FRAUD IN THE ACCOUNTING INFORMATION SYSTEM

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28 Aug. 13

Table of Contents

Assessment of the failure of Enron’s accounting information system.. 3

Risks and Responsibilities relevant to outsourcing accounting function to Third party. 5

Determination of advances in accounting and / or information technology could have prevented the Enron collapse  7

Evaluation of the changes should be made to both the Sarbanes-Oxley Act of. 9

Recommendations. 11

Works Cited. 13

 

Assessment of the failure of Enron’s accounting information system

The case for this paper is Enron Company, which one had been the most innovative company and the seventh biggest company in the US by 2000. The problems started occurring when the Enron failed to generate the sufficient cash flows and valued its assets inappropriately and reported the overstated profits. The immediate cause of the Enron’s failure was the announcement on November 2001 that its profit were stated by $586 million, which shook investors and resulted in bankruptcy; the accounting system did not warn about the troubles, the executives sold 1 million shares between June and October 2001, which raises the concerns for more aggressive auditing rules (Sterling, 2002). The profits were overstated, and the company utilized the profit of non current period to the current period, hence showing more profit in one year, and the loss in other year, for creating the high value of the shares in the market. The officials of the company also participated in the failures and transferred the loss to the public investors and the shareholders, as the executives had the potential information, they predicted the failure of the company, and sold all of their shares before the official announcement of the loss reporting period. The investors had to bear the consequence of this mistrust and the executive did not bear nay loss because they had sold their shares in the company, hence they were held liable for utilizing the insider information for their own purposes.

The failure of the Enron was not due to the fraud but due to the failure of the system; the failure was connected with the deficiencies related to the parties involved in it and the overall system, the participating parties were bribed, and exploited or silenced including the directors, auditors and the investment banks and consultants (Veron, Autret, & Galichon, 2006). The factors behind the Enron failure were the creative and manipulative accounting and there are ethical concerns regarding the accounting practices of the Enron. The failure of Enron was not the Failure of the company, but it was also the failure of the corporate governance framework at that time. Those who accomplice in the failure of the Enron’s Failure were bribed and they were dealt illegally and unethically so that they cannot report the status of the company, before it became inevitable to announce the circumstances of the company. The auditors were required to report on the circumstances of the company, the directors and the investment banks were also responsible for not reporting the circumstances, as they had the insider knowledge of the affairs of the company.

The Enron Scandal resulted in the Shareholder’s loss of $74 billion, the employees lost their jobs due to the failure of the company, and the CEOs who were held responsible had to face prison (CorporateScandals). This scandal had the widespread effect on the corporations, regulations and the people, and the people lost their significant earnings with the failure of the company, and also the employees lost their jobs and became redundant, the retirement earnings were lost because of this, and this scandal resulted in the overall decrease in confidence of public.

The key officials of the company including the Chief Executive officers have to face the criminal prosecution rather than the civil prosecution and they were held liable for the fraud and misrepresentation for the company’s information, as they actually did. The Enron Scandal shook the investors, and they have to bear financial loss because of the concealment, misrepresentation of the information done by the CEOs of the company. The CEOs of the company were also responsible for the misrepresentation of the information in the case of Enron’s, and the CEOs hid the debt of the company through their personal influence on the process of publishing the financial statements. This corporate scandal resulted in the change of relevant corporate legislations.

From the accounting information system perspective’s the Enron collapsed because of problems including aggressive earning targets, the use of aggressive accounting practices, setting high expectations, lack of the ability of generating sufficient cash flow, and the inappropriate valuation of assets, liabilities, revenues and expenses (Thomas, 2002). The accounting perspective provides the insights related to the drawbacks in the accounting framework and its ineffectiveness as the accounting framework did not prove efficient in preventing such large corporate failure. The company was held the most innovative company in the use of technology and the company had been the most proficient company in the energy sector in the USA and in countries other than USA. The company utilized inappropriate accounting practice in the company, which was later called the creative accounting.  

Enron used several methods to value the assets and the company according to the desires of the CEOs and the superficial benefit of the company and the stakeholders. The revenues and the profits were overstated for a period to boost the market of the shares and the debts were hidden from the people as they were not reflected in the financial statements of the company. The company also set the unrealistic targets and the company was not able to achieve these targets reasonably, and this created high expectancy in the people at the time when the company was not even able to generate sufficient cash flow for its operations.

Risks and Responsibilities relevant to outsourcing accounting function to Third party

Outsourcing is common practice in the contemporary corporate environment, and the accounting function is one of the important functions that is outsourced. The reason for outsourcing is the advantages as the outsourcing involves the less costs, and the training and development costs are reduced, also the management is not burdened with the accounting issues, and however the responsibility for the true and fair account remains on the shoulder of the management. The management is responsible for the true and fair accounts and not the service provider in the case of outsourcing the accounting function so the clerical tasks related to the accounting functions can be transferred, but the responsibility for these tasks cannot be transferred or outsourced.

