Ethical Financial Reporting Article

Ethical Financial Reporting Carl Burch, CMA, CIA Hock Accountancy Training (www.hocktraining.com) Moscow, Russia +7(495) 645-0080 [email protected] “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 reporting of both private and public companies1. But, the basis of this article will center on the ethical reporting of public companies, not private. We are doing this because it is the financial reporting of public companies that is under the scrutiny of the US federal government. 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 that country’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

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Clearly, concisely and accurately reflect all transactions that occurred during the financial accounting period, including transactions with both owners and non-owners.

It’s understandable that management of these large public companies are under enormous pressure to “perform,” to bring favorable returns that meet investors expectations. How does management meet investor’s expectations? Investors’ expectations are met by increased share prices. And, how do you get higher share prices? It’s all based on earnings, or expected future earnings. 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 scan through the business and financial publications to realize that financial statement manipulations 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 be unethical. It has often been sited that the reason for these accounting scandals was because of the complexity of the firms’ accounting, including the use of derivatives, special purpose entities, etc., but, in most cases, what was going on was not too difficult to understand, even for a first year accounting student.

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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.

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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 in the 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 largest telecommunication’s company in the US, the company during the 1990s went on an acquisitions binge. From 1991 to 1997, WorldCom spent $60 billion on acquisitions, and as it acquired companies, the analysts kept recommending the stock; thus, pushing up share prices. As share prices went up, the company used company stock to purchase additional companies. Acquiring companies and making sure operations mesh is not easy and takes a great deal of careful planning and considerable management attention. Unfortunately, in WorldCom’s case, management was unable to properly integrate the acquired companies into its own operations, and thus, overall company performance and profitability was diminished. 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 did not have the management team in place that could properly integrate the acquisitions into WorldCom operations. Management lacked the competence to properly plan and manage the acquisitions. This in-of-itself does not constitute unethical behavior, but it indicates the lack of controls, which makes it easier for management to manipulate financial numbers.

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Capitalizing Operating Expenses. The most common way to measure performance is based on earnings. The easiest way to increase earnings is through the manipulation of financial reports. WorldCom found an easy to do this by capitalizing certain operating expenses, such as maintenance costs. Basic accounting states that maintenance costs have to be expensed in the current reporting period. WorldCom simply deferred these costs out to future years; thus causing income to be greater than it should’ve been. A simple exercise in manipulation. 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, Enron still garnered more press because it really did represent the worse of corporate greed, or for a better word – self interest. It’s hard to believe that before the scandal broke, Enron was considered to be one of the best companies in America. As a matter of fact, Enron had been billed by Fortune magazine as “America’s Most Innovative Company” for six straight years from 1996 to 2001. It’s even harder to believe that Enron was filing for bankruptcy by December 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 look for evidence of fraud. The purpose of the investigations was to determine whether management intentionally manipulated the company’s financial information to conceal negative information about its finances. The important word here is intent. Intent is not a mistake. Intent is “knowing” something is wrong, but doing it anyway.

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In order to give the impression of increasing earnings, management had to use accounting methods that did not follow US GAAP. This is sometimes referred to as “creative accounting.” Unfortunately, both internal and external controls did not detect this so-called creative accounting until it was too late. The most famous of its creative accounting was hiding 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 was highly unethical. What is an SPE? A SPE is a separate legal structure created to fulfill a narrow, specific purpose, such as to isolate financial risk or provide less-expensive financing. For companies, the nice thing about the SPE is that is not included on the balance sheet of the company. In other words, it is off-balance sheet, and it is for this reason that companies like SPEs. Quite simply, “an offbalance entity is created by a party (the transferor or the sponsor) by transferring assets to another 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 International Ltd. Dell which owns 70 percent of DFS, sells its accounts receivables or the loans it makes to customers who buy Dell computers on credit, to DFS. This allows Dell to reduce its collection period and costs. However, Dell does not control DFS and therefore, does not consolidate the company into its financial statements. Tyco’s management states that it considers 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 losing money 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 from the parent. Unfortunately, for Enron this was not the case. The SPEs relied on Enron mangers for Enron stock for capital. This went on for some time before the outside auditors got wind of what management was doing, and forced the company to take a one billion dollar 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 contracts abroad, and manipulating California’s energy market. All together these activities brought the 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 to manipulation of the financial reports. They do it in order to maintain their jobs, or possibly to get a larger bonus. Whatever the reason may be, the pressure to perform is there, and will 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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The US government came down hard on those found guilty of skirting the law, including jail time for those found guilty of intentionally falsifying financial statements, obstructing justice, etc. In response to these scandals, particularly due to Enron, the US Congress passed the Sarbanes Oxley Act of 2002 (SOX). Under this new legislation, top management (i.e., CEOs and CFOs) of public companies are required to sign off on the accuracy of the financial reports, or risk going to prison, if they “willingly” and “knowingly” file false statements. Being held accountable for the accuracy of the statements is a step in the right direction of getting management to report as honestly as possible on their performance. But, as we discussed above, holding management accountable does not guarantee that the reports will in fact, be honestly prepared and presented for the simple fact that management is still under pressure to perform, and to show results at any cost. As long as management has this pressure they will continue to do what is necessary, even if this means skirting ethics to improve earnings. Earnings are still the litmus test for measuring management’s performance. What has changed? In addition to getting management to sign-off on the financials, SOXs also attempted to strengthen the role of the audit committee within the organization. This was done to provide stronger oversight of management’s activities. An important aspect of the audit committee members is for them to be independent - independent of day-to-day operations and independent of undue management and board pressure. The specific functions of the audit committee include: 

