Report on Role of Ethics and

Judgement in financial reporting

By Nabin Thapa
Student no. 5035077

TBS801: Accounting and Financial Management

Lecturer: Dr Shantha Yahanpath
University of Wollongong
Sydney Business School
18 September 2015

1.ExecutiveSummary
This report provides an analysis of the importance of role of ethics and
judgement in financial reporting highlighting the key areas of ethics and
judgement that need to be considered in financial reporting. It also looks
at the possible damage in case ethics and judgments are not considered
while preparing financial reports. The report looks at three cases of
Computone Corporation, Enron Corporation and WorldCom Corporation
where ignorance of accounting ethics and judgements led to their
downfall. Methods of analysis include thorough literature review of the
concerned subject and the secondary data available in this regard.
Findings suggest that ethics and judgement play a major role in the
modern day accounting practices. It can have a negative impact on both
the company as well as the economy as a whole. Key areas where
accounting ethics become important are revenue recognition, asset
valuation, and provision for future costs. Failing to make the right decision
in these areas can cause huge losses to the organization. The argument is
further supported by looking at the accounting scandals that prevailed in
Computone Corporation, Enron Corporation and WorldCom Corporation.

Table of content
1. EXECUTIVE SUMMARY
2. INTRODUCTION
3. IMPORTANCE OF ETHICS AND JUDGMENT IN FINANCIAL REPORTING
4. KEY AREAS OF ETHICS AND JUDGMENT IN FINANCIAL REPORTING
4.1 Revenue Recognition
4.2 Valuation Issues
4.3 Depreciation
4.4 Provisions for Uncertain Future Costs

5. POTENTIAL LOSS WHEN ETHICS AND JUDGEMENT ARE IGNORED

6. SUPPORTING CASE STUDIES
6.1 Computone Corporation
6.2 Enron Corporation
6.3 WorldCom Corporation

7. CONCLUSION
REFERENCES

2.Introduction
Ethics in accounting is of a major issue in todays dynamic world of
business where todays biggest corporation can plummet by tomorrow just
because of poor accounting practices. The recent accounting scandals of
some of the largest organization of the world such as Enron, WorldCom,
Tyco , HealthSouth, Lehman Brothers and Satyam among others have
raised eyebrows of many communities and government authorities and
has raised awareness about the complexities of various decision making
processes that goes into accounting and preparing financial reports. It has
become for accounting professionals to understand the importance of
ethics and judgement in the field of accounting and their implications.
This report will using literature and secondary resources, pay due
attention to the importance of ethics and judgement in preparation of
financial reports and discuss the key areas therein. The report will discuss
the areas such as revenue recognition, assets valuation and provision,
future costs, and depreciation where accounting practices should be
carefully considered. Wrong judgements and unethical practices in
accounting can cause damage not just to the organization but also to the
overall economy.

This report will also look at the cases of accounting

dereliction in Enron Corporation, Computone Corporation and WorldCom

Corporation which led to their demise and finally conclude by justifying
the argument that ethics and judgment are essential in accounting
practices.

3.ImportanceofEthicsandjudgmentinfinancialreporting
Oneofthemostessentialways forabusinessorganizationtocommunicateits financial
operationsandpositionisthroughitsfinancialstatements.Financialreportingisimportant
forstakeholdersinthesensethatitprovidesthemthenecessaryinformationintheirdecision
makingprocess.Forexample,aninvestorcan,afterinterpretingthefinancialreports,makea
decisionregardinghisinvestmentonthecompany,lenderscandecideongivingdebtstothe
organization,boardmemberscanevaluatetheperformanceofthemanagement,allbasedon
thefinancialperformanceoftheorganizationindicatedbythereports.Similarly,government
authorities,consumers,employees,socialgroups,etc.areinterestedinthesereportsandmake
manyoftheirdecisionbasedupontheinformationgiveninthereports.Therefore,theroleof
professionalaccountantsbecomescrucialin contextofpreparing,auditing,andpresenting
financialstatementsthatportraythebusinessinthebestwaypossibletoitsstakeholders.
Professionalaccountantsorauditorsareresponsibleforpresentingfinancialreportsthatare
trueandshowtheactualperformanceandpositionoftheorganization.Malhotra(2013,p.16)
citesthat theaccountingpracticecomprisesofseveralprocessesthatinvolvedealingwith
many issues related to judgment and resolving differences in conflicting approaches to
deliveryoftheoutcomeofthefinancialtransactionsandevents.Ononehand,professionals
inthefieldofaccountinghaveasignificantobligationtowardsthegeneralpublictoprovide
themwithinformationregardingthefinancialstatusofthecompanyontheotherhandthe
sameprofessionalsmighthavetoworkintheinterestoftheemployersortheclientswhich
mightbeconflictinginnatureandthiscouldresultinasituationthatputstheaccounting
professionalsindilemma.AccordingtoLeung&Cooper(1995,p.28),inaninquiryof1500
accounting professionals, conflict ofinterest, client proposal to manipulate accounts,and
clientsproposalfortaxevasionwereamongstthethreemostoftencitedethicalproblems
facedbytheprofessionals.Thestudyshowedthatethicalproblemsconcernedwithcreative
accountingweremoreoftenthantheonesrelatedwithtaxevasion.Thisisamajorissue
becausecreativeaccountingisnotparticularlyanillegalpractice,itismerelyaccounting
policy'sflexibilityinpracticethatcanbearguedasmorallyunethical(Malhotra2013,p.16).
Therefore, the very nature of the profession of the accountant makes it imperative for them to
be ethical. The professional judgments made by the accountants can alter the decision made
by the stake holders. These decisions during the course of time have an impact on the
allocation of resources in the economy.

