Impact of Ethics and Judgement on the Financial Position and Performance of a Firm - Essay Example

Accounting Ethics and Judgment Name: Course Professor’s name University name City, State Date of submission Table of Contents Executive Summary 3 1.Role of Ethics and Judgment in the Production of Financial Statements 3 2.Impact of Ethics and Judgement on the Financial Position and Performance of a Firm 6 3.Conclusion 7 References 8 Executive Summary Corporate failures have become the bane of ethics, corporate governance and auditor independence. With the collapse of Enron Corp. in 2001 that was followed by the collapse of its external auditors, Arthur Andersen, in 2002 these two topics have received increased scrutiny from regulators and the public alike. It was with these topics in mind that the Sarbanes-Oxley Act was passed in 2003 with other countries adopting various it in various forms [Sun14]. However, the passing of strict laws did not prevent the global economic crisis of 2007-2009 from occurring. Studies have attributed the crisis to failures in corporate governance mechanisms that did not arrest some dubious business practices [Gra09]. More to this, accounting and auditing standards have been proved to be insufficient in some cases[Gra09]. This is because the accounting and disclosure of information forms a basic tenet of corporate governance[Mun14]. Therefore, the aim of this paper is to explore the role ethics and judgment in the production of financial statements. Moreover, the role played by ethics and judgment in producing and auditing financial statements on firm performance will be investigated. These aims will be accomplished through the use of case studies as examples. 1. Role of Ethics and Judgment in the Production of Financial Statements Reading through accounting standards such as IAS 8 (Accounting Policies, Changes in Accounting Estimates and Errors), one gets the impression that there is a lot of judgement to be done by an accountant and auditor when it comes to producing financial statements. This is the case because one accounting standards is meant to cover as many industries as possible, and it would be difficult if not impossible to tailor specific guidelines for each industry. It is often left to an accountant to determine what applies to the company and what is to be left out. This has become more pronounced as the world moves towards the adoption of the IFRS that have been said to be based on principles [The08]. The adoption of principles-based accounting standards has placed emphasis on the use of the accountant’s moral obligation towards what is right depending on societal expectations. Generally known as ethics, this calls for the accountant to acquire moral knowledge and skills and apply the same in solving daily problems and dilemmas[Sam11]. While the discussion of the philosophies behind ethics is beyond the reach of this paper, it is important to note that the underlying principle is that the accountant is expected to honour the fiduciary trust placed on him by clients and employers. The application of ethics by accountant is meant to assure the client or employer that the financial statements that will be produced are free of any material error. Moreover, the application of ethics in the preparation of financial statements is meant to assure the client and employer that the accounting information will not be manipulated to reflect the personal desires of a few powerful people within the organization. For an accountant to prepare financial statements that reflect the true and fair view of the company, he has to appear and be independent. This means that he must maintain a level of distance between himself and the client or employer so as to ensure that a more than friendly relationship does hamper his judgement of issues at hand. As exemplified in the cases of HIH and Adelphia, auditor independence is questioned after the failure of the companies [Peu07]. By providing both audit and non-audit services to the same client, a public accountant risks his independence. This is because questions are raised on how independent an accountant can be when he is auditing work done by himself, however indirect[Peu07]. The best case scenario is for an accountant to provide one line of service and leave the rest if it harms his independence with the client. While the provision of non-audit services the client is one way of waning an accountant’s independence, the provision of personal accounting services to officials of the company is equally if not more disastrous. As noted in the case of HIH, Arthur Andersen engaged in the provision of these services to some executives in the client company. The accountants dully received fees for the provision of these fees and it was not far from the truth that their ethical standing was doubtful. It is difficult to imagine that an accountant, whose duty of care is owed to the shareholders, can maintain his independence while having an eye on the fees provided by the company’s management. Owing dual duties of care to members of the company’s management and shareholders places the accountant in a demanding ethical position that is difficult to manage as was proved in the case of HIH [Peu07]. The provision of dual services to the management of HIH and the company’s shareholders was also a breach of a fiduciary duty. A fiduciary duty is defined as a “legal duty to act solely in the interests of another party.”