The Relationship between Prescribed Accounting Principles and Fraud - Case Study Example

December 2, Accounting Fraud Introduction Accounting fraud entails violating prescribed societal accounting standards. The paper delves on the concept of accounting fraud. The paper focuses the Enron accounting scandal and the WorldCom accounting scandal. The paper discusses the relationship between prescribed accounting principles and fraud. Intentional non-compliance with prescribed accounting standards or principles constitutes fraud. Project description There are several definitions of fraud. Fraud is a common term that has several meanings. It includes all activities that are ingeniously devised to take advantage of another person, entity, or group. The activities include using false means as well as give false reports or messages to the intended victims of the fraudulent scheme. Fraud is often characterized as any surprise, cunning, trick, or unfair strategies to mislead the readers or users of the false information or report (Singleton, 2010). Further, corporation fraud is fraud that involves a corporation as perpetrators or victims. Usually, corporation management spearheads the corporation fraud. Next, the corporation line and staff employees may be forced to implement the fraudulent corporation management’s marketing and/or production plan (Singleton, 2010). Moreover, the presence of wrong information in a financial report does not automatically equate to fraud. Wrong information may be due to the delay in the transmittal of information. The accountant preparing the financial information is bound by generally accepted accounting standards or principles to generate reports that are based on supported original documents and data (Mittal, 2010). Further, fraud is an intentional crime. The culprits are aware of their illegal activities. They blatantly refuse to comply with prescribed accounting principles and standards. The culprits may intend to overstate revenues and assets. The same culprits may understate expenses, and liabilities. The accounting standards encompass how much should be properly recorded in the book of original entry, journal book. The standard emphasizes when the sales, expenses, or other accounting entry should be correctly recording in the general journal book (Singleton, 2010). In addition, fraud entails the presence of victims. The victims are normally the readers of the financial reports. The victims include those who apply for job at the company. Another victim is the unsuspecting investor. A third victim is the government. The fraudulent individuals may victimize both customers and suppliers (Singleton, 2010). Problem 1: WorldCom Fraud Accounting How Fraud was committed. The fraudulent WorldCom practices included recorded all expenses as capital expenditures. The fraudulent practice understated the company’s operating expenses. Consequently, the understated operating expenses produced a fraudulently overstated net profit figures. When the investors learned of the cash flow overstatement, many investors withdrew their investments from WorldCom. After the announcement reached the ears and eyes of the current and future WorldCom investors, the company’s stock market price dropped from the previous day’s very high $ 0.79 cents per share to the dismally humiliating $0.12 cents per stock market share. During 2002, WorldCom admitted the company fraudulently overstated their earnings by as much as $3 billion. As the high number of WorldCom investors leaving the company, WorldCom was forced to file to bankruptcy during July of 2002 (Jennings, 2014). In 2002, WorldCom recorded an estimated $4 billion expenses as capital investment as follows (Bloomberg, 2002). The management officers connived and conspired to intentionally defraud the users of the financial reports. The entry was erroneously recorded as an addition to the company’s property, plant and equipment account. By fraudulently recording the expenses as capitalized assets, the operating expenses amount was understated. The fraud was done to fraudulent overstate the company’s net profit figure. What should have been Done. The correct accounting procedure to comply with established United States Gen. Accept Accounting Principles. The principles require the recording of the paid amounts as an operating expense (Mittal, 2010). How to prevent a recurrence of the Fraud Solution A Management must hire a top notch accounting graduate. The accounting graduate will be adept at recording the correct accounting entries (Messier et al., 2011). Hiring a mediocre or low I.Q. unschooled employee to make accounting entries will wreak havoc on the accounting records. The company must hire an internal auditor. The constantly rotated internal auditor will approve the accounting clerk’s journal entries. Rotation of auditors prevents collusion between the fraudulent or erroneous accounting clerk and the internal auditor. The solution will reduce or eliminate the future fraud occurrences. Surely, solution A correctly significantly reduces fraud. Solution B To prevent future occurrences of the fraud, the WorldCom management must implement certain internal control procedures (Johnstone et al., 2012). The procedures will reduce or eliminate the occurrence of the fraud. First, management must hire an accounting clerk who is adept at implementing the United States prescribed accounting