Essay Extract - The failure of accounting policy and its impact on the financial markets
Chapter 1 - Introduction
Context of the problem
The failure of Enron Corporation, WorldCom and other companies which led to a financial scandal in the stock market led to investigations which purported that accounting policy was defective in these firms. The collapse of other companies in the financial markets supported the fear that there is something wrong with policies in the free market and that there would be many companies which will follow the Enron disaster.
The bankruptcy of Enron in December 2001 shocked the business world since prior to its bankruptcy, it was just recently declared a top performing company. Its bankruptcy was a result of too much debt and high risk investments. However, its disaster was not mainly due to the fault of the company but by other factors such as regulations (Niskanen, 2002). As such, this study is being conducted so as to determine the factors that led to the firm’s demise particularly accounting policy.
Statement of the problem:
In the main, this study is being undertaken to investigate the role of accounting policy in the failure of Enron, WorldCom, and Health South which led to a financial scandal that caused a crash in the stock market. As such the following research questions will be answered:
- Who benefited from the accounting policy of these corporations?
- What were the defects in the accounting policy of these corporations which led to a financial scandal that affected the financial markets? and
- What were the warning signs that everyone ignored?
Hypothesis
The hypothesis of this study are the following:
- The accounting policy of Enron Corporation, and WorldCom are defective and this led to their failure which also caused a huge financial scandal that resulted to a crash in the financial markets, and
- The accounting policy of Health South is defective and is affecting their current financial situation and is causing a scandal in the financial markets.
Significance of the study
The significance of this study is that it will contribute to the existing body of knowledge in accounting policy and theory since the results of the defects of accounting policy in the case study would be able to help solve accounting policy problems which caused economic disaster such as a crash in the stock and bonds market.
Moreover, since a crisis or devastation in the stock market is very dangerous to the economy, it is imperative that a more detailed study of the accounting policy of big corporations so as to prevent a repeat of the many other companies that followed Enron Corporation’s and WorldCom’s failure.
Also, factors which are outside accounting policy might have also caused the failure and this paper may be able to uncover. The results and findings of this study will be valuable to government policy-makers, corporate executives, and graduate students of accounting since these findings will explain the deficiencies of current accounting practices in the United States.
This study would also formulate recommendations which are useful to the government and private firms which are concerned and affected by a turmoil in the stock market. Thus, this paper will be able to help the proper development of the financial market and the economy since this paper will form policy recommendations which will prevent future scenarios of disaster in the economy of the United States.
Research design and methodology
Qualitative Research Methodology
This research study will make use of the qualitative research method, which involves the analysis of data such as words, pictures or objects. This research method was selected because it makes use of the exploratory approach in describing complex phenomena, tracking unique or unexpected events, understanding the experience and interpretation of events by actors or players with different stakes and roles, and is useful for conducting initial explorations to develop theories (Yin, 1989).
The qualitative research methodology is particular useful for purposes of this thesis because it is characterized by an emphasis on describing, understanding, and explaining complex phenomena. The phenomena this study seeks to understand are factors that lead to the failure of accounting policy of Enron Corporation. The qualitative research methodology is also the appropriate research tool to use for studying the relationships, patterns, and configurations among factors, and the context in which activities occur (Creswell & Plano-Clark, 2006).
This methodology was selected over the quantitative research method, which seeks to draw conclusions by making use of random sampling techniques to draw inferences from sample populations. These samples populations are typically made up of a large number of respondents. With this research methodology, surveys and questionnaires are the most common types of tools used for gathering data and information (Creswell & Plano-Clark, 2006).
The problem with using the quantitative research methodology is that it often involves controlling a variable to determine how other variables are influenced (Wolcott, 2001). Such an approach is not applicable to this thesis because there is no control variable to begin with, which renders it useless to determine how this control variable will influence other variables.
Case Study Research Strategy
The exploratory approach is a component of the case study methodology, which in turn is one of the most common research strategies under the qualitative research methodology.
The case study approach was selected as the research strategy for this thesis since it is the ideal method to use for in-depth investigation for a phenomena or area of study. The case study research strategy is useful for bringing out the details from the view point of participants through the use of multiple sources of data (Stake, 1995).
