Preparation of financial statements

Finance

Changes in Financial Reporting after Accounting Disasters

If the twentieth century has been the century of globalization and international expansion, the twenty-first century emerged as a time of financial troubles. The ability to expand the businesses internationally has led to the creation of billion dollar turnovers. With increasing pressures to register high levels of profit, increase shareholder value and create a favorable market perception, multinationals have often engaged in illicit operations in order to enhance (and later on protect) their organizational status and reputation. Some of these actions include the forging or destruction of financial documents, the granting of large loans to corporate executives, the desire to hide the amounting debts or the offering of large premiums and bonuses to corporate executives. The situations in which this approach has succeeded are not known by the public; however, those situations in which the approach failed were highly mediatized. Two most relevant examples in this sense are the scandals at Enron and WorldCom.

The aim of this paper is to present the changes that have occurred in financial reporting in the period after the accounting scandals. To properly achieve this however, it is necessary to commence with a short presentation of the scandals at Enron and WorldCom, followed by a section on the need for change. Ultimately, the actual modifications will be presented. The paper will come to an end with a section on concluding remarks.

2. The Enron Scandal

By 1987, Enron has risen from scratch to become America's seventh largest company, employing 21,000 individuals in over 40 countries. Unfortunately however, it was proven that the company's success had been based on an "elaborate scam." The company's management had misused and wrongfully accounted their financial status. They even leaked false information to investment brokers in order to further attract investors. They inflated their profits and lied in corporate documents in order to preserve an image of a highly profitable organization. In all this, they had the help of audit organization Arthur Andersen (the audit organization also suffered greatly as a result of the scandal). When the first signs of problems were perceived by the public, the company kept on lying; but when investors begun to leave and the company's stock plunged overnight, Enron was forced to declare bankruptcy. "Enron lied about its profits and stands accused of a range of shady dealings, including concealing debts so they didn't show up in the company's accounts. As the depth of the deception unfolded, investors and creditors retreated, forcing the firm into Chapter 11 bankruptcy in December" (BBC News, 2002).

3. The WorldCom Scandal

The situation encountered at WorldCom was similar to that emerged at WorldCom in the meaning that the executives also amounted billion dollar debts, that they would not admit to. They also leaked information that ensured the company was strong and collaborated with broker investors to attract more funds. The executives hoped that the price of the stock would increase, salvaging as such the company's status. What is interesting about WorldCom is that the problems were revealed by their team of internal auditors. This was not however easy, as the auditors were often advised to turn a blind eye to the inconsistencies in the financial reports. They as such worked at night, behind closed doors, and often feared for their safety. Despite this, they managed to unveil the illicit operations (Cooper, 2007). The company filed for bankruptcy and is currently struggling to salvage what is left of their status and reputation.

4. The Need for Change

Following the accounting scandals at the beginning of the twenty-first century, the business community was characterized by reduced trust. As a result, some changes were imposed. The need for these modifications emerged from the analysis of several accounting red flags, amongst which the following:

Some multinational organizations were using scams to hide debt and other related data

Some organizations would fail to disclose the costs of the sold goods

They were beginning to amount both inventories as well as accounts receivable

They would often change auditors in order to hide their illicit operations (or the auditors would help the companies with their misreported accounts)

The occurrence of doubtful accounts and entries in financial records

Differences in the growth rates of the net income and the overall sales

The cash flow from operations would often be negative or highly fluctuant

Companies would often become engaged in multiple commitments and revealed various contingencies

The individual expense items would register suspiciously high increases / decreases

The profit margins would grow unexpectedly

Unusual sources would generate large profits; entries of "other" to account for elements in financial statements

Rapidly decreasing assets, concomitant with rapidly increasing liabilities

Strong link between financial statement measures and the bonuses to the executives and the stock option plan (Creative Financial Analysis Limited).

5. Modifications in Financial Reporting

The scandals at Enron and WorldCom were not isolated incidents, and similar situations were encountered at Xerox, Global Crossing, Reliant Resources, CUC International or Rite Aid. The problems affected the stock market, the pension funds or the boards of corporate directors and shuttered the trust in the public reporting system of the corporations' financial status. As a result, discussions emerged at the U.S. Senate and the House of Representatives as to the measures that could be taken.

The most important endeavors revolved around insuring higher levels of transparency related to corporate actions. This transparency would not only offer a clearer understanding of the organizations, but would also allow for more effective comparative analyses to be conducted. "Financial reporting is said to be transparent if the presentation of information gives the user a clear indication of the financial condition of a company. To achieve a high degree of transparency, corporate disclosures should be clear, timely, and contain all information that will have a material impact on the company. Transparency is enhanced when financial information can be understood both in the context of the individual company and within an industry segment. Comparisons with prior filings and with similar firms help put financial information into context" (Hannon, 2002).

A useful tool that has been promoted to increase transparency and reduce the chances of fraudulent actions is called XBRL. The acronym stands for eXtensible Business Reporting Language and this represents an informational and computerized system that "can provide an electronic method for companies to report financial information in accordance with generally accepted accounting principles (GAAP)" (Hannon, 2002). The system is highly helpful as it will allow regulatory institutions to more efficiently browse through corporate records and identify any illicit operations. In 2001 for instance, the Securities and Exchange Commission was only able to review the corporate fillings of 16% of the organizations; Enron's financial statements had not been reviewed by SEC since 1997 (Malpass, 2002).

The efforts to improving the financial reporting system have been condensed into the Sarbanes-Oxley Act of 2002. It came as a response to the growing number of accounting scandals and it represents the most important regulating act of the past 70 years. It is enforceable both in the firms within the United States, as well as those in other global regions. The act applies to all six players in the corporate reporting supply chain, which includes the organizational executives, the board of directors, the information distributors, the third-party analysts and the investors and other categories of stakeholders (such as employees, customers, governmental and non-governmental institutions). Each of the six players has distinct responsibilities, but the commonality of all modifications is the focus on three key-elements to building trust - "spirit of transparency, culture of accountability [and] people of integrity" (Bautista, 2004).

The provisions of the Sarbanes-Oxley Act are divided into nine sections, each dealing with specific issues: (1) public company accounting oversight board, (2) auditor independence, (3) corporate responsibility, (4) financial disclosures, (5) conflicts of interest, (6) resources and authority, (7) studies and reports, (8) corporate and criminal fraud accountability, (9) white-collar crime penalty enhancements (Website of the Sarbanes-Oxley Act, 2002). A notable provision sees that the companies are obliged to change their auditor every five years and that the auditing organizations are banned from performing certain types of non-audit services to their clients (Lee).