Reconstructing Financial Reporting Following the Accounting Fraud Disclosure at Enron Energy Company
Hotaling, Andrea, Lippitt, Jeffrey, International Journal of Management
There have been apparent breakdowns in the financial reporting process as evidenced by the recent numerous restatements of financial results and legal actions brought against both companies and their auditors. In designing the appropriate corrective measures we need to keep in mind that the financial reporting process involves a variety of parties with differing responsibilities. This article points out some of the weaknesses in the current reporting standards illustrating that much of the divergence from actual economic reality is the responsibility of the standard setters. CPAs are often prohibited from deviating from the rigid standards as promulgated even if strict application of the standards results in misleading financial information.
In response to the public cry for action following the Enron bankruptcy and other recent business failures the US Congress has passed the Sarbanes-Oxley Act, which addresses a variety of abuses by management and auditors. Less attention has been focused upon the standard setting process and the standards themselves. Current U.S. reporting is very rule-based, emphasizing the uniformity of the application of accounting principles across firms so that similar transactions should receive similar accounting treatments. This improves the financial statement users' ability to make informed judgments about financial performance and position. This means however, that the rules may actually dictate the form of a transaction in order to assure a specific accounting treatment. Many critics are calling for accountants to be more responsible for compliance with the spirit of accounting rules and less focused on helping their clients avoid the spirit of the rules while complying with the letter.
There are several reasons why accountants and auditors cannot be reasonably expected to comply with the "spirit" of many accounting rules as they are currently stated. Most importantly is the prohibition by the rule makers themselves, the FASB (Financial Accounting Standards Board). The FASB promulgates generally accepted accounting principles that are required to be followed and auditors then attest to that compