Principle-Based Accounting and the Enron, Worldcom and Adelphia Cases - Essay Example

Running head: ACCOUNTING SCANDALS 19th May 2 pages summary of pages 277 - 290 Since 2000, accounting scandals have been on the increase. Some of the notable companies that have experienced the vice include AOL, Cendant, Conseco, Bristol-Myers, Federal Home Loan Mortgage Corporation, HealthSouth, Qwest, Rite, Sunbeam, Waste management, WorldCom and Enron. Based on their scope, WorldCom, ComROAD AG and Royal Ahold are some of the major scandals that had adverse effects. Based on their quick spreading, the scandals have resulted into various effects. These includes decline in the reputation of the US institutions such as the GAAP, security analysts, auditors, regulators, managers and complicit banks among others. In order to come up with the solutions and ways to prevent the accounting scandals, various academic commentators have come up with various issues. For instance, social norms, ethics, corporate culture, incentive-based compensation, audit standards have been related to the scandals. All these issues among others may be divided into two important aspects that include the perspective of the market for corporate governance and financial reporting and the perspective of the political or regulatory process. This report intends to provide various events that indicate the differences between the two perspectives. For instance, section 3 as well as 4 indicates the regulatory and political market responses of the 2001 to 2002 scandals events. The events were caused by various issues including reporting negligence and fraud as well as earning management. Earning management entails manager’s intervention on their own financial reporting. Some of the major practices of the earning management include the practices that are legal and generally viewed as ethical for example structuring transactions with regard to their effects and timing assets sales to book gains in years with lower profits. It also covers gross negligent for example failing to comply with GAAP, fraudulent reporting as well as practices that are legal do not violate accounting standards or principles but on the other hand they may violate accepted standards of disclosure. According to James Wilson, for an event to be regarded as scandalous, two conditions must hold. One the events must be shocking implying must counter our norms and secondly they must be unusual meaning that they are not frequent. The 2001 and 2002 events did not only clash with our norms, but they were also unusual. There are various issues that resulted to the rash of scandals for example, with the end of US longest boom in 2001, sequences of events likely happened. These includes extended boom, high growth that was built into performance including increase in revenue and share prices among others. As a result, managers were under pressure to improve the financial performance of their companies. Additionally, tax increased. According to Coffee (2005), share ownership is one of the major issues that make US to be more prone to financial reporting problems. Managers commit financial reporting fraud due to the financial incentives that they are promised such as bonuses, promotion, stock appreciation rights and avoiding termination among others. Three major properties that are shared by the financial frauds includes inability to meet performance expectations, personal costs of failing to meet expectation and convincing oneself that real performance will soon improve. Regulatory reaction to the scandals has two branches that include legislative proceedings that focus at reducing incidences of future fraud and criminal proceedings against individual involved in negligent acts. The Sarbanes-Oxley Act that was a major legislative proceeding under the George W. Bush administration covered various provisions. These includes that CEOs as well as CFOs must certify their financial statements, independent audit committees, prohibiting misleading auditors, rotation of audit engagement partners, increased disclosure of matters and prohibiting of corporate loans to the officers. On its part, market reaction to the scandals has two branches that include penalties assessed against individual involved in fraud as well as adaptive changes in institutional arrangements. As compared to criminal proceedings, civil litigation is a market issue of enforcing implicit and explicit contracts among the shareholders, managers, auditors and contracting parties. 2 pages summary of pages 290 - 300 Additionally, the reputation effect which is one of the market mechanisms has also been viewed as to have inappropriately acted. During its tenure as the auditor, Andersen was faced with problem due to its ineffective audit of firms such as Enron, Sunbeam, Waste management and WorldCom. This resulted to an international concern that led to the downfall of the company. Another notable aspect of market mechanism is bonding. This implies that audit partners form partnership thus making it possible for them to monitor their own behaviors thus enforcing compliance. As the result of the ineffectiveness of Andersen, the company was involved in various lawsuits that included settling Sunbeam with $110 million, Waste management $27 million, Baptist Foundation of Arizona with $217 million, $40 million for Enron and WorldCom for $65 million (Ray, 2009). Andersen was forced to cease its operations due to the evidence of involving top managers instead of engaging audit partners. Another notable public and political reaction to the accounting scandals is related to audit firm conflict of interest. This is indicated by the performing of non audit work by audit