Ethics in Financial Reporting
Introduction:
Ethics in accounting is of a major issue in today’s dynamic world of business where today’s biggest corporation can plummet by tomorrow just because of poor accounting practices. The recent accounting scandals of some of the largest organization of the world such as Enron, World Com, Tycho , Health South, Lehman Brothers and Sat yam among others have raised eyebrows of many communities and government authorities and has raised awareness about the complexities of various decision making processes that goes into accounting and preparing financial reports. It has become for accounting professionals to understand the importance of ethics and judgement in the field of accounting and their implications. This report will using literature and secondary resources, pay due attention to the importance of ethics and judgement in preparation of financial reports and discuss the key areas therein. The report will discuss the areas such as revenue recognition, assets valuation and provision, future costs, and depreciation where accounting practices should be carefully considered. Wrong judgement s and unethical practices in accounting can cause damage not just to the organization but also to the overall economy. This report will also look at the cases of accounting dereliction in Enron Corporation, Compute Corporation and World Com Corporation which led to their demise and finally conclude by justifying the argument that ethics and judgment are essential in accounting practices.
Importance of Ethics and judgment in financial reporting:
One of the most essential ways for a business organization to communicate its financial operations and position is through its financial statements. Financial reporting is important for stakeholders in the sense that it provides them the necessary information in their decision making process. For example, an investor can, after interpreting the financial reports, make a decision regarding his investment on the company, lenders can decide on giving debts to the organization, board members can evaluate the performance of the management, all based on the financial performance of the organization indicated by the reports. Similarly, government authorities, consumers, employees, social groups, etc. are interested in these reports and make many of their decision based upon the information given in the reports. Therefore, the role of professional accountants becomes crucial in context of preparing, auditing, and presenting financial statements that portray the business in the best way possible to its stakeholders. Professional accountants or auditors are responsible for presenting financial reports that are true and show the actual performance and position of the organization. Malhotra (2013, p. 16) cites that the accounting practice comprises of several processes that involve dealing with many issues related to judgment and resolving differences in conflicting approaches to delivery of the outcome of the financial transactions and events. On one hand, professionals in the field of accounting have a significant obligation towards the general public to provide them with information regarding the financial status of the company on the other hand the same professionals might have to work in the interest of the employers or the clients which might be conflicting in nature and this could result in a situation that puts the accounting professionals in dilemma. According to Leung & Cooper (1995, p. 28), in an inquiry of 1500 accounting professionals, conflict of interest, client proposal to manipulate accounts, and clients proposal for tax evasion were amongst the three most often cited ethical problems faced by the professionals. The study showed that ethical problems concerned with creative accounting were more often than the ones related with tax evasion. This is a major issue because creative accounting is not particularly an illegal practice, it is merely accounting policy's flexibility in practice that can be argued as morally unethical (Malhotra 2013, p. 16). Therefore, the very nature of the profession of the accountant makes it imperative for them to be ethical. The professional judgments made by the accountants can alter the decision made by the stake holders. These decisions during the course of time have an impact on the allocation of resources in the economy.
Key areas of ethics and judgment in financial reporting:
There are several areas where accounting professionals need to be vigilant about making decisions as these decisions can have long term impact on the business organization. Following are brief discussions on the key areas of ethics and judgment in financial reporting,
Revenue Recognition:
The matching principle of GAAP clearly states that revenues should always be matched with the expenses. Therefore, expenses and revenues are reported on accrual basis, i.e. when the transaction event takes place and a profit or expense is gained or incurred respectively. If a judgment is made to generate report without matching revenues with their related expenses, companies can produce financial reports that will provide insufficient information about the organization. Therefore, while trying to analyze financial statements one needs to keep in mind the professional judgments that may have been taken by the accountants to produce reports that are guided by the company policies of either being aggressive or conservative in revenue recognition. Aggressive revenue recognition could overstate a firm’s revenue and income performance. Micro Strategy, a data-mining software producer, in 2000, announced to reevaluate its revenue recognition approach led the firm's reported profit of $12.6 million plummet into a loss of more than $34million (Sherman & Young 2001, p. 131). This was a result of improper measurement of contract revenue before it was due. Therefore, it is essential for professionals to have an ethical judgement in order to manage and recognize revenues properly.
