Introduction
The causes of financial statement failure vary from case scenarios of different firms. These companies are typically under financial trouble which made them to present a financial statement that lacks informational content and/ or distorts the reality of their operations. This paper describes the two case global companies that reflect their adversary towards their failure to present a sufficient and useful financial statement. The Enron case shows how the failure is related to dishonesty and fraud of corporate executives using financial statements for their vested-interests. On the contrary, the assumption of financial statements is for public use. The second case is about Excite@Home that shows how the failure is related to inability of corporate executives to provide information useful to investors and the public. The assumption of financial statements is its use not only by internal organization but the outside stakeholders.
The Case of Enron
Under opportunistic perspective, the economic incentives of Enron can vary depending if they opt to engage in fraud or take risks with regards issuing options. The perspective is an accounting policy used by an organization that is based on manger’s incentives to increase their wealth; however, this will be shouldered by other parties within and beyond the organization (Day & Hartnett 1997). When they employ fraud, they can manipulate accounting methods providing a tampered profits and performance ratios. According to the survey of Deegan (1997), most managers are remunerated from the profits or ROA of their respective firms. In effect, executives will not only impress employees to undergo option grants but as well impress the investors to provide higher incentives believing that the firm is doing well.
Further, Christie (1987) showed that restrictive covenants formed by corporate debts are surmountable by fraud to improve accounting numbers. The process will begin after executives have manipulated financial ratios permissible to the constraints of creditors. In effect, the firm can enjoy strategic actions it cannot implore when the manipulation did not take place. In return, the firm can implement strategies that will ultimately lead to profitability and growth in either prospective or actual sense. When this information is delivered to employees, they will think that stock options are attractive investments. They will purchase stocks unknowing that they are merely funding the efforts of executives to conceal mismanagement or possible bankruptcy. As a result, executives are rewarded two-fold. They can manage the firm with the support of creditors and implementing strategies with employees in full support due to the stock options the latter is currently holding. The cover-up ultimately leads effective fraud on the part of executive whose incentives goes beyond remuneration rather long-term employment, promotion and fame within the industry.
In a similar case, political groups can impede strategic actions of the firm if it reports high earnings or disclose issues pertaining to adverse external effects of their operations (cited in Day & Hartnett 1997). The government may impose tax sanctions or legal remedies on tax evasion while environmental groups can boycott its products when informed about negative externalities (like oil spills). These situations have their adverse impacts in both short-term and long-term existence of the company. In effect, fraud to accounting methods can result to lack of disclosure and computational manipulation to arrive at a standard level of accounting reports. This is why the study of Deegan and Rankin (1996) found that firms with environmental disclosures still used them for corporate image building. As a result, similar to the benefits of corporate ability to bypass creditor restrictions, the firm can induce its strong business outlook to employees deepening the need of the later to resort to option grants. Executives can distort the likelihood of disruptions from external actors from a major mental lapse in decision-making through designing accounting methods that can hinder such mistake.
The Case of Excite@Home
The firm is formed in 1999 as a merger between an internet service provider and an internet portal (Hitt et. al. 2003). The short business life of the firm emphasizes stakeholders’ role not only how to sustain competitive advantage, but most importantly, how to survive. With questionable business plan the firm competed head-to-head against Yahoo! This abrupt strategy and lack of direction resulted into customer dissatisfaction, conflicts among directors, executive turn-over and demoralized workforce. As early as 2001, the CEO was replaced. This should be a sign of hope for the sake of stakeholders, however, the root cause of problems in the planning and positioning stages was so vigorous that the firm’s stock value had fallen to 47 cents. Aggravated this condition was its lender’s demand for the $50 million payment and withdrawal of its two largest distributors that ultimately throw the firm into bankruptcy in 2001.
