How companies change their accounts using accounting ratios?
The introduction of accounting scandals in the US has shaken the world over. Professionals, stakeholders, shareholders and regulatory authorities blame a multitude of factors for the proliferation of situations like Enron, Tyco, WorldCom and Xerox etc. The researcher is of the view that the growing quantity of bankruptcies and scam cases in the corporate sector has been the result of weakness within the financial system and regulatory benchmarks. In america especially the flexibility of the financial benchmarks has given firms the opportunities to control accounts by making use of financial and accounting pros for the benefit for top management. These individuals have knowledge of GAAP (generally accepted accounting rule) and its own loopholes. They capitalize on these loopholes to the extent of crippling the current economic climate and professional specifications. The next research investigates the rationale for businesses that vacation resort to accounts manipulation through financial ratios and exactly how maybe it's curbed. It identifies the measures for counteracting unethical professional behaviour by outlining the key weaknesses within the accounting expectations and systems. It also compares the US requirements with those of the UK to conclude that the united kingdom is less liable to fraudulent behaviour because its expert has taken procedures to strictly regulate accounting pros, auditors and top professionals to avoid engage in accounting manipulation and scams.
Table of Contents
Chapter 1 Introduction
Chapter 2 Books review
Differing Accounting Criteria in the UK and US
Chapter 3 Research Methodology
Secondary and Most important Resources
Chapter 4 Data collection and analysis
Chapter 5 Conclusion and Recommendations
The growing variety of accounting scandals with famous brands Enron, Tyco, WorldCom and Xerox etc. has lifted cause for concern for stakeholders, shareholders, professional bodies and trade government bodies alike. They are of the view that commercial finance has been through change for the worse in the last a decade. Williams' research (2002) indicates that correctness of profits and earnings help in operational decision support and formulation of commercial technique for almost 60 percent of the organizations. Others, approximately 58 percent, feel financial reporting transparency and compliance (93 percent) with exterior reporting requirements imperative for effective commercial and industry performance. However, the growing amount of scandals related to deceptive earnings, inflated property ideals and understated liabilities have undermined this system of corporate and business governance (Lev 2003). Buyer self-assurance has been shaken as each scandal shows the weak foundation of financial information system of general population companies and regulatory power that oversees them. When Enron submitted for Section 11 personal bankruptcy on Dec 2, 2001 and WorldCom have the same later, shareholders blamed their business failures on accounting manipulations. This practice is not new. Actually according to Mishra and Drtina (2004) some 200 companies in the past five years have restated their profits because of this of accounting manipulations. CFO Newspaper survey indicates chief financial officials (CFOs) are obligated to misrepresent earnings or are pressured to violate generally accepted accounting key points (GAAP) to satisfy shareholders and top professional management. Accounting manipulation not only offers the opportunity for companies like Enron and WorldCom to increase the property valuation but also to understate liabilities that would appreciate stock prices, conceal losses and increase company valuation. The practice is not limited by the US only.
In the united kingdom accounting manipulation is also called creative accounting. According to Amat, Blake and Dowds (1999) creative accounting identifies "an activity whereby accountants use their understanding of accounting rules to manipulate the results reported in the accounts of the business. " Because the accounting process itself is flawed in the sense that it provides overall flexibility, and opportunities for manipulation and misstatement, financial experts think it is easy to engage in creative accounting. The practice helps in presenting increased profits, genuine economic expansion and management efficiency whereas the contrary may also be true.
According to Kamal Nasser (1993 qt. Amat, Blake and Dowds 1999) "Creative accounting is the transformation of financial accounting figures from what they actually are from what preparers desire by firmly taking advantage of the prevailing rules and/or overlooking some or most of them. " The views of these authors indicate that accounting guidelines in American countries are vulnerable and offer lots of room for manipulation. The destruction caused by accounting manipulation impacts the accounting guidelines that the stakeholders, general public and investors be based upon and use to estimate, judge and forecast corporate and business performance. The usefulness of accounting principles has regulated market sectors, balanced investment movement and capitalization in the past. However, Enron and the loves have proved that accounting concepts (that the people have depended on before) are unreliable. The scandals verify that accounting tools like financial percentage analysis or fundamental evaluation for accounts estimation and prediction do not truly indicate the worthiness of the investment. Man-made transactions can be used to change balance sheet amount; revenue can be moved from period to period; and investments can be re-arranged to depict a good financial standing up.
Amat, Blake and Dowds (1999) are also of the view that companies utilize creative accounting to easy income and report a steady expansion. This is achieved by manipulating accounts to depict improved upon revenue even in vulnerable monetary conditions to harmonize the ongoing income. Buyers, following accounting key points often utilize accounting ratios to guage and estimate the performance of organizations, consider dependable income expansion as stability and evaluate a non-volatile stock as a good investment. Likewise Fox (1997) is of the view that accounts manipulation is for the intended purpose of normalizing income so the company's management can boost show price by reducing the levels of borrowing, lower hazards and generate capital through new shares. Utilizing the accounting rules companies often organise financial accounts so that they would not echo in the total amount sheet, income affirmation or cash flow statement.
The problem develops when the overall flexibility within the financial key points allows accountants of companies to control accounts to avert buyers, banks and financial institutions scrutiny. This kind of flexibility is bound in some countries although it is more pronounced in others. In america including the FASB (Financial Accounting Standard Board) rules that income from extended guarantees may be accepted at the time of sale. Banks might not exactly identify this when they compute the debt to equity ratios to permit the company to borrow through inventory. In the united kingdom on the other hand there is certainly less provision for using debt and inventory as a way to diminish liabilities and inadvertently fill profitability.
