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With accounting primarily being a construct of the calculative mentality focussed upon maximising the rates of return on invested capital, the current challenges of globalisation call for a uniform system of accounting "as a precondition to the globalisation of capitalism." (Kaelber, 2006)
Whilst international accounting representation has for decades been dominated by the requirements of US GAAP, (Generally Accepted Accounting Principles), recent years have seen the increasing adoption of IFRS (International Financial reporting Standards) guidelines by a number of European and Anglophone nations. (Gornik-Tomaszewski & Mccarthy, 2003) Although the requirements of the US SEC (Securities Exchange Commission) have dominated the formulation of US GAAP and are significantly influencing IFRS guidelines, the currently occurring convergence between US GAAP and IFRS indicates the growing desire in the accounting community for the adoption of an International Accounting Standards Board (IASB) backed global "principles based accounting system," in place of the rules based US GAAP approach. (Gornik-Tomaszewski & Mccarthy, 2003)
A recent White Paper signed by CEOs of the world's six largest accounting firms, Deloitte Touche Tohmatsu, Ernst & Young, PricewaterhouseCoopers, KPMG, Grant Thornton, and BDO Seidman finds overwhelming support for a single, global set of high-quality accounting standards based upon "faithful presentation of economic reality, responsiveness to needs for clarity and transparency, consistency with a clear conceptual framework, based upon an 'appropriately-defined scope that addresses a broad area of accounting,' clear and concise writing in plain language, and allowance for the use of 'reasonable judgment.'" (Taub, 2008) "It is our view that the move toward global adoption of IFRS as promulgated by the IASB (International Accounting Standards Board) must be continued, along with the global convergence of audit and independence standards," the CEOs said in the paper, titled "Principles-Based Accounting Standards." (Taub, 2008)
The essence of the debate over the issue stems from a growing feeling that a rules based approach is inappropriate for an increasingly complex business scenario because it (a) becomes unnecessarily complex and unwieldy with new rules being needed for the treatment of each new variable, (b) becomes mired in detail, (c) facilitates financial engineering, (d) encourages creativity of the wrong kind in financial reporting, and (e) allows management to stretch the limits of what is permissible under the law; even though such actions may not be ethically or morally acceptable. (Houston & Reinstein, 2001)
In light of the occurrence of a spate of financial scandals in the late 1990s and the early 2000s being linked to the leeway provided to CFOs and corporate managements by the rules based approach, this essay attempts to examine two relevant issues, (a) the reasons for management to provide an inaccurate picture and (b) the ways how application of an accounting policy can produce an inaccurate picture.
Commentary and Analysis
Reasons for Accounts Manipulation
In an age of increasingly large business operations, corporate managements tend to have numerous responsibility centres manned by different teams of managers. With factors like greater decentralisation of functions, the presence of internal and external auditors, and the existence of elaborate systems making it difficult for solitary managers to misrepresent accounts, accounting manipulation on a significantly large scale requires (a) the involvement of a large number of disparate employees at various hierarchical levels, (b) the concurrence, and in most cases the leadership of senior management, and (c) the misleading of internal and external auditors, if not their carelessness, negligence, or covert collusion. (Leuz & Others, 2004) Examined below are the accounting practices of Enron and Royal Ahold, where managements took advantage of existing rules in accounting presentation to misrepresent and manipulate revenue figures.
Enron, in the early and mid 1990s was considered to be an enormously successful global company, operating in a complex, technologically advanced, and competitive business. An American company, it was audited by Arthur Anderson, (the largest auditing firm in the world at that time), and whilst known to be an aggressive competitor and good at working with foreign governments, its financial probity had never come up for discussion or criticism. As per information now available, manipulation of accounts at Enron commenced as early as 1997, (a time when the company's financial indicators and ratios also started showing contradictory results), and led to what is now known to be one of the most elaborate earnings management exercises ever. (Catanach & Catanach, 2005)
The Treadway Commission, in its report of 1987 stated that three particular conditions normally exert undue pressure on the preparation of financial statements, namely performance pressure, oversight issues, and changing structural conditions. (Catanach & Catanach, 2005) In the case of Enron all three of these elements were present in ample measure. With a number of contractual incentives in their hands by way of debt and stock options and handsome performance bonuses, members of the management at Enron were under significant pressure to sustain and improve corporate performance. (Catanach & Catanach, 2005) The fact that many managers also held shares in the company, the market price of which depended upon the company's operational performance, increased the pressure to post good operational results. The complex ownership structures utilised by the company for their Special Purpose Entities (SPEs) to further its business strategy made it exceedingly difficult for auditors to assess, analyse, and monitor its results, thus increasing the chances of oversight. Finally the company was significantly impacted by changes in its working environment. Developments like the decline on the technology sector (Catanach & Catanach, 2005) and the long drawn out dispute with the government of Maharashtra in India over the supply, erection and commissioning contract of a mega power station, hurt its operations significantly, and possibly incentivised the management to engage in accounting misrepresentation. Whilst such rationalisation is all very well for the purpose of academic or social research, most people see the actions of Enron's management to be little more than fraud, deceit and trickery for the personal gain of managers.
