Adelphia - Ethics and Professional Judgment in Financial Accounting - Case Study Example

ETHICS & PROFESSIONAL JUDGMENT IN FINANCIAL ACCOUNTING By Student’s Name Code + Course Name Professor’s Name University Cite, State Date Table of Contents Executive Summary……..………………………………………………………………3 A. Introduction...…………………………………………………………………….4 B. Importance of Ethics and Judgement in Financial Reporting...............................4 C. Key Areas of Judgement in Financial Reporting..................................................4 Adelphia Case Study.............................................................................................6 HIH Insurance........................................................................................................7 Alan Bond..............................................................................................................8 D. Potential Loss When Ethics & Judgement Is Ignored............................................8 E. Conclusion.............................................................................................................8 References List..................................................................................................................10 Executive Summary The adoption of ethics and professional judgment in financial reporting is deemed an imperative. In fact, Professional judgment and ethics is a fundamental skill for the preparers, auditors as well as the immediate regulators of company’s financial statements especially in the case of principle-based accounting reporting frameworks. Through such case studies as Adelphia, Alan Bond and HIH Insurance, it can be seen that the different users of financial statements should at all time employ ethics and positive judgment in order to present valid and useful information. Accounting scandals like HIH Insurance, Adelphia and Alan Bond that have resulted to negative public image, inhospitable coexistence with surrounding communities as well as huge penalties and operations closure. All of these areas of judgement should adhere to relevant standards and practices in future preparation and assessment of financial reports in order to avoid unnecessary conflicts of interests A. Introduction Professional judgment and ethics is a fundamental skill for the preparers, auditors as well as the immediate regulators of company’s financial statements especially in the case of principle-based accounting reporting frameworks (Enderle, 2004). It is important to understand that the process of making effective and efficient decisions is one challenging task given the fact that there is always more than a single solution to each reporting issue. Being able to make effective and efficient decisions and in a timely manner, proves to be a cornerstone of executing accounting duties professionally (Dunfee, 2002). A professional judgment and ethics framework is a fairly-presented process that preparers and auditors, with distinctive level of knowledge and experiences as well as goals, can structure opinions on most of accounting concepts and practices alike in relation to underlying relevant and reliable facts that have been provided by applicable accounting standards (Enderle, 2004). Effective and valid financial reporting requires reliable judgments and ethics being made while the different interest groups involved in the reporting process can be protected from imminent regulatory issues due to the benefit of hindsight (Sparks & Pan, 2010). The objective of this report is to formulate a discussion directed towards analysing the importance of ethics and judgment in financial reporting while highlighting the fundamental areas of judgment and any possible losses that might emanate from ignoring the aspect altogether. B. Importance of Ethics and Judgement in Financial Reporting The immediate validity and usefulness of an efficient financial reporting framework depends greatly on ethics and professional judgments in the course of preparation as well as presentation of the public at large. Prior to Enron and Andersen reporting scandals, there was little or no public attention given to the truthfulness of a firm’s financial reporting standard and framework (Hardin, 2002). There was little concern for establishing whether public-owned companies would engage in misrepresentation of their respective financial activities since much trust and confidence was put towards auditors’ ability to sufficiently and accurately depict firm’s yearly-financial statements. However, recently, this level of confidence seems to have been significantly shaken given that serious doubts and even cynicism appear to have taken long strides in reporting frameworks (Hardin, 2002). Following this line of argument, it can be noted that there was now a need for a professional judgment and ethics framework to restore the dignity, trust and confidence levels of the different groups involved in preparation and presentation of financial reports. For instance, the launching of the framework ensured that regulators and other substantial users of the financial reports could now trust the preparers as well as the auditors , who in turn, are expected to promote the element of professionalism at all times (Dobson,1997). It is argued that professional judgement and ethics plays a critical role in emphasising the aspect of quality as well as integrity of the judgments executed and thus, also ensure there is enough level of trust in the operation of principle-based accounting standards and practices (Shen, Wang, & Xue, 2004). Under IAS-8, the standard dictates that whenever making judgments the goal should rest with the fact that the resultant information is relevant and reliable at all times. It is important that the different interested parties to financial statements like auditors and preparers practice ethics at all times whenever executing necessary judgments and ensure that they cannot be compromised under any undue pressure or