Thus, accounting manipulation undermines the moral and moral standards that are expected of public limited companies. Decreasing evident volatility in income, inflating debt to avoid taxes, smoothing income to produce artificial opportunities for purchases and manipulating accounting principles to regulate market mechanisms depict the weakness within the economy. It also reflects on the moral criteria and moral of the job of accounting and auditing. Regardless of the knowledge and acknowledgement of this fact, professionals in the united kingdom from a study (Nasser 1993) suggest creative accounting is a problem that can't ever be solved (91 percent). In the US creative accounting is more regular because it capitalizes on the mandate for specific accounting rather than broad concepts, which makes it even harder to discover fraud.
The trend in fraud indicates that the building blocks of accounting procedures and ratios that organizations, institutions and general public use to estimate financial statements are not reliable. Corresponding to Mishra and Drtina (2004) financial record ratios tend to focus on success not quality of the performance of the company. Ratios such as go back on property and come back on equity are not adequate to gauge the firm's potential to meet debt obligations or to gauge the financial distress it is in. Likewise, ratios that accounting models use to tract shifting revenues and expenses through cash flow statement information just asses the firm's cash level predicated on operations, funding or investing activities. It is limited in calculating the worthiness of the organization based on free cash flows or net income that affect cash flows. As a result, often firms have a tendency to resort to bankruptcy declarations because of the insufficient cash inflows. Furthermore, company's stock performance is based on the performance of the stock prices but these ideals are risk centered and the prices are arranged with the assumption that market value of the firm is effective and the stock prices echo information in the financial assertions. However, when experts starting their decisions on ratios such as price to income, dividend yield and price to reserve ratios they are wholly dependent on information in the financial assertions, which may be fraudulent (Mishra and Drtina 2004).
When companies are constrained by scams hazards such as: opportunities, pressure and rationalization of unethical management, company information itself sorts the basis for risky (Hillison, Pacini and Sinason 1999). Matching to Cressey (1973) non-sharable financial need is responsible for the unethical practice that bring about fraud such as accounts manipulation. The urgency, which forces management to pressure accountants and auditors to commit fraud, is due to the necessity to appropriate belongings and resources to curb financial losses. In the process they undermine their professional integrity (See Appendix 1) (Hillison, Pacini and Sinason 1999).
Riahi-Belkaoui and Picur (2000) in their attempt to understand scams in the accounting environment write 59 percent of the KPMG 1998 Scam Survey respondents believe fraud can be more prominent in the foreseeable future. The reasons they cite include economic pressures, inadequate abuse for conviction, weakening sociable values, insufficient emphasis on prevention and diagnosis, and criminal elegance. Accounts manipulation is the result of favourable situations where criminals recognize versatility within the financial reporting system and audit failing to discover manipulation.
Furthermore, when organizations gain electric power, privileges and position to build a host conducive to white training collar crime, members are likely to acquire revenue management knowledge that are within the construction of the accounting guidelines and alternatives. Abdelghany (2005) records that income management help financial professionals select certain target and tailor the financial results of the firm to match it. The essential premise is the fact management can manipulate soft numbers caused by accrual accounting.
As mentioned earlier firms engage in accounts manipulation scheduled to several reasons some are unethical while some are because of the environment in which they operate. The approach to manipulate accounting ideas to reap the benefits of consistent high quality earnings and impact process decisions inspire firms to simple income, inflate earnings, restate cash flow and deflate liabilities. They try to meet the analyst's prospects and company performance predictions (Abdelghany 2005). Other reasons include debt covenant avoidance, costs of investment, ecological long-term performance and achieving up with benefit plan requirements etc. amongst others. The stresses of management performance, authority, market inability, and future loss tend to stimulate top management to conceal interior misappropriations and misstatements. The influence of these stresses on the reported assertions is great as analysts rely upon the info to make investment decisions, debt covenant, and professional prediction. Mistreatment by means of manipulating accounts affects not only the company but also the industry and the overall economy at large.
Given the aforementioned rationale the researcher is of the view that there surely is a great need to study accounts manipulation and its own affect on establishments, the general public, accounting and auditing experts, and the investment environment all together.
The objectives of the study are the following:
- To check out how companies like Enron and WorldCom engage in accounts manipulation using financial ratios.
- To investigate the ethical and professional implications of financial ratios manipulation through accounting misstatements, income management and restatements.
- To research the role of the regulatory specialist in contributing or deterring accounts manipulation by assessing the accounting expectations in america and UK.
The researcher is designed to evaluate important industry practice by assessing case studies of Enron and WorldCom. The researcher shall also explore issues of accounting guidelines weaknesses and the role of the specialist in contributing to the current craze of accounting fraud and manipulation. Subsequently, the study shall benefit specialists who are in the field, trying to find solutions for the existing trend and how to suppress it. Academicians will dsicover the use of theoretical frameworks to study an up-to-date accounting issue interesting and contributory to future works. Additionally, the researcher desires the results of the study enumerating to both students and academicians alike who are enthusiastic about the analysis of accounting fraud and manipulation.
However, readers will dsicover the scope of this study limited in the sense that it'll be focused on accounts manipulation particularly in the utilization of financial ratios. A couple of other ways of accounting manipulations, which is protected briefly in the study. Overall, readers will see the findings useful and educational.
The study will be divided into the following sections:
Chapter 1 introduces the topic through a brief overview of the current norms and methods in accounts manipulation. In addition, it points out explanations why there's a need for the study with goals for directing this issue for discourse in the next chapters.
Chapter 2 is a Literature Review, which shall track the Enron and WorldCom scandals in the light of accounts manipulation. In addition, it reviews books on financial ratios scams and its results. Lastly, it shall research the accounting benchmarks adopted by the united kingdom and US to compare which is more prone to accounts manipulation.
Chapter 3 shall outline the many methods considered and chosen for the development of the current research.
