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Ethical Financial Reporting

Carl Burch, CMA, CIA


Hock Accountancy Training (www.hocktraining.com)
Moscow, Russia
+7(495) 645-0080
carl.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 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
 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.

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 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.
2) 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.

2
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 off-
balance 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

3
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.
 Approving external auditor work plans,
 Receiving copies of all external and internal audit reports and communications, and
management’s responses to them,
 Reviewing all financial communications and statements to be publicly issued by the
company,
 Reviewing the strategy, activity and work plan of the internal audit activity, ensuring
that it has sufficient staff and resources to function as planned,
 Reviewing evaluations of risk management, control and corporate governance reported by
auditors,
 Communicating as necessary with the chief executive officer, either inside the
meeting, or by other means, and
 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.

4
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.
2) 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.
3) 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.
4) 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.