Illegal Accounting Practices

This investigation considers the implicit assumptions that are made when organizations publish their annual financial statements. Through a careful examination of the assumptions in this context, it will be possible to demonstrate that preparers and investors cannot simply assume that the organization has chosen to employ principles of an ethical nature to establish financial records that are commensurate with the expectations of shareholders. Effectively, this research will demonstrate that the binding ethical premises that are viewed as universal in the context of financial statements can not longer be assume when it comes to the financial statements of organizations.

Financial Statements-Their Meaning and Purpose

In order to begin this investigation, it is first necessary to examine the context of financial statements, how they are perceived by those that use them and the underlying assumptions that are made when they are read. Reviewing what has been written about the basic assumptions that are made in the context of financial statements, Colson (2005) notes that after the conclusion of World War II, the Financial Accounting and Standards Board (FASB) began working on the "standards for general purpose financial statements." Colson goes on to argue that standards for accounting are focused on two specific goals:

First, standards reduce the costs of specific negotiations over the form and content of financialstatements. Standards for general purpose financial statements facilitate contracting because they constrain insiders from producing financialstatements that reflect only inside concerns. Second, publication of such general purposefinancialstatements dramatically reduces the costs of searching for financial information about a company, which benefits potential equity, debt, and credit suppliers as well as company management (p. 80).

Colson goes on to argue that the establishment of (GAAP) by the FASB has created a conceptual framework for financial reporting for the organization. Under the GAAP the financial statements produced by the organization are to be reflective of the analyst's fair valuation of the organization's assets and liabilities. What this effectively suggests is the GAAP creates the basic assumptions upon which most financial statements prepared by the organization should be predicated. Colson argues that while the basic principles of accounting for the organization established under the GAAP clearly have salience for ensuring the integrity of the financial statements produced, they are predicated upon assumptions that all organizations are utilizing the same frameworks for the development of their financial statements.

Although the GAAP provides a clear framework for the development of accounting practices and financial reporting, McClenahen and Jusko (2002) observe that because the FASB cannot institute laws with respect to the development of financial statements, the ability of government to enforce the standards developed under the GAAP becomes an issue of paramount concern. According to these authors, the situation created because of the inability of the government to enforce the GAAP as law is one that continues to erode the very integrity of financial statements reported by all organizations: " reporting should be transparent, truthful and complete whether it is 'old economy' or 'new economy' accounting... A new model for accounting won't be worth much if managers are opaque, misleading and deficient. The issues we face are more ethical than they are technical" (p. 11). What this implies is that even though there are accepted rules of conduct that are accepted in the preparation of financial statements, there are few specific laws in place that can mitigate the ethical manner in which some organizations choose to manage their finances.

Problems with the System

Clearly, the evidence that has been presented thus far argues that while accounting principles and standards have been established under the GAAP, the inability of government to effectively enforce legislation that mandates that an organization act in an ethical manner, makes it difficult for independent auditors and investors to know for sure if the organization is engaged in ethical accounting and reporting practices. While this issue of accounting is one that has been assumed for a number of years, one only needs to consider the development of recent corporate scandals in order to understand how the basic assumptions outlined in the GAAP can and have been violated by organizations.

Considering some of the most notable examples of accounting misconduct in recent years, Frederick, Carter and Smith (2002) examine the accounting problems at Sunbeam that lead to the financial collapse of the organization in the late 1990s. According to these authors, Sunbeam engaged in a number of "aggressive" sales maneuvers in the late 1990s as a means to boost the overall revenue of the organization. Specifically, this organization is best known for its policy of "bill and hold." Explicating how this process worked, Frederick and coworkers go on to note that in order to dump some of its inventory, the organization sold items at deep discounts in the off-season. Distributors were given six months to pay for the merchandise and flexible terms that made these "deals" seem unbeatable. In addition, Sunbeam offered to hold the merchandise in warehouses until the distributors wanted to take delivery. Although Sunbeam had not received for payment for or delivered the merchandise, the organization recorded these sales immediately as revenue for the organization.

When the "bill and hold" policy subsequently came to light, it became clear that under the legal guidelines for organizations established by the SEC, Sunbeam had committed no crime. However, as Frederick, Carter and Smith note, the organization had violated a basic principle of the GAAP. As noted by these authors, the income reported by Sunbeam under the bill and hold sales was not definitive revenue for the organization: "the firm hadn't come close to fulfilling its obligations, was less certain than usual that it would get paid, and was less certain than usual that its products wouldn't be returned" (p. 72). Under the guidelines established by the GAAP, this type of transaction could not be classified as revenue for the organization. However, because Sunbeam was not engaged in practices that were illegal, there was no effective way for auditors or the public to identify discrepancies that existed with respect to this issue. When the financial statements produced by the organization were published, on paper the Sunbeam organization looked as if it had become overwhelmingly profitable.

Sunbeam is not the only organization to manipulate the legal/ethical dichotomy that has been created as a result of the inability of the government to enforce the standards of accounting set forth under the GAAP. Enron is another clear example of an organization that did not violate any government laws when it produced its financial statements. Researchers examining the accounting methods used by Enron have noted that special purpose entities (SPE) were used by the organization to hide crippling debt. While the GAAP provides general rules for disclosing the organization's debt, Enron's use of SPEs was legal under the law established by the SEC (Schwarcz, 2002). As such, even though Enron cost investors and employees millions of dollars because of their unethical accounting standards, the actions taken by executives in the organization was not illegal.

Conclusion

The information presented in this investigation clearly demonstrates that the inability of the government or other agencies to enforce the principles of accounting that have been established under the GAAP has created a situation in which organizations are now actively exploiting ethical loopholes as a means to boost overall profitability. Until there are formal laws in place that prohibit what is now considered to be unethical behavior in accounting standards, auditors can no longer assume that the financial statements prepared by the organization are predicated upon the same assumptions. For financial auditors caught in the middle of this quagmire uncertainty will continue to loom.

References

Colson, R.H. (2005). General purpose financial statements. CPA Journal, 75(4), 80.

Frederick, J., Carter, A., & Smith, S.D. (2002). The trouble with earnings. Money, 31(3), 72-76.

McClenahen, J.S., & Jusko, J. (2002). Goodbye to GAAP? Industry Week, 251(3), 11-14.

Schwarcz, S.L. (2002). Enron, and the use and abuse of special purpose entities in corporate structures. Financier, 9(1-4), 23-30.