Under the case study method, there are several other research strategies which may be used to analyze data:
- Exploratory research strategy. This strategy is used to provide insights regarding a particular case, in order to understanding the foundations or basis for a solution that is sought. This strategy is especially useful at the preliminary stages of research (Yin, 1989).
- Explanatory research strategy. This method is used for causal investigations of case studies (Yin, 1989).
- Descriptive research strategy. This strategy is used to develop a descriptive theory at the start of the research project (Stake, 1995)
- Intrinsic research strategy. This case study research strategy is used when the researcher has a personal interest in the case (Stake, 1995).
- Instrumental research strategy. This method is used if the case to be used is more than what is observable to the researcher (Stake, 1995).
- Collective research strategy. This strategy is used when the researcher wants to study multiple cases (Stake, 1995).
This thesis can actually make use of a combination of these case study research strategies, particularly the exploratory, explanatory, descriptive, and collective research strategies. However, the descriptive and exploratory approaches have been selected as the primary case study research strategies for purposes of this study.
Organization of the study
This study is divided into six chapters. Chapter on discusses the context of the problem, the statement of the problem, hypotheses, the significance of the study, research methodology, and the organization of the study. Chapter two discusses the review of literature. Chapter three, four, and fice would discuss and analyze research sub-questions one, two, and three respectively. Finally, Chapter six summarizes and concludes the study.
Chapter 2 - Review of literature
The Enron Debacle
On December 2, 2001, Enron Corporation filed for Chapter 11 bankruptcy protection. CNNMoney.com reported:
The court filings in the U.S .Bankruptcy Court in New York are the climax of a precipitous slide that has seen shares of Enron, which once ranked seventh among the Fortune 500, plunge from $90.75 in August 2000 to a close of 26 cents on Friday, November 30, 2001….Enron’s loss of credibility in the market stemmed from revelations that its chief financial officer was running a partnership that allowed the company to keep half a billion dollars in debt off its books. Early in November, Enron restated its earnings back to 1997, eliminating more than $580 million in reported income. (“Enron in chapter 11 filing,” 2001, n.p.)
Subsequent investigations and court proceedings revealed not just outright fraud and deception but a systematic approach to creatively financing deals, mostly between Enron and its subsidiaries, and transfers of assets from one company to another at inflated values. Moreover, in some cases, phantom companies were established to hide losses and shift money around. At the same time, Ken Lay and Jeff Skilling (both former CEOs) were making exorbitant profits for themselves, for their close associates, and others around them. In the end, both Lay and Skilling were convicted of the crimes of conspiracy and fraud. The article entitled “The Guiltiest Guys in the Room” summed it up in the following manner:
The most important implication of the verdict, though, is the lesson it delivers for business itself. In the beginning it seemed such a simple story, demanding swift justice: A highflying company disappeared almost overnight; a CEO bolted before the collapse; top executives sold tens of millions of dollars worth of stock--some of it secretly--while employees and investors were left with nothing. (McLean & Elkind, 2006, n.p.)
Simply put, here are some of the results of Enron’s bankruptcy in human terms, “It would be laughable if so many people hadn't lost so much—stockholders lost $60 billion in market value, long-serving employees lost more than $2 billion in pension money, and 5,600 people lost their jobs” (Pellegrini, 2002, n.p.).
The WorldCom Scandal
The headlines say it all: “WorldCom Files Largest Bankruptcy Ever” (Beltran, 2002). “The WorldCom We Hardly Knew,” declared Forbes (Ackerman, 2002). In vivid detail, CNNMoney.com stated,
WorldCom, crushed by its $41 billion debt load, made its filing in the Southern District of New York. With $107 billion in assets, WorldCom's bankruptcy is the largest in United States history, dwarfing that of Enron Corp. The Houston-based energy trader listed $63.4 billion in assets when it filed Chapter 11 late last year. WorldCom's non-US units were not included in the filing. (Beltran, 2002, n.p.)
You may ask why WorldCom filed for bankruptcy protection. The answer was a not a surprise to most in the investment community. WorldCom was the high-flying second largest long-distance phone company behind AT&T and its bankruptcy came about after it announced that it had improperly booked about $3.8 billion dollars in expenses.