An outside organization will have access to the extremely confidential data and the lack of appropriate internal controls or incompetency in service provider can cause material errors and fraud, any organization can outsource its functions but it cannot outsource the responsibility for implementing internal controls (Hall, 2011). The outside organization will tackle the accounts of the company, it will have the access to the potential information, which can be used for the insider trading, and the third party can personally get the benefits but selling or purchasing the shares when the prices are expected to rise or fall.

The risks related to the outsourcing the accounting function is the clash with the auditing function, and this occurs when the firm, which is providing the outsourcing services, also performs the external audit of the company’s accounts. The accounting function and the auditing function create similarities and the outsourcing firm may have personal interest when auditing the same firm with which it were in contract with providing the accounting services. The auditing function  will not be independent and the company can hide its drawbacks in the auditing report, as the company is examining itself, and it have certain interest for enhancing its performance.

The outsourcing of the accounting function increases the risk, and the company cannot transfer the risk responsibility by transferring the outsourcing function to the third party (Cortucci, 2010). The outsourcing functions also have ethical concerns and the precious accounting service provider can provide the auditing services which raises ethical issues. The other issues related with the accounting and auditing function clash is familiarity issue in addition to the inherent interest, and most importantly, the responsibility cannot be transferred for any discrepancy in detecting and preventing fraud. The management of the company is responsible for the prevention and detection of the fraud, the task of the accounting service provider is to provide the extension of the organization function but it would not limit the responsibility of the company in maintaining the true and fair financial statements. The auditors are also not responsible for preventing and detecting the fraud, but they are liable to make opinion on the financial statements regarding the truth and fairness of these reports.

Determination of advances in accounting and / or information technology could have prevented the Enron collapse

The Enron scandal have resulted in more strict scrutinizing of the other companies; the financial data does not disclose the true information, and the degree of disclosure varies from country to country and the true profitability and the asset values could be concealed, the data was available after 3, or 4 months after the year end (Fight, 2004). The Enron Scandals could have been prevented if the drawbacks in the accounting system would have been detected earlier. The tighter scrutiny of the accounts and the regulations regarding the independency of auditing function may have prevented from the failure of the Enron. The auditors are liable to form opinion regarding the truth and fairness of the financial information, and the auditors’ performing their duty by providing external audit is the legal requirement, both now and at the time of Enron’s collapse. The auditor did not predict about the affairs of the company, and the disclosure regarding the going concern of the company was not published with the financial information. Presently, any issues relating to the going concern of the company must be disclosed, as they hold potential value for the investors and the shareholders.

The collapse of the failure resulted in the lack of confidence in shareholders and their interest was exploited by the company’s management and other stakeholders. Very strict regulations were implemented to restore the confidence in the people regarding the publicly listed companies and the publicly traded stock of these companies as this phenomenon had provided setback to the people. The Sarbanes Oxley Act was the immediate consequence of the corporate scandals like Enron and WorldCom etc. and this law resulted in stronger independence for auditors, and the auditors are required to be rotate every five years, requires CEO and CFOs to personally certify the statements, requires audit committees and code of ethics in place (Kieso, Weygandt, & Warfield, 2011). The Sarbanes Oxley Act has many implications and one of which is the establishment of the board that regulates the auditing function. The Sarbanes Oxley Act proposed the independence of the auditors.

 The independence of the auditors has various aspects. The auditor must be a proficient person and it must be an associate of the professional accounting body, and must hold appropriate competence to form opinion on the financial statements, and secondly the auditor must not have familiarity to the company. The firm that is providing the accounting services should not provide the auditing service to the company in the context of external audit, and there must be no personal familiarity. The personal familiarity, partnership in business or acquaintance is likely to affect the professional opinion of the auditor, therefore it has been recommended that the auditor should be independent; the auditor should be competent and must possess independence.

The selection of the auditor can defeat the motive of independence and the remuneration of the auditor, and the timing of the audit fee can affect the auditing function, therefore independent audit committee is recommended. The audit committee sets the remuneration, and this remuneration must not be excessive, and also it should not include any bribe or ‘gift’ to the auditor, and it is the ethical responsibility if the auditor to leave or resign, if there are issues with the independence and the remuneration of the auditor. The company’s may put pressure on the auditor if there is significant amount is in balance regarding the remuneration of the audit.

Evaluation of the changes should be made to both the Sarbanes-Oxley Act of

The Sarbanes Oxley Act has resulted in increased costs because it requires the establishment of different committees and the costs are increased for the compliance requirements; this act is the major factor in the decision of going a company public, and public company, this act is making more difficult to hire and retain qualified directors (Niskanen, 2007). The setting of various committees is an extra cost for business and the companies, which are converting from the private companies to public companies, will have to bear substantial costs in setting these committees and meeting the requirements of this legislation. The companies, which are public companies, tend to go private because of the burdens that this act has levied on the companies. The responsibility of the companies have been increased at the public level as they hold the investors and shareholders’ investment in the business therefore the strict regulations are the necessity for the corporate systems, and without this act the confidence of the shareholders may not have been restored.

