Accounting Theory Research Essay

Financial accounting plays a crucial role in management of all companies, as it is the basis within which decisions will be made by the management.  The measurement of wealth and income differs between different companies due to the flexibility allowed in measuring them.  Due to this flexibility, some methods of measuring wealth and income have certain advantages over others.

According to Carey and the American Institute of Certified Public Accountants (2000: 1-5), there are also differences in reporting standards by different firms, with the major two standards being the International Financial Reporting Standards and the Generally Acceptable Accounting Principles.

There have been many companies which have recently collapsed since the onset of the global financial crisis.  The use of some accounting standards and methods has been blamed for the collapse of some of these companies.  This necessitates the need to analyse the accounting standards which have contributed to the collapse of such companies, with an aim of correcting the weaknesses in these methods.

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This paper aims at analysing the role of financial accounting in relation to the collapse of these companies.  It also aims at analysing benefits and costs of reducing flexibility in the reporting of financial information.  Finally, a brief conclusion and recommendation is given on the issue.  It is important to note that the paper uses case studies based on America companies since they are huge scandals which have happened fairly recently and are known to many people globally.

Corporate failures.

Lehman Brothers.

This company was formed more than one and a half centuries ago, in 1850 and is a provider of financial services to large corporations and governments.

  In engages in investment banking, investment management, equity sales, asset management, and research among other services.  Henry Lehman is the founder of this corporation and he began operating from a single shop.  His brothers soon joined him and they founded "Lehman Brothers".

They began trading in cotton, which was at the time, one of the main cash crops.  Gradual growth saw the company venture into the brokerage and commodity market.  After the civil war, the company helped in the reconstruction of Alabama, which enabled it trade in bonds.  Subsequent growth ensured that the company enjoyed success until the 1970s, when there was an economic recession.  However, the greatest financial challenge faced the company in 2007 after the mortgage crisis started.

The mortgage crisis was caused by a combination of factors, but the main one was the predatory practices by bankers.  Bankers lent money to people who had poor credit ratings in a bid to possess their collateral.  Banks usually estimate the probability that a person will repay a loan which he or she has been given, through the study of characteristics of people who have previously taken loans, and who have similar characteristics with the client.

They intentionally gave loans to people they suspected would not be able to repay them, with the intention of keeping the collateral given to act as security.  Many people who had taken the loans defaulted on payments and the banks seized their collateral.  Since the banks seized the collateral of thousands of people, the value of the collateral fell.  However, since Lehman Brothers used GAAP standards in valuing assets, it did not realise this, and became aware of the situation when it was too late.  The collateral held had significantly lower value than the loans which were taken, which led to losses by the mortgage banks.

Analysis.

It is clear that the financial system used by Lehman Brothers was responsible, to a large extent, for the collapse of the firm.  It is likely that if Lehman brothers had used IFRS standards in accounting, the damage would have been significantly lower, since it would have detected the decline in value of the collateral early enough and made the necessary adjustments.  It is therefore imperative that firms be advised to use this accounting standard, and this can only be achieved if the flexibility of using accounting standards is limited.

Berny Madoff Ponzi scheme.

This is another scandal which caused the collapse of Madoff securities, and the loss of more than $50 billion by stakeholders (Zambito and Smith 2008).  Madoff orchestrated this scheme, in which investors received returns based on the amounts collected from the subsequent investors, as opposed to profits.  He used a split-strike investment strategy which ensured he diversified risks.  He made much profit from the ponzi schemes, which initiated investigations into his activities.

This was because his split-strike investment strategy was unknown to bring many returns.  However, he was never caught, until the US economy started experiencing the mortgage crisis (Henriques 2008: A1).  This sent investors into a panic and they demanded their money.  He could not pay them all, which made him confess about the Ponzi scheme.  Currently, he is under house arrest awaiting the ruling from an ongoing court case.

Analysis.

Berny Madoff succeeded in defrauding the stakeholders mainly due to the absence of checks in accounting procedures.  For instance, his firm was among the largest which handled securities, and yet he had an audit team of two.  There was only one accountant who handled the financial affairs of such a large company, which would have raised concerns had there been checks.  His split-strike strategy of investment could not also lead to the realisation of such high profits.  Concerns were raised about this issue but the investigation done was not thorough enough.  If a comprehensive investigation had been carried out, the fraud would have been unearthed early enough and prevented the loss of billions of dollars.