A CBS news report (2005, n.p.) stated,
WorldCom's accounting scandal led to the largest bankruptcy filing in U.S. history last July. Portions of one of the reports that emerged last week revealed that former Chairman Bernard Ebbers had been in meetings in which company officials discussed ways to artificially inflate revenue…The report, produced by lawyer William McLucas at the request of the company's new board, faulted Ebbers for fostering a poisonous corporate culture and said he was ‘aware, at a minimum, that WorldCom was meeting revenue expectations through financial gimmickry.’
On March 15, 2005, Ebbers was convicted of fraud and conspiracy in what is considered to be the largest (to date) accounting scandal in U.S. history, as a result of WorldCom's false financial reporting, and subsequent fraud by some accounts totaling $11 billion (Ackerman, 2005). On July 13, 2005, federal judge Barbara Jones of the U.S. District Court, Southern District of New York in Manhattan, sentenced Ebbers to 25 years in a federal prison in Mississippi, the toughest sentence yet among other recent corporate accounting scandals. His conviction and sentence were upheld after an appeal.
CBS News reported,
The government filed new bank fraud charges against former WorldCom chief financial officer Scott Sullivan, accusing him of lying on financial statements to secure $4.25 billion in credit for the company…Sullivan was already charged with ordering WorldCom accountants to move operating expenses off the books, making the company appear profitable when it was losing money. He has pleaded innocent to the charges…. A new indictment unsealed in federal court in Manhattan adds charges of bank fraud and making false statements to the counts Sullivan already faced. On August 11, 2005, Sullivan was finally sentenced to 5 years in prison by a judge who called him "the architect" and "day-to-day manager" of the largest accounting fraud in U.S. history. (“Ex-WorldCom CEO Gets 5 Years,” 2005)
The Downfall of a Giant
Callisto Tanzi established Parmalat after inheriting a small family shop in Parma in 1961. In 1990, Parmalat was listed in the Milan stock exchange and it had diversified from milk into biscuits, fruit juices, and pasta sauces and had expanded abroad. By April 22, 2002, the Parmalat share price had reached to new records, giving the company a value of 3.7 billion Euros ($4.4 billion). The company employed more than 30,000 people in 30 countries (“Parmalat Fraud Trial is Suspended,” 2005).
The meteoric rise of the small family business into the world giant it became was itself a point of discussion, admiration, and prestige for Italians and Italian industry. Parmalat in 2000 alone purchased over 18 businesses throughout the world. As late as 2002, Parmalat was reporting gross sales of 2 billion Euros in the European markets, and even in South America, sales had exceeded their targets and had reached the $2 billion mark. Parmalat’s business spanned from Italy to most of Europe, South America, Southern Africa, Canada, and the US. The Independent (Nisse, 2003) reported the trouble started for Parmalat in October 2003. Consob, the Italian market regulator, asked Parmalat for clarification of some balance sheet items before Parmalat published its third-quarter 2003 results. Consob had raised questions about the accounting treatments of Parmalat’s current assets investments, debenture loans, and the nature of inter-company financing agreements. In response, Parmalat revealed some details about its Cayman Island subsidiaries, in particular the financing vehicle called Bonlat (Nisse, 2003).
The article entitled “How Going Global Compromised Parmalat,” stated that Enrico Bondi, the turnaround specialist whom the board had hired and the government had approved, finally gave the world a picture of the magnitude of Parmalat’s problems. Some of his findings were that revenues for 2002 were overstated by over 1.5 billion Euros; net debt had been understated by 12.5 billion Euros; and Parmalat’s real indebtedness amounted to 14.3 billion Euros, as opposed to the 1.8 billion Euros stated in the September, 2003, 2002, and 2001 accounts (Hamilton, 2005).
While Bondi was trying to secure the future of Parmalat for investors, creditors, and the employees of the company, the government went after the owners, executives, and officers of the company, bankers, accountants, and investment advisors, and started rounding them up for questioning. In some cases they were formally charged with embezzlement, fraud, deception, and cover-up and arrested (Nisse, 2003).
The investigations also included the Bank of America, Deloitte & Touche, Grant Thornton, and many other highly regarded and well known firms. No one clearly knows exactly where the money has gone. Some believe that it was filtered through the many holding companies of the family and the parent company Parmalat SpA (Hamilton, 2005).
In the final analysis, Parmalat, like its predecessors Enron and WorldCom, affected many thousands of lives: individuals who trusted the company and the regulators and invested in those companies. In some cases, those investors were financially ruined, losing their life savings and their nest eggs for retirement. The other many thousands of victims of these greedy, selfish people are those people who worked hard for the success of the companies and eventually ended up losing their jobs, their livelihoods, and their pensions.