Chapter 4 is an analysis of the data collected and assessed from the researcher's point of view based on the expertise of the scholars discussed in the Literature Review.
Chapter 5 shall conclude the findings, and offers some recommendations to solve the issues layed out in the targets.
An reliable capital market is one that allows prices to switch swiftly in response to the latest information because open public information is conveyed successfully, interpreted and analyzed to make effective decisions. Disclosure therefore is an obligation imposed for legal reasons to facilitate market performance. Companies are obligated to provide information so that buyers and the general public can interpret information to participate in the marketplace decisions. Professional ethics is relegated through understanding among accountants, auditors, management and professionals on the idea that the market is entitled to acquire full accounts and reviews of companies' performance as per regulatory authority. The proper execution and content of the average person or consolidated accounts is regulated by the company regulation and by accounting benchmarks given to the accounting specialists and auditors. However, sometimes publicly exchanged company budget becomes tradeoffs credited to limited liability, deficits and performance pressure. Any bargain in their performance ends up with negative market effect, as they are bound by requirements and targets placed by the general public. This sort of market behaviour push companies to resort to unethical tactics (Ferran 1999).
Alternatively, when laws change in response to the demand of the marketplace, companies have to reshuffle their internal systems to comply with them. The planning of accounts relating to suitable accounting expectations often issue with the business's standards and worth. New accounting information requirements and benchmarks are often looked at with apprehension as they put pressure on the statutory requirements. Including the Listing Guidelines of the London STOCK MARKET require annual information and accounts of companies to contain "additional information". The changing environment therefore creates a problem for companies to align current with earlier shows (Ferran 1999).
To measure a company's financial ranking, experts use ratios to estimate and examine its performance by checking it with the current status or against the industry's specifications. Financial professionals of companies know about the use of this tool to evaluate company's performance. Within the framework of legal accounting benchmarks they use planning and capital framework decisions to gauge the performance of firms. Ratios such as price to earning, for example, are of particular interest to shareholders interested in gauging the performance of the business they would like to spend money on (Pike and Neale 1996). When pressured, accountants can manipulate accounts information, such as passions, liabilities, and pre-tax income etc, to significantly inflate or deflate certain accounts according to the needs of the firm's targets for the brief or long term. For example some companies might inflate earnings per show to depict higher dividend to improve the company's investment appeal. Others might deflate liabilities to depict low personal debt to equity percentage, to generate opportunities for borrowing. Whichever the reason, the fact is that firms engage in accounts manipulation within the accounting rules framework. They are simply within their legal rights to hire such methods, which allow them to create a positive picture to buyers, creditors and corporations. What lengths can firms employ such methods and what extent constitutes unethical or illegitimate practice will be looked into in the following sections.
Among the recent cases of accounts manipulation is Enron. Enron products and services relate with gas and energy wholesale, as well as retail to a host of customers. The company is considered one of the most innovative with an efficient management team and a innovator who's the envy of the industry. Regarding to Mishra and Drtina (2004) Enron filed bankruptcy in 2001 when it acquired just revealed its strategic plans in the light of advantage and non-asset expansions. The business's plan have been to extend into energy trading expertise with a bunch of new products and services. At that time its share had been bought and sold at $90. From 1999 to 2001 the business underwent great changes in conditions of its income per share from $1. 27 in 1999 to $0. 999 in 2000. To deflect speculation, Enron used off-balance sheet partnerships to funding and sustain its investment progress and ranking (Mishra and Drtina 2004).
This method is not really a new practice but is utilized by 27 percent of companies. Enron however used it to hide its massive money by inflating income with gain from deal of investments to off-balance sheet partnerships by guaranteeing the partnerships' debt with stocks. As a result Enron needed to restate its cash flow from time to time to reflect the decrease in shareholders' equity because of the relationship. The stock price began to decline to significantly less than $1 in November 2001 even though the company had been considered one of the speediest growing companies in the industry. While the reserve value of the possessions tripled from $23. 5 billion in 1997 to $65. 5 billion in 2000, in most cases Enron have been deteriorating in its market capitalization (Kedia and Philippon 2005). Enron is a typical example of accounts manipulation where misreporting to show increased investment value and simulated income have created manufactured resources whereas the business had been jogging into higher level of debts. The true cost of manipulation eventually displays in the earnings.
Earnings management has been used to improve stock prices so that professionals can profit from the share trading however in effect undermine the organization's value. Theoretically the utilization of cash flow management helps organizations to control price earning ratios to, firstly show firm's potential activities, and second of all to restate the value of the firm. However, as a consequence, the wages created theoretical progress in investment and employment depicting strong progress (Kedia and Philippon 2005; Healy and Wahlen 1999). Based on the authors, Kedia and Philippon (2005), Enron used an profits manipulation model, which includes resulted real-time inefficiencies, as it does not account for the fundamental value of the firm's equity or take into account the allocation of resources.
Wamy's (2004) research discloses that Enron "inflated profits by almost one billion dollars and top employees raked in millions of dollars (they shouldn't have obtained) through complex and special partnerships to cover up debt, inflate revenue and to take part in allied unethical and heinous business procedures. " The business's unique business model depicts real human capital as the leveraging point for its investments, instead of fixed investments. Since its people are believed physical assets, it might allocate cash flow to they to create higher value for the company that has them.