4.Keyareasofethicsandjudgmentinfinancialreporting
There are several areas where accounting professionals need to be vigilant about making
decisions as these decisions can have long term impact on the business organization.
Following are brief discussions on the key areas of ethics and judgment in financial reporting.

4.1 Revenue Recognition

The matching principle of GAAP clearly states that revenues should always be matched with
the expenses. Therefore, expenses and revenues are reported on accrual basis, i.e. when the
transaction event takes place and a profit or expense is gained or incurred respectively. If a
judgment is made to generate report without matching revenues with their related expenses,
companies can produce financial reports that will provide insufficient information about the
organization. Therefore, while trying to analyze financial statements one needs to keep in
mind the professional judgments that may have been taken by the accountants to produce
reports that are guided by the company policies of either being aggressive or conservative in
revenue recognition. Aggressive revenue recognition could overstate a firms revenue and
income performance. Micro Strategy, a data-mining software producer, in 2000, announced to
reevaluate its revenue recognition approach led the firm's reported profit of $12.6 million
plummet into a loss of more than $34million (Sherman&Young2001,p.131). This was a
result of improper measurement of contract revenue before it was due. Therefore, it is
essential for professionals to have an ethical judgement in order to manage and recognize
revenues properly.

4.2 Valuation Issues

International Valuation Standards Council (IVSC) defines valuation as the process of
establishing the value of an asset or liability or the amount representing an opinion or
estimate of value (2015). Valuation could be of tangible or intangible assets. Tangible assets
include plant, inventory, equipment, collectables, property, etc. These are assets that are
physically present while intangible assets include goodwill, shares, rights, intellectual
property, businesses and financial instruments. Assets can be valued in generally on one of
the two bases: book value basis and the market value basis. Generally Accepted Accounting
Principles (GAAP) generally follows the book or original cost accounting basis. So, if a
company buys an asset for $5 million, the value of the asset for accounting reasons will be $5
million until the asset is sold at which point the market value of the asset will be calculated
to measure any capital gain or loss. However the issue here is that book value does not
represent the true value of the assets in the market. Moreover, firms also hesitate to follow

market value approach because this will reflect volatility in firm's earnings as the market
value is not always static. Therefore, an accountant needs to make certain professional
judgement with respect to assets and liability valuation as well. The recent Kinross Gold
scandal is an example of overstated asset valuation.

4.3 Depreciation
A company's performance is also determined by its depreciation policy. There can be several

policies from which a firm can decide to choose their depreciation policy. Which one to
follow is the area of professional judgment by the accountant and the management? Various
determinants like duration, disposal value, depreciation policy are responsible for
ascertaining the amount of depreciation. The amount of depreciation in a financial statement
can contribute to major share of its expenses. Therefore, firms often misrepresent the
numbers to show higher income in their financial statements and it is evident that this is key
area where ethics and judgement of a professional comes into play. For example, Delta
Airlines update the useful life of their aircraft twice within the period of ten years which
resulted in creation of significant increase in profit in both cases ( Sherman&Young2001,p.
131). The motive behind such changes is a question for subjective debates on moral and

ethical judgement issues.