Enron Corporation.

Enron Corp. was formed after Omaha merged with Houston Natural Gas in 1985.  The company created a nationwide pipeline system for supplying natural gas after incorporating several pipeline systems (Lawyershop Website 2007).  In 1987, the company faced one of its scandals, where the company lost $142 million.  The company recovered from this scandal, and in 1988, it adopted a change in strategy where it pursued markets which were not regulated.  This saw it open offices in England and subsequent venture into South America in 1992.

Enron began trading in electricity and further growth made the company rake in profits of $100 billion by 2000.  According to Culp et. al. (92-94), in 2001, the Enron scandal was revealed, and it involved irregular procedures in accounting, which made the firm file for bankruptcy.  The financial scandal was as a result of special purpose entity deals, which made a lot of losses and debts to be hidden (Hays 2003: E03).  The value of the shares for Enron dropped by almost half after the announcement of the scandal.  It led to prosecution of the top management among them the founder, Lay, who died before serving his prison sentence (Kurt 2006: 23-28).

Analysis.

Enron collapsed due to inefficient accounting practices which involved irregularities in operations. This firm opened offshore entities which were used to avoid taxes, which made the business to appear more profitable than it actually was.  This strategy continued for a long time, which led to a false impression of profitability, while in reality, billions were being lost.  The top executives took advantage of the high prices of stock, which was caused by the impression of profitability, to trade the stock.  The Chief Finance Officer was responsible for these practices, and he benefited from millions of dollars worth of stock traded.

During this period, the management misled investors into believing that the share prices would appreciate, while they secretly sold the shares which they possessed.  By the time Enron collapsed, the CEO and his friends had sold shares worth millions of dollars, while the investors stood to lose hundreds of millions of dollars.

There was a weakness in the accounting systems, which allowed such mismanagement to be practiced without the detection from the stakeholders of the company.  For instance, the accounting system allowed Enron to use SPEs to conduct acquisitions in a bid to conceal liabilities.  When undertaking checks and balances, Enron used its employees, and not independent people, yet this was not detected.

Another weakness was in terms of consolidation, and Enron did not consolidate SPEs, which made it possible to conceal liabilities and assets.  It the accounting policies considered these weaknesses, there would have been checks which would have detected the fraud early enough.  For instance, the auditor rotation law in Australia, which prevents an auditor from working for the same clients for a term exceeding five years, would have ensured that that irregularities were detected and reported early enough.  The policies would also have led to consolidation of SPEs, which would have made it very difficult to conceal assets and liabilities.  This would have prevented the losses faced by creditors and shareholders.  This is another reason why the flexibility of accounting systems needs to be curtailed.

Benefits and costs of reducing flexibility in the reporting of financial information.

There are various ways of reporting financial information, and these are guided by two major international standards used.  The first is the Generally Acceptable Accounting Principles, and this is an accounting framework which is widely used in the US.  It regulates the conventions, standards and rules which are used to prepare financial information by accountants (Eskew and Jensen 2000: 40-42). It uses several principles such as the principle of regularity, sincerity, consistency, non-compensation among others.

The second major accounting standards which are used are the International Financial reporting standards (Nelson 2008: 22-26).  These standards operate using principles which include relevance, understandability, comparability and reliability.  Most companies use either of the two standards when reporting financial information.  However, the Generally Acceptable Accounting Principles possesses some weaknesses, some of which are attributed to the collapse of major financial lenders, mainly in the US.  One example of a financial lender which collapsed due to the use of this system is the Lehman Brothers Corporation.

Benefit.

The major benefit of reducing the flexibility in reporting of financial information is to prevent the collapse of banks and other financial lenders which rely on collateral as security for the loans they give.  Lehman Brothers and other financial lenders in the US collapsed partly due to the weaknesses in GAAP's method of valuing assets.  GAAP uses the historical cost to value assets and securities, yet their prices change with time (Jaffee 2008: 33-36).

The mortgage crisis in the US led to the fall in prices of these assets, but since this system uses the historical prices in valuation, and then their values were not representative of the market prices.  Once the home owners defaulted in payments and the banks had to seize the collateral, they realised that they had significantly lower values than the loans owed.  This led to the collapse of some of the financial lenders.