firm for their clients. In response, Sarbanes-Oxley Act prohibited performing of non audit work by audit firm in order to prevent their interference for being independence. In addition, public companies are restricted from hiring from their audit firm by the Sarbanes-Oxley Act for example Section 206. Another firm that faced a loss due to bankruptcy was Enron. Based on its poor financial performance, Enron made large number of its workers to be out of work. Market misreporting is another notable problem that causes accounting scandals. Thus markets have put in place mechanisms of penalizing individuals involved in financial scandals. Major market responses to the 2001 and 2002 scandals included awarding of damages, bankruptcy and reputation effects. GAAP versus Accounting Principles That Are Generally Accepted In a market setting, codified standards emerge as one of the key ways of satisfying market demand. For example, producers are ready to incur high costs in their efforts to inform their consumers about their brands. In cases where there is no regulation and certain professions exist, there is a high possibility of professional standards existing. Some of the major questions that that arise including whether in the financial reporting market the use of standard is an efficient solution or does it arise due to regulations? Additionally, the question is what the relationship between market and political forces. For any individual to be accepted in the market as an audit professional, one must meet accepted practices. States have thus gravitated to professional accounting bodies such as American Institute of Certified Public Accountants, GAAP standards as well as the International Financial Reporting Standards. GAAP indicates that US financial reporting is based on rules. If effectively implemented, the principle based approach of IFRS, will result to a better balance sheet that indicates economic substance as well as all the financial implication on the company. Merits related to principles based as well as rules based accounting has internationally been discussed due to their establishment of IFRS and United States GAAP. 2 pages summary of pages 300 - 317 The debate on the principles based and rules based accounting took another direction particularly as the result of the recent accounting scandals. As the result of the firm following the rules to the letter instead of their spirits, the scandals also increased. Similarly, due to managers and the accountants adoption of rule-checking mentality, the 2001 to 2002 scandals emerged. There is need therefore to evaluate the standard against which the financial reporting is undertaken in US. According to rule 203 of the AICPA, a mechanical application of formal GAAP pronouncement can result to misleading financial reporting. One of the major strategies that managers must adopt is to reconcile the requirements of Rule 2003 with GAAP regulations in order to ensure that proper professional judgment is made. Thus, accountants are advised to extensively use principle based accounting instead of rule based. A notable case that depicts the legal implication of accounting principles was the US versus Simon. During this case, the judge indicated that an accountant cannot escape conviction for fraud by indicating that financial statement he knew were misleading has been prepared based on the GAAP (Ray, 2009). In addition, the judge indicated that just complying with professional accounting standards does not result to a sufficient defense but the most important point is as to whether the financial statements represented an organization position in this case it was Continental Vending Machine Corporation. Principle based accounting and the Enron, WorldCom and Adelphia cases Enron executives that included Lay and Skilling were not charged for violating GAAP rules but due to misleading employees as well as investors in addition to withholding materially bad news, misrepresenting the firms earnings and financial position. Extent to which Enron financial statements did not conform to the GAAP was not an important issue but the failure to present fair picture Enron profitability was the key aspect. According to Bernie Ebbers, the ex-CEO of WorldCom stated that the prosecution did not prove that he violated GAAP. Just like in the case of Simon, Adelphia case applied the same principle. During the case of Adelphia that involved Rigas family, the prosecution was successful in arguing that certain aspects of Adelphia financial statements were false and misleading. The allegation did not take into consideration whether GAAP were followed. According to managers and accountants, the US financial reporting was rule based due to lack of regulation. Similarly, their position was that the scandals were also caused by the regulations. Thus the introduction of Sarbanes-Oxley Act was important since it ensured deterrence, detection and correction of frauds and negligence. According to Coffee (2007) deterrence model has resulted to allocating disproportionately high resources during the enforcement of law (Ray, 2009). However, it is effective in addressing scandals. On the political perspective, Sarbanes-Oxley Act has been effective in facing off accounting scandals especially in small companies. In conclusion, by initiating rules, detecting scandals was effective but not preventing them from occurring. Depending on whether one takes a political or market perspective, one is able to determine whether Sarbanes-Oxley Act was an overreaction. References Ray, B. (2009). Market and Political/Regulatory Perspectives on the Recent Accounting Scandals. Journal of Accounting Research Vol. 47 No. 2 May 2009. Read More