Valuation Issues:
International Valuation Standards Council (IVSC) defines valuation as “the process of establishing the value of an asset or liability or the amount representing an opinion or estimate of value” (2015). Valuation could be of tangible or intangible assets. Tangible assets include plant, inventory, equipment, collectables, property, etc. These are assets that are physically present while intangible assets include goodwill, shares, rights, intellectual property, businesses and financial instruments. Assets can be valued in generally on one of the two bases: book value basis and the market value basis. Generally Accepted Accounting Principles (GAAP) generally follows the “book” or “original cost” accounting basis. So, if a company buys an asset for $5 million, the value of the asset for accounting reasons will be $5 million until the asset is sold at which point the “market” value of the asset will be calculated to measure any capital gain or loss. However the issue here is that “book” value does not represent the true value of the assets in the market. Moreover, firms also hesitate to follow “market” value approach because this will reflect volatility in firm's earnings as the market value is not always static. Therefore, an accountant needs to make certain professional judgement with respect to assets and liability valuation as well. The recent Kinross Gold scandal is an example of overstated asset valuation..
Depreciation:
A company's performance is also determined by its depreciation policy. There can be several policies from which a firm can decide to choose their depreciation policy. Which one to follow is the area of professional judgment by the accountant and the management? Various determinants like duration, disposal value, depreciation policy are responsible for ascertaining the amount of depreciation. The amount of depreciation in a financial statement can contribute to major share of its expenses. Therefore, firms often misrepresent the numbers to show higher income in their financial statements and it is evident that this is key area where ethics and judgement of a professional comes into play. For example, Delta Airlines update the useful life of their aircraft twice within the period of ten years which resulted in creation of significant increase in profit in both cases (Sherman & Young 2001, p. 131). The motive behind such changes is a question for subjective debates on moral and ethical judgement issues.
Provisions for Uncertain Future Costs:
Sherman & Young (2001, p. 131) state "Companies must make provisions for costs they know will arise, even if the amounts can't be known with any certainty: losses from inventory obsolescence, uncollected accounts, product returns, restructuring costs, damages from product recalls-the list goes on". There is a significant room for firms to play here that can alter financial statements. Firms can either exaggerate the provisions to produce hidden reserves which can then be used in future to jump their profit flow or can reduce the size of the provision to portray higher net income in the current period. This is also a key area for the accounting professionals to practice ethical judgments and decisions.
Potential loss when ethics and judgement are ignored:
Lapse of ethics and judgement mainly contributes to the failure of professional accountants and auditors to meet their obligations of fair reporting of financial performance of business organization to their investors. The role of investors is critical in context of the current system of distributed democratic economies which is perceived to attend the interest and ambition of all taxpayers. These investors contribute towards continuous capital formation in the economy by directing the mobility of financial resources towards to most lucrative sector of the economies and much of that decision making depends upon the reliable information provided by accountants and auditors. If accountants and auditors fail to function within their fiduciary duties, to meet their obligations, and to behave ethically, there could be a significant loss to the investors, citizens and to the whole economy at large (Staubas 2005, p. 6). Several companies have collapsed due to improper accounting practices such as The Bank of Credit and Commerce International in 1991, Enron in 2001, Bernie L. Madoff Investment Securities LLC, etc.
Supporting case studies:
The discussion on the importance of ethics and judgement in financial reporting is not merely a theoretical concept but rather a global phenomenon. Many corporate scandals associated with misrepresentation of financial information have been recorded over the years and such cases have risen in numbers most recently. Some of these scandals have led to the downfall of few of the biggest corporate firms in the world. We will look at three cases of how failure to be in compliance with ethical behaviors and ethical judgement has had severe impact on the organization spoken of.
Compton Corporation:
Compton Corporation which has now been renamed to Symbiat, Inc. is a United States based company, has been in the field of Information technology since 1984 and designs, manufactures and markets products and services that are directed towards IT enterprises mostly associated with internet communication hardware (Stallworth & Braun 2007, p. 320). Computone Corporation faced extreme liquidity issues starting from 1992 when the company reported huge amount of working capital deficiency. This resulted in the firm being delisted from NASDAQ because it could not meet the minimum requirements to be listed in NASDAQ. In an attempt to get re-listed, Computone made numerous changes to its capital structure and took various steps that finally brought the company back to the NASDAQ list by the end of 1994. This sounds like a success story but however by 1997 Computone was alleged by its former employees regarding its accounting practices and financial reporting process. The allegations stated that the company's senior management had in an orderly manner made efforts to amplify the company's revenue and total profits during the three years between 1993 and 1997 (Stallworth & Braun 2007, p. 321). The investigation made by United States Securities and Exchange Commission (SEC) in this matter showed that the senior management of the firm was involved in extensive deceit which created exaggeration of income in the financial statements between the year 1994 and 1997. There were 240 8 business transactions which were not recognized correctly in the accounting books. This as we discussed previously is a key area where ethics and judgements come into play. The case indicates that the management of Computone, in a desperate attempt to improve its financial situation opted to follow creative accounting and illegal accounting practices disregarding accounting ethics for their own self-benefit. This resulted in charges against the people in senior management position. The company's stock value declined and it was again de-listed for failing to meet the minimum requirements.
