Accounting Fraud – Its repercussions

.

Enron, WorldCom, Lehman Brothers, Arthur Anderson. Who would have thought that these companies will be companies of the past, something that future generations would read in history lessons. But the truth is that we lost these companies, and all in just a few years.

Before its demise in late 2001, Enron was an electricity and natural gas giant. It was known all over the world and was hugely successful; at least on paper (with $101 billion in what they claimed to be revenues). It was popular with the press, with Fortune magazine naming the company for six consecutive years as the “America’s Most Innovative Company”. When the bubble burst and the truth was revealed, it wasn’t a pretty picture. The company had duped everyone to believe they were a successful company.

The so called success was being sustained only by creative accounting or in simpler terms accounting fraud. The company had established a number of limited liability special purpose entities, some of them offshore and moved a huge amount of debt and losses to these entities. These entities were not rolled into the financials of the parent company, so the company looked far healthier than what it truly was. But in August 2001, when Daniel Scotto the first analyst to publicly disclose Enron’s financial flaws came out with his report “All Stressed up and no place to go”, the truth started to unfold and by end of 2001 the company filed for bankruptcy. It was the end of a giant!

Enron’s demise had two big impacts on the accounting industry, first was that this scandal made the government take more notice of accounting fraud and thus began the idea of Sarbanes Oxley and the second was that along with Enron, the accounting community lost one of the big 5 (at that time) accounting firms, Arthur Anderson, the audit firm of Enron.

But apart from the impact on accounting industry, the collapse of any big corporation has a ripple effect. There is a big list of affected parties in a situation like this. The employees, the customers, the suppliers, the creditors, the investors and the total market. Each party feels the heat, even though some may feel it more than other.

The employees, they not only lose their job, (at the time of the revelation of Enron’s fraud, the company employed 22,000 people) and hence their current source of income but they also lose their future source of income in the form of losses on their 401Ks. In case of Enron, most of the 401K investments were almost wiped out as more than 60% of the assets held in the company’s 401(K) retirement plan consisted of Enron shares. The share price dropped from over $90 to just pennies at the time the fraud was unraveling. So basically 60% of the asset base was completely wiped off. The rest 40% was affected as well, because when such behemoths are lost the market sentiment goes down, the entire market takes a hit. So the employees lose their safety net for the future with no source of income for the present.

When big companies fail, they tend to have a bigger impact on the market as a whole. The investors become wary of the whole market. The mentality becomes of wait and watch; no one wants to do any more investments because they think if things like this can happen to such big companies what is to say smaller organizations won’t get wiped out! And after being hit with big losses due to investment in the lost giant, very few people rise out of it and start investing again.

Customers lose too. They lose their source of supply, and in cases where there are fewer suppliers, the customers are faced with the dilemma of who to choose. With fewer suppliers in the market, the law of economics would kick in- the suppliers would have an upper hand in setting up prices and there is a chance of deteriorating service as fewer suppliers have to meet the demand of more customers. Which raises the question, would customers get the supply they need; now that the demand supply equilibrium needs to be readjusted.

The suppliers suffer. They are able to recover a smaller portion of their outstanding bills and will have to write off a big portion; thereby affecting their margins. Some smaller suppliers might very well be wiped out if they have a very few client base and their biggest client files for bankruptcy.

Other creditors like the utilities, the equipment and space providers, other service providers also lose on their outstanding bills. Banks that work on investment as well as commercial banking for such clients get burnt too. In case of Enron Citigroup and J.P. Morgan Chase took a big blow.

Is it possible to stop such activities and save corporations from being wiped out? Sarbanes Oxley and now Dodd-Frank Acts are trying to do just that. Will they be successful? They will be helping in laying down the rules and regulations and the penalties. But it will take a holistic approach to solve this situation. The auditors need to be much more involved, the employees need to raise their voice is they see something fishy, investors should not just look at the main financial indicators and stock price but try to read between the line, the analysts tracking the companies should be more thorough in scrubbing the numbers and last but not the least, the executives should realize that greed is good but too much of it can land them in prison!

Kenneth Lay, Jeff Skilling, Andrew Fastow; the accounting community will not forget these names. These names will go down in the accounting history as the executives who schemed the investors into believing what was not even close to the truth.

~0~

.

Globalization and Accounting

.

Much has been said about the cons of globalization, a big one being the cheap imports from China that are suffocating the small scale industries in a lot of countries including US. But there are definitely some positives effects- especially related to the world of accounting.

In October 2002, the US accounting standard setter Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced the issuance of a memorandum of understanding (“Norwalk Agreement”), this was the first formal step towards the commitment of the two organizations to converge US and International accounting standards. The working of the IASB and the FASB in conjunction to converge and implement rules is the first example of the positive impact of globalization. Convergence of the standards would mean that accountants will, from here on, be truly a global breed. A US based accountant could easily work on the financials of a Japanese firm because the rules would be similar. The accounting field is moving towards being one, consistent world.

The use of International Financial Reporting Standards in preparation of financial statements of organizations around the world is the second example of globalization benefiting the accounting world, converging it to one common understanding. At the last count 123 countries in the world either required or permitted IFRS reporting. Use of the same standards worldwide actually is a boon for smaller organizations who want to do business or invest in the international arena, the use of single set of accounting standards will reduce the cost of conversion of the financial statements. If an organization wants to raise capital in the international market, the company does not need to restate its financial statements to adhere to the standards of different countries; thereby resulting in reduction of cost of raising capital overseas.

Another similar movement that is taking effect now is the use of eXtensible Business Reporting Language or XBRL. It is the language for the electronic communication of business and financial data. Companies all over the world are moving to filing their financial statements in the XBRL format. The language streamlines the process of understanding the data in financial statements. It standardizes the financial statements across the board, so one can compare and contrast a company’s performance with its peers and even across a broader set.

Actually once the standards are converged and XBRL becomes a standard process, the accounting world will move to the next level; a truly global and technologically higher level. Not only will the basis for the financial statements be similar and comparable due to converged standards, but also the language of reporting will be comparable due to use of XBRL.

On a similar note, globalization is also a trend that ensures adherence with accounting rules. Any organization that wants to market its products or invest or raise capital in the global world needs to ensure that they adhere to the rules and regulations. Because it is a global world the news about rule breakers travels fast. A good example is Satyam. How many of us here in the US had heard about Satyam or its CEO Raju? Maybe a few people were aware of the company, but since the news of the huge scandal in the organization in 2009 people have taken notice, people all over the globe.

Why do you think that happened, it is because the world is one now due to globalization. People are watching companies like Satyam that are servicing clients’ world over. So in the economies where companies could tweak a few rules and still get away, now if one wants to be a global player one has to ensure compliance with not just the rules of their country but of the world.

So globalization isn’t necessary a bad thing, it is getting the accounting world close and making the accountants a true global professional.

~0~