Theorists blame the business's manipulated accounts as the basis for its individual bankruptcy in 2001. Others (Barlev and Haddad 2004; Wamy 2004) blame it on the move within the accounting construction. Barlev and Haddad (2004) attribute the switch of accounting tactics due to the addition of the new paradigm of reasonable value accounting has increased the speed of confirming in companies. The authors in their research show that the new paradigm upgraded full disclosure, transparency and management efficiency mandates. However, the fragile control system that governs accounts information contributed to maltreatment and manipulations. They have allowed Enron to sell its stakes to special purpose entities thereby minimizing reported activities. Since Enron "took the position that consequently of the reduction in its ownership interest, it no more handled [SPEs] and was not required to consolidate [SPEs] in its balance sheet. " SPEs had been acquired through loans and credit debt issuance, which resulted in high debts to equity ratio, but concealed from the shareholders. As business deals at Enron grew, the company is also met with its inability to pay for these trades (Dodd 2002). Further, the business has also abused the reasonable value construction by using hedging musical instruments such as changing reasonable value of investments and liabilities, variable cash moves and foreign currency exposure to stress on its valuation (Barlev and Haddad 2004) by saving inaccurate revenue and earnings growth. Enron reported prices and known fictitious unrealized increases to account for pretax income worthwhile $1. 41 billion for the entire year 2000, which is attested by its auditors to be true (Makkawi and Schick 2003).
WorldCom (now MCI) is one of the major distance telephone companies in america to declare themselves bankrupt in 2004. The reason have been accounting irregularities that equal to $11 billion. Corresponding to Scharff (2005) the business's declaration have been one of the most significant accounting frauds in america history. The writer writes of the perpetrator as being the organizational composition, group procedures and culture, which mitigate scam that got become a fundamental element of WorldCom's procedures. WorldCom's rationale for carrying out a corrupt plan of action stems from groupthink behavior and competitive industry environment that pressurize customers of the business to make decisions to go after deceptive activities (Whyte 1989).
Scharff (2005) traces the development of WorldCom's individual bankruptcy and records that through the 1990s the company have been under strong pressure to keep up cash flows and earnings before interest. As the telecommunication industry is subjected to strict laws, WorldCom executives resorted to scam to allocate costs of capital as prepaid. Likewise, it also engaged in incorrect release of accruals so as to reduce current year expenses to increase revenue. Not only this, the business also ensured that minor earnings entries are created to increase operating cash flow (Scharff 2005). The money and accounts department had been motivated by top management to activate in deceptive behaviours (See Appendix 2) to hide for the invulnerable position the organization had been in.
However, the most important issue had been when the company found out about loopholes in the GAAP that could support the entries the professionals wanted to include. Through them, the company also were able to inflate cash flows for five quarters with the assumption that the business received cash moves from functions whereas the majority of its activities had been predicated on accruals.
According to Tergesen (2002) the accounts manipulation engaged at WorldCom had been targeted at inflating consolidated cash flows to present a confident operation picture so that investors are enticed in buying its stocks to increase capitalization. Realizing that buyers are risk averse, and steer clear of company stocks that increase cash through financings, such as debt or investment related activities such as assets, WorldCom were able to pose a confident and attractive picture through accounts manipulation. It were able to secure functions cash moves through securitizing, which is the advertising of account receivables. Offering of receivables is regarded as cash collections, even though they can be collected in the foreseeable future. Although this practice is regular, the timing and the manner of entry helps it be culpably the basis for accounts manipulation. Not only this, Tergesen also notes that WorldCom employed in capitalizing expenditures. This practice involves the capitalization of costs of resources in the total amount sheet and writing it off as twelve-monthly instalments. To compensate for the lack of cash, WorldCom also manipulated the GAAP guidelines of allowing cash elevated through securities sales saved in the "cash from businesses" section, even though the activity is not related to cash flow. (Tergesen 2002).
The motivation matching to Zekany, Braun and Warder (2004) stemmed from the pressure to meet experts and investors' prospects. WorldCom had been closely connected with the stock market and a popular of investors. To meet experts' forecast goals, WorldCom used its open public relation as instruction for getting together with such targets. These expectations are derived from earnings estimates, securities performance and market position of its stocks. WorldCom, pressured from the power of investment demand and experts' prospects, devised financial measures to meet up with the financial requirements. To improve the stock market value, the most notable executive had to engage in expansionary acquisitions, to increase revenue growth. At exactly the same time the business's performance deteriorated along with the industry yet it acquired to confirm that it works above others (Zekany, Braun and Warder 2004). The accounting office at WorldCom experienced become an important functional component under the directives of its executives employed in accounts manipulation activities to improve E/R ratio. The authors clarify that WorldCom implemented the collection cost accruals system to pay for the accrual earnings and the responsibility reported in the balance sheet. However, because the accrual system is highly high-risk, it is difficult to make provision because of its accurate reportage. The pressure to meet up with the collection cost accruals encouraged professionals to find creative accounting suggestions to reduce and save costs. This approach would have been successful, however since the industry had been strived by deterioration, earnings could not be inflated to attain the expected levels to portray a good E/R percentage. E/R is basically a ratio to gauge the come back on business resources open to the management. It really is similar to a measure of shareholder collateral and management performance. (Alexander 2001).
Fraudulent financial reporting has given new measurements to corporate scams. Both external and internal auditors are trying with the legal liability to detect deceptive financial statements, to be able to save damage to their professional reputation and also to prevent open public dissatisfaction (Kaminski and Wetzel 2004). Previously specialists relied on the efficiency of ratios to identify expectation mistakes to make decision pertaining to stock prices, hazards and value of stocks for future growth. Subsequent decisions derive from the credible reportage. Shareholders, borrowing establishments and the general public, use accounting ratios to anticipate comes back or performance. Ratios rely on cash flow and booklet value to measure a firm's value. Performance is expected by the cross-sectional aggregate and indications from figures in the financial statements. Shareholders use strategies such as fundamental ratio evaluation, accruals examination and fundamental value research, to take into account their decisions and treatment of investment portfolios. However, Daniela, Hirshleifer and Teohb (2001) are of the view that these strategies are not effective predictors of future stock returns. They write:
"Earnings reported on organizations' financial claims differ from cash moves by accounting changes known as accruals. They are designed in basic principle to mirror better economical circumstances. . . high accruals forecast negative long-run future results. " (Daniela, Hirshleifer and Teohb 2001)
This strategy is influenced by the discretionary working capital accrual and new collateral. This is so because shareholders are fixated by profits numbers. Consequently they tend to underestimate other accrual factors.