4.4 Provisions for Uncertain Future Costs

Sherman & Young (2001, p. 131) state "Companies must make provisions for costs they
know will arise, even if the amounts can't be known with any certainty: losses from inventory
obsolescence, uncollectible accounts, product returns, restructuring costs, damages from
product recalls-the list goes on". There is a significant room for firms to play here that can
alter financial statements. Firms can either exaggerate the provisions to produce hidden
reserves which can then be used in future to jump their profit flow or can reduce the size of
the provision to portray higher net income in the current period. This is also a key area for the
accounting professionals to practice ethical judgments and decisions.

5. Potential loss when ethics and judgement are ignored

Lapse of ethics and judgement mainly contributes to the failure of professional accountants
and auditors to meet their obligations of fair reporting of financial performance of business
organization to their investors. The role of investors is critical in context of the current system
of distributed democratic economies which is perceived to attend the interest and ambition of
all taxpayers. These investors contribute towards continuous capital formation in the
economy by directing the mobility of financial resources towards to most lucrative sector of

the economies and much of that decision making depends upon the reliable information
provided by accountants and auditors. If accountants and auditors fail to function within their
fiduciary duties, to meet their obligations, and to behave ethically, there could be a significant
loss to the investors, citizens and to the whole economy at large ( Staubas2005,p.6). Several
companies have collapsed due to improper accounting practices such as The Bank of Credit
and Commerce International in 1991, Enron in 2001, Bernie L. Madoff Investment Securities
LLC, etc.

6. Supporting case studies

The discussion on the importance of ethics and judgement in financial reporting is not merely
a theoretical concept but rather a global phenomenon. Many corporate scandals associated
with misrepresentation of financial information have been recorded over the years and such
cases have risen in numbers most recently. Some of these scandals have led to the downfall of
few of the biggest corporate firms in the world. We will look at three cases of how failure to
be in compliance with ethical behaviors and ethical judgement has had severe impact on the
organization spoken of.

6.1 Compton Corporation

Compton Corporation which has now been renamed to Symbiat, Inc. is a United States based
company, has been in the field of Information technology since 1984 and designs,
manufactures and markets products and services that are directed towards IT enterprises
mostly associated with internet communication hardware (Stallworth & Braun 2007, p. 320).
Computone Corporation faced extreme liquidity issues starting from 1992 when the company
reported huge amount of working capital deficiency. This resulted in the firm being delisted
from NASDAQ because it could not meet the minimum requirements to be listed in
NASDAQ. In an attempt to get re-listed, Computone made numerous changes to its capital
structure and took various steps that finally brought the company back to the NASDAQ list
by the end of 1994. This sounds like a success story but however by 1997 Computone was
alleged by its former employees regarding its accounting practices and financial reporting
process. The allegations stated that the company's senior management had in an orderly
manner made efforts to amplify the company's revenue and total profits during the three years
between 1993 and 1997 (Stallworth & Braun 2007, p. 321). The investigation made by
United States Securities and Exchange Commission (SEC) in this matter showed that the
senior management of the firm was involved in extensive deceit which created exaggeration
of income in the financial statements between the year 1994 and 1997. There were 240

business transactions which were not recognized correctly in the accounting books. This as
we discussed previously is a key area where ethics and judgements come into play. The case
indicates that the management of Computone, in a desperate attempt to improve its financial
situation opted to follow creative accounting and illegal accounting practices disregarding
accounting ethics for their own self-benefit. This resulted in charges against the people in
senior management position. The company's stock value declined and it was again de-listed
for failing to meet the minimum requirements.

6.2 Enron Corporation

The examples of accounting scandals are incomplete without the inclusion
of the famous Enron Scandal. Enron Corporation was one of the biggest
corporations in USA. Enrons went bankrupt in December 2001. The main
reason behind the downfall is the misrepresentation of income and assets
in the financial statements. One of the reasons behind the failure of Enron
Corporation

was

the

mark

to

market

approach

followed

by

the

organization while evaluating their assets value ( Elluletal.2014,p.299). Mark

to market approach is basically the method of valuation of assets on
market value rather than the traditional way of measuring the assets
value on book value. Assets evaluation as was discussed previously is a
key area where ethics and judgement is required. The ethical judgement
made by Enron Corporation to follow market value caused its own demise.
Moreover, Enrons policies towards Revenue recognition were also highly
controversial. The most outrageous example can be the fact that Enrons
revenue recognition included the revenue that originated from increment
in the price of its own shares following the equity method ( Baker & Hayes
2004, p. 778). Enron Corporation also identified and listed revenue that

were derived from long term contracts whose value was again based upon
the mark-to-market approach that was institutionalized by the corporation
(Baker & Hayes 2004, p. 778). These are only the tip of the iceberg for all
the underlying accounting failures that contributed to Enron Corporations
failure. However once can generate a fair idea as to how the ethical
decisions

and

judgements

made

by

the

corporation

resulted

in

misrepresentation of its financial position which were although totally

valid under legal systems of accounting, led to serious consequences one

after another and eventually directed the corporation towards bankruptcy.