The demise of these three companies, and hundreds of other companies that met the same fate as these three, aroused the public’s anger and intensified the call for harsh measures against the perpetrators of these crimes. The governments of the United States, the EU, and member states in their own legislative bodies were forced to a flurry of legislation and rules and regulations to avoid similar disasters in the future.
The Nature and Scope of the Problem in Other Parts of the World
The rest of the world is not immune to the impacts of the giants such as Parmalat, Enron, and WorldCom. By the nature of the investments and acquisitions these companies were involved in, some of their acquisitions had to end up declaring bankruptcy or being auctioned off to the highest bidder. Here again, the local investors in these public companies suffered the consequences in much the same way that investors in the developed world suffered. They lost their jobs, their livelihoods, their pensions, and their investments in the companies affected.
In some cases, these acquisitions were made for the sake of transferring funds from one shelter to another or one investment vehicle to another. Neither the financial conditions of the companies involved, nor the well being of the investors or the workers, were a concern to the executives in these large conglomerates. It was none of their concern if the companies were shut down and lives were ruined. These executives were merely shuffling the deck of cards, and in the end, how much money they made or the corporation made was what would gain them fame, fortune, and prestige in the eyes of Wall Street and the business communities.
Other countries of the world have similar problems of corruption, fraud, and mismanagement. From time to time, stories appear about the corruption trial of a government official, a banker, or corporate head in other parts of the world. Some of these countries include Japan, South Korea, Russia, Taiwan, China, Greece, Australia, Canada, and Mexico. On a smaller scale but with equally devastating impact, these bureaucrats, corporate leaders, and government officials either have committed a crime for personal gain or falsified records, lied, or cheated in order to help themselves, their families, their friends, their communities, their company, or their region. Their actions are no less objectionable than those of Lay, Skilling, Ebbers, Tanzi or the other executives involved in the fraud and deception that brought down their companies. The scale and the level might be different, but the result is the same. These individuals have committed highly criminal activities, and lives of innocent people have been affected emotionally and financially.
Lessons from Enron, Parmalat, and World Com
If there are any lessons to be learned from the high-profile bankruptcies and financial disasters brought about by the Enrons, the WorldComs and the Parmalats of this world, it is the unanimous call for overwhelming and immediate action to bring the culprits to justice. In addition, imposition or establishment of safeguards should be initiated either by government regulations or by legislation.
The Sarbanes-Oxley Act
To that end, the U.S. Congress, the European Union, and other nations on their own have established rules and regulations that impose strict standards and rules of conduct. In the U.S., the Congress has passed and the President has signed into law the Sarbanes-Oxley Act of 2002. The Act is designed to:
- Improve quality and transparency in financial reporting and independent audits and accounting services for public companies,
- Create a public company accounting oversight board,
- Enhance the standard-setting process for accounting practices,
- Strengthen the independence of firms that audit public companies,
- Increase corporate responsibility and the usefulness of corporate financial disclosure,
- Protect the objectivity and independence of securities analysts,
- Improve Securities and Exchange Commission resources and oversight, and for other purposes.
Some considered Sarbanes-Oxley to be overkill and considered its demands to be burdensome. Others welcomed it as a savior or viewed it as the least that can be done to protect the unsuspecting public, investors, and employees working for these corporations.
EU News and Policy Positions indicated in its March 17, 2004, statement, “After open clashes last year, EU and U.S. regulators say they are now converging on the objectives to be set for overseeing audit firms. Auditor rotation is likely to become the future norm” (“Commission proposes,” 2004, n.p.).
The Foreign Corrupt Practices Act (FCPA)
Long before the Sarbanes-Oxley Act came into being, largely because of the corporate scandals such as Enron and World-Com, in 1977, the United States had enacted the Foreign Corrupt Practices Act (FCPA). The FCPA effectively outlawed offers, promises, and payments by U.S. firms to foreign officials, political parties, party officials, and candidates to secure a business advantage (United States Department of Justice [USDOJ], 2001). A release by the Bureau for International Narcotics and Law Enforcement Affairs (USDOJ, 2001) states that the FCPA has two components: the anti-bribery provisions and the accounting and record keeping provisions. The anti-bribery provisions of the FCPA make it unlawful for a U.S. person, and certain foreign issuers of securities, to make a corrupt payment to a foreign official for the purpose of obtaining or retaining business for or with, or directing business to, any person. Since 1998, they also apply to foreign firms and persons who make any act in furtherance of such a corrupt payment while in the United States.
