Ethics in Corporate Accounting

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Introduction

This paper will examine the issue of ethics and responsibility in the accounting profession. This focus will be on contrasting the theory of accounting ethics versus what occurs in actual practice. An attempt will be made to determine how much of a disparity exists between theory and practice. It will also attempt to explain why this difference exists and what has been done to mitigate it. This paper will investigate how Managerial Accountants, Accountants, Financial Managers, Managers, and Investors make decisions based on firms' accounting data. It will examine whether decisions are made in the best way possible and if not, why.

This paper is divided into six main sections. The first section is the introduction which is setting up the research questions for this essay. Section two will briefly discuss what professional standards should exist in investment-related decision-making in the accounting profession. Section three will examine the actual practice of investment-related accounting decision-making. As part of this section the accounting scandal that occurred at Enron will be reviewed as a case example. Section four will examine the effects of these scandals on the accounting profession and what the official response has been. Section five will review what impact the official response has had on changing the ethical climate in which investment related accounting decisions are made. It will also discuss why such scandals occurred and what measures could be taken to prevent them from happening again. The final section is the summary and conclusion.

Accounting Codes of Conduct

According to Mattli & Büthe (2005, 400) standards exist in the accounting profession, to stipulate the ways in which business developments and assets are to be recorded on firms' financial statements. It's expected that all accountants are to observe these codes of conduct. It's particularly crucial to do so when estimating and reporting financial data. This data can include profits, expenses, assets, liabilities, and revenues (Mattli & Buthe 2005, 400). This information is reported to shareholders and is also publicly available. Therefore, it's important that the integrity of this information be unimpeachable. Indeed, how else can financial analysts make accurate and meaningful comparisons of different firms' financial positions if the data they received have been manipulated?

Moreover, poor accounting standards can exact a cost to society. This was already well known and understood as far back as the 1929 stock market crash. This crash precipitated the Great Depression which led to a decade of global financial ruin. Yet, it is often the case, that such established professional codes of ethics are violated. This paper will attempt to undertake how and why this occurs. The next section will begin with a discussion of the accounting scandals at Enron.

Enron: A Case Study

There are numerous cases to choose from when conducting a review of accounting scandals. However, when undertaking a review of the literature, it became clear that the Enron case best encapsulates the full range of transgressive behavior in the accounting profession. It is thus, the best case example of what went wrong in corporate accounting. It's also helpful, as will be discussed in a later section, in determining what can be done. It's enough to note that there are many cases of similar accounting malfeasance. Some examples of these include ImClone, MCI WorldCom, Global Crossing, Kozlowski and Tyco, Qwest Communications, and Adelphia. This is hardly an exhaustive list and a full recount could fill volumes.

Background

Enron began as the product of a merger between InterNorth and Houston Natural Gas in 1985. The resulting firm owned a 38,000-mile-long network of pipes which was the largest natural gas transmission network in the country. A major outcome of the merger was the heavy debt load the new firm was burdened with. This debt proved to be a hindrance to any plans for rapid company expansion (Giroux 2008, 1210).

Natural gas was highly regulated until the 1980s, with tightly controlled gas prices, until a policy of deregulation was begun by the Reagan Administration. Prior to deregulation most natural gas contracts were long term and presented minor risks for buyers and sellers. Although profits from the pipeline tended toward the low end of the scale they were reliable and consistent (Giroux 2008, 1211).

After deregulation, natural gas prices were exposed to prevailing market conditions and tended towards volatility. With more potential for lower prices, natural gas consumers moved from long-term contracts to the spot market. It should be noted that a spot market is a futures transaction for which commodities are expected to be delivered for use in thirty days or less. Also, the commodities may be transacted using spot prices. However, the commodities are exchanged in a future physical marketplace ("Spot Market" n.d.). The pricing trend in this now volatile market saw an initial plummet in prices, followed by a decline in supply with a subsequent price recovery. Such market conditions were not optimum for a pipeline firm's profitability (Giroux 2008, 1211).

n this newly deregulated business environment, locating new natural gas reserves and selling gas became ventures with high levels of inherent risk. As a result, banks were reluctant to loan money to natural gas producers. In 1989, to overcome the problem of credit availability, Enron organized Gas Bank, run by Jeffrey Skilling. Gas Bank was to restore market stability to natural gas trading by setting up Enron as the middle man. The bank worked by contracting producers to sell their future natural gas to the firm. The firm would then give the producers a loan against the projected natural gas sales. The producers would then locate new natural gas reserves and pay their loan to Enron off in gas instead of cash (Giroux 2008, 1211). At the same time, Enron set up contracts with buyers to sell the projected natural gas, at some future date, at a set price.

