Docstoc

Accounting Fraud

Document Sample
Accounting Fraud Powered By Docstoc
					                    Aggressive Accounting: How much is too much?

“There are more financial misstatements and fraud now, SEC spokesman Thomas Newkirk said. There
was a time it was a rare day to get caught in a fraud case. In the last year or two lots of big capitalization,
nationally known companies have been involved in financial fraud.” (1)

“The Security Exchange Commission says that it currently has about 260 accounting investigations under
way, according to the Wall Street Journal. About 40 of the companies, or 15 percent of the total, are
among the 500 largest companies in the country. „If we had nothing else to do, the accounting
investigations alone could keep us busy for the next five or 10 years‟, Richard Walker, the SEC‟s
enforcement chief, told the paper, „The size and magnitude are crushing‟ “. (5)

“In November, Waste Management itself paid $475 million in fines to settle charges of violating securities
laws in its 1998 merger with USA Waste Services and its 1999 financial statements.” (1)

“In 1999, Cendant Corp., the travel and transportation conglomerate that owns Ramada Hotels and the
Avis car rental chain, agreed to pay shareholders $2.83 billion to settle a suit alleging irregularities in its
merger with CUC International Inc.” (1)

“Appliance maker Sunbeam Corp. was forced to restate financial results for 1996 and 1997 last May, and
the SEC sued former CEO Al Dunlap (Chainsaw Al) and other executives after he was accused of using
phony accounting to boost profits. The company later filed for bankruptcy” (1)

“The Securities and Exchange Commission said Tuesday that Arthur Andersen LLP‟s audits of Waste
Management Inc.‟s financial statements were false and misleading, and that the accounting firm agreed
to pay $7 million to settle the case. The agency said it was the largest civil penalty ever assessed against
a Big Five accounting firm. The SEC said it found financial statements that were issued as “clean”
opinions by Andersen overstated Waste Management‟s shareholders and the investing public, said
Richard H. Walker, SEC‟s Director of Enforcement, in a statement. Given the positions held by these
partners and the duration and gravity of the misconduct, the firm itself must be held responsible for the
false and misleading audit reports issued in its name.” (2)

“Auditors have uncovered hundreds of millions of dollars in previously unreported accounting fraud at
HealthSouth, . . . a forensic audit by PricewaterhouseCoopers had found enough additional fraudulent
entries to raise the total to between $3.8 billion and $4.6 billion” “. . . HealthSouth expected to name a
chief executive by the middle of the year to replace Richard Scrushy, its founder, who was indicted in
November on 84 counts of fraud.” (3)

“. . . markets were hammered following last night‟s announcement that WorldCom had inflated profits by a
staggering $3.8 billion over the past five quarters” (4)

        The examples above are only a few of many accounting fraud cases that have

occurred over the past several years. Accounting fraud can have devastating
consequences for investors, customers, and the employees of those companies that

engage in cooking the books. Accounting fraud rarely begins with outright illegal

activity, but instead usually begins with selection of alternative accounting procedures

and aggressive accounting practices that may not be in and of themselves illegal. The

question of when application of various accounting principles or changes is appropriate

is an important one. The person choosing accounting procedures and principles is

influenced by many forces that may lead them to misstate financial results despite an

original intent to follow the law. Even well-intentioned managers or employees within an

organization can be caught-up in activities that lead to misleading financial statements

when placed in a setting where top executives or the corporate culture may place them

under intense pressure to follow orders.

       In this era of greater financial scrutiny, a recent finding by Professor John

Graham of Duke University indicates that rather than engaging in illegal activities, many

CFOs are making decisions that benefit short-term earnings at the expense of long-term

cash flows and profitability. (11) Managers and accountants within the organization, the

audit committee, and outside auditors all should play important roles in ensuring that

financial statements are produced with integrity and that they accurately reflect the

financial position and history of the company. It is important to consider the pressures

and biases of all of these groups and to consider what can be done to motivate

unbiased ethical financial reporting, oversight, and auditing.