Aiding the board in selecting external auditors, detailing the scope of their work, reviewing engagement letters and negotiating fees.

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Approving external auditor work plans,

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Receiving copies of all external and internal audit reports and communications, and management’s responses to them,

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Reviewing all financial communications and statements to be publicly issued by the company,

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Reviewing the strategy, activity and work plan of the internal audit activity, ensuring that it has sufficient staff and resources to function as planned,

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Reviewing evaluations of risk management, control and corporate governance reported by auditors,

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Communicating as necessary with the chief executive officer, either inside the meeting, or by other means, and

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Reviewing policies to eliminate illegal and unethical practices.

It cannot be overstated the importance of the audit committee in the whole financial reporting process. The other independent activity within the organization that also works to improve the quality and transparency of the financial reports is the internal audit activity (IAA). It is the IAA that can really play an important role in making sure that the financial reports are truly transparent and do represent the actual health and performance of the company. The IAA is in a unique position of being able to detect when management is trying to get too creative with the financials, whether manipulating the financials for their own benefit, or for the company’s benefit.

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An example of an internal audit activity that did what it was supposed to do is the story of Cynthia Cooper, the internal auditor of WorldCom. It was Cynthia Cooper who finally brought to light the unethical financial reporting that was occurring at WorldCom. Even though, she was pressured by management not to go forward, she did, and was able to finally to present her findings to the WorldCom’s audit committee. Because of the action she took, WorldCom had to come clean about its financial situation. This is the internal audit activity at its best. On the other hand, the audit committee and internal audit activity at Enron were asleep at the wheel. They did not fulfill their responsibility to anybody, i.e., shareholders, employees, etc. While it is true that the financial schemes that management were putting together were complex, but it was the internal auditor’s responsibility to understand what was going on. These schemes were so convoluted that not even highly trained accounting experts could understand what was going on, let alone members of the audit committee. This scheme should have been caught and stopped long before the scandal broke. Summary It’s obvious that the passing of SOXs will make some managers think twice before trying to be creative in their accounting. Basically, SOX is saying that if a person wants to run the company, then he or she will have to know what’s going on in the company, and, most importantly, be held accountable. Let’s take the story of WorldCom’s former CEO, Bernard Ebbers. During his trial, Ebbers maintained that he did not know what was going on in the company, as far as the accounting. In his testimony, he stated, “I know what I don’t know” and “I don’t know technology and engineering” and “I don’t know accounting.” Unfortunately, for his sake, the jury did not believe him and convicted him anyway. In summary, there are four key points that can help a company develop an ethical financial reporting system, including: 1)

Not accepting unethical behavior in the organization. Every company should have a “Code of Ethics” and this Code should be part of the company culture.

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If unethical behavior is witnessed or suspected, companies should have a way for employees to communicate this behavior to management (i.e., hot line, etc.). Companies should encourage employees to come forward if they suspect fraud or some other kind-of unethical behavior.

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The audit committee needs to take a more active role in making sure the financial reports are being prepared in good faith. They can do this by actively supporting the internal audit department, and making sure the objectivity and independence of the IAA is protected.

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Finally, the internal audit department needs to play a key role in evaluating and contributing to the improvement of risk management, control and governance systems. This particularly relates to the reliability and integrity of the financial and operating repots. In addition, in order for the IAA to fulfill its obligations, it is vital that it have the support of top management and the audit committee.

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