Enron Corporation:
The examples of accounting scandals are incomplete without the inclusion of the famous Enron Scandal. Enron Corporation was one of the biggest corporations in USA. Enron’s went bankrupt in December 2001. The main reason behind the downfall is the misrepresentation of income and assets in the financial statements. One of the reasons behind the failure of Enron Corporation was the mark to market approach followed by the organization while evaluating their assets value (Ellul et al. 2014, p. 299). Mark to market approach is basically the method of valuation of assets on market value rather than the traditional way of measuring the assets value on book value. Assets evaluation as was discussed previously is a key area where ethics and judgement is required. The ethical judgement made by Enron Corporation to follow market value caused its own demise. Moreover, Enron’s policies towards Revenue recognition were also highly controversial. The most outrageous example can be the fact that Enron’s revenue recognition included the revenue that originated from increment in the price of its own shares following the equity method (Baker & Hayes 2004, p. 778). Enron Corporation also identified and listed revenue that were derived from long term contracts whose value was again based upon the mark-to-market approach that was institutionalized by the corporation (Baker & Hayes 2004, p. 778). These are only the tip of the iceberg for all the underlying accounting failures that contributed to Enron Corporations failure. However once can generate a fair idea as to how the ethical decisions and judgements made by the corporation resulted in misrepresentation of its financial position which were although totally valid under legal systems of accounting, led to serious consequences one after another and eventually directed the corporation towards bankruptcy.
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Ethics in accounting is of a major issue in today’s dynamic world of business where today’s biggest corporation can plummet by tomorrow just because of poor accounting practices. The recent accounting scandals of some of the largest organization of the world such as Enron, World Com, Tycho , Health South, Lehman Brothers and Sat yam among others have raised eyebrows of many communities and government authorities and has raised awareness about the complexities of various decision making processes that goes into accounting and preparing financial reports. It has become for accounting professionals to understand the importance of ethics and judgement in the field of accounting and their implications. This report will using literature and secondary resources, pay due attention to the importance of ethics and judgement in preparation of financial reports and discuss the key areas therein. The report will discuss the areas such as revenue recognition, assets valuation and provision, future costs, and depreciation where accounting practices should be carefully considered. Wrong judgement s and unethical practices in accounting can cause damage not just to the organization but also to the overall economy. This report will also look at the cases of accounting dereliction in Enron Corporation, Compute Corporation and World Com Corporation which led to their demise and finally conclude by justifying the argument that ethics and judgment are essential in accounting practices.
Importance of Ethics and judgment in financial reporting:
One of the most essential ways for a business organization to communicate its financial operations and position is through its financial statements. Financial reporting is important for stakeholders in the sense that it provides them the necessary information in their decision making process. For example, an investor can, after interpreting the financial reports, make a decision regarding his investment on the company, lenders can decide on giving debts to the organization, board members can evaluate the performance of the management, all based on the financial performance of the organization indicated by the reports. Similarly, government authorities, consumers, employees, social groups, etc. are interested in these reports and make many of their decision based upon the information given in the reports. Therefore, the role of professional accountants becomes crucial in context of preparing, auditing, and presenting financial statements that portray the business in the best way possible to its stakeholders. Professional accountants or auditors are responsible for presenting financial reports that are true and show the actual performance and position of the organization. Malhotra (2013, p. 16) cites that the accounting practice comprises of several processes that involve dealing with many issues related to judgment and resolving differences in conflicting approaches to delivery of the outcome of the financial transactions and events. On one hand, professionals in the field of accounting have a significant obligation towards the general public to provide them with information regarding the financial status of the company on the other hand the same professionals might have to work in the interest of the employers or the clients which might be conflicting in nature and this could result in a situation that puts the accounting professionals in dilemma. According to Leung & Cooper (1995, p. 28), in an inquiry of 1500 accounting professionals, conflict of interest, client proposal to manipulate accounts, and clients proposal for tax evasion were amongst the three most often cited ethical problems faced by the professionals. The study showed that ethical problems concerned with creative accounting were more often than the ones related with tax evasion. This is a major issue because creative accounting is not particularly an illegal practice, it is merely accounting policy's flexibility in practice that can be argued as morally unethical (Malhotra 2013, p. 16). Therefore, the very nature of the profession of the accountant makes it imperative for them to be ethical. The professional judgments made by the accountants can alter the decision made by the stake holders. These decisions during the course of time have an impact on the allocation of resources in the economy.