6.3 WorldCom Corporation

WorldCom, which is currently renamed to MCI, Inc. is an American based
telecommunication corporation based in United States which was involved
in one of the biggest accounting scandal in the United States. In the year
2002, WorldCom filed for bankruptcy. This was right after the bankruptcy
of Enron. The reasons were identified to be several inappropriate practices
followed by the WorldCom Corporation. Listed are few of them,

Overstated income by more than $1.4 billion which was confirmed

by the SEC (Soltani 2014, p. 263)

Capitalized line costs (Royalties paid to other telecommunication
companies for accessing their network) worth of $ 3.8 billion which

were not in line with the GAAP (Lavey 2006, p. 619).

About 50 % out of the total assets worth of $ 104 billion reported in
the 10-k were good will and other intangible assets ( Giroux 2008, p.
1227).

Even though the company asserted of producing financial reports

within the laws and accounting standards, it is evident that the
company made certain ethical decisions in its accounting practices that
led to misrepresentation of its financial reports and which eventually
led to its downfall. This is another strong case of the loss that is
witnessed ethics and professional judgements are ignored by an
organization.

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7.Conclusion
Caldwell shows that (2004, p. 779) that ethical and value based
principles of virtue ethics have potential to benefit the modern day
organization. It can be seen that the role of ethics and judgement in the
field

of

accounting

has

significance

implication

in

any

business

organization. Accounting professionals face constant dilemma in their

occupation due to conflicting interest of their clients and their own
professional ethics. The modern day business is in constant pressure to
perform well financially and reflect profitability in their business. This
however seems to captivate companies in providing enticing but
misleading

information

to

the stakeholders.

This

has

led

several

companies to its downfall and also has a negative impact on the economy
as a whole due to unproductive movement of funds and investment in the
economy. Several key areas are applicable where role of ethics and
judgments are essential such as revenue and expenses recognition and
treatment, tangible and intangible assets valuation, provision for future
cost, depreciation calculation etc. The example cases of Enron, WorldCom,
Computone, etc. further prove the importance of ethical judgment within
the ethics of accounting.

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References
Baker, CR, & Hayes, R 2004, 'Reflecting form over substance: the case of
Enron Corp', Critical Perspectives on Accounting, vol. 15, no. 6/7, pp. 767785.
Ellul, A, Jotikasthira, C, Lundblad, CT, & Wang, Y 2014, 'Mark-to-market
accounting and systemic risk: evidence from the insurance
industry', Economic Policy, vol. 29, no. 78, pp. 297-341.
Caldwell, C 2004, 'Examining corporate citizenship: Balancing duties and
opportunities in the modern organization', Business Ethics Quarterly, vol.
14, no. 4, pp. 775-780.
Giroux, G 2008, 'What went wrong? Accounting fraud and lessons from the
recent scandals', Social Research, vol. 75, no. 4, pp. 1205-1238.
International Valuation Glossary 2015, International Valuation Standards
Council, viewed 15 September 2015, <http://ivsc.org/glossary#letter_v>.
Lavey, WG 2006, 'Responses by the Federal Communications Commission
to WorldCom's accounting fraud', Federal Communications Law Journal,
vol. 58, no. 3, pp. 613-682.
Leung, P, & Cooper, BJ 1995, 'Ethical dilemmas in accountancy practice',
Australian Accountant, vol. 65, no. 4, p. 28.
Malhotra, AK 2013, 'Curbing creative accounting: role & effectiveness of
ethics', International Journal of Finance & Policy Analysis, vol. 5, no. 2, pp.
15-26.
Sherman, HD, & Young, SD 2001, 'Tread lightly through these accounting
minefields', Harvard Business Review, vol. 79, no. 7, pp. 129-135.
Soltani, B 2014, 'The anatomy of corporate fraud: a comparative analysis
of high profile American and European corporate scandals', Journal of
Business Ethics, vol. 120, no. 2, pp. 251-274.
Stallworth, HL, & Braun, RL 2007, 'Computone Corporation: An
instructional case in earnings management and revenue recognition',
Issues in Accounting Education, vol. 22, no. 2, pp. 319-332.

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