principles to every journal entry. Next, the supervisor must check the validity or correctness of the accounting clerk’s accounting journal entries, if wrong; the supervisor will teach the accounting clerk to correct the journal entry. The supervisor must be adept at United States standard accounting concepts. Third, management must hire an internal auditor. The same auditor checks if the journal entry done by the accounting clerk is correct. If not correct, the internal auditor instructs the accounting clerk to correct the fraudulent accounting entry. Next, the board of directors will hire an external auditor. The external auditor will determine whether the financial statements are fairly presented. The external auditor will recommend an adjusting entry to correct the fraudulent entries. Further, the external auditors examine the financial reports to determine if there are red flags (Johnstone et al., 2012). Red flags signal the auditor to possible fraudulent financial report journal entries. Upon discovery, the auditor recommends the recording of adjusting entries. Failure to implement the adjusting entries may force the auditor to divulge the fraud to the affected parties, people who will use the financial reports for their decision making activities. Clearly, Solution B correctly eliminates fraud. Every 3 years, the external auditors should be replaced to prevent collusion (connivance) between Enron officers and members of the external auditing team. Problem 2: Enron Auditing Problem How Fraud was committed. Watkins confided with Enron’s Board of Directors chairperson Kenneth Lay that there were some accounting irregularities perpetuated by some scrupulous management as well as line and staff employees of Enron (Franzese, 2009). Sherron Watkins discussed to Ken Lay that one of the Enron accounting frauds as the non recording of certain Enron debts (Franzese, 2009). The non-recording of Enron debts is classified as off-balance sheet accounts. The balance sheet formula is total assets less total liabilities equals shareholders equity (Assets – Liabilities = Shareholders’ equity). The assets represent cash, inventory, buildings, furniture, equipments, vehicles, land, and other items owned by the company. The assets include goodwill as well as franchises that are researched and developed by the company (Mittal, 2010). Further, the liabilities include all debts of the company. The debts include the current liabilities. The current liabilities are expected to be paid within one year after the close of the accounting period, usually December 31 of the current year. The current liabilities include the accounts payable as well as the notes payable accounts. The current liabilities include the currently maturing portion of the company’s long term debts. Advances from customers are also classified as the company’s liabilities. Advances are amounts paid in advance by customers. The payments are received by the company as deposit from the customers. The payments will be used for the customers’ future purchases of the company’s products or services (Mittal, 2010). Furthermore, the long term debt of the liabilities portion of the balance sheet usually involves bigger amounts. Usually, the company borrows money from the banks and other financial institutions. The huge amount is classified as long term debt. The debt payment is expected to be completely paid more than one year after the close of the financial report date, usually December 31. The account title includes bank loans payable. Another long term debt is the bonds payable. The bonds may be paid in installment basis. The installment payment bonds may be classified as serial bonds. In exchange for the long term loans, banks or financial institutions earn interest. The more popular interest payments include 5 percent interest for one year, 10 percent interest for one year, or 12 percent interest for one year (Mittal, 2010). In addition, the shareholders equity portion of the balance sheet includes several amounts (Mittal, 2010). One amount is the investment contributed by the company’s current investors. The equity portion also includes the retained earnings amount. The retained earnings amount represents the updated balance of the company’s yearly net profit figure or net loss amount. The share holders’ equity portion includes preferred shares of stocks. The preferred shares of stocks indicate the investors of the same shares receive priority in the distribution of the company’s cash dividends. After the preferred shareholders receive their proportionate cash dividend shares, the remaining cash dividends (if any remain) shall be distributed on a per share basis among the common stock shareholders. Further, returning back to the Enron case, the non-recording of the liabilities creates a fraudulent impression among the Enron Company’s financial statement readers. The company assets are usually generated from two sources. One of the sources is classified as liabilities or debts. The other source is shareholders’ equity, investments by investors (Mittal, 2010). By recording the off-balance sheet loan amounts, the readers of the financial report will understand that some of the company’s assets came from borrowings or loans. By not recording the off balance sheet amounts, the financial statement readers are falsely given that impression that some of the assets came from the