Skilling was a proponent of mark to market accounting. This accounting method involved valuing assets or long-term contracts in terms of current market valuation instead of historical cost. Historical cost is where income would be spread out over the lifetime of the contract and correspond to actual cash flows. Enron expanded its use of mark to market because it was a huge generator of earnings for the firm. However, it was also a source for manipulation of quarterly earnings. It should be noted the later sub-prime mortgage scandals also used mark to market accounting (Giroux 2008, 1213).

The only problem with mark to market accounting at Enron was that gas prices were not reliable on contracts timed one to ten years into the future (Giroux 2008, 1213). As a result, pricing estimates were developed based on mathematical models. The models could be used to predict big gains in sales and profit before the gas or cash was even exchanged. The model's predictions were always optimistic because trader incentives were based on trading value instead of on the gas deliveries (Giroux 2008, 1213). Whenever Enron felt a cash crunch, the predictions could be made to appear still more optimistic when quarterly recalculations were performed (Giroux 2008, 1213-1214). Thus, Enron was providing credit to natural gas producers via its Gas Bank operation, it would then use its mark to market accounting to log projected earnings. At this point, no cash was produced. This was only exchanged several years later when the gas was delivered.

The firm then contracted with offshore enterprises for future natural gas delivery. In exchange, Enron would receive cash payment. This payment was recorded as cash from operations. It should be noted that offshore enterprises were created by Chase Manhattan Bank and other Enron creditors (Giroux 2008, 1214). These creditors made the payments appear to be from revenue sales when they were in fact loans or prepays against future sales. These loans were reportedly in the billions of dollars and could be used by the firm to disguise capital losses. This technique was often used when a firm was reporting earnings of significant size. The firm also didn't report the cash inflows as liabilities on its balance sheet (Giroux 2008, 1214).

Structured Financing

A key technique that Enron, and firms in the finance sector, used in its unethical accounting is structured financing. This type of financing is expressed in special purpose entities (SPE). Essentially, SPEs are separate legal structures, apart from the main firm, that can be used to move assets and liabilities either in or out from a parent firm's balance sheet. In the 1980s, banks and other financial institutions used SPEs to move mortgage and loan receivables. They would then securitize these assets for resale as bonded financial instruments (Giroux 2008, 1215). The rationale behind securitizing is to convert tangible or intangible assets into securities based on predicted cash flows. These securities would then be sold off to investors in return for cash.

Before the corporate accounting scandals of the mid-2000s, SPEs were required to have a minimum one independent equity investor. This investor is required to contribute assets worth at least 3 percent of the fair value. This benchmark was raised to at least 10 percent following the Enron debacle (Giroux 2008, 1215). An investor meets the qualification for independence only if an outsider and assuming the risk of the involved transactions (Giroux 2008, 1215). Firms used SPEs in order to undertake specific assignments and to isolate risk from the firm's core assets. If the indicated requirements weren't met, the firms were required to incorporate the SPE into its core financial operations and report appropriately. Yet SPEs were used by Enron to hide its liabilities by moving them off the parent firm's financial statements and convince investors its financial condition was stronger than it actually was (Giroux 2008, 1215).

Enron's financial difficulties stemmed from its inception. As noted above, it was saddled with massive debt and received junk bond rating status. Although this bond status was, for a time, raised to low investment grade. To manage its aggressive growth strategy, the parent firm looked to SPEs, with Skilling hiring an SPE specialist, named Andrew Fastow. Fastow created the firm's first SPE in 1991, which was used to provide credit to producers in the oil and natural gas industry. Roughly $ 1 billion in contracts were securitized and then sold off to institutional investors such as General Electric. In return, Enron was paid using loans, the investor cash equivalent to what the commodities producers received. The debt was, in turn, moved off the balance sheet to the SPE. As the firm's debt problems mounted, the use of SPEs became more widespread and complex. Eventually, Enron needed the SPEs to disguise new and existing debt, to book its earnings, and to create cash flow for operations. They thus became prime tools for accounting manipulation (Giroux 2008, 1216). Giroux (2008, 1215) notes that structured financing played a major role in the subprime mortgage scandals of the second Bush Administration as well (2000-2008).