The Sarbanes Oxley Act has made the directors and the Chief executive officers personally responsible for the financial statement and the financial affairs of the company. This act requires the CEOs to sign the financial statements and hence they are legally held responsible for the affairs of the company, and they should exercise their authority and power to prevent and detect any fraud in the company. The directors are not necessarily being committing fraud, the employees of the company may commit the frauds and they may not be the actor of the CEO in committing fraud, and they may commit fraud or misstatement for their personal benefits. However, the CEO should ensure that there are proper controls, which protect the company, form the fraudulent activities or misrepresentation.

The setting of the auditing company is helpful in maintaining the internal audit function. It helps in coordinating the internal audit function with the external audit function to ensure the objectivity and the independence. The internal audit function have to face more issues related to the independence in contrast to the external audit, but as the internal audit is not the legal requirement, therefore no strict regulations were in place in regarding to the internal audit function. The internal auditor may face the hurdles in reporting on the drawbacks in the system or reporting any misstatement or fraud, especially if the management is involved in it, but setting the audit committee helps the internal audit to function more effectively.

 The audit committee in contrast to the internal audit department is not required to report to the manager, but the audit committee is required to report to the upper level employees, which are the directors of the company; therefore the manager may not exercise undue influence of the representatives of the internal audit department.

 The Sarbanes Oxley Act requires the establishment of various committees such as audit committee and the remuneration committee and these committees ensures the independence in both the audit and remuneration function. The directors can set very high pays for themselves, which may not be appropriate; however, with the establishment of such committees they may hold the shares and can get the higher incentives for their performance in addition to their salaries. The purpose of the remuneration committee is also to hire and retain the directors of the company, and this is useful making the board of directors for the company. The board of directors must include the executive and non executive directors. The executive director’s look after the day to day functioning of the company, whereas the non executive directors analyze the executive level information, however the board of directors must include a person with the required expertise in relevant field for example accountancy.

The structure of the board of the directors has the prime importance to the company, and the board of directors are both the representative of the company, employees and the shareholders; therefore the Sarbanes Oxley act applied stricter regulations to include the non executive directors in the company, as they will not have interest in the concealment of the information, as in the case of executive directors and in contrast to the executive directors, they cannot benefit from any manipulation or fraud.  The structure of the board of directors is the corporate level preventive approach in protecting the fraud and manipulation and ensuring the independence at the higher organizational level.

Recommendations

The US congress passed the Sarbanes Oxley Act after the corporate failure of the companies like Enron etc., this law establish new Public Company Accounting Oversight Board with the power of licensing the auditing firms, and regulating accounting functions; it requires the CEO and CFOs to personally sign the financial statements, hence they are personally liable (Graham & Smart, 2011). The Sarbanes Oxley was passed in 2002 and its approach is rules based approach in contrast to the UK approach, which is the principle based approach. This act provides the regulation regarding the accounting functions and the accounting policies, and it requires the company, specifically the publicly listed companies, to include the vouching certificate with their financial statements. This act is helpful in restoring the confidence of the people in the accounting, auditing, and the overall corporate governance system. The companies, which are listed oublicly, are the ultimate target of this act, as their shares are public traded, and the public at large have interest in keeping these shares. The boards of directors are responsible for the misstatement and the prevention and detection of fraud, and they may face criminal prosecution if they are found guilty of committing fraud and concealment or manipulation in the financial statements.

The information failure may have been prevented in the Enron if the company has adopted a fair valuation of the assets and appropriate accounting policies. The accounting policies must be consistent, and they should not be adjusted according to the necessity. The accounting polices should have retrospective affect when they are changed and the concern in bringing retrospective change is the consistency in the financial statements.

The financial statements should be published timely, and the auditing function must be carried out in rather short time. The publishing of the financial statements is very lengthy process, and the auditing of these statements may also take time, therefore the information, which is brought to the people after 3 or 4 months, will not have the usefulness as if it were on time. These processes cannot be eliminated; however, their efficiency can be enhanced to provide the timely information of the stakeholders and those who have interest in the company. The disclosures for the significant events must be announced at the AGM with the financial statements and the relevant reporting criteria must be met.

Works Cited

CorporateScandals. (n.d.). The 10 Worst Corporate Accounting Scandals of All the Time. Retrieved August 28, 2013, from Accounting-Degree.com: http://www.accounting-degree.org/scandals/

Cortucci, P. (2010). A Short Guide to Ethical Risk. Gower Publishing, Ltd.

Fight, A. (2004). Understanding International Bank Risk. John Wiley & Sons.

Graham, J. R., & Smart, S. B. (2011). Introduction to Corporate Finance: What Companies Do, Abridged Edition, 3rd ed. Cengage Learning.

Hall, J. A. (2011). Accounting Information Systems (Hall), 8th ed. Cengage Learning.

Kieso, D., Weygandt, J. J., & Warfield, T. D. (2011). Intermediate Accounting, Volume 1. John Wiley & Sons.

Niskanen, W. A. (2007). After Enron: Lessons for Public Policy. Rowman & Littlefield.

Sterling, T. F. (2002). The Enron Scandal. Nova Publishers.

Thomas, W. C. (2002). The Rise and Fall of Enron: When a company looks too good to be true, it usually is. Journal of Accountancy .

Veron, N., Autret, M., & Galichon, A. (2006). Smoke & Mirrors, Inc: Accounting for Capitalism. Cornell University Press.