The beginning of organised creative accounting for Enron goes back to 992 when Jeff Skilling, president of Enron's trading operations, convinced federal regulators to allow the company to use an accounting method known as "mark to market", a technique previously used only by brokerage and trading companies. (Dharan, 2003) In mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This being money that might not be collected for years, a change of rules by federal authorities allowed Enron to treat what was ostensibly future income as current revenues and thereby inflate their revenues substantially. (Dharan, 2003) Revenue recognition, under the IASB framework is guided by IAS 18, which defines revenues as "the gross inflow of economic benefits during the period arising from the ordinary activities of an entity when the inflows result in an increase in equity, other than increases relating to contributions from equity participants." (Similarities and differences, a comparison of IFRS and US GAAP, 2007) Although the concept statement of US GAAP defines revenues as actual or expected cash inflows, or equivalents, which have occurred or will result from an entity's ongoing operations, the absence of a laid down standard can well lead to liberties in its interpretation, which in turn could go against accounting correctness in a rule based regime. For example, whilst both IASB and US GAAP frameworks require revenue to be measured in cash or cash equivalents received or receivable, the IASB framework very clearly needs deferred income to be discounted to present value. (Similarities and differences, a comparison of IFRS and US GAAP, 2007) Such an accounting approach would have clearly discouraged Enron's mark to market accounting by demanding clarification of the periods in which future inflows were expected and resulted in significant reductions in current revenues.
In The Netherlands, an Enron style financial scandal rocked one of its largest companies Royal Ahold, N.V., in 2003. The company, which recorded phenomenal global growth during the 1990s, (from 7.7 billion Euros in 1990 to 62.7 billion Euros in 2002), became the 3rd largest retailer in the world by the turn of the century, after a professional management team replaced the controlling Heijn family in 1987. (Knapp & Knapp, 2007) Royal Ahold, which found it progressively difficult to manage its huge chain of stores outside The Netherlands, sought to fuel its growth through targeting an increase of profits by 15 % every year and a doubling of turnover every 5 years. With employees struggling to achieve unrealistic targets year after year, and the company management feeling the public achievement of such targets to be intrinsic to the company's expansion and capital raising plans, the company's auditors, Deloitte, found material distortion in the company's periodic financial statements in 2002. Deloitte's suspension of its audit in 2002 caused widespread public embarrassment in The Netherlands and sharp and adverse impact upon the company's operations. (Knapp & Knapp, 2007)
Investigations revealed that the largest chunk of misrepresentation of the company's performance arose from improper inclusion of the results of certain foreign joint ventures in its consolidated financial statements. (Knapp & Knapp, 2007) Royal Ahold was to found to have included the complete sales of many of its joint ventures, in which it held only 50 % ownership, in its consolidated group sales on the basis of then existing Dutch GAAP rules. These rules allowed companies to consolidate the financial data of a joint venture company in their statements if they controlled its operations; such control being evidenced by more than 50 % ownership in the joint venture or through other means. Royal Ahold took advantage of this rule by obtaining letters from the joint venture companies, in which it held 50% ownership, (for the benefit of Deloitte), acknowledging operational control, to include their full sales in their books; thus driving up sales to far higher levels than they actually were. (Knapp & Knapp, 2007)
Reporting of sales in joint ventures, which under IASB guidelines are governed by IAS 31 and 28, should, under the principle based approach, follow the equity method of incorporating revenues in accordance with percentage of holding; where the holding is significant but not controlling. (Comparison of IAS 31 with US GAAP, 2007) The application of such a principle would never have allowed such misrepresentation to happen.