Key areas of ethics and judgment in financial reporting:
There are several areas where accounting professionals need to be vigilant about making decisions as these decisions can have long term impact on the business organization. Following are brief discussions on the key areas of ethics and judgment in financial reporting,
Revenue Recognition:
The matching principle of GAAP clearly states that revenues should always be matched with the expenses. Therefore, expenses and revenues are reported on accrual basis, i.e. when the transaction event takes place and a profit or expense is gained or incurred respectively. If a judgment is made to generate report without matching revenues with their related expenses, companies can produce financial reports that will provide insufficient information about the organization. Therefore, while trying to analyze financial statements one needs to keep in mind the professional judgments that may have been taken by the accountants to produce reports that are guided by the company policies of either being aggressive or conservative in revenue recognition. Aggressive revenue recognition could overstate a firm’s revenue and income performance. Micro Strategy, a data-mining software producer, in 2000, announced to reevaluate its revenue recognition approach led the firm's reported profit of $12.6 million plummet into a loss of more than $34million (Sherman & Young 2001, p. 131). This was a result of improper measurement of contract revenue before it was due. Therefore, it is essential for professionals to have an ethical judgement in order to manage and recognize revenues properly.
Valuation Issues:
International Valuation Standards Council (IVSC) defines valuation as “the process of establishing the value of an asset or liability or the amount representing an opinion or estimate of value” (2015). Valuation could be of tangible or intangible assets. Tangible assets include plant, inventory, equipment, collectables, property, etc. These are assets that are physically present while intangible assets include goodwill, shares, rights, intellectual property, businesses and financial instruments. Assets can be valued in generally on one of the two bases: book value basis and the market value basis. Generally Accepted Accounting Principles (GAAP) generally follows the “book” or “original cost” accounting basis. So, if a company buys an asset for $5 million, the value of the asset for accounting reasons will be $5 million until the asset is sold at which point the “market” value of the asset will be calculated to measure any capital gain or loss. However the issue here is that “book” value does not represent the true value of the assets in the market. Moreover, firms also hesitate to follow “market” value approach because this will reflect volatility in firm's earnings as the market value is not always static. Therefore, an accountant needs to make certain professional judgement with respect to assets and liability valuation as well. The recent Kinross Gold scandal is an example of overstated asset valuation..
Depreciation:
A company's performance is also determined by its depreciation policy. There can be several policies from which a firm can decide to choose their depreciation policy. Which one to follow is the area of professional judgment by the accountant and the management? Various determinants like duration, disposal value, depreciation policy are responsible for ascertaining the amount of depreciation. The amount of depreciation in a financial statement can contribute to major share of its expenses. Therefore, firms often misrepresent the numbers to show higher income in their financial statements and it is evident that this is key area where ethics and judgement of a professional comes into play. For example, Delta Airlines update the useful life of their aircraft twice within the period of ten years which resulted in creation of significant increase in profit in both cases (Sherman & Young 2001, p. 131). The motive behind such changes is a question for subjective debates on moral and ethical judgement issues.
Provisions for Uncertain Future Costs:
Sherman & Young (2001, p. 131) state "Companies must make provisions for costs they know will arise, even if the amounts can't be known with any certainty: losses from inventory obsolescence, uncollected accounts, product returns, restructuring costs, damages from product recalls-the list goes on". There is a significant room for firms to play here that can alter financial statements. Firms can either exaggerate the provisions to produce hidden reserves which can then be used in future to jump their profit flow or can reduce the size of the provision to portray higher net income in the current period. This is also a key area for the accounting professionals to practice ethical judgments and decisions.