Similarly, the authors also remember that the fundamental value analysis strategy to forecast future stock comes back, "depends on stock prices from an imputed value based on a simple value model" (Daniela, Hirshleifer and Teohb 2001). Even in this model the low priced value of expected future residual cash flow are defined in the framework of normal return employed in future years. In reality, earnings prediction depends upon the value of the index as well as the incremental booklet/market profits. Frank and Lee (1999) in their research reveal that internationally such a model, when put on cross-country businesses such as Enron or WorldCom have a tendency to produce abnormal dividends, resulting in limited strategy for checking stock prices or its performance prediction. In that condition misevaluations can occur and so will manipulation. That is known as timing. Timing can be used to mislead stock happenings to influence "when and whether" buying actions (Legoria, Cagwin and Vendors 2000). Legoria, Cagwin and Sellers (2000) note that when firms engage in timing of discretionary accruals they are motivated by opportunities for new debt, creditor self confidence, and favourable reversals over arrears issuance, especially in organizations where revenue are volatile they are viewed as high-risk. Reporting volatile profits reduce stock appeal for investors. Because of this accounting ideas allow professionals to smooth cash flow conducive to positive investment decisions.
Another author Mcmenamin (1999) points out that weaknesses in asset-based valuation methods on the other hand ignores earnings or cash flow generating potential of the organization. Instead investors take up the price/cash flow (P/E) solution to predict future earnings to beat the weakness mentioned above. P/E ratio is a popular method for show valuation between investment analysts, professionals and shareholders. It gauges the wages potential of the company's earnings per show (EPS) and compares it with the share's market price. P/E is determined by dividing the marketplace price of the company's ordinary talk about by EPS. P/E ratios reveal individual circumstances of the company based on the business's returns, risks and future prospects. It is sensitive to the shareholders' need to asses the business's potential and future performance to wield high comes back (Mcmenamin 1999).
However, Chan, Jegadeesh and Sougiannis (2004) are of the view that although ratios have been sufficient methods for cash flow evaluation, nevertheless income manipulation is common practice for US companies. They find that we now have an increasing number of literatures that account for the utilization of accruals to counteract cross-section stock results such as size, book-to market and earlier returns. The wages management approach to report income not only relegate manipulation behaviour among professionals, but also induce over-optimism over income. Cash flow management allows accountants and financial managers to adapt cash flows, so as to revert accruals into cash flow to meet analysts' expectations on the companies' future performance. This inadvertently causes low future earnings and high current accruals so the negative influence on future accruals is minimized but there's a great impact on the current revenue. According to the authors, firms with relatively high stock prices, which result in high P/E and high market-to-book (M/B), are motivated to control these stock statistics because of their own benefit. In the long run however, accruals manipulation often reverts in regressive future profits. (Campbell and Ammer 1993).
Despite the disadvantage of the practice it is expected that firms engage in earnings manipulation to reflect on negative exchange impact. The magnitude of its impact will depend on the itinerary that the organization has used to control profits such as receivables, inventory, world wide web working capital or total accruals. Such materials overstatement or misstatement may, according to Rosner (2003), violate GAAP, with regards to the techniques and degree used for deliberate manipulation. Recognition can be done through an array of existing financial analytical types of procedures. Kaminski, Wetzel and Guan (2004) are of the view that unintentional and intentional misstatements are possible through analytical types of procedures such as quantitative and percentage analysis. They point out the use of stepwise-logistic models such as financial leverage, capital turnover, property composition and organization size, as significant factors for detecting fraudulent financial reporting. Since analytical methods are endorsed by insurance policy makers, it is also the official way for detecting accounts manipulation in organizations to detect bankruptcy earlier. Additionally, such methods ensure that exploration cover limits and opportunities provided by the accounting concepts, implemented by the industry (Kaminski, Wetzel and Guan 2004).
Harrington (2005) writes that financial misstatements can be diagnosed by using ratios to counter check company's profits and performance information in the financial record. The writer is of the view that income claims and balance bedding produce results that are obscure leading to accounts manipulation such as increasing receivables, decreasing gross profit margins, decreasing advantage quality, high sales progress and increasing accruals. The thing is mediated by using the next ratios to find potential scam:
a. Sales progress index assists with detecting fraud regarding companies that manipulate revenue to meet anticipations of management and analysts.
b. Gross margin index is another proportion, which allows that you detect the key reason why gross margins deteriorate by analyzing cost of goods sold and sales characters.
c. Property quality index picks up total resources congruent to the realization of hazards and how proportionate it is to the deferred costs and performance of the firm.
d. Times' sales in receivables index assist in the way of measuring of receivables change which may or may well not inflate revenue.
e. Sales, general and administrative index, solution and rationalize the inclusion of bills that relate to earnings (Harrington 2005).
In each one of the above the writer points out that the ratios can find scams to the amount it has been used to control accounts, which makes the activity legal, or within the paradigms of the GAAP.
Overall however, Neely (2002) writes "There exists thus no definitive set of financial ratios that can be said to gauge the performance of a business. " Instead, financial ratios simply enable pros to gauge different aspects of the firm's financial performance to benefit their own cause (See Appendix 3). Financial studies in essential are derived from the use and manipulation of accounting concepts. Thus it is not uncommon for businesses to "window dress" reported financial statements within the paradigms of GAAP. The casual use of creative accounting however, must be curbed and this responsibility is entrusted to the external independent auditors.