investors’ own funds. The fraud in the case is that the investors never funneled cash to pay for some of the affected assets. By not recording the off balance sheet loan amounts, the company is creating a fraudulent impression that the company’s assets came from net profits generated during the years of fraudulent report (Franzese, 2009). Specifically, Enron created fictitious companies. The companies were partly or fully owned by Enron. Watkins reported to Enron board of directors chairperson Kenneth Lay that some of the company’s Special Purpose Entities are subsidiaries of partly owned by Enron. The fraudulent practice was for Enron accounting-related officers to transfer the Enron liabilities to the subsidiaries. Consequently, the fraudulent Enron balance sheet hides the liabilities. The same liabilities are fraudulently recorded as part of the loans of the subsidiaries. The practice violates established United States generally accepted accounting principles (Franzese, 2009). Further, the fraudulent practice fooled many current and future investors. The Enron officers’ fabricated financial reports enticed many investors to put more money into the coffers of Enron (Franzese, 2009). When the fraudulent Enron practice was divulged, panic ran through the veins of the current and future Enron investors. Almost all of the current investors withdrew their investments from Enron. The investors hurriedly sold their stocks to the first available Enron stock buyer. Due to the increase in the investors’ desire to withdraw their Enron investments, the stock market price of the Enron stock dropped to bankruptcy levels. As expected, the sudden deluge of investors withdrawing their interest in Enron led to the bleeding of Enron assets, specifically cash assets. The inevitable occurred. Enron was forced into bankruptcy. Furthermore, the external auditors of Enron connived and conspired with the Enron management officers. The External auditing firm, Arthur Andersen, was forced into bankruptcy. After an eyewitness reported in court that the external auditors of Arthur Andersen connived and conspired with Enron management officers to present fraudulent financial reports, the people’s trust and confidence with the Andersen auditing firm dropped. Consequently, the Arthur Andersen auditing firm was likewise forced into bankruptcy (Franzese, 2009). In addition, the Enron officers connived and conspired with the accounting clerks and external auditors to present fraudulent financial reports. One of the major fraudulent accounting entries occurred in 1997. In 1997, Enron guaranteed to pay a $240 million unsecured loan for its subsidiary, Chewco. Enron fraudulently did not record the amount in its financial reports. As expected, the company’s balance sheet did not show the $240 million as part of its long term liabilities. Consequently, the amount led to an increase in the company’s cash fund by the same amount, $ 240 million (Niskanen, 2007). Moreover, the investigations affirmed the management officers of Enron orchestrated the fraudulent preparation and presentation of its financial reports, falsely indicating that the company is generating high net profits. Kenneth Lay, the board of directors’ chairperson and chief executive officer was not able to use his influential power to prevent his arrest and incarceration. Kenneth Lay connived and conspired with other management officers and external auditors to present fabricated financial reports. Kenneth Lay was convicted to serve the remaining years of his earthly life caressing the cold jail cell bars. Kenneth Lay died in 2006, at the ripe old age of 64 (Franzese, 2009). Moreover, Enron’s high ranking management officer, Andrew Fastow, turned government state witness. He divulged how the fraudulent financial reports were orchestrated. Andrew Fastow pointed to Kenneth Lay and Skilling as the masterminds of Enron’s flagrant violations of established United States generally accepted accounting standards or principles (Franzese, 2009). What Should Have Been Done. The management officers and external auditors should instruct the accounting clerks to comply with prescribed United States accounting standards. The accounting clerks should record the above loan amount as an addition to the company’s total liabilities account. The account is part of the company’s balance sheet section of the annual financial reports. By doing so, the balance sheet informs the users of the financial reports that the above $ 240 million cash inflows came from borrowings. By not reporting the loan amount, the readers misinterpret the cash inflows as part of cash inflows from the sale of the company’s products and services (Johnstone et al., 2012). How to Prevent future occurrences of the Fraud. Solution A Management must hire a knowledgeable accounting clerk. Hiring a mediocre or low I.Q. unschooled employee may generate wrong or erroneous accounting entries and financial reports (Messier et al., 2011). The internal auditor will check and ask the accounting clerk to correct the erroneous or fraudulent accounting entries. The internal auditors should be rotated in order to avoid connivance between the accounting clerk and the internal auditor. Undoubtedly, solution A correctly reduces fraud to allowable levels Solution B To ensure eradication of future accounting-related fraudulent transactions, the Enron management must implement