As this paper is not intended to be a full recounting of the history of the firm's downslide into bankruptcy, so much as a review of its manipulative accounting practices, it will move forward to the next section which will discuss the impact of these infamous accounting scandals. It is enough to say that it all unraveled for Enron after the Tech bubble burst in 2001. At this time, Enron's manipulative and fraudulent accounting methods came under closer scrutiny. It's notable that federal officials almost didn't get involved with proposing new legislation in the wake of the fall of Enron. It was only when similar accounting scandals emerged at other firms, particularly at MCI WorldCom in 2002, that new legislation was proposed (Giroux 2008, 1208) The next section will discuss this new legislation with some estimation of the impact it has had on achieving more ethical outcomes in corporate accounting.

Accounting Scandals Outcomes

These fraudulent business practices had disastrous effects on the nation's economy and adversely impacted thousands of workers. The many thousands employed at these now-bankrupt firms were unemployed. But also the dissolution of their retirement savings, which were tightly bound up in the companies now worthless stock. At Enron alone 4,000 workers were laid off and billions worth of retirement investments were erased (Bragg 2002). It's notable that senior leadership at the firm was still able to cash out their stock options and pockets millions of dollars just before the crash (Giroux 2008, 1209). The sense of betrayal and mistrust was quite palpable.

The accounting scandals had wide-ranging impacts on the accounting profession. A survey of prospective accounting students found opinions on the profession had declined significantly. Some students acknowledged the accounting scandals had tarnished the reputation of the profession and made their major less attractive as a result. There is also some evidence that enrollments in accounting programs declined in the wake of the collapse at Enron, MCI WorldCom and other firms (Coleman, Kreuze, & Langsam 2004, 139).

The scandals also tainted professionals in other related industries. Indeed, one of the problems noted above was lax enforcement from government regulatory agencies. This appears to provide additional evidence that government agencies are captured by private sector interests and serve to enable their fraudulent behavior (Berry 1984, 524-525). As reported above, federal regulatory agencies were slow to respond with reforms when the many white-collar criminal and unethical business practices were revealed at Enron. It wasn't until a similar scandal emerged at MCI WorldCom that discussions regarding substantive reform began to take place. Similarly, corporate law firms, that also interact with corporate accountants and regulators, have taken great pains to not become tainted with the widespread fraudulent accounting practices. It's reported that this is a source of stress between accounting firms and corporate law firms (Dezalay & Garth 2004, 615).

Research into public attitudes towards ethics showed a decided disapproval of the accounting profession. Conroy & Emerson (2006, 395-396) report, in the wake of the scandals at Enron and ImClone, that public disapproval of the profession increased. This approval extended to the use of financial manipulation and insider trading. Boatright (2003, 13) argues, the American capitalist system is rather schizophrenic. It blends an economic system that promotes individual self-interest with one in which fiduciary responsibility to the interests of others is crucial.

In the wake of the MCI WorldCom scandal, the Bush Administration signed into law the 2002 Sarbanes-Oxley (SOX) Act. SOX created the Public Company Accounting Oversight Board (PCAOB) whose responsibility is to oversee the auditing profession ("The Laws That" 2013). However, in 2008 similar widespread scandals erupted in the subprime mortgage sector (Giroux 2008, 1215, 1231). Notably, financial firms in the housing sector conducted the very same business practices that led to so many business failures just a few years earlier. This seems to indicate that mere legislation is not enough to ensure proper ethical accounting practices. The next section will consider some causes and suggest a different method of intervention.

Accounting Scandals: Causes and Solutions

At the outset, it was the view of this paper that greed is the main cause behind the accounting scandals. While it is obvious that greed is the clear motivator, the ability to carry out so many fraudulent techniques and practices, is not easily explained by greed. That is, such practices also require an opportunity to successfully execute. Therefore, the literature was reviewed for potential causes of the accounting scandals.

According to Nott & Adjiboloso (2005, 53), the cause of the bankruptcies was rooted in a lack of spiritual capital. The authors theorize, in their human factor analysis, that business schools should teach spirituality along with the techniques of market analysis. In their view, individuals in the business world are too motivated by profit and need to seek a deeper grounding in their lives.

Other research takes a different approach. Couch, Hoffman, & Lamont (1995), writing prior to the era of large-scale bankruptcies, argued that the behavior of financial managers was mainly situational. In their view, managers who were confronted with the real prospects of firm survival were likely to set aside ethical considerations in their search for solutions. In this view, such managers' behavior is modifiable by external stimuli. This seems to suggest that individuals don't consciously choose to behave unethically if there are alternatives.

