There are five general principal financial statements that relate to the decision-usefulness of financial reporting that were clearly flawed when analyzing the Madoff and Enron cases: balance sheet (statement of financial position), income statement (statement of earnings), statement of comprehensive income, statement of cash flows, and statement of stockholders’ equity. Overall financial statements are useful because they help investors and creditors make better economic decisions. Financial statements are an approximation of economic reality because of the selective reporting of economic events by the accounting system; this is very useful to many users and is sometimes the primary source as it relates to making informed decisions.
The reasons for the Madoff and Enron collapses fall under corporate governance, accounting, and auditing. Prior to the collapse of Madoff and Enron, there were a many accounting scandals that involved major corporations, including Tyco International, Peregrine Systems, WorldCom and others. In wake of the number of scandals, and the allegations surrounding the scandals, which ranged from accounting fraud, to involvement with auditors of public companies, there was a need to incorporate analyze the defining elements of the collapse.
What Madoff and Enron did was a combination of being fraudulent, unethical, and practicing poor accounting. In addition, the intentions of the managers were fraudulent to begin with. They wanted to purposefully distort the financial figures of the company to make it appear as if they made money, when it was really the resellers being bribed to buy their products from another company, which caused them to lose money in reality. This is unethical, because they were misleading people by making appear as if they were earning revenue (Joyce para 7).
There are other examples like Madoff and Enron – as well as other violations, but the idea is that, financial reporting was being abused and violated by many pubic companies. Madoff and Enron had a lot of violations where management was not accountable for the custody and safekeeping of a company’s assets, since the financial reporting was not providing the necessary check on the efficiency and capability of management. Madoff and Enron was directly manipulating records that allowed management to report and account to shareholders or investors on the state of the entity’s financial affairs and changes to those affairs, which were erroneous or misleading.
Accounting fraud doesn’t seem shocking anymore since it seems every month a new fraud is being discovered. We can thank the major contributors (i.e., WorldCom, Adelphia, Madoff, Enron, Global Crossings, HEALTHSOUTH, etc.) for shedding light on such issues. The Sarbanes-Oxley Act has done a lot to guide and enforce public companies into complying with stricter auditing standards. With SOX audits and the additional limitations of CPA firms and a bigger emphasis on independence for auditors more reliance can be placed on the value of these audits.
Without requiring companies like Madoff and Enron to go through the rigorous audit process, it increased the risk of fraud because all aspects of accounting systems were not reviewed. In addition to the security and programming of computer systems involved at these bigger companies, management is reviewed with heavy emphasis on tone-at-the-top issues and segregation of duties, (Canadian Accounting Standard Board 7). This is where the issue of auditor independence is most important. Auditors used to be the necessary oversight for firms like Madoff and Enron, but prior to SOX, there were some blatant violations of auditor ethical relationships with firms. The duties that were violated in the Madoff and Enron scandals included registration of auditors, compliance with policies and ethical control and enforcing the other elements of good corporate governance.
Also related to the collapse and violations was auditor independence that ensures that there is no conflict of interests between auditors and firms. Madoff and Enron violated elements of this from auditor reporting requirements, auditor restrictions as it relates to interrelated clients, and approval mandates. Madoff and Enron’s collapse was also based on the corporate responsibility mandate that ensures senior executives comply with the law as it relates to corporate responsibility and accurate financial reporting.
The failure of Madoff and Enron was also based on failures related to the oversight of auditors and unethical behavior from senior executives and board members, auditors’ conflict of interest, and overall poor judgment from banks and related industry and security analysts who provided investors with false information and helped to solidify accounting fraud in many cases.
The SOX Act has had a tremendous amount of positive influence and praise from individuals within the field. It is argued that it has been developed and enacted quickly, and has functioned effectively. More importantly SOX has been attributed with the fact that it has reinforced the principle that shareholders own corporations and managers should try to allocate resources in the most efficient manner on behalf of shareholders.
There is the general notion that SOX has not addressed the fundamental issue of management ineffectiveness (Lin 5). That is, the fundamental issues were due to management decisions that were fraudulent and unreliable, but SOX has placed a stigma on accounting principles that is not to be blamed. In it is argued that, if SOX does not address the issue, it is unlikely the problem will be addressed, since faulty management structures can always override any internal control or processes put in place. This is exactly what Madoff, Enron, and WorldCom did, since “management systems dictate all business process” (Lin 3).
It is imperative that SOX does not override or conflict with other principles and policies. It is argued that SOX, has resulted in interactions with international corporate governance regulations, that have multinational corporations unduly burdened. There is the general consensus that the effects of SOX have been global and has had implications for many companies doing business in the United States that are based abroad; this has resulted in some conflicts between SOX and corporate governance and regulations outside the United States.
Although there are many notably criticism of SOX, it is clear that the Act was needed, and has been somewhat successful, this maybe due to other factors because companies know that they are being scrutinized. To measure the success of the policy, it is best to ask, if SOX was in place, would, for example, Enron and WorldCom still be able to happen? Some analysts say, yes, because the fundamental issue has not been addressed by SOX, while some say highly unlikely, since the provisions such as the internal audits, the integration with accounting systems, and the oversight mechanism, would have made it unlikely that these companies could have continued to do what they did (Hague and Villamann 3).
Why is the concept of oversight so important? Have there been any activities that warrant this attention or analysis? The Sarbanes-Oxley Act of 2002 was passed amidst scandals and evidence of accounting fraud that were public and affected major companies. These causes highlighted a major flaw within the financial reporting stream, the ‘watchdogs’ of companies – the auditors had diverse interests that oftentimes conflicted with firms and were at the crux of many of the fraudulent activities. There were some indications of bribery and many auditors were not having the necessary independent relationship with firms that was required (Lennard 12). This resulted in many fraudulent activities and SOX’s first title was related to the PCAOB- this was like the oversight for the auditors.
In closing, the Institute of Management Accountants (IMA) provides a superb definition statement for ethical practice and overarching ethical principles: “Honesty, Fairness, Objectivity, and Responsibility and states that members shall act in accordance with these principles and shall encourage others within their organizations to adhere to them.” At the end of the day the accounting scandals that seem so prevalent in the corporate world today will not stop by creating more rules and procedures because unfortunately dishonest people will find ways around them. The best ways to ensure scandals like Madoff and Enron become a thing of the past is to led by example and adhere to the common principles of honesty.
References
Bullen, H. & Crook, B. ‘Revisiting concepts’, Financial Accounting Standards Board and International Accounting Standards Board, May, 2005. Available at
Canadian Accounting Standards Board. ‘Fair Value, Historical Cost, Replacement Cost……….How should Assets and Liabilities be measured on Initial Recognition Papers, November, 2006. Available at
Hague, I. and Villmann, R. ‘Measurement Bases for Financial Reporting’, Canadian Accounting Standards Board, April, 2006. Available at
Joyce, E.”Symbol Fraud Charge Spread: Probe Continues”. Business, 2003. Available at http://www.internetnews.com/bus-news/article.php/2225231
Lennard, A. , ‘Measurement in Financial Reporting, September, 2006. Available at
Lever, K. ‘The conceptual framework: A preparer’s view’, UK Accounting Standards Board Roundtable Debate, 2006. Available at
Lin, H.. ‘Limitations of Section 404 of the Sarbanes-Oxley Act’. The CPA Journal. March, 2006. Available at
Institute of Management Accountants. Statement of Ethical Professional Practice, 1997 – 2008. Available at http://www.imanet.org/about_ethics_statement.asp