effective internal control steps (Johnstone et al., 2012). First, management must hire an accounting clerk who knows how to apply the United States accounting principles. Next, the accounting expert, Enron supervisor, must ensure and help the accounting clerk prepare the correct accounting entries. Third, management officers must ensure the internal auditor helps reduce fraudulent and erroneous accounting entries. Next, the external auditor should examine the correctness of the journal entries. The same auditor must propose adjustments to correct errors and fraudulent amounts. Further, the auditors can locate and seek a correction of possible journal entry errors of the innocent accounting clerk. Errors are classified as unintentional recording of accounting-related business transactions (Johnstone et al., 2012). As human beings, some accounting personnel and management officers commit errors. Consequently, the auditors examine the financial transactions to dig out the errors. Next, the auditors recommend the recording of responsive adjusting entries that will correct the mistake-tainted reports. The Enron 1997 financial statements do not show any unintentionally wrong journal entries. Every 3 years, the company must replace its external auditors to eliminate collusion (connivance) between Enron officers and the external auditing staff. Without a doubt, Solution B reduces fraud. Counterargument The issue that fraud cannot be prevented is false. By implementing the above prescribed internal controls. Fraud is presented. With two or more persons checking the validity, accuracy, and timeliness of the journal entries, fraud is reduced to allowable insignificant levels. Strict implementation of effective and efficient auditing procedures eliminates fraud complete (Messier et al, 2011). Enron Accounting Scandal One of the most infamous accounting scandals shows how fraud is committed by corporations. Enron violated some provisions of the United States generally accepted accounting standards or principles require companies should present its liabilities in the financial reports. The financial reports include the balance sheet and the income statement. The balance sheet includes the liabilities section. The section lists down all the company’s debts. In the infamous Enron case, Sherron Watkins, Enron Vice President insisted that Enron Chief Executive Officer Ken Lay investigate some of the fraudulent accounting activities of its officers (Franzese, 2009). Next, Jeff Skilling was Enron’s Chief Operations Officer. Skilling was convicted for contributing to the fraudulent preparation of the financial reports. Skilling was found guilty of the charge of conniving with the external auditors and other Enron management officers. The officers and Skilling violated the established generally accepted accounting standards or principles by hiding their liabilities. Skilling failure to cooperate with the authorities to correct the financial reports, in compliance with established generally accepted accounting standards or principles, led to his meted a 24 year jail sentence (Franzese, 2009). WorldCom Accounting Scandal Another good accounting scandal example that literally rocked the United States is the WorldCom scandal. The federal government convicted its management officers for violating the United States generally accepted accounting standards or principles. Upon investigation, courts found the officers connived and conspired to present falsified (fraudulent) financial reports. The indicted WorldCom management officers included Scott Sullivan, Betty Vinson, Troy Normand, David Myers, and Bufford Yates. Mr. Sullivan, Mr. Yates, Ms. Vinson, and Mr. Normand gave guilty pleas during the court hearings (Jennings, 2014). Further, the WorldCom Scandal is a premeditated or intentional criminal act. When asked why Ms. Vinson entered fraudulent journal entries that violated established United States generally accepted accounting standards or principles, Ms. Vinson replied that she was forced to connive and obey the management officers’ instructions because she needed the money to feed the mouths of her hungry children. Ms. Vinson affirmed that management officer Sullivan persuasively forced Ms. Vinson to connive or resign. Ms. Vinson preferred to connive in order to feed her hungry family. The investigation in the WorldCom scandal showed very glaring violations of the United States generally accepted accounting standards or principles. The most glaring violation was WorldCom’s overstating its cash flows by as much as an estimated $ 4 billion during 2001 alone (Jennings, 2014). Effect on IRS The fraudulent financial reports significantly affect the Internal Revenue Service reports (Mittal, 2010). By overstating the revenues, as in the case of both WorldCom and Enron, the fraudulent companies are required to pay higher income taxes. A fraudulent increase in the revenues of both Enron and WorldCom resulted to the payment of higher IRS tax payments. As in the case of WorldCom, an understatement of expenses will increase net profits. Consequently, the higher WorldCom net profits require the payment of higher income taxes. By hiding the liabilities as off balance sheet accounts, the Enron Company overstates its revenues. Consequently, the Enron Company must pay higher taxes. 