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Ethical Financial Reporting
Carl Burch, CMA, CIAHock Accountancy Training (www.hocktraining.com)Moscow, Russia+7(495) 645-0080carl.burch@hocktraining.com“
Ethical Financial Reporting
” (or lack of it) is a phase that has certainly gained a lot of attention the past few years, particularly, since the Enron, WorldCom, Adelphia, Parmalat(Italian milk processor) accounting scandals.But what exactly constitutes “
Ethical Financial Reporting? 
” When we talk about “ethical financing reporting” we are referring to the financial reportingof both
private
and
public companies
1
. But, the basis of this article will center on theethical reporting of public companies, not private. We are doing this because it is thefinancial reporting of public companies that is under the scrutiny of the US federalgovernment.All public companies, whether trading on a US exchange (i.e., New York Stock Exchange,NASDAQ, or American Stock Exchange), or on another country’s exchange have to provide,at a minimum, annually audited financial statements to their shareholders, and to thatcountry’s exchange commission (i.e., US, Securities Exchange Commission (SEC); UK,Financial Services Authorities (FSA) and others).Submitted financial statements should:
Adhere to the country’s accounting principle (e.g., US GAAP, or IFRS), and
Clearly, concisely and accurately reflect all transactions that occurred during thefinancial accounting period, including transactions with both owners and non-owners.It’s understandable that management of these large public companies are under enormouspressure to “perform,” to bring favorable returns that meet investors expectations.
How does management meet investor’s expectations? 
Investors’ expectations are met byincreased share prices.
 And, how do you get higher share prices? 
It’s all based on earnings, or expected futureearnings.Unfortunately, because of the pressure to perform, or because of plain corporate greed,management can find ways to manipulate the financial statements. One only needs to scanthrough the business and financial publications to realize that financial statementmanipulations were taking place.In some cases the manipulations were blatantly unethical, or for a better word - fraudulent;in other instances, the report maneuvering is more subtle.Now, we want to talk about what were these companies doing that was considered to beunethical. It has often been sited that the reason for these accounting scandals was becauseof the complexity of the firms’ accounting, including the use of derivatives, special purposeentities, etc., but, in most cases, what was going on was not too difficult to understand,even for a first year accounting student.
1
A public company is one which is traded on a stock exchange, such as on the New York Stock Exchange, or London, etc. Public companies by law have to periodically present financial information to the market.
1
 
Two companies that really epitomized this “
corporate wrongdoing
” are
WorldCom
and
Enron
. Together these companies filed bankruptcy totaling more than $170 billion in assets($107 billion for WorldCom, and $63.4 billion for Enron).Now, let’s take a look at each company’s downfall, starting with WorldCom.
WorldCom
: WorldCom at one time was the second largest telecommunication company inthe US. Today, this company does not even exist.
So, how did WorldCom get from second largest to non-existent? 
There were essentially two reasons for WorldCom’s downfall:
1)
Growing too fast through acquisitions
. In order to become the second largesttelecommunication’s company in the US, the company during the 1990s went onan acquisitions binge. From 1991 to 1997, WorldCom spent $60 billion onacquisitions, and as it acquired companies, the analysts kept recommending thestock; thus, pushing up share prices. As share prices went up, the company usedcompany stock to purchase additional companies. Acquiring companies andmaking sure operations mesh is not easy and takes a great deal of carefulplanning and considerable management attention. Unfortunately, in WorldCom’scase, management was unable to properly integrate the acquired companies intoits own operations, and thus, overall company performance and profitability wasdiminished. This became particularly obvious after its last acquisition, MCI.What happened to WorldCom is not unusual for fast growing companies,particularly, if growth comes through acquisitions. In case of WorldCom, they didnot have the management team in place that could properly integrate theacquisitions into WorldCom operations. Management lacked the competence toproperly plan and manage the acquisitions. This in-of-itself does not constituteunethical behavior, but it indicates the lack of controls, which makes it easier formanagement to manipulate financial numbers.
2)
Capitalizing Operating Expenses
. The most common way to measureperformance is based on earnings. The easiest way to increase earnings is throughthe manipulation of financial reports. WorldCom found an easy to do this bycapitalizing certain operating expenses, such as maintenance costs. Basicaccounting states that maintenance costs have to be expensed in the currentreporting period. WorldCom simply deferred these costs out to future years; thuscausing income to be greater than it should’ve been. A simple exercise inmanipulation. Management at WorldCom did this to the sum of $3.8 billon.
Enron:
Even though the size of the WorldCom bankruptcy was larger than Enron’s, Enronstill garnered more press because it really did represent the worse of corporate greed, or fora better word – self interest. It’s hard to believe that before the scandal broke, Enron wasconsidered to be one of the best companies in America. As a matter of fact, Enron had beenbilled by
Fortune
magazine as “America’s Most Innovative Company” for six straight yearsfrom 1996 to 2001. It’s even harder to believe that Enron was filing for bankruptcy byDecember 2001. This is what is referred to as a spectacular collapse.
So, what was it that Enron did that was considered unethical? 
When Enron finally had to file for bankruptcy, this caused several US governmental agencies(i.e., the Federal Bureau of Investigation (FBI), and Internal Revenue Service (IRS)) to lookfor evidence of fraud. The purpose of the investigations was to determine whethermanagement
intentionally 
manipulated the company’s financial information to concealnegative information about its finances. The important word here is intent. Intent is not amistake. Intent is “
knowing
” something is wrong, but doing it anyway.
2
 