The inability of the managers to impress stakeholders and provide them the direction in the start-up stages of the firm installed an environment where the latter is positioned in an ambiguous state. As a result, the unpredictability of the firm’s performance caused its lenders and suppliers to withdraw support at the time the firm needed them most. Even the directors that used to be calm and focused in the organizational long-term goals were unable to curb the fall and helped the new CEO to shift the organizational inertia. This could be the effect of the absence of benchmark. Planning and positioning served as signals whenever a firm is on the verge of trouble. Without them, stakeholders’ apprehension and signal of dissatisfaction or optimal risk-absorption cannot be identified. There is lack of financial and business goals were such signals can be quantified and solved when they occur. Thus, this resulted in a vicious turmoil within the organization that the only tool that can cut it is resorting to bankruptcy filing. If on the other hand the firm has a clear intention, its resources can be more manageable and leveraged against the amount of stakeholders’ insertion or withdrawal of their firm support. It can be more flexible because it has a road map (short- and long-term strategy) that even the firm detours or drives in a slippery road, it knows that it has the tools box (contingency plans) or better mechanical bystanders (lenders) to give a hand (capital to recover).
The Case of HSBC
The method of valuation of investment properties is disclosed which justifies the increase of their net book value and crediting to income statement. However, there is no explicit terminology (e.g. sum-of-years, double-declining balance) to described the depreciation method being applied as well the asset’s useful lives and depreciation rates. Computations on carrying amount and accumulated depreciation are shown with current and previous year comparisons. Carrying amounts at the beginning through the end of the period are adjusted by considering additions, disposals, and exchange differences among others.
Bearing in mind that PPE of HSBC are land and buildings, other disclosure involves their nature as finance lease contracts, expenditure and commitments but there are no third party compensation clause. In the revaluation of its investment properties, HSBC disclosed the effective date of revaluation (e.g. every 31 December), involvement of independent professional valuers (e.g. DTZ Debenham Ltd), use of open market basis and recognition of contractual obligations on investment properties. However, there is no presentation on alternative cost model. There are no disposed non-current assets that HSBC has executed. As there is no specific depreciation method used, it is undeterminable to comment about its semblance with pattern of asset’s economic benefits and consumption.
In valuing intangible assets, HSBC seemingly is not within the scope of IAS 38 because it included goodwill arising from issuance contracts which is beyond the scope of the standard. However, the analysis will be focused on certain contents which coincide with the provisions of IAS 38. For example, HSBC created a classification of intangible assets under “other” account which make it impossible to assess its ground for recognition. There are also figures concerning present value of in-force long-term insurance benefits. Further, adjustments for PPE and intangible assets have the same accounts (e.g. additions, exchange differences, etc.). However, the lack of text explanations for the notes to goodwill and intangible asset presentations inflicted the validity of internally-generated software which accounts for the biggest intangible property.
The strength of HSBC especially pertaining to current assets is that it revalues its non-assets regularly to avoid huge discrepancy of the previous period to the succeeding ones. This is aided by presenting comparative revaluation results year-on-year. As investment properties are only the ones that are revalued, HSBC also rescinded in revaluing non-current assets under finance lease contracts (FLCs). This move is according to IAS guide on revaluation model. In addition, investment properties are also imputed with the same adjustments and comparative presentations like non-current assets under FLCs. As both accounting year 2006 and 2005 have revaluation surplus, it should be recorded in equity but HSBC opted to reflect it on notes under “non cash items included in profit and tax” and ultimately in income statement (IS).
One advantage of HSBC’s approach to non-current assets is that it applies a comprehensive valuation of PPEs even though the company does not gain most of its income from non-current assets such land and building. This reflects managerial evaluation due to inability of available depreciation methods to suffice representation needs. However, this strategy can also minimize the “true and fair” impression on its BS because of excessive non-objective application of valuation techniques. In contrast, HSBC is able to redeem some spots of unbiased stance by regularly evaluating its techniques, inclusion of outside valuer and stating non-current asset restrictions. However, the inability to reflect the revaluation surplus in equity account rather on IS makes the increase less useful to shareholders.