The FCPA also requires companies whose securities are listed in the United States to meet its accounting provisions. These accounting provisions, which were designed to operate in tandem with the anti-bribery provisions of the FCPA, require corporations covered by the provisions to make and keep books and records that accurately and fairly reflect the transactions of the corporation and to devise and maintain an adequate system of internal accounting controls. The FCPA is enforced jointly by the Securities & Exchange Commission (SEC) and the U.S. Department of Justice.
The business community did not receive the enactment of this law with open arms. They complained that they (U.S. firms) are being penalized for what is considered common business transactions in other parts of the world. They also indicated that they are being left out of major business transactions in other parts of the world, putting them at a competitive disadvantage. Congress had an earful from the business lobby and started looking for ways to address this issue. It recognized that in some countries foreign companies were being allowed to pay the bribes and deduct payments as legitimate expenses from their taxes. Accordingly, in 1988, the Congress directed the Executive Branch to commence negotiations in the Organization of Economic Cooperation and Development (OECD) to obtain the agreement of the United States’ major trading partners to enact legislation similar to the FCPA (USDOJ, 2001). The same source indicated that in 1997, nearly 10 years after the initiation of the negotiations, the U.S. and 33 countries signed the OECD Conventions on Combating Bribery of Foreign Public Officials in International Business Transactions. The United State ratified the Convention and enacted implementing legislation in 1998.
Under the FPCA, the sanctions against bribery carry severe penalties. For criminal cases, the following criminal penalties may be imposed for violations of the FCPA's anti-bribery provisions: (a) corporations and other business entities are subject to a fine of up to $2,000,000; (b) officers, directors, stockholders, employees, and agents are subject to a fine of up to $100,000 and imprisonment for up to 5 years. Under the civil provisions, the Attorney General or the SEC, as appropriate, may bring a civil action for a fine of up to $10,000 against any firm as well as any officer, director, employee, or agent of a firm, or stockholder acting on behalf of the firm, who violates the anti-bribery provisions. In addition, in an SEC enforcement action, the court may impose an additional fine not to exceed the greater of (a) [i] the gross amount of the pecuniary gain to the defendant as a result of the violation, or (b) [ii] a specified dollar limitation. The specified dollar limitations are based on the egregiousness of the violation, ranging from $5,000 to $100,000 for a natural person and $50,000 to $500,000 for any other person (USDOJ, 2001).
Corruption, Fraud and Mismanagement in Other Countries
The U.S. Department of Justice indicated in its release of May 2001 that as a result of SEC investigations in the mid-1970s, over 400 U.S. companies admitted making questionable or illegal payments in excess of $300 million to foreign government officials, politicians, and political parties. The abuses ran the gamut from bribery of high foreign officials to securing various types of favorable action by foreign governments to so-called “facilitating payments” that allegedly were made to ensure that government functionaries discharged certain ministerial or clerical duties. Congress enacted the FCPA to bring a halt to the bribery of foreign officials and to restore public confidence in the integrity of the American business system.
The USDOJ (2001) release continued, explaining that the FCPA was intended to have, and has had, an enormous impact on the way American firms do business. Several firms that paid bribes to foreign officials have been the subject of criminal and civil enforcement actions, resulting in large fines and suspension and debarment from federal procurement contracting, and their employees and officers have gone to jail. To avoid such consequences, many firms have implemented detailed compliance programs intended to prevent and to detect any improper payments by employees and agents (USDOJ, 2001).
As stated above, the FCPA was enacted to prevent or reduce the ever-escalating level of outright bribery in the way business is done overseas, and because of the concern over what the implications of corruption would be in a democratic society.
