Critically evaluate the role of the accountancy profession in recent corporate scandals such as Enron, Xerox and WorldCom
It is expected that the accountancy profession would play quite an important role in scandals such as Enron, Xerox, and Worldcom, as all they all deal with the financial accounts not showing a true and fair view the company. Hence it is the role of accountants to prepare and check the financial statements.
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Therefore I feel that in the essay it is worth analyzing who exactly in the accountancy profession was responsible for each action in scandals, and show how ‘accountants move easily from watchdogs in their capacity as auditors to being the architects of clever deals and frauds as CFO’s and CEO’s.’ (lies damn lies)
In the Statement of Auditing Standards 100, published in March 1995, we are told that ‘the responsibility for the preparation of the financial statements is that of the directors of the entity’. Therefore the auditor is only responsible to act as a watchdog and make sure that the directors’ of the company have prepared the statements in accordance with Auditing and Accounting Standards.
Authur Andersen LLP (Enron’s auditors) were therefore responsible for providing shareholders with ‘reasonable assurance’ that the financial statements presented a true and fair view of the company’s financial position. Consequently one could argue that because they failed to do this that they were entirely responsible, as far as the public is concerned, in Enron’s scandal. The fact that thousands of pages of documents were shredded proves on itself that Andersen was guilty of fraud, as this is a violation of the law and Justice Department.
In response to these accusations, Andersen stated that their only role in this scandal was to ‘express an opinion on the financial statements prepared by the company,’ (accountancy age) and therefore will hold themselves responsible for any errors in the auditing.
In addition to this, it has been ‘publicly acknowledged that there was one error of judgment in the treatment of one partnership’ (Accountancy Age). Though in another partnership matter, they have defended their case in saying that they were not provided with the necessary information by Enron. According to SAS 600 it was Andersen’s role to qualify the financial statement, and thus disclaim it if the effect of this limitation of scope was pervasive enough to make the statements as misleading as they were.
However, the situation was much more complex than this, as it was Enron who prepared the financial statements in the first place. It is believed that the financial statements were prepared in such a way that they would show a profit, and failed to report billions of dollars in debt. This was done to make its stock attractive to unsuspecting investors.
As accountants Andersen had an obligation to be neutral in examining the company’s financial statements and making sure that all financial transactions were duly reported. Therefore we should question Andersen’s motive to accept such manipulated accounts. The reason has been simple, they were paid $52 million last year, hence not only were they been paid for auditing work and consulting services but their role was also ‘to make Enron profits and stock prices appear much more attractive than they really were’ and therefore become an accomplice in Enron’s fraudulent projects.’ (Enron was a corporate icon)
An interesting aspect of Enron’s account was that Andersen was paid more for consulting than for the actual auditing. This on itself is suspicious, as it can be suggested that the money that was been used to bribe them, was appearing as consulting fees in Enron’s accounts.
Therefore Andersen found themselves in this agreement with Enron. Enron ‘evolved from being a company with rather dull set of physical assets in a regulated market into a financially sophisticated risk management company that shaped its own trading environment.'(SEP) This was achieved by investing in a large number of risky projects and so the problem arose when its investments and new markets were not proving to be as successful as they thought they would be. Therefore Enron found itself in a precarious situation where they found themselves dependent on their continuing management credibility and creditworthiness. As a result, they ended up resorting to the manipulation of financial statements.
The first major fraud was ‘Enron’s executive’s apparent use of Special-Purpose Entities (SPEs) to deceive shareholders and to enrich themselves.’ (Accounting issues at Enron)
In other words, Enron was applying for the loan through the SPEs meaning that these debts would not appear on their financial statements. Not only this but investors were willing to accept a lower interest rate because to them it appeared that the repayment of their loan was a sure thing since the SPE would have no other debt.
Consequently, Enron found itself in a situation where they needed to increase the number of SPEs to keep moving debt off the balance sheet and so began using its own stock as collateral. This resulted in the SPEs recording ‘an increase in Enron’s stock as income, which would thereby allow Enron to increase income by utilizing the equity method of accounting’ (Accounting Issues at Enron). $30 million in profits on investments in Enron SPEs transactions was the result of this fraud. (Partners to the end?)
Profits generated from the SPEs were been used in order to structure off-balance sheet treatment of assets and liabilities, meaning that Enron was able to carry such transactions because of the fact that the accounting standards had not kept pace with new techniques in off-balance-sheet financing. This meant that off-balance sheet items were been used to keep liabilities off its books.
All this was possible because Enron managed its SPEs by making sure that at least one SPE investor had put up at least 3% of the SPE’s equity. According to the US GAAP, this meant that the company could contribute the rest and still qualify for off-balance sheet treatment. In the 1990s Enron began to take many of its assets and liabilities off its reported balance sheet because they continued using off-balance-sheet vehicles to access capital and to reduce risk. As long as they followed various accounting rules in would not have to reveal many details about these financings.
Enron also resorted to cut-off fraud; this basically consisted of recording revenues early and/or recording expenses and liabilities late. ‘According to GAAP, revenue is recognized when the earnings process is complete and the rights of the owners have passed from seller to buyer’ (timing is of the essence). However, the exact techniques used by Enron are unknown, but there are three main ways of illegally recognizing revenue. The method most commonly used was to hold the open books past the end of the accounting period to accumulate more sales, this meant that companies were holding the open books until they reached their target sales, which they might have promised to shareholders.