For the low-educated type of people, the BS of the company will be appreciated because it maximized managerial evaluation in determining the “true and fair” value of non-current assets for the purpose of information. However, on the part of credit rating agencies (e.g. Standard & Poor), the opposite impression will result. The same adjustment elements for non-current assets that are evaluated are also helpful in establishing ease of analysis from low-educated people. In the contrary, agencies would prefer more complex numerical data to suffice the claim like the movement in PVIF shown in adjusting the values of intangible assets. For both users, HSBC could infuse more textual explanations to the arrived figures especially in valuating goodwill and intangible assets because fewer details would mean confusion and speculations.
Actions from Accounting Regulatory Bodies
Just like US, Australia (AU) is convinced that such explicit regulation cannot picture the dynamic business landscape and so oversight boards should be installed (Corporate Governance Alert 2002). US have created the Public Company Accounting Oversight Board (PCAOB). On the other hand, AU has been biased to such idea of overseeing since its regulation maneuvered to intensify regulatory oversight boards to replace the “ax” of SOA. It increased the powers of Financial Reporting Council, Stock Exchange and other audit/ accounting bodies under the government including the creation of Shareholders and Investors Advisory Council.
In the contrary, Australian standards approached non-auditing services as quite liberal (Inform Magazine 2003). The principle does not prohibit auditing firms to conduct non-audit services to their clients. However, the safeguard to prevent impairment of audit independence, which also serves as the rationale behind US regulations however with stricter provisions, should be supported by clients who is required to indicate in their annual report the extent of audit being done and non-audit fees being paid to auditing firms. As noted, this policy falls short of the US since the latter practitioners are bound the disclosure of the nature and the split of non-audit services.
The country based their apprehension not only on the US shocks due to Enron and World Com scandals but also to UK (Inform Magazine 2003). Internally, regulators also have their concern of another giant insurance crash such as HIH. And like the US, the country also draws much concern to the public’s confidence on FS being made by auditors which have perceived or actual impairment of independence. In effect, intensified scrutiny is regarded as fitted to the current ambiguous situation of the national economy.
The reason of guarding non-audit services in AU stemmed behind monetary rewards that auditors may have when they are performing other services for clients outside their primary duty which is public in nature (Inform Magazine 2003). This reason is more intensified rationale than the US as non-audit services are considered as the greatest threat to independence. Another, the four conditions that set-up by US-SEC to identify emergence of independence impairment is added by AU with the provision of the presence of intimidation from the part of clients. This supplementary condition is unique to AU.
In comparison with non-audit service that could create threat to audit independence, AU is more general especially when the condition of self-review is observed (Inform Magazine 2003). Bookkeeping and valuation services (US Version) is summarized by AU under the circumstance wherein the auditor is posing independence threat when it actually prepares original data to be used in financial reporting that itself to be audited by him. Also, self-review AU version includes the threat when a former officer or significant employee of the audit-client will perform non-audit services (as being now an employee/ officer of the auditing firm).
Personal View
Auditing profession is so vital for the efficient transfer of public funds to the hands of the business for the former purpose of increasing future wealth, quality improvement of products/ services, among others. Their submission to invest in a publicly listed firm based on bias and unreliable FS evaluation could have micro- and macro-adverse effects. This can range from ineffective saving that would affect households spending that in turn result to impairment of their welfare. Other businesses that are acting in good faith might also loose the opportunity of getting enough capital that would in turn make their products more competitive. In the part of the government, such adverse effects will serve additional funding for public utilities and pump-priming activities as household and business sectors are worse-off at the moment.
Although such scenarios would arguably an exaggeration due to imperfect information between firms, the existence of several professional organizations aggravated by closed operations of firms (except of course to external auditor’s scrutiny) contributes to band wagon effect that would not be monitored by overseeing bodies. Granted that the government and professional bodies are aware of the existence of threat to audit independence in the business sector; can they mitigate the already crippled non-audit services on both legal and professional curtailment? In effect, the tight policies of US are more appropriate to control the excessiveness of independence decline (excessive since isolated cases cannot be easily reprimanded unless through scandal).