2002 Sarbanes and Oxley Law The Sarbanes and Oxley Law cropped up to as a consequence of the several fraudulent business transactions committed by many companies (Stein, 2012). One of the fraudulent companies is Enron. Another company is WorldCom. The law helps significantly reduce the preparation and presentation of fraudulent financial reports. The law places strict financial report requirements on certain companies. The law targets all companies listed in the stock exchanges. The law brings back to the trust and confidence of the general public, current and future stock market investors on the viability of placing their hard earned cash and other assets in some of the companies listed in the stock exchanges. Further, the United States Congress approved the 2002 Sarbanes & Oxley Law. The law was the brainchild of two United States senators, Senator P. Sarbanes as well as Senator M. Oxley. The law creates an oversight committee. The committee is called Public Accounting O. Board. The committee focuses on ensuring all companies listed in the stock exchanges will comply established United States generally accepted accounting standards or principles (Stein, 2012). As expected, the committee ensures compliance with accounting standards. The committee conducts investigations into companies’ compliance with prescribed generally accepted accounting standards or principles. The committee sets up stringent accounting reporting standards. Likewise, the same committee compulsorily requires all companies listed in the stock exchanges to comply with established ethics provisions and accounting report preparation and presentation rules. The same committee has the authority to penalize external auditing firms caught conniving and conspiring with companies who insist on the preparation of fraudulent balance sheet and income statement amount (Stein, 2012). Cost Accounting Further, costing accounting principles require the expenses of World com and Enron should be recorded at the amount paid. This is classified as the historical cost method (Kinney, 2012). Consequently, it is correct to record the operating expenses at $ 4 billion, the amount paid. It is the amount that WorldCom pays for the actual maintenance and repair of the company’s deteriorating property, plant, equipment, and other asset accounts Recording the expenses at other amounts, fluctuating market values, violates United States generally accepted accounting standards or principles (Vanderbeck, 2012). International Accounting Fraud To prevent international accounting fraud, companies are required to comply with the provisions of the international financial reporting standards or IFRS (Kirk, 2009). The International A. Standards Board crafts and requires compulsory implementation of the IFRS provisions. The standards include the international accounting standards. International Accounting Standard (IAS) no. 1 focuses on the correct presentation of financial statements. IAS no. 2 focuses on the correct way to record inventories in the financial reports. IAS no. 7 focuses on the proper way to report cash flow statement amounts. Further, there are many similarities between the United Kingdom –based IFRS accounting standards and the United States –based generally accepted accounting standards or principles (Bragg, 2010). Both accounting standards focus on the preparation of acceptable fraud-absent and error free financial reports. The non-compliance with either the provisions of the International Accounting Standards or the United States generally accepted accounting standards or principles creates an impression that the financial reports are filled with errors and/or fraudulent amounts. Conclusion Based on the above analysis, accounting fraud involves evading compliance with established societal accounting standards. Fraud is an intentional violation of established accounting principles. Fraudulent transactions are meant to victimize the readers of the financial reports, especially the current and future stakeholders. Enron and WorldCom violated the provisions of United States generally accepted accounting standards or principles. Consequently, the two companies were convicted for fraud and forced into bankruptcy. The financial reports must comply with accounting standards or principles. Failure to comply may lead to fraud charges. Evidently, the premeditated non-implementation of prescribed accounting standards or principles equates to accounting-related fraud. References Bloomberg, (2002, July 7). How to Hide $ 3.8 Billion in Expenses. Retrieved 4 December, 2014 Bragg, S. (2010). IFRS Made Easy. New York: J. Wiley & Sons. Franzese, R. (2009). The Sociology of Deviance. Albany: C Thomas Press. Jennings, M. (2014). Business Ethics. New York: Cengage Learning. Johnstone et al., (2012). Auditing. New York: Cengage Learning. Kinney, M. (2012). Cost Accounting. New York: Cengage Learning. Kirk, R. (2009). IFRS: A Quick Reference Guide. New York: Elsevier Press. Messier et al. (2011). Auditing & Assurance Services. New York: Cengage Learning. Mittal, R. (2010). Management Accounting and Financial Accounting. New York: F K Press. Niskanen, W. (2007).After Enron: Lessons for Public Policy. New York: Rowman & Littlefield. Singleton, T. (2010). Fraud Auditing and Forensic Accounting. New York: J. Wiley & Sons. Stein, D. (2012). The Sarbanes Oxley Act. New York: Grin Press. Vanderbeck, E. (2012). Principles of Cost Accounting. New York: Cengage Learning. Read More