Accounting disclosures and determinants examination is two of the most important areas of monitoring businesses in the context of their businesses and activities. The majority of the disclosure information for analysis and examination have been predicated on scores of centered variables that buyers, shareholders and the public use to relate with its performance. However, such disclosures are tied to the dominating practice in the market and the businesses' culture of publicized information. Companies like Enron, WorldCom, Xerox and AOL etc. have been subjected to great scrutiny, because they are perceived to have violated provisions for disclosure by the united states accounting criteria (Chavent M. et al 2004). The general premise had been that the guidelines used for disclosure, offer rooms for manipulation so that companies can decide to bottom part their accounts reportage predicated on company businesses (Aharony, Falk and Yehuda 2003). The ability of companies to misstate or omit accounts to project positive financial statement disclosures has purported financial scams, which brought up concerns from all spheres. The argument is the fact that GAAP leaves room for deceptive reporting and accounts manipulation. You will find no control systems that counteract great losses from clear bankruptcies.
According to Spathis and Zopounidis (2002) accounts manipulation isn't just costly for the stakeholders and shareholders also for the economy. THE UNITED STATES with several gathered declaration of bankruptcies and financial fraudulence had to acknowledge the fact that there surely is great need for a regulatory body to counteract them. The Affirmation on Auditing Specifications (SAS) No. 82 considers that, assessment of hazards and encouragement of interior control system would mitigate financial fraudulence. However, even though this standard had been carried out in 1997 it has not been in a position to deflect fraud hazards. Some of the known reasons for the inefficacy of SAS No. 82 had been management characteristics, industry conditions, and financial stableness (Spathis and Zopounidis 2002).
Rezaee, Olibe and Mimmier (2003) creates that the number of profits restatements by open public companies in the US have sharpened the Securities and Exchange Commission as well as the STOCK MARKET(s) to modify financial reporting process and interior control framework as well as audit functions of firms. The Sarbanes-Oxley Act of 2002 could very well be the main legislation that expanded the responsibilities of the accounting expert in america. It specifies the role of the exterior auditors and mandatory rules for reportage. According to the authors Consumer Oversight Board (POB) of the SEC Practice Section of the North american Institute of Certified Public Accountants (AICPA) (1993) has played out an important role in revising corporate governance role in organizational management and accounting management. You will find six major requirements that the Sarbanes-Oxley Act of 2002, which influence the role of auditors and the continuing future of financial assertions, audit:
"1 the audit committee should be composed entirely of independent members of the mother board of directors;
2 the audit committee should be immediately accountable for the appointment, settlement, and oversight of the work of exterior auditors;
3 the audit committee must have authority to activate advisors;
4 the audit committee should be properly funded to effectively perform its responsibilities;
5 auditors must report to the audit committee all "critical accounting plans and practices" utilized by your client; and
6 the SEC should issue guidelines to require public companies disclose whether at least one member of their audit committee is a "financial expert. " (Rezaee, Olibe and Mimmier 2003).
Despite these mandates however, generally accepted auditing requirements (GAAS) and a bunch of other restrictions seem to be under progress and require professional organizations' popularity for effective implementation. Moreover, there is great dependence on the SEC to be vigilant of commercial activities of general population companies especially on the top management including the chief executive officers and key financial officials by subjecting them to stiff fines for deceptive behaviours. Nevertheless, Caro and Maoz (2003) are of the view that GAAP compliance and SEC mandates through the Sarbanes-Oxley Take action is inadequate as these do not have internal settings for disclosure of all financial information necessary for gauging firms' performance or for gauging misleading and manipulating activities (Caro and Maoz 2003).
Lawrence (2002) is of the view that accounting irregularities in the US have critical tasks in implicating "the future development of the accountancy profession" at the global level. It also affects global policy manufacturers such as those in the united kingdom to set standards and regulate fraudulence. In the UK, the author records the Statements of Standard Accounting Practice (SSAP) and the Financial Reporting Expectations (FRS) and the International Accounting Criteria (IAS) are accountable for regulating one place requirements of reportage. This convergence model relating to Lawrence has been critical in aligning change in the united kingdom GAAP with the IAS. The IAS has turned into a regular national standard for practice. However, the united kingdom SSAPs and FRSs differ from the Accounting Specifications Board (ASB). This is because the UK functions based on local benchmarks but sometimes have to meet the regulatory requirements as arranged by europe. The differences within these specifications and its own adoption expose companies, traders and shareholders to discrepancies and opportunities for fraud. Just like the US GAAP, the FRS 18 Accounting Policies and the IAS 8, record net profit or loss, fundamental mistakes and changes in accounting insurance policies with room for specific interpretation. However the accounting plan has established a benchmark for modification of accounts, nevertheless it still exposes cash flow and changes of retained cash flow in the balance sheet, to scams.
Alternatively, Bruce (2005) creates that post-Enron actions have undermined the assurance of organizations and professionals likewise. In the united kingdom, the formation of the Financial Reporting Review -panel, under the directive of the Financial Reporting Council, has specified legislation to govern confirming as well as procedures for confirming anomalies. THE UNITED KINGDOM is challenged by the situations in the US. To counteract potential financial manipulation the specialist has selected steps that would help detect deceptive behaviours, as well as firm's tendency to breach legislation.
Research in virtually any field is completed with the view to obtain knowledge or to critique learned happening. Acquisition of knowledge requires rationale by thinkers to validate the info acquired for this day. Modern-day research in this framework is dependant on two periods of research rationale, specifically: inductive and deductive reasoning.