       There is no question that accounting fraud is wrong. There are many issues that

are not so clear, however. Corporate executives, accounting managers, audit

committees, and outside auditors all must face questions of exactly what financial and

accounting decisions are acceptable and which are not. When presented with a

                                                                                           2
subjective assessment, how should these groups make decisions on what is right? If

company officers are expected to meet earnings targets as a key component of their

jobs, what can they do to achieve those results and still act in an ethical manner?

When an outside auditor is reviewing financial statements, how much leeway should

company management be given? What should auditors do when they discover a host

of gray or questionable issues that seem to all fall in favor of the company’s short-term

financial goals?



Corporate Executives and Managers

       Corporate executives are often judged in a large part by their ability to meet

short-term earnings goals. If executive compensation and job performance are based

on these criteria, is it acceptable for these executives to do everything within their legal

capacity to meet these targets or are they responsible to other stakeholders such as

employees, customers, society, debt-holders, and long-term investors? Some methods

of increasing short-term earnings may come at a significant cost to employees that may

face employment uncertainty including threat of layoffs, low wages, or benefit cuts.

Customers may suddenly receive a lower quality product or receive lower quality

service. Depending on the community, the actions of the corporation may shut down

the major employer in a town or have environmental consequences in terms of air or

water quality. Some short-term financial fixes may be at the expense of long-term cash

flows and profitability and may have negative consequences on debt-holders and long-

term investors. Examples include sale of a promising business segment in order to

recognize a short-term financial gain, finding creative ways to accelerate revenue




                                                                                            3
recognition, or deferring needed maintenance on capital equipment in order to keep

short-term expenses down.

       While the preceding list is not comprehensive, it illustrates some of the choices

and trade-offs that executives and managers often make. Depending on the decision-

makers values, a decision that is legal and in their own best interests or in the bes t

interests of shareholders may not be in agreement with their personal values and may

negatively impact some of the other stakeholders mentioned. The decision-maker must

weigh the effects of their decisions on all affected stakeholders given the legal

environment in which they operate and their personal values. A further complication

that is important for decision-makers to consider is the fact that we all have known and

unknown biases that have significant influence on our decisions.



Audit Committee and Board of Directors

       The Audit Committee and the Board of Directors has responsibility for setting

policy, for providing oversight, as well as setting the course and direction for the

company. The values that the Board and the Audit Committee express have a

tremendous impact on what the values of the company will be in regard to all the

various company stakeholders. Like corporate executives and managers, the Board

must balance various stakeholder interests and consider their values when making

decisions. The Board must consider what impacts their decisions will have on company

stakeholders and their responsibility to these different groups. Board members

operating under the premise that they are responsible only to shareholders will do

whatever is legally acceptable to maximize shareholder value. Others may believe that




                                                                                           4
they have responsibility not only to shareholders but also to company employees, the

communities in which they operate, to society, and to their customers.


Everyone is doing it

       Most businesses operate in a very competitive environment. In order to

compete, companies must be creative and innovative. Many corporate executives feel

that this also extends to company accounting policy and financial reporting. Meeting

financial targets is often an important aspect of being a successful company. If

aggressive accounting and massaging the numbers is commonplace and is an

expected practice, managers may feel these measures are necessary and legitimate.

Besides, missing the numbers may unnecessarily scare off valuable customers or drive

up financing costs, which could lead the company into a downward spiral. Corporate

executives and mangers may believe that massaging the numbers is a legitimate way to

help a company live to see another day until the business climate improves, a new

product is introduced, or until a new strategy is implemented. Corporate leaders may

believe that they are protecting investors and employees. After all, after a few bad

quarters, the stock price will likely be hit and there may be intense pressure to let

employees go – to downsize.