Research, conducted years after the accounting scandals, appears to confirm part of this argument. Prechel & Morris (2010, 331) explanation of financial malfeasance is rooted in organizational-political embeddedness theory. This theory holds that social structures create dependencies, incentives, and opportunities to undertake financial malfeasance. This would suggest that if the social structures were modified, then the fraudulent behavior would have fewer outlets to manifest itself. The authors argue that, during the period 1986-2000, neoliberal economic reforms were enacted by a succession of Republican and Democratic administrations. These reforms weakened financial industry related regulatory and oversight mechanisms. With these weaker mechanisms in place, individuals felt empowered to pursue whatever perverse and predatory urges that presented themselves.

The authors report three main contributory factors. The first is that capital dependence on investors creates perverse incentives. The second, the stress to increase shareholder value perversely incentivizes financial managers to use unscrupulous methods to achieve their goals. Finally, the multi-level subsidiary organization incentivizes perverse financial strategies. The authors also found that a political structure that permits corporate political action committee (PAC) donations to public officials creates a climate in which malfeasance, is not only encouraged, but rewarded (Prechel & Morris 2010, 335).

It's important to note that the public policies enacted during the reference period were undertaken at the behest of private-sector financial managers. These individuals, and the organizations they serve conducted a long-term campaign of policy reform aimed at deregulating the financial sector. This campaign also led to policies that gave tremendous power, independence, to corporations. This included the freedom to engage in unethical and criminal behavior.

As noted above, a number of policies made the new regulatory environment more conducive to malfeasance. These include the Tax Reform Act of 1986, which was promoted by a few hundred major corporations. In the view of its supporters, existing tax laws had high depreciation allowances, encouraged corporations to maintain poorly performing assets, such as old manufacturing plants (Prechel & Morris 2010, 335). These firms had also wanted to reduce their dependence on bank loans by promoting the wider use of equity financing. As we saw above, this involved issuing securities without much initial scrutiny from the Securities and Exchange Commission.

The Tax Reform Act of 1986 removed the New Deal era tax on capital transfers that occurred within a corporation. According to Prechel & Morris (2010, 335), the rationale for this tax was to deinstitutionalize holding companies and disincentivize financial predation. It was also a means for monitoring agencies to use to track financial transactions within corporations. In the wake of the passage of the Act, many of the larger US corporations re-organized their firms by creating new subsidiaries out of existing divisions. This is the multilayer-subsidiary type of organization. In this type of organization, the parent firm at the summit of the hierarchy takes on the role of financial manager. Then, there are at least two levels or layers of legally separate subsidiary organizations incorporated under it. The authors report that nearly 85 percent of the 2002 Fortune 500 firms were organized using this form of organization. Most individuals don't realize the web of relationships, between a parent firm and its subsidiaries, because their public identities promote the illusion of disconnectedness (Prechel & Morris 2010, 335).

As was noted with Enron, this form of organization allows a parent firm to perform capital transfers and hide them from both regulatory agencies and potential investors. By 2004, the average number of corporate subsidiaries among the Fortune 500 was 39. However, some firms had many more subsidiaries than others. Thirty-seven firms owned over 100 subsidiaries structured pyramidally in up to 8 different layers of organization. About ten firms had created over 200 such subsidiaries and two firms had as many as 300 subsidiaries (Prechel & Morris 2010, 336). These different levels of organization create many opportunities for capital transfers that can move debt on and off the parent firm's balance sheet.

Another key legal change was the weakening of both the 1933 Glass-Steagall Act and the1956 Bank Holding Company Act. These acts greatly limited commercial banking activity diversification into other kinds of financial services such as investment banking and insurance (Prechel & Morris 2010, 338). These laws were effectively repealed in 1999 with the passage of the Gramm-Leach-Bliley Financial Services Modification Act. In the wake of passage, large financial conglomerates were formed that provided a range of financial services to the same corporate clients (Prechel & Morris 2010, 338). These services included loans, stock analysis, stock and bond underwriting, mergers and acquisitions advice, insurance, and investment guidance. Thus was created an environment in which multiple conflicts of interest could thrive. The act also created perverse incentives for firms to exaggerate the parent company's balance sheets.

Conclusion

In sum, this paper has reviewed the need for professional standards in corporate accounting. It's crucial from a fiduciary standpoint, for the investing public to trust that corporate accountants are not engaging in criminal or unethical business practices. However, the corporate accounting scandals are not rooted in simple greed or a lack of moral values. The scandals can be traced to very specific changes in the regulatory structure of the financial services industry. These changes created many perverse incentives and opportunities to engage in predatory capitalist practices. The key to preventing future scandals is to return to the regulatory regime that existed from the New Deal era until the Reagan Administration. But such a change won't be made without significant opposition from many of the same corporations that led the deregulation movement in the 1980s.

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