conflicts of interest (Shen, Wang, & Xue, 2004). They are required to engage different ethical standards and guidance structures whenever necessary in order to assure of effective operations of principle-based financial reporting. C. Key Areas of Judgement in Financial Reporting The first line of judgement in financial reporting lies in the auditors tasked with forming an opinion of the already prepared financial statements. These auditors are by the International Standards of Auditing required to engage professional scepticism in the period of conducting audits as well as in the course of evaluating a client’s immediate level of judgements (ICAS, 2012). The ISAs portray professional scepticism as being a certain level of auditors’ attitude, which incorporates constant questioning, being extremely alert to situations that might translate to imminent misstatement due to aspects of error and fraud as well as fundamental assessment skill in audit evidence. In essence, this requirement calls for high-quality audit and is significantly related to the aspect of ethics and professional judgment (ICAS, 2012). The second line of judgement involves the regulators of financial reporting framework. It is argued that professional judgment helps the regulators to comprehend the rationale behind the making of fundamental judgments by the providers of the financial reports so that they can assess whether or not these decisions were indeed appropriate and necessary at the time of their application (ICAS, 2012). Notwithstanding, it should be understood that even in the case that there is certainty of the framework having been adhered by both the preparers and the auditors, still, regulators have the responsibility to determine whether it was appropriately applied. The reporting framework is purposed to assist with the entire judgement process as a way of ensuring that there is necessary documentation for justification of that judgment. It is established that the judgements employed for any given scenario might fall under a given degree of possible end results (ICAS, 2012). Given the level of subjectivity involved in executing a judgement, the framework cannot be relied upon to oversee and protect against judgments that fall outside of a degree of acceptable end results or rather depicted as being incorrect at all. The third line of judgement area rests with the preparers of the financial reporting. The management of a company should ensure that they engage in financial reporting that is trustworthy and effectively transparent (ICAS, 2012). These providers have a moral and legal duty to ensure transparency and this, can be attained through adopting professional judgment. The preparers should ensure that the financial reporting standards put in place are conducive to execute the responsibility. For instance, they are expected to prevent any possible conflicts of interests that might arise from auditing and other extensive non-auditing functions. It can also be seen in conflicts that arise between investment research and investment banking as well De (George, 1993). Notably, these preparers should be able to make effective judgmental decisions that set out to deal with impeding enormous amounts of information asymmetries that risk activities of the overall individual company and the sector as a whole. Adelphia Case Study Adelphia is a perfect example of a case that saw the auditors fail to provide critical judgment and form an opinion towards elements of fraud happened in Adelphia. The discovery of fraud happened in Adelphia in early 2002 when Tim Rigas, the CFO, indicated that the firm had already consigned at least $2.3 billion of loans that had been drawn by numerous partnerships operated by the extended Rigas family members (Peursem et al 2007). The firm was expected to jointly claim liability to pay back the loan but had instead chosen to omit this fundamental revelation in its immediate accounting books (Kaidonis, 2008). SEC investigations into the matter indicated three-levels of fraudulent activities; first, there were significant efforts made to conceal the level of debt into the unconsolidated financial books of the subsidiaries of the company. This was achieved by way of reducing the debt-level of the company while increasing that of its subsidiaries with a similar amount of money balance, which gave potential and existing investors to the company that the firm was engaged in a rigorous leveraging as well as paying-off debts. Subsequently, it misrepresented the stakeholder group through public statements and reports that deceptive transactions and fake documents to indicate that the debts had already been paid (Peursem et al 2007). The second form of fraud involves the fact that the firm engaged in an intentional spree of misrepresenting its overall financial performance in order to meet the expectations of the analysts as well as duping potential investors to buying into their fictitious level of growth (Kaidonis, 2008). Thirdly, the firm engaged in a large number of fraudulent misrepresentations and omissions of material fact conducted to cover-up for self-dealing by the entire Rigas family that included acquisition of $1.3 billion of company stock and notes directly from Adelphia’s capital funds through imminent manipulation of their cash management system at the time (Peursem et al 2007). In all this undertakings, the company had contracted Deloitte to be its foremost external auditor. The auditing firm was charged by SEC for professional negligence, breach of contracts as well as fraud and imminent failure to discover massive levels of fraudulent activities at the firm in the period between 1999 and 2000 (Peursem et al 2007). It later paid a total of $50 million to settle charges with two of its senior auditors being charged for improper professional conduct especially because they failed in their duties to give unqualified opinion on the company’s annual report for the financial year that ended