Influential Forces and Human Bias

Market Expectations and Executive Compensation
    “Aaron Beam, a former chief financial officer at HealthSouth Corp., testified that a $2.7 billion
    accounting fraud began in 1996 when company founder Richard Scrushy ordered him to “fix”
    a revenue shortfall. Beam said that he and William Owens, a former finance chief who also
    pleaded guilty, told Scrushy they could no longer use legitimate aggressive accounting to
    meet forecasts. He said, „It‟s not an option to miss our numbers. You guys need to fix the
    numbers‟.“ (7)



                                                                                                        5
    The financial markets have a short-term outlook and typically will punish companies

that miss quarterly earnings projections by driving down stock price and driving up the

cost of borrowing. Besides their performance being judged by the ability to meet

quarterly earnings targets, top executives are generally provided with additional

incentives to meet these targets through some type of stock-based compensation.


    “We find that the probability of accounting fraud is increasing in the percent of total executive
    compensation that is stock-based (termed stock-based mix) . . . For managers to undertake
    fraud they must perceive positive benefits from it . . . evidence suggests that compensation
    committees face a trade-off between the positive incentive effects afforded by stock-based
    compensation and the negative effect of increasing the probability of accounting fraud.” (6)

    The perceived positive benefits of various accounting decisions for executives must

be considered as a potentially strong influence in the decision-making process.

    “Many major corporations still play things straight but a significant and growing number of
    otherwise high-grade managers have come to the view that it‟s O.K. to manipulate earnings
    to satisfy what they believe are Wall Street‟s desires.” Warren Buffet (9)

    Top executives and directors have very strong incentives to meet quarterly earnings

targets. Some executives further create an environment where employees are

pressured to do whatever it takes to meet targets. Even employees that desire to act in

an ethical manner may begin to make small compromises, which in turn may lead to

material misstatements down the road or when combined with a number of other “small

compromises”.



Choice of Accounting Principles:

       Many accounting decisions are subjective and therefore aggressive accounting

can be an effective tool for corporate executives to meet quarterly earnings targets.

Aggressive accounting techniques are numerous and are very often the first step down




                                                                                                        6
the path of accounting fraud when, over time, legal aggressive accounting techniques

are not enough to meet earnings targets.

    “Sixty percent of senior executives and managers say questionable accounting practices are either
    very or somewhat common while only 8 percent say they are very rare, based on our national
    survey.” (10)
    “Because of the often subjective nature of accounting and the tight relationships between accounting
    firms and their clients, even the most honest and meticulous of auditors can unintentionally distort
    the numbers in ways that mask a company‟s true financial status, thereby misleading investors,
    regulators, and sometimes management. – Annie O‟Neill, Post-Gazette (8)

    Since there is latitude for judgement in selecting accounting principles, it is easy for

those responsible for producing financial statements to convince themselves that

selection of some aggressive accounting principles is ethically ok, particularly if the

outside auditors bless the numbers year after year.



Close relationship between auditors and the companies that hire them:

    Auditors are hired and fired at the will of the company being audited.

Auditors often have a lot of revenue on the line with their clients, particularly with

large corporations. Auditors may not feel that they can afford to lose a large

corporate client. Further, auditors generally develop long-term relationships with

management, which will often introduce bias into their decision making.


       “. . . most of the proposed reforms, including recently enacted legislation, ignore the
       deeper, more pernicious problem with corporate auditing, as it‟s currently practiced – its
       vulnerability to unconscious bias.”
       “Three years ago, Moore, Bazeman and Loewenstein received a grant from the American
       Accounting Association to study auditor independence. Their experiments found that an
       auditor‟s judgement is likely to be biased and that these biases aren‟t easily corrected
       because an auditor might not be fully aware of them. Auditors aren‟t evil people. Most
       don‟t set out to break the law or mislead investors or the public. Indeed, their profession
       already has high ethical standards. But Moore said there was ample research showing
       that our desires influence the way we interpret information even when we try to be
       objective and impartial. If people want to reach a certain conclusion, they usually do.
       Auditing isn‟t an exact science but an art. Besides, auditors have powerful incentives to
       please their clients – that is to come up with a report that supports the claims of a
       company‟s management.”




                                                                                                     7
       “The fact that auditors work closely with corporate executives increases the chances of
       biased thinking, since they will be less likely to harm those with whom they are familiar
       than they would be with strangers.” (8)
    For the reasons referenced above, auditors frequently operate with bias and are

therefore more likely to allow significant aggressive accounting practices that would not

otherwise be deemed appropriate in the absence of such bias.