Recording revenue when services are still due and shipping merchandise to private warehouses for storage before the sale is final, and counting the shipments as sales, were two other types of cut-off fraud. ‘Under SAB 1010 issued 1999, the SEC established four main criteria for proper revenue recognition: evidence than an arrangement between a buyer and a seller exists, delivery of a product or rendering of a service, a set or determinable price, and an insurance that payment can be collected.’ (Revenue Recognition)
WorldCom, the nation’s second-largest long-distance phone company was also found guilty of accounting fraud. The basis of this fraud was very similar to that of Enron in that it used window-dressing to inflate profit. However, WorldCom’s major sham was that they disguised $3.8 billion in expenses over 15 months. This was carried out in the strategy operated by their Chief Financial Officer, in which operating costs like basic network maintenance and line-costs were booked as capital investments.
Unlike Enron’s scam, the theory behind WorldCom’s scandal is much simpler – treating operating costs as capital expenditure meant that the costs could be depreciated in pieces over time. Hence this meant that expenses incurred in the year would not have such a great impact on its cash flow, but instead push expenses were been pushed into the future. The problem, therefore, arose because all this was doing was delaying payments in the financial statements, but after all the costs were going to be incurred.
Hence the company would have to hope that more revenue was going to be received over the next years and so WorldCom’s CFO defended his actions by stating that ‘because WorldCom wasn’t receiving revenue, he could defer the costs of leasing the lines until they produced revenue.’ His mistake was that he was doing this in the anticipation that the agreements would start producing revenue later, but he ended up discovering that 15% of these connection agreements were not producing revenue.
Surprisingly WorldCom’s auditors were also Arthur Andersen LLP, who say that they were never consulted or notified about the line-cost capitalization. However an accounting professor at Columbia Business School in New York went against them in saying that ‘auditors are supposed to look at material expenditures and make sure they are reported properly, this is accounting 101.’ (WorldCom Accounting debacle)
Nevertheless, WorldCom was forced to replace Andersen, who were been described as ‘the scandal-plagued Arthur Andersen’, with KPMG. Ironically KPMG is currently been sued in respect to the Xerox scandal mentioned below. Through its involvement in the WorldCom scandal is doubted because of its late involvement with this case.
Photocopy giant Xerox was found guilty of fraud by The Securities and Exchange Commission (SEC) for misstating four years worth of profits, resulting in an overstatement of $3 billion. Xerox booked the value of leased products at the time that the lease was entered, accounting also for the cost of financing and servicing the equipment during the lease period, based on local market conditions.
In other words, Xerox was altering its accounting to treat more finance and servicing revenue as part of the value of the equipment, allowing Xerox to recognize a greater portion of revenue from leases immediately in its financial statements.
However whether Xerox’s auditors, KPMG LLP, were part of the scandal or not is not as clear as in the Enron case, ‘The SEC sued KPMG LP saying the accounting company let Xerox Corp. manipulate its accounting practices’ (http://www.sltrib.com/2003/Jan/01302003/business/24540.asp).
‘There was no watchdog at Xerox. KPMG’s bark sounded no warning to invests; its bite was toothless the SEC said
Consequently, KPMG defended their accusation by stating
Apart from all the complex and illegal accounting chicanery mentioned, an accountant can find it relatively easy to window-dress a financial statement, perhaps because of some of its weaknesses.
The first one being that the accounting standards allow financial statements can be prepared using different conventions with respect to major balances. This means that two companies with identical transactions can declare different results. However, this is unavoidable because it is due to calculations such as the depreciation of fixed assets, which can be done using the straight-line or the reducing balance method. Another potential source for confusion is in the Accounting Standards, this is because ‘different accounting standards govern financial statements in the major market economies’ (Lies, Damn lies)
The USA uses GAAP while the international community other than the UK applies International Accounting Standards. Therefore the problem is that it would be very unusual for accounts prepared under different rules to generate the same result. The fact that auditors only use a sample of transactions and balances in auditing can affect the fair presentation of the financial statements, as it very possible for significant matters to escape their attention. The public is therefore been led to believe wrongly that accounts signed off by auditors are accurate.
At this stage it can be said that the role of the accounting professional is enormous in these scandals, as The Financial Times of London said ‘accounting goes to the heart of Enron’s failure’ (Financial times of London, lies…) Though confusion still exists on the role of auditors and directors in carrying out these scandals. The reason for this being that the whole truth is unknown, because of actions such as the shredding of documents.
Therefore it could be said that it depends on the judgement of the individual. Though at this point I feel that it would be correct to conclude that everybody was responsible some way or another. An advisor of PricewaterhouseCoopers is therefore correct in saying that ‘it is not the responsibility of auditors or accountants to detect fraud, it is the responsibility of management. So given the problems of Enron and WorldCom, it is important that everyone appreciates that everyone has a role to play. It is a chain that begins with the preparing of accounts to manage, to accountants and auditors’
However, even if auditors are been truthful in claiming not to be aware of the fraud, they are still wrong in giving the public the confidence that the financial statements are accurate. As the USA, SAS no. 53 (AICPA, 1988, para.8) requires auditors to ‘exercise due care in planning, performing and evaluating the results of audit procedures, and the proper degree of professional scepticism to achieve reasonable assurance that material errors or irregularities will be detected.’ (age 41). Though the problem with stating that it should provide ‘reasonable assurance’ is that it does not have a discrete boundary, but instead lies along a continuum. Therefore opinions will differ as to the cut-off point between what is reasonable and unreasonable to expect of auditors.
In conclusion, one could say that no matter whether directors or auditors are responsible, they are all part of the accountancy professions. The accountancy professions has shown itself ‘weak in technical matters, spineless in standing up to CEO’s and eager to sacrifice its integrity for profits.’
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