in December of 2000 (Kaidonis, 2008). From this case, it can be seen that the auditors are expected to practice professional judgment and ensure to refer to ethical standards at all times in carrying out their respective audit procedures that can help to avail reasonable and reliable assurance of discovering improper omissions in the different types of balance sheet. HIH Insurance The company was one of Australia’s largest general insurers that were later put under provisional liquidation due to huge sums of debt that estimated between $3.6 billion. The scandal involved a failed corporate governance structure, poor regulation and auditing workmanship as well as poor levels of decision-making skills by the sitting management team (Peursem et al 2007). Some of the notable early indications of the scandal could be seen in significant reduction of profit margins, downgraded credit degree as well as an enormous share price fall. The Royal Commission investigations into the matter revealed that there was a failure in both the business and auditing practices like over-pricing of corporate acquisitions as well as corporate extravagance (Kaidonis, 2008). Corporate extravagance of operations resulted from the fact that the firm’s management team failed to conduct business in accordance with the minimum solvency requirements that was set out by the prudential regulators like the APRA and the Insurance Act 1973 (Li, 2010).Ernst & Young also contributed to the collapse of the company by failing to identify most of the pertinent issues like overlooking the treatment of reserves that later resulted to disruptions in the level of asset-base within the balance sheet (Peursem, Zhou, Flood, & Buttimore, 2007). Alan Bond The scandal happened in the 1980s when there was a high level of unsustainable spending that later compelled banks to write-off debts amounting to A$28 billion in the period between 1989 and 1993 (Kaidonis, 2008). The scandal was largely attributed to Bond’s high appetite for international level of spending with borrowed amounts of money. Most of the company’s projects were funded through debt, which helped to increase the level of growth but put operations under immense risk. For instance, Bond engaged back-to-back form of loans, which he used to try and resolve the liquidity crisis by acquiring large portions in Bell Group and later using its asset-base to fund another subsidiary: Markland House (Kaidonis, 2008). D. Potential Loss When Ethics & Judgement Is Ignored There are numerous losses that companies face whenever they choose to overlook the aspect of ethics and judgment. For instance, there is a risk of collapse of a company and thus, immediate closure of its overall operations as can be seen in the case of Enron, which filed for bankruptcy before winding up operations altogether by a directive of SEC (He Xuefei, 2008). There is also a risk of auditors being required to pay huge sums of money as compensation while others are closed like in the case of Arthur Andersen (Nelson, Price & Rountree, 2008). Companies are also exposed to negative public image and diminished coexistence with surrounding communities, which is indeed useful for successful operations (He Xuefei, 2008). E. Conclusion To sum up the discussion, it can be said that professional judgment and ethics is a fundamental concept that should be adopted by the preparers, regulators as well as the auditors in order to come up with useful and valid financial reports. There have been recent accounting scandals like HIH Insurance, Adelphia and Alan Bond that have resulted to negative public image, inhospitable coexistence with surrounding communities as well as huge penalties and operations closure. All of these areas of judgement should adhere to relevant standards and practices in future preparation and assessment of financial reports in order to avoid unnecessary conflicts of interests. References List Dunfee, T 2002, An ethical framework for auditor independence. Paper presented at the Transatlantic Business Ethics Conference on September 27–29, 2002 at Georgetown University, Washington, DC. De George, R. T1993, Competing with integrity in international business. New York: Oxford University Press. Dobson, J 1997, 'Ethics in Finance II', Financial Analysts Journal, vol. 53, no. 1, pp. 15-25. Enderle, G 2004, Global competition and corporate responsibilities of small and medium-sized enterprises. Business Ethics—A European Review, vol.13, no. 51–63. He Xuefei. 2008, The Responsibility of False Accounting and Governance. Journal of Central South University of Forestry & Technology (Social Sciences),vol.2, no4, pp. 69-72. Hardin, R 2002, Trust and trustworthiness. New York: Russell Sage Foundation. ICAS 2012, A professional judgment framework for financial reporting: An international guide for preparers, auditors, regulators and standard setters.pp.1-17. Retrieved from https://www.icas.com/__data/assets/pdf_file/0013/2605/Professional-Judgement-Framework-Report-ICAS.pdf Kaidonis MA, 2008. The accounting profession: Serving the public interest or capital interest? Australian Accounting Business & Finance Journal, vol.2, no.4, pp.1-5. Li, Y 2010, The case analysis of the scandal of Enron. International Journal of Business & Management, vol.5 no. 10, pp.37-41. Nelson KK, Price RA, & Rountree BR 2008, The market reaction to Arthur Andersen's role in the Enron scandal: Loss of reputation or confounding effects? Journal of Accounting & Economics, vol.46, no.2/3, pp. 279-293 Peursem, KV, Zhou, M, Flood, T & Buttimore, J.2007, Three cases of corporate fraud: An audit perspective, The University of Waikato-Working Paper Series. Shen Z, Wang J & Xue S 2004, Orientation Conflict of Accounting Standards Setting. Journal of Finance and Economics, vol.30, no.6, pp. 77-85. Sparks, J, & Pan, Y 2010, 'Ethical Judgments in Business Ethics Research: Definition, and Research Agenda', Journal of Business Ethics, vol. 91, no. 3, pp. 405-418 Read More