[Cor14]. Profiting from the relationship between the accountant and HIH’s shareholder required express consent that was not given according to the facts in the case [Peu07]. The casual breach in fiduciary duties was highly unethical and could have hampered the accountant’s capability to prepare financial statements that were free of material error or misstatement. An ethical accountant is expected to perform his duties to the best of his knowledge and expertise. In the preparation of financial statements, an accountant is expected to apply due diligence so as to satisfy his responsibilities fully to either the client or the employer. Such steps as proper planning and client risk assessment are mandatory to ensure for a number of factors. One, proper planning ensures that the audit of financial statements is well-organized in a way that will be thorough to uncover any material problems and issues. Secondly, assessing clients as either high or low risk ensures that the necessary measures are put in place to reduce the accountant’s exposure to risk. It would be expected that thorough sampling would be done for high-risk clients as there is a higher chance of them trying to conceal material items[Ern131]. In the case of Adelphia, Deloitte classified the client as high risk[Peu07]. The public accountant also had doubts about the truthfulness of management presentations but these doubts were not presented to the audit committee nor disclosed to the investors. This shows that the auditors failed to honour their obligations fully to protect the shareholder’s interests even when they had all the necessary information. The application of judgement in the use of principles-based accounting standards comes as a logical conclusion. It is also stated in a number of standards issued by various standard setters. Sound judgement is often needed in determining the number of key accounting matters. One of these matters is the materiality of an event or item in relation to the business. Materiality is defined by IAS 8 as an item whose omission or misstatement could influence the economic decisions of users of financial statements [Del144]. Therefore, in the case of Adelphia an off balance sheet loan ought to have been disclosed though its nature did not demand so. This is because it still remained to be a debt that would have to be repaid. Secondly, its size was material enough in relation to the entire business to demand some form of disclosure by the auditors. Judgement is also required in determining the accounting policies to adopt and change [Del144]. This is because one of the aims of providing financial statements is to give a transparent representation of the company’s operations. However, this might not be possible owing to the accounting policies in place. Therefore, judging that the financial statements need to be more reliable and relevant, the account should change the accounting policies [Del144]. Moreover, accounting standards demand that the accountant recognizes and discloses that an error was made in the previous period as soon as it is discovered. In disclosure and amendment of the error, the accountant has to judge the error based on the level of materiality[Del144]. In the case of HIH, the accountants failed to disclose and amend a material error that left liabilities understated to the tune of $18 million and under reserved by $41 million in 1992 [Peu07]. Knowing that these errors were material in the financial statements, the auditors erred in not having them amended and disclosed accordingly. The result was the overvaluation of HIH acquisitions that led to the company’s eventual bankruptcy. An accountant is also expected to express proper judgement when handling related party transactions. Accounting standards require that an accountant should ensure that related party transactions are disclosed even when these transactions are not easy to discover. In the case of Bond, auditors should have uncovered the inter-company loans that helped keep Bond Corp operational even under unfeasible conditions[Peu07]. While the transaction might not have been easy to identify, judgement was required to acknowledge that Bond Corp was highly diversified and that related party transactions were more than likely to occur. 2. Impact of Ethics and Judgement on the Financial Position and Performance of a Firm The application of judgement during the preparation of financial statements has a number of impacts on the company’s financial position and performance. One, judgement on the amount of estimations to be provided for assets and liabilities has the effect of either making the company seems too large or too small than is the case. For example, HIH understated liabilities and under-reserved for future claims [Peu07]. The impact on the company financial position was the appearance of a firm that was doing exceedingly well as it reduced the amount of liabilities. However, on the long run, HIH was faced with liquidity problems as claims became due, and there were little reserves to back them up[Peu07]. Judgement in the area of depreciation and impairment has dual