting sometimes exceed voluntary disclosure due to the need for mandatory ones on the simple argument that companies would not want to say unfavourable things to the public. Another argument against regulation is that if regulators would require such mandatory ones, it could also be discouraging if not discriminating the small companies who lack the financial or technically to comply with regulatory requirements. More rigorous requirements should convert to hiring better professionals and essentially this would be generating more cost to small investors. Viewed differently, such act is creating economies of scale for those bigger companies which could afford the higher disclosure costs, while easing out small companies which do not have the capabilities. Thus it is argued that not making regulation applicable only to big companies could backfire to the betterment of society. If abetted by government, improper regulation would contradict one of the purposes of promoting free market for industry players. A government regulating is such way, in effect wants to destroy or restrict good competition, which it was bound to encourage. Mandatory disclosure does also produce indirect cost also to capital market participants (Soule, 2003). Providing more information to users would in effect of allow other parties like labour union, competitors, tax authorities and regulators to have access to information which could improperly use to make the demands from companies . To compel company to provide information regarding the profitability of line of business do have the effect of inspiring competitors since proprietary information could be revealed although not expressed in the process. Inviting competitors to kill your business can be considered as against the interest of legitimate business entities which have rights to exclusively deal on their products or services. To invite them to come in that line of business and to tempt tax authorities to come in also into the picture could really create problem. Tempt the labour groups and they be more interested in pursuing their demand for better salaries and benefits as a result of better profitability, thereby causing instability in the business and create lack of flexibility Compulsory disclosure could actually dishearten business entities since the latter would have less flexibility to defend their trade secret. They could end up in a worse position or they could hardly maintain their profitability that could sustain the viability of the business (Higgins, 2007). However, some decision makers are not easily tricked by those that are not making revelation since the former are still to make decision even without the comprehensive information. Thus, responsible corporations can actually take benefit by providing information to the public as they could actually tell that there is overproduction in an industry and this could discourage new entrants. The ideal situation is for companies to be candid to what is beneficial to the public as the latter is an essential part of the group of stakeholders in accordance with the principle of corporate governance. 4. Conclusion Motives and desires for maximized wealth for shareholders come with personal interest as driven by free economy but the same must be balanced with the need for social responsibility. There is need also to consider other stakeholders, like workers, the customers, the government and the public rather than just the shareholders. Creative accounting is created by the law of supply and demand but the human freedom cannot be absolute. Thus, there is the need for government to require financial reporting regulation and good business ethics to prevent accounting frauds. Having regulation is better than having none at all. Self-regulation may help but where market forces are allowed completely, the externalities are also realities. Thus, it is necessary to properly address the latter with effective and proper regulation in financial reporting and through corporate governance principles. As precautionary measure, given the chance of possible overregulation, a continuing research is advised to balance acts of regulation in accordance relevant with the changing needs of the business and social environment. References: Brigham and Houston (2011) Fundamentals of Financial Management, Concise Edition. Cengage Learning Brown (1999). The regulation of corporate disclosure Front Cover. Aspen Publishers Online Chaubey, M. (2006). Case Study - HealthSouth Corporation: Fraud, Greed and Corporate Governance. International Conference on Management Cases DeVay, D. (2006). The Effectiveness of the Sarbanes-Oxley Act of 2002 in Preventing and Detecting Fraud in Financial Statements. Universal-Publisher Dietrich, M. and Krafft, J. (2012). Handbook on the Economics and Theory of the Firm (Google eBook). Edward Elgar Publishing Epstein, M. and Lee, J. (2008).Advances in Management Accounting. Emerald Group Publishing Higgins (2007) Analysis for Financial Management, Eighth Edition. The McGraw−Hill Companies Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Kranacher, M. R. Riley and J. Wells (2010). Forensic Accounting and Fraud Examination. John Wiley & Sons Lee (2007). Financial Reporting and Corporate Governance. John Wiley and Sons Pagach, et al (2006). Intermediate accounting: financial reporting and analysis. Cengage Learning Rapoport, N. and Dharan, B. (2004). Enron: corporate fiascos and their implications. Foundation Press Ribstein, L., 2005. Sarbanes-Oxley after Three Years. University of Illinois Law & Economics Research Paper. Soule, E. (2003). Morality & Markets: The Ethics of Government Regulation. Rowman & Littlefield Stice,E. and Stice, J. (2011). Intermediate Accounting Cengage Learning Read More