This recognition is strengthened by the fact that US-SEC designed the stricter policy for both situations of small and large firms where the former is more vulnerable to indulging in non-audit service to cut costs (US-SEC 2001). Such allowance is conceived to adhere to both justice and order (a very rare combination in a modern society). Although US authorities are very sensitive due to the status of their economy, they do not compromise the rights of small to medium enterprises including other contingent situations (for the part of big companies) that would make non-audit service a very lucrative alternative to internal or outsourcing methodologies.
For the part of AU version, the monitoring of authorities and reporting of clients and auditors make their framework tedious and self-defeating (relative). Non-audit services can be allowed as long as it adheres to efficiency and the winner of such act is the general public. There is also the provision of prohibited acts in order for the discipline to find itself in the minds of auditors and clients. This will then offset the economic/ personal gains from collusion unlike the AU model wherein policies have multi-layered stages to be able to enforce. As a result, it provides the den for independent auditors to act as they are dependent to their “same-kind” firms and collusive clients rather the general public.
Limiting non-audit services to same audit clients is a debate by policy-makers, companies, auditing firms and the public at large. The criticality of audit independence can be suspected as more important in the US than AU considering differences in their regulations. Nonetheless, it is acknowledged that US has an active public investing in capital markets and has relatively bigger economy. Formality theory, thus, took place and dearer to US. Overall, policies should be formed within the framework of the present economic structure including PEST analysis. These are public policies for public welfare and therefore should be externally-stimulated rather than internally-contemplated through bargaining of self-vested large firms and auditing companies.
Conclusion
The paper shows how Enron and Excite@Home failed in their businesses because of the fact that their financial statements also failed. Without due care in preparing, analyzing and presenting financial statements, the investing, operation and financing activities of the firm will be in jeopardy. It is also a control mechanism imposed by regulators in assuring the safety of public at large that is a customer, employee, supplier, investor, shareholder and even the manager of the organization. In this effect, the inability of the two organizations to develop a good financial statement based on reality not creativity of executives would likely lead to corporate scandals and financing difficulties. Financial statements provide information about the firm’s performance and basis of stakeholder decision. If it is weak, the firm will not maximize its financial-poling capabilities. When based on fraud, the firm will faced scandal and imprisonment of corporate executives.
Bibliography
Books
Hitt, M, Hoskisson, R & Ireland 2003, Strategic Management: Competitiveness and Globalization, 5th Edition, South Western; Thomson Learning, Singapore. *
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Christie, A 1987, On the cross-sectional analysis in accounting research, Journal of Accounting and Economics, December, pp. 231-258.
Deegan, C 1997, “The design of efficient management remuneration contracts: A consideration of specific human capital investments”, Accounting and Finance, vol. 37, no. 1.
Deegan, C & Rankin, M. 1996, "Do Australian companies report environmental news objectively? An analysis of environmental disclosures by firms prosecuted successfully by the Environmental Protection Authority”, Accounting, Auditing and Accountability Journal, vol. 9. no. 2. pp. 50-67
Electronic Sources
Corporate Governance Alert; 2002; Mallesons Stephen Jaques; viewed on 25 January 2008; http://www.mallesons.com/publications/alerts/6025300W.htm
Day, R & Hartnett, N 1997, SIRCA, viewed on 25 January 2008 < http://www.sirca.org.au/>
Inform Magazine; 2003; Queensland; Queensland Audit Office; viewed on 25 January 2008; http://www.qao.qld.gov.au/publications/document/Inform10.pdf
US Securities and Exchange Commission; 2001; Washington DC; viewed on 25 January 2008; http://www.sec.gov/rules/final/33-7919.htm
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