effects. One, depreciation is an expense item. Therefore, an increase or decrease in the amount provided for depreciation has a direct impact on the amount of profits made by the firm. This affects the firm’s financial position as it can either erode profitability with an increase in the provision or bolster income by a reduction in provision. IAS 8 allows the firm to alter its accounting policies, such as depreciation rates if such a move has a positive effect on the information contained in the financial statements [Del144]. A change in deprecation rates is often necessitated by changes in the expected economic value of an asset and judgement is necessary for determining the appropriate rate. Such changes have a direct impact on the company balance sheet too as they can either diminish or increase the value of assets held by a company. Revaluations have been the subject of many acquisitions that went awry as the targets tend to inflate the value of their assets so as to demand a better take over price. Since this revaluation is not supported by an increase in economic activity, the acquiring firm has to write down the target’s assets soon after it has made the deal. For instance, HIH had a history of paying heavily for targets that added little or no value to the parent company. However, the acquisition of FIA went south faster than before, and HIH had to write off $400 million from the target’s assets[Peu07]. Where a company is found to be ethical and of sound judgement in financial reporting, it is likely to dodge corporate failure. This is outlined by the fact that the practice of ethical behaviour sis not only an individual effort but one that is cultural and collective. For instance, the fraudulent behaviour of the Rigas family was a culture stemmed into the Adelphia genetics; lying was so commonplace that the family members did not know when they were telling the truth about the company’s financial position [Peu07]. Moreover, the practice of ethical behaviour means that accounting fraud is avoided and reported early and action taken to correct the trend. Thereby, the company continues as a going concern and performance either boosted or maintained, all other factors held constant. In the cases of Bond, Adelphia and HIH it can be taken that they would be operational today if they took steps to institute proper ethical behaviour among all employees and officers in all ranks. The companies engaged in fraud and poor governance for too long until it was too late to turn back. 3. Conclusion Ethics and judgement play an important role in the preparation of financial statements. As accountants continue adopting principles-based accounting standards, the value of ethics in the preparation of financial reports has become even more important. This is because the new accounting standards require that the accountant makes the right judgements when preparing reports. Of crucial importance is the ethical requirement that the accountant must be independent of the client or employer when working towards preparing financial reports. He must not only appear to be independent, but he must be independent. The implication is that financial statements must be the representation of independence on the auditor’s part. There must not be bias that hinders one party from knowing company’s on goings. One of the areas where an accountant is expected to express judgement is the provision losses and liabilities. Moreover, an accountant should express sound judgement in determining whether certain transactions are material or not for disclosure. Other areas include the determination of whether a party is a related party and how to disclose these transactions. The practice of judgement can alter the assets amount as recorded in financial statements. This is through a change in depreciation policies that also alter the company’s profitability. Poor judgement in the valuation of a target can lead to overvaluations with the result being the writing off of asset value after the merger or acquisition is done. One impact of having an ethical and sound judgment culture within a company is that fraud and errors are detected and amended early. In the cases of HIH, Adelphia and Bond Corp, it is evident that fraud and gross governance problems were at the core of their collapse[Peu07]. While fraud boosts short-term performance, it erodes the company’s ability to compete under strenuous economic conditions as evidenced by various case studies [Peu07]. References Sun14: , (Sun, et al., 2014, p. 455), Gra09: , (Kirkpatrick, 2009, p. 6), Gra09: , (Kirkpatrick, 2009, p. 9), Mun14: , (Muneeza & Hassan, 2014, p. 125), The08: , (The American Institute of Certified Public Accountants, 2008), Sam11: , (Senaratne, 2011), Peu07: , (Peursem, et al., 2007, p. 20), Peu07: , (Peursem, et al., 2007, p. 20), Peu07: , (Peursem, et al., 2007), Cor14: , (Cornell University Law School, 2014), Ern131: , (Ernst & Young, 2013, p. 7), Peu07: , (Peursem, et al., 2007, p. 9), Del144: , (Deloitte Global Services Limited, 2014), Del144: , (Deloitte Global Services Limited, 2014), Peu07: , (Peursem, et al., 2007, p. 29), Peu07: , (Peursem, et al., 2007, p. 16), Peu07: , (Peursem, et al., 2007), Peu07: , (Peursem, et al., 2007, p. 17), Peu07: , (Peursem, et al., 2007, p. 10), Read More