The International Financial Reporting System on the other hand, ranks the market information according to its reliability (Gongloff 2007: 32-37).  Information which is derived from the market is deemed to be most reliable and it is given the most weight.  Information from unreliable sources is given the least weight, and companies use these weights when preparing financial results as well as making decisions.  Reducing the flexibility in financial reporting will enable companies to use the International Financial Reporting System, and therefore prevent the collapse of companies due to unreliable methods of financial reporting.

Cost.

The major cost of reducing flexibility of reporting financial information would be ensuring uniformity in different economic environments (Aizenman and Pinto 2005: 65-73).  There are many types of organisations which operate in different environments, such as developed and developing countries.  These environments have different demands depending on the macroeconomic and micro -economic environment.  It is therefore very challenging to develop an accounting system which can be replicated in all these environments with successful results (Bazerman and Neale 1999: 54-57).

It is also expensive to change the policy and adopt a new one, since this affects almost all operations in any organisation.  Change in the accounting policy is a long term change and requires professionals to implement it, a fact which small and medium organisations may find a challenge to meet.

Conclusion and recommendations.

Accounting standards have been seen to play a crucial role in any organisation.  The use of inferior accounting standards is attributable to the collapse of most of these companies.  The weakness of the GAAP reporting standards have also been seen to be major contributors of the collapse of companies such as Lehman Brothers.

The superior qualities of the IFRS system of reporting is being embraced by many countries, among them US.  This is due to the experience that these countries have faced regarding the GAAP system (Plantin 2007: 15-19).  It is imperative that all countries shift towards this accounting system in order to reap its benefits and prevent losses attributed to the GAAP standards of reporting.  Finally, there should be adequate checks to ensure that the accounting policies are followed, since this will discourage fraud and mismanagement of companies (Kwok 2005: 30-38).

Bibliography.

Aizenman, J., Pinto, B. 2005. Managing Economic Volatility and Crises: A Practitioner's           Guide. London: Cambridge University Press.

Bazerman, M., Neale, M. 1999. Negotiating Rationally. New York: Free Press.

Carey, J., American Institute of Certified Public Accountants. 2000. Professional Ethics of        Public Accounting. Massachusetts: Ayer Publishing.

Culp, C., N. 2003. William Cato Institute. Corporate Aftershock: The Public Policy Lessons        from the Collapse of Enron and Other Major Corporations. New York: John Wiley       and Sons.

Eskew, R., Jensen, D. 2000. Financial Accounting. UK: Random House, Business Division.

Gongloff, M. 2007. A FAS 157 Primer. Wall Street Journal, 15 November, 2007.

Hays, K.  2003. Conspiracy with Merrill Lynch charged in Enrol trial.  The Washington Post,     September 22, 2004. Retrieved on January 22, 2009 from             <http://www.washingtonpost.com/wp-dyn/articles/A39044-2004Sep21.html>.

Henriques, D. 2008. Prominent trader accused of defrauding traders. 2008. The New York         Times, December 11, 2008.  Retrieved on January 25, 2008 from <www.nytimes.com/2008/12/12/business/12scheme.html>.

Jaffee, D. 2008. The US sub prime mortgage crisis: Issues raised and lessons learned.    Retrieved on January 25, 2009 from <growthcommission.org>.

Kurt, E.  2003. 4 at Merrill accused of an Enron fraud. The New York Times, March 18, 2003.  Retrieved on January 25, 2009 from <http://query.nytimes.com/gst/fullpage.html?res=9C03E0DA1431F93BA25750C0A9659C8B63&sec=&spon=>.

Kwok, B. 2005. Accounting Irregularities in Financial Statements: A Definitive Guide for           Litigators, Auditors, and Fraud Investigators. New York: Gower Publishing, Ltd.

Plantin, G. 2007. Fair value accounting and financial stability. Journal of financial          accounting. Retrieved on January 25, 2009 from <papers.ssrn.com>.

Zambito, T., Smith, G. Feds say Bernard Madoff's $50 billion Ponzi scheme was worst ever.     2008. Daily News, December 13, 2008. Retrieved on January 25, 2009 from             ;http://www.nydailynews.com/news/ny_crime/2008/12/13/2008-12-            13_feds_say_bernard_madoffs_50_billion_ponz.html;.