In order to give the impression of increasing earnings, management had to use accountingmethods that did not follow US GAAP. This is sometimes referred to as “
creativeaccounting
.” Unfortunately, both internal and external controls did not detect this so-calledcreative accounting until it was too late. The most famous of its creative accounting washiding of losses through the use of what is legally called “special purpose entities” (SPEs).Even though SPE’s are legal ways of setting up partnerships, the way Enron used them washighly unethical.
What is an SPE? 
A SPE is a separate legal structure created to fulfill a narrow, specific purpose, such as toisolate financial risk or provide less-expensive financing. For companies, the nice thingabout the SPE is that is not included on the balance sheet of the company. In other words, itis off-balance sheet, and it is for this reason that companies like SPEs. Quite simply, “an off-balance entity is created by a party (the transferor or the sponsor) by transferring assets toanother party (the SPE) to carry out a specific purpose, activity, or series of transactions.Such entities have no purpose other than the transactions for which they are created.” 
2
 Let’s look at a real life situation of an SPE at work. “Dell computers have a joint venture, Dell Financial Services (DFS), with Tyco InternationalLtd. Dell which owns 70 percent of DFS, sells its accounts receivables or the loans it makesto customers who buy Dell computers on credit, to DFS. This allows Dell to reduce itscollection period and costs. However, Dell does not control DFS and therefore, does notconsolidate the company into its financial statements. Tyco’s management states that itconsiders the customer, not Dell, responsible for payment and consolidates DFS. Therefore,Dell shifts the risk of bad debt to Tyco.” 
3
The key issues with the use of SPEs are intent and transparency. In the case of Enron,Enron’s management intentionally used these SPEs, as a matter of fact, 4,000 (estimated)of them, to hide losses from just about everybody. In Enron’s case, assets that were losingmoney were sold to the SPEs. Enron then listed the sale of these assets as earnings.However, according to US GAAP accounting rules, these SPEs must be legally isolated fromthe parent. Unfortunately, for Enron this was not the case. The SPEs relied on Enronmangers for Enron stock for capital. This went on for some time before the outside auditorsgot wind of what management was doing, and forced the company to take a one billiondollar charge against earnings.Enron’s use of these SPEs was unethical. In addition, Enron was also accused of manipulating the Texas power market, bribing foreign governmental officers to win contractsabroad, and manipulating California’s energy market. All together these activities broughtthe wrath of the US federal government down on Enron, and its employees.
Pressure to perform
The pressure to perform is considered the main reason why management resorts tomanipulation of the financial reports. They do it in order to maintain their jobs, or possiblyto get a larger bonus. Whatever the reason may be, the pressure to perform is there, andwill continue to be there for the foreseeable future.
What can be done? 
2
The CPA Journal (online), Accounting for Special Purpose Entities Revised: FASB Interpretation 46R.www.nysscpa.org 
3
Graziadio Business Report, Special Purpose Entities,www.gbr.pepperdine.edu 
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hismritidixit

Can you please send me the copy ...... Email - hismritidixit@yahoo.co.in Thanks & Regards Smriti Dixit

reply12 / 17 / 2009
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