Inductive reasoning is defined as follows:
"A process whereby from sensible singulars recognized by the senses, one arrives at universal concepts and principles organised by the intellect. " Johnson-Laird and Byrne 1991). Thus inductive reasoning could be described as the motion of knowledge from the specific to the general. Inductive research and rationale is dependant on the identification of facts and fundamental reality to hook up with broader accepted frameworks. Wisdom regarding the approval of the incident of the case, event or rationale could then be exceeded to establish new or endorse existing facts.
Deductive reasoning on the other hand is described by Spangler (1986) the following:
"The human process of going in one thing to another. . . In other words the rational person through what he already has learned can exceed his immediate belief and solve very obscure problems" (Spangler 1986). Deductive research consists of expanded knowledge produced from general theoretical frameworks adopted by theorists and studied by peers. Knowledge can be derived from the generalized ideas to study the subsequent specific data, hypothesis or research rationale.
Depending on the nature of the study, researchers may take up the deductive or inductive reasoning for rationalizing research effects.
Research is also sorted out in line with the qualitative or quantitative research, depending on the benefits that the researcher really wants to achieve. Matching to Myers (1997) software of research methods depends upon the disciplines and fields of use. Qualitative research is usually adopted by social science researchers who study social and social happening. Qualitative methods, such as action research, circumstance studies, and ethnography for example, count on data options from observation and participation to file the researcher's observations (Myers 1997).
Alternatively quantitative research is developed and used in the inspection of natural sciences. Study methods, lab experiments, numerical computations and mathematical modeling are a few examples of quantitative research methods, which are used to deduce accurate numerical results. One of the down sides of quantitative results is that it is limited by the numerical values that are attained through formulas or numerical musical instruments. Any interpretation is wholly reliant on the values arranged by the pragmatic relevance of the statistics.
On the other side qualitative research often looks for exploratory study, observation and objective interpretation of theoretical frameworks before any sort of deduction is made. Qualitative analysis is more preferred by the sociable sciences because it offers a great deal of room for rationalizing different perspectives leading to several options for resolutions.
Research studies tend to be based on set up frameworks and peer publications. This can be bought from the overview of secondary or key research. Supplementary resources make reference to documents such as newspaper publishers, magazines, Internet and works citing others. Alternatively primary resources refer to first hand account whether published in the form of books, journals, observations or interviews. Usually research studies combine key and secondary resources to ensure no point of view is still left unturned. However, there are some studies that exclusively rely on extra or principal resources.
For the goal of achieving the goals of the research the researcher has chosen to look at the combination of deductive and inductive research. The premise is that the problem of accounts manipulation is no isolated incident pertaining to Enron or WorldCom only but is shared by a bunch of US and UK companies. It is therefore ideal to adopt both approaches to create a theoretical framework to study the explanation behind the fast development of commercial scandals, resulting from accounts manipulation and exactly how it could be found through ratios.
As very good as the decision of qualitative and quantitative research can be involved, the researcher has chosen to look at a qualitative strategy. It is because this issue of accounts manipulation and ratios pertain objective discussions only. It investigates and traces the introduction of accounts manipulation through financial ratios, and exactly how firms can be inspected to curb such practices in the foreseeable future. There is no need for hypothesis tests or derivatives because of the restriction of space and time.
Secondary and principal resources have been used to form a major part of the research outlining the theoretical frameworks, as well as in understanding the rationale of businesses' motivation to engage in malpractice. The inclusion of both supplementary and key resources is also scheduled to desire to have study of diverse expert views and views.
At the beginning of the study the researcher has establish the following targets, the results which are analyzed below:
- To check out how firms like Enron and WorldCom take part in accounts manipulation using financial ratios.
The Enron and WorldCom debacles are the consequence of an inefficient US currency markets. The firms had been strived with industry performance pressure and experts expectations so much, that they have to sustain earnings progress. Enron for example due to the deteriorating oil and gas sector has been compelled to adopt creative accounting steps to hide substantial debts. The explanation had been to provide positive income whereas the truth had been in any other case. Companies like Enron take up accounts manipulation because they're aware of the strategies implemented by investors, experts and creditors to measure the performance of the company. By inflating revenue and deflating liabilities Enron stands to gain when these professionals use financial ratios to determine its performance. Enron have been able to engage in restatements and manipulation of accounts due to the inefficient financial reporting systems and regulatory criteria in the US.
This routine is also seen in other bankrupt and fraudulent companies including WorldCom. The books review clearly implies organizations that modulate unethical routines often vie for weakness within the control system for their own benefit or even to adhere to industry pressures. Regarding WorldCom it had been the industry environment pressure, as well as the corrupt groupthink behaviour of people working in the company. WorldCom, as Tergesen (2002) notes, had been obligated to present a confident operational performance and income to increase its potential, for nurturing capital, despite the risky stocks and options it harbours.
Clearly the examples of WorldCom and Enron depict accounting system weakness and unethical behaviours of professionals, which have resulted in the manipulation of accounts. They may have capitalized on the loopholes within GAAP and the recurrent use of financial ratios as strategies used by investors to determine strong performance.
- To investigate the moral and professional implications of financial ratios manipulation through accounting misstatements, cash flow management and restatements.
Fraudulent accounting is costly not only to the shareholders but also to traders, stakeholders, open public and the overall economy. Financial manipulation to misstate earnings or to restate revenue impact the wider market if not prevented in time. Relating to Kedia and Philippon (2005) Enron and WorldCom's circumstances illustrate the point that misreporting and manipulation of accounts bring about long-term slow production. Moreover, when firms are proven guilty of such malpractices top management's integrity, organizational culture and framework become questionable.
According to Kaminski and Wetzel (2004) for example professionals engaged in the effective relegation of open public traded company information, reporting of credible financial statements, and the ones who screen the companies' performance are responsible for maintaining the expectations and benchmarks set by the industry, economy and the specialist. Earnings misstatement, fraudulent behaviours as well as manipulation of accounts information affect ratios and in that way investor decisions undermine the professional physiques that govern the financial framework and paradigm as well as general public accountability expectations.
