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Consolidation of Financial Statement Analysis

In the wake of the Enron collapse, the chairman of the Securities Exchange Commission (SEC) repeated his calls for the nation's securities laws to be updated in an effort to avoid another such case. In an article in December 11, 2001's Wall Street Journal, Harvey Pitt wrote that the Enron collapse underscores the need to update and improve the nation's financial reporting and disclosure laws that were first developed in the 1930s. Pitt emphasized that investors needed current, not quarterly or annual, corporate information. The current approach to remedying a clearly broken system have been too little, too late according to some observers. Clarke and Oliver, for instance, point out that, "Paradoxically, one of accounting's grandest inventions to achieve financial clarification is its most virile medium for deception. From its introduction, giving special status to a group of related companies and the methods of consolidating its accounts has facilitated financial deception." Rather than engaging in fundamental reforms that address the underlying issues, Clarke and Oliver point out that the responsible regulatory bodies as well as the accounting profession have preferred to "patch up" consolidation accounting and even in the post-Enron reforms, such "patching up" continues. "Indeed," they say, "there is no evidence that proscribing the group structure and consolidated financial statements has ever been considered seriously." To determine whether the existing piecemeal approach will provide satisfactory reforms, this paper provides a review of the literature to identify the relevant issues, followed by an assessment of the viability of such an approach in view of the scope of the problem. A summary of the research is provided in the conclusion.

Executive Summary and Synopsis

Introduction

Background and Overview: Explanation of Clarke and Oliver Observation...

Analysis

Financial Statement Composition Today

Patching Up" Initiatives

Sufficiency of Initiatives to Date

Conclusion

Accounting Reform in the Post-Enron Era: Is "Patching Up" Too Little Too Late?

Introduction

According to Clarke and Oliver, "Paradoxically, one of accounting's grandest inventions to achieve financial clarification is its most virile medium for deception. From its introduction, giving special status to a group of related companies and the methods of consolidating its accounts has facilitated financial deception." Rather than engaging in fundamental reforms that address the underlying issues, Clarke and Oliver point out that the responsible regulatory bodies as well as the accounting profession have preferred to "patch up" consolidation accounting and even in the post-Enron reforms, such "patching up" continues. "Indeed," they say, "there is no evidence that proscribing the group structure and consolidated financial statements has ever been considered seriously." In order to determine whether the existing piecemeal approach will provide satisfactory reforms, this paper provides a review of the literature to identify the relevant issues, followed by an assessment of the viability of such an approach in view of the scope of the problem. A summary of the research will be provided in the conclusion.

Review and Discussion

Background and Overview: Explanation of Clarke and Oliver Observation. In his assessment of the eventual Enron collapse, Edmond Warner reiterates P.T. Barnum's advice that "There's a sucker born every minute": "Derivatives are nothing new, but I doubt whether, 400 years ago, merchants calculated an option price after consideration of its delta, gamma, theta, or rho, but the underlying principles are timeless" (Warner 2002, p. 5). Warner says that the majority of the trade in "plain vanilla" derivatives based upon the most popular underlying assets (e.g., the big currencies, government bonds and equity indices) takes place through derivatives exchanges. In providing a standardized framework for contracts, these exchanges are able to create a trading environment that encourages liquidity and thus fine pricing. Warner points out that this "on market" trading of derivatives is not what bothers regulators because the regulatory audit trail for recognized exchanges is fairly straight-forward.

However, in contrast to the "on market" exchanges, derivative transactions that are conducted "off market" (these are, in effect, non-standard direct contracts between bilateral parties), have attracted increasing attention from regulators with good reason: "Over the past decade or so, the volume of such transactions, across a wide swath of asset classes and instruments, has been extraordinary" (Warner 2001, p. 5). In the market in which Enron competed, schedules of fees for buying and selling securities are not fixed, and dealers derive their profits from the markup of their selling price over the price they paid. The investor may buy directly from a dealer willing to sell stocks or bonds that he owns or with a broker who will search the market for the best price.

This growth in off-market activity reflected an increase in both willing buyers and sellers. Warner says the end buyers in these transactions are often "real" businesses that are seeking methods by which they can balance their risk and revenue streams. Warner points out that Enron's implosion constitutes a "stark reminder of counterparty risk. At the time of these transaction, Enron was the world's largest energy trader; Enron stood on the other side of vast numbers of such derivative contracts. "In many, many cases, the only guarantee behind the contract will have been Enron's own name and balance sheet. These are now revealed to be worth nothing" (Warner 2001, pp. 7-8). According to Thomas C. William, on the surface at least, the motives and attitudes behind decisions and events leading to Enron's eventual downfall appear simple enough:.".. individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyone -- the company, its employees, analysts or individual investors -- wanted to believe the company was too good to be true. So, for a while, hardly anyone did" (William 2002, p. 41). Clearly, then, the sufficiency of financial reporting measures that do not reveal that a company is "cooking the books" is inadequate, but can there be a "one-size-fits-all" approach to financial disclosure in today's increasingly diverse and globalized marketplace? The consolidated financial statement approach has been tried, of course, but significant problems remain.

Consolidated Financial Statements Today. According to Walter G. Blacconiere and Patrick E. Hopkins (2002), the overwhelming majority of U.S. public companies report consolidated financial statement information. For instance, Accounting Trends and Techniques (American Institute of Certified Public Accountants 1998) noted that 97.2% of the firms surveyed include "Consolidation Policy" in their footnotes (Blacconiere & Hopkins, 2002). Alexander Sannella (1991) reports that in order to present financial statements in accordance with GAAP, published financial statements must include the three basic general purpose financial statements:

1) The balance sheet or the statement of financial position;

2) The income statement and the statement of profit and loss or the statement of operations; and 3) The cash flow statement.

In addition, a complete set of financial statements requires full disclosure in the form of footnotes.

The three basic financial statements are reported to be general purpose financial statements because they are designed to satisfy the needs of a wide spectrum of user groups, including investors, creditors, financial and credit analysts, insurance companies, labor unions, employees and government agencies. While these are considered to be general purpose, the majority of financial information is provided to satisfy users with limited ability and authority to obtain additional information. Ordinarily, the primary users are identified as investors and creditors; however, Sannella points out that from a practical perspective, investors will most likely be the primary user group addressed by the accounting profession in published annual reports. For the most part, he says, the other user groups can demand and obtain additional information or request clarification of data included in the annual report. For instance, if a company wants to obtain additional financing, it would probably be willing to satisfy a potential creditor's demand for additional information (Sannella, 1991).

The balance sheet is a listing of the assets, liabilities and capital of the entity at a point in time. From an economic standpoint, the balance sheet presents the stock of wealth of the firm. The assets of the firm have been defined as economic resources owned or controlled by the firm and having future service potential (economic benefit) to the firm. Notice that the assets of the firm do not have to be owned. As long as the economic resources are controlled and provide future economic benefit, they can be included among the assets of the entity. As will be discussed in a later chapter, under certain conditions leased equipment can be included among the assets of the firm (i.e., "capitalized"), even if not owned (Sannella, 1991).

Liabilities are the debts owed to outsiders (i.e., creditors) by the firm. Liabilities are also known as "creditors' equity or the creditors' claim against the assets of the firm. The capital of the firm represents the owners' wealth which is a residual claim to the assets of the firm, or the owners' equity. Because the creditors' claims must be satisfied first, the owners' equity has also been called net worth or net assets. The balance sheet is based on the fundamental accounting or balance sheet equation: Assets =…[continue]

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