Enron's Use of SPEs
Subsequent investigations have revealed Enron to have used numerous transactions with Special Purpose Entities (SPEs) controlled by the company to cloak bad investments. Such transactions were used to create more than a billion dollars of false incomes, mostly at the time of quarter endings, through regular or back dated entries, so that incomes could be built to satisfy investor hopes and expectations. (Dharan, 2003)
SPEs, which were first used in the 1970s by the financial services industry, can take the form of trusts, partnerships or corporations, and relate to entities formed by sponsoring companies and groups of outside investors in designing of joint ventures with charters that restrict them to specified activities. (Dharan, 2003) With such entities being useful for securitising illiquid and non-marketable securities and for providing liquidity to certain assets, thus facilitating a larger market for sharing of risks, their increased usage in the business world also opened opportunities to managements like Enron's for using them to achieve specific accounting objectives like off balance sheet financing, (where loans taken by the SMEs are not reflected in the books of the sponsoring company) cloaking of poor performing assets by transferring such assets to SPE books, reporting of gains and losses as and when desired by sponsor managements, and speedy execution of transactions with related parties at desired parties. (Dharan, 2003)
Whilst the Financial Accounting Standards Board (FASB) in the United States had not promulgated general guidelines on the consolidation of results of such SPEs with the sponsors' financial statements, it had attempted to address the use of SPEs in leasing transactions in 1990 by indicating that consolidation was not necessary if 3% or more of the value of the assets were held by owners other than the lessee. Making use of this guideline, Enron ensured nonconsolidation by obtaining 3% outside investment in their SPEs. (Dharan, 2003)
The Enron management used SPEs with names like Braveheart, LJM1, LJM2, and Chewco, in various ways in order to manipulate accounting statements.
- Poor performing investments like Rhythms NetConnections were transferred to SPEs to ensure non-recognition of value declines of such assets in the financial statements of Enron. In 2000 and 2001 alone, Enron was able to hide as much as 1 billion dollars of losses from poor-performing merchant investments by these types of SPE transactions
- The company transferred a business contract, an agreement with Blockbuster Video to deliver movies on demand, to an SPE for a "gain" of 111million GBP.
- SPEs like LJM1 and LJM2 were used for related party transactions when needed, prices in such cases were not done at arm's length and arrived at between parties with conflicting interests. The Blockbuster transaction was arranged in December 2000, to ensure 53 million dollars of the "gain" amount could be incorporated in 2000, and the balance in the first quarter of 2001. (Dharan, 2003)
Enron took advantage of APB 18 and EITF 90-15 (by keeping its investment at 50 % and ensuring 3% outside interest) to ensure that the operations of the SPEs were not consolidated into its books, despite the fact that it effectively controlled their operations through its senior managers and arranged for their financing from banks like Barclays by guaranteeing their loans. Keeping SPEs like JEDI and Chewco as unconsolidated despite effectively controlling their operations enabled Enron to overstate its net income and shareholders equity by 405 million GBP from 1997 to 2000 and understate its liabilities from 561 million to 711 million GBP during the same period. (Catanach & Catanach, 2005)
"While bad business strategy and bad investment decisions can and do contribute to a Company's fall, it is a company's desperate attempt to use accounting tricks to hide bad decisions that often seals its fate." (Dharan, 2002)
Recent years have seen company managements bending accounting rules to engage in creative accounting and "manage" their publicly presented earnings. Possibly driven towards these ends because of performance pressures as well as structural and economic changes and developments, financial managers and corporate leaders have time and again tried to utilise the complexities of the plethora of rules in existing accounting policies and practices to mislead auditors and manipulate and misrepresent accounts to achieve their own objectives. Both Enron and Royal Ahold manipulated the controlling interest rules regarding equity holding in joint ventures to overstate their earnings/ reduce their losses in desperate bids to get access to vital funds from lenders and shareholders. Similar issues have arisen with companies like Xerox and ISoft.
Such developments could have possibly been avoided under the principles based approach, which under IAS 28 and 31 advocates full consolidation in instances of existing operational control and on the basis of equity when holding is significant but does not amount to control. The application of a principle based approach does help in eliminating the clutter created by a plethora of rules and in auditors avoiding traps that can be set up by enterprising and manipulative managements. With more than 100 countries having already adopted or announced plans to adopt IFRS standards and the SEC announcing that some non-US companies may not have to reconcile with US GAAP (Taub, 2008) as long as they used IASB standards, the gradual global adoption of principles based accounting appears to be a fait accompli.