Experts are of the view that organizations like Enron and WorldCom, which take part in reporting abnormal results to fill stock prices and have an impact on buying decisions, create opportunities to breed unethical behaviours but also give the impression that it's alright to falsify income for the good thing about stakeholders. In such cases the executives and stakeholders employed in the firm are not the only real ones at fault. Accounting rules through the assistance of policy manufacturers are being developed hastily without account for loopholes offer opportunities for unethical behavior. When coupled with industry pressures and high-risk levels, organizations are destined to holiday resort to manipulation and fraudulent behaviour to safeguard their hobbies.
- To study the role of the regulatory specialist in adding or deterring accounts manipulation by assessing the accounting specifications in america and UK.
In such situations the regulatory specialist is responsible for developing deterring options to curb fraudulent behaviours. In the US such methods could be viewed in the form of accounting criteria, legislation and new legal mandates such as SAS No. 82 and the Sarbanes-Oxley Action. Nevertheless, these mandates are still at the original stage of development. As rigorous polices are applied and organizations are required to assess against benchmarks, new loopholes are expected from the new expectations and regulations. This is not to say that the US accounting system is fragile and encourages accounts manipulation. In fact, the plethora of accounting scandals and firms employed in financial frauds will be the results of opportunists or organizations that are pressured by peer and industry performance.
In the UK likewise regulations are set similar to the US but because of the risks and encouragement from local and EU, regulators have grown to be more vigilant. It really is one of the reasons why the united kingdom has witnessed lesser incidents of fraud and misstatements as compared to the US. Furthermore, the united kingdom GAAP is dependant on a combo of local and international benchmarks dissimilar to the united states. Because of this companies have to purely adhere to the required rules for reportage as well as moral conduct. Nevertheless, the UK could be thought to relatively follow a stricter guideline that discourages accounts manipulation with less loopholes and opportunities for businesses to manipulate financial strategies and ratios to job bogus performance and revenue. Cash flow management have a significantly different meaning when compared between the US and UK.
Overall, the literature review and analysis on the introduction of Enron and WorldCom's bankruptcies suggest that there is great potential within the GAAP to proliferate accounts manipulation and financial ratios manipulation. This is because a large body of professionals is employed in investment decisions predicated on accounts ratios. It is not hard to pin point frequently used ratios by traders, shareholders and the general public to make investment decision. Even credit establishments find it relatively easy to rely upon financial ratios, to determine a firm's audio performance and quality materiality despite the fact that they are fragile strategies.
Researchers in the past have affirmed the value of financial statements for the purpose of accountability. It really is named the communication standard for the company as well as the statement of governance. However, when financial assertions do no follow the standardized benchmarks and quality required by its audience it translates some other message that could render information useless to its users. Financial misstatements, restatements, manipulation of accounts information to alter financial ratios and deceptive disclosures lead to public doubt and undermine investment self confidence. When one reads of Enron and WorldCom and a bunch of other companies following the same way the pattern depicts a unfortunate and deteriorating corporate discourse, which must be re-evaluated and modified. In the framework of the aforementioned research, the researcher has come to the following conclusions that some advice have been offered:
a. Enron and WorldCom's bankruptcies have proven the actual fact that the current accounting expectations have loopholes that firms can manipulate for his or her benefits. Accounts manipulation such as income, inventory, receivables and liabilities manipulation can cause positive financial performance for the organization to draw in or sustain trader interests. In the case of Enron earnings have been "managed" to inflate revenue while liabilities have been shifted to partnership accounts to depict low credit debt to equity ratio. Similarly, WorldCom has been pressured by the industry to execute to the anticipations of analysts. To support its position as the second most significant telecom company in the US it resorts to financial manipulation to indicate high material property whereas its resources have been intangible. Such manipulation of accounting principles is regular however the extents to which these companies have used them have elevated cause for matter for the professional body as well as industry stakeholders.
Recommendation: It is strongly recommended that stricter actions through combined work of the experts as well as industry stakeholders to suppress such procedures.
One solution could be through corporate governance while others may include the establishing of benchmarks and regulatory power that scrutinize the financial assertions and financial systems of companies more closely on a regular basis. Penalties should be levied to ensure there is no repetition of such unethical behaviours among corporate leaders.
b. Experts are of the view that the increasing numbers of accounting scandals have been the consequence of weak accounting requirements and control systems. Upon researching the various areas of the accounting specifications it has been revealed that the US accounting expectations is comparatively weakened to the united kingdom in the sense that it is flexible. This flexibility allows users to conform the rules and standards based on the need of the industry. Yet it is the same fact, which has been found in an unethical manner for the good thing about chosen few - particularly the management of companies and high-level executives. They manipulate and violate accounting principles to solve issues of financial performance, sustaining stock prices as well as investment appeal.
Recommendation: To resolve, it is recommended that accounting requirements and control systems should be standardized. These should also be predicated on strict regulations that leave less room for overall flexibility to allow deceptive practice. Furthermore, those who apply them such as auditors and accountants should be placed accountable for any kind of financial fraud giving them more electricity over firm's management.
c. Accounting requirements and regulatory physiques in different parts of the planet have different legal requirements to meet the requirements of particular region or industry of their own country. However, when companies operate at the international level it is easy to allow them to make reference to international requirements to deviate from the article requirements or financial disclosure. For this reason, Enron and WorldCom have been in a position to capitalize on their multinational status to control financial assertions.
Recommendation: For this function, it is recommended that there be one harmonized system to help organizations follow similar criteria and legal requirements even when they operate overseas.
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