     Considering all the pressure to use aggressive accounting principles to manipulate

earnings, the question becomes: when is it ok to change accounting principles or to use

so-called “aggressive” accounting principles that may move earnings in the desired

direction? Generally Accepted Accounting Principles (GAAP) provide guidance on how

to make such decisions. While GAAP spells out appropriate accounting principles for

an extensive number of circumstances, there are still many situations (too many to

discuss in this paper!) in which management and auditor discretion is called for. GAAP

tells us that when given the choices between various options, the accountant is to select

the accounting principle that best represents the value of a transaction, asset, expense,

or financial condition of the company. For example, when an accountant is faced with

the decision of whether to capitalize or expense an item he/she should honestly

consider the nature of the item and its useful life rather than capitalizing everything that

they can get away with in order to boost short-term profits.

     If the accountant is putting together financial statements and the auditors

examining them acted with integrity, were objective, and were unbiased there would be

no problem with financial misstatements outside of honest errors. Leaving intentional

fraud aside, even otherwise honest accountants and auditors are subject to bias that

can result in the use of accounting principles that may be inappropriate. Several of

such decisions can lead to a material misstatement or be the first step leading to fraud.



                                                                                                   8
Corporate Audit Committees

     While corporate employees, executive officers, and even outside auditors have

been subject to liability for faulty financial statements, audit committee members have

gone largely untouched. Corporate audit committees are charged with ensuring that

company managers are reporting financial results honestly and with integrity. Audit

committees are also to ensure that outside auditors act with independence and are

provided the resources and cooperation needed to conduct a comprehensive and

objective audit of the financial statements of the corporation.

    “A report issued by the National Commission of Fraudulent Financial Reporting in 1987 recognized
    that a key factor in reducing the incidence of fraudulent financial reporting was the establishment of
    an informed, vigilant, and effective audit committee to oversee the company‟s financial reporting
    process.” (9)


       Unfortunately, audit committees frequently do not live up to their responsibility.

Many members do not have a financial or accounting background and do not even have

the ability to read and understand basic financial statements. Few audit committee

members put in the time necessary to accomplish the task set before them. Many audit

committees spend only a few days per year to fulfill their duties. Meanwhile, in case

after case of accounting fraud, audit committee members have escaped any liability for

reporting failures and frauds.

______________________________________________________________________

       Due to the complexity of financial transactions and the fact that no two situations

are every exactly the same, there will always be subjectivity and the need for human

judgement when putting together financial statements and making financial decisions.

There is no simple answer to financial fraud or accounting misstatements. Regulations,



                                                                                                         9
laws, policies, and procedures cannot completely compensate for human greed and

bias. Understanding what influences decision-makers and understanding the biases

that they operate under is important to consider when dealing with questions of what is

appropriate and what is not.


Questions



1. What are some important things for company executives and mangers to keep in
   mind when making accounting / financial decisions?

2. Is “some” aggressive accounting OK? How should those decisions be made?
   Where should the line be drawn?

3. Is recent Sarbanes Oxley legislation an important part of the solution to accounting
   misstatements/fraud?

4. Is the Board of Directors / Audit Committee responsible for corporate financials and
   executive accounting decisions? If so, to what extent?

5. How should corporations balance the sometimes conflicting interests of various
   stakeholders including shareholders, employees, community/society, the
   environment, and debt-holders?

6. How do company employees decide if what they are asked to do (accounting
   entries) by managers is OK?

7. What should employees and managers do if they feel their company’s financials are
   misleading or if they are asked to do something that they feel may not be right?

8. Should outside auditors be rotated? – i.e. should the employees within an auditing
   firm or the auditing firm itself be changed every few years?

9. Should executive compensation programs be geared toward goals other than short-
   term net income? What are some better/other goals to use?

10. How much are individual and institutional investors to blame for accounting fraud?




                                                                                          1
                                                                                          0
1
1