Potential loss when ethics and judgement are ignored:
Lapse of ethics and judgement mainly contributes to the failure of professional accountants and auditors to meet their obligations of fair reporting of financial performance of business organization to their investors. The role of investors is critical in context of the current system of distributed democratic economies which is perceived to attend the interest and ambition of all taxpayers. These investors contribute towards continuous capital formation in the economy by directing the mobility of financial resources towards to most lucrative sector of the economies and much of that decision making depends upon the reliable information provided by accountants and auditors. If accountants and auditors fail to function within their fiduciary duties, to meet their obligations, and to behave ethically, there could be a significant loss to the investors, citizens and to the whole economy at large (Staubas 2005, p. 6). Several companies have collapsed due to improper accounting practices such as The Bank of Credit and Commerce International in 1991, Enron in 2001, Bernie L. Madoff Investment Securities LLC, etc.
Supporting case studies:
The discussion on the importance of ethics and judgement in financial reporting is not merely a theoretical concept but rather a global phenomenon. Many corporate scandals associated with misrepresentation of financial information have been recorded over the years and such cases have risen in numbers most recently. Some of these scandals have led to the downfall of few of the biggest corporate firms in the world. We will look at three cases of how failure to be in compliance with ethical behaviors and ethical judgement has had severe impact on the organization spoken of.
Compton Corporation:
Compton Corporation which has now been renamed to Symbiat, Inc. is a United States based company, has been in the field of Information technology since 1984 and designs, manufactures and markets products and services that are directed towards IT enterprises mostly associated with internet communication hardware (Stallworth & Braun 2007, p. 320). Computone Corporation faced extreme liquidity issues starting from 1992 when the company reported huge amount of working capital deficiency. This resulted in the firm being delisted from NASDAQ because it could not meet the minimum requirements to be listed in NASDAQ. In an attempt to get re-listed, Computone made numerous changes to its capital structure and took various steps that finally brought the company back to the NASDAQ list by the end of 1994. This sounds like a success story but however by 1997 Computone was alleged by its former employees regarding its accounting practices and financial reporting process. The allegations stated that the company's senior management had in an orderly manner made efforts to amplify the company's revenue and total profits during the three years between 1993 and 1997 (Stallworth & Braun 2007, p. 321). The investigation made by United States Securities and Exchange Commission (SEC) in this matter showed that the senior management of the firm was involved in extensive deceit which created exaggeration of income in the financial statements between the year 1994 and 1997. There were 240 8 business transactions which were not recognized correctly in the accounting books. This as we discussed previously is a key area where ethics and judgements come into play. The case indicates that the management of Computone, in a desperate attempt to improve its financial situation opted to follow creative accounting and illegal accounting practices disregarding accounting ethics for their own self-benefit. This resulted in charges against the people in senior management position. The company's stock value declined and it was again de-listed for failing to meet the minimum requirements.
Enron Corporation:
The examples of accounting scandals are incomplete without the inclusion of the famous Enron Scandal. Enron Corporation was one of the biggest corporations in USA. Enron’s went bankrupt in December 2001. The main reason behind the downfall is the misrepresentation of income and assets in the financial statements. One of the reasons behind the failure of Enron Corporation was the mark to market approach followed by the organization while evaluating their assets value (Ellul et al. 2014, p. 299). Mark to market approach is basically the method of valuation of assets on market value rather than the traditional way of measuring the assets value on book value. Assets evaluation as was discussed previously is a key area where ethics and judgement is required. The ethical judgement made by Enron Corporation to follow market value caused its own demise. Moreover, Enron’s policies towards Revenue recognition were also highly controversial. The most outrageous example can be the fact that Enron’s revenue recognition included the revenue that originated from increment in the price of its own shares following the equity method (Baker & Hayes 2004, p. 778). Enron Corporation also identified and listed revenue that were derived from long term contracts whose value was again based upon the mark-to-market approach that was institutionalized by the corporation (Baker & Hayes 2004, p. 778). These are only the tip of the iceberg for all the underlying accounting failures that contributed to Enron Corporations failure. However once can generate a fair idea as to how the ethical decisions and judgements made by the corporation resulted in misrepresentation of its financial position which were although totally valid under legal systems of accounting, led to serious consequences one after another and eventually directed the corporation towards bankruptcy.
Read More Order Now
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