Congress had evaluated the consequences of corruption and bribery and considered it a destabilizing factor to any nation’s economy. In 1988, Congress instructed the Executive Branch to develop some guidelines that business could use to comply with the statutes of the FPCA. The DOJ developed what is known as “Guiding Principles for Fighting Corruption and Safeguarding Integrity among Justice and Security Officials” (DOJ, 2001, Appendix C). The basic tenets of the guiding principles are that corruption, dishonesty, and unethical behavior among public officials represent serious threats to the basic principles and values of government, undermining public confidence in democracy and threatening to erode the rule of law. The aim of these guiding principles is to promote public trust in the integrity of officials within the public sector by preventing, detecting, and prosecuting or sanctioning official corruption and unlawful dishonest or unethical behavior. There is no disagreement as to whether corruption, bribery, and so on increase the cost of doing business. The only argument among several schools of thought is-what level and magnitude of corruption will have a detrimental impact on the economy of a nation. However, that is a separate topic and is not addressed here.
Examples of the impact of the FPCA abound. When U.S. power-generating company, Bechtel, withdrew its bid after being asked for a $3 million bribe in the Middle East, a Japanese company quickly stepped in. At the same time, Lockheed was convicted of making payments of $1.5 million to an Egyptian government official in 1995 and was fined $24 million (Lambsdorff, 1998, p. 41).
Following are some examples of the FCPA related litigations (Burr, 2005) listed by the World Bank Institute in a recent press release.
Monsanto Co.: Settled an SEC complaint in January alleging that the company funneled more than $700,000 in corrupt payments to Indonesian government officials between 1997 and 2002. Monsanto agreed to pay the SEC and DOJ $1.5 million in fines and negotiated with the DOJ to defer the prosecution on criminal charges.
American Rice, Inc.: A jury convicted two former executives of American Rice, Inc., of bribing Haitian officials to reduce duties and taxes on rice imported to Haiti and sentenced them to multi-year prison terms. The case is being appealed to the U.S. Court of Appeals for the 5th Circuit.
Halliburton Corp. and Chicago Bridge and Iron Corp.: The SEC is investigating both companies for possible FCPA violations involving a liquefied natural gas facility under construction in Nigeria.
ExonMobil, Chevron Texaco, Marathon Oil, Devon Energy, and Amerada Hess, as well as several other oil companies: These reportedly are involved in SEC investigations into bribes allegedly paid to government officials in Equatorial Guinea. The violations came to light during the SEC’s investigations into Riggs Bank accounts, which the SEC suspected were being used to launder corrupt payments to Equatorial Guinea leaders and their family members.
The above are just a few examples of the extent of FPCA enforcement. These are provided as illustrations of how corruption added to the cost of doing business for companies, not only for wrong-doing but to educate their employees, comply with FCPA and Sarbanes-Oxley, and their financial record keeping requirements, as well as to monitor their business dealings in the course of transacting business in other countries.
In the end, the financial disasters on both sides of the Atlantic had severe and debilitating implications far beyond the two regions. The financial and emotional scars left by the Enrons, the WorldComs and the Parmalats will be felt for many years to come. The investors in those companies have a combined loss of a staggering $200 billion. The loss of confidence in the markets, in the regulatory agencies, and in the auditing firms is incalculable. Add to that the recent disclosures of corruption in the congress and the lobbyist scandals, and it has diminished the role and prestige of public servants and corporate leaders alike.
However, the safeguards that are being put in place in order to avoid the repeat of these disasters are worthwhile efforts that will help bring confidence back to the markets. The investment dollars in those corporations will continue to fuel the need for goods and services and for innovative products and will allow more growth and development for the benefit of all humankind.
Safeguards, rules and regulations, and various mechanisms to attempt to address the issues of corruption have been tried and exercised by both private and public institutions at the local and international level. One such effort has been the World Bank’s prudent emphasis on eliminating graft or corruption in its lending practices and the administration of the loan proceeds in lender countries. That is a much anticipated and welcome approach that most of Africans had been requesting. Although that approach has been criticized by some as too harsh and unacceptable, a majority of Africans and Africans in the Diaspora have been asking for even more restrictive, transparent, and accountable ways to handle loans and grants at the national level. At the U.S. government level, the enactment of the FCPA is addressing the issue of bribery and corruption at the trade and investment transactions, while the Sarbanes-Oxley Act is dealing with public accountability, transparency, and proper financial reporting requirements in public companies
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www.ghbcpa.com/industries/sec/articles/article_boak_sec_enron.html
www.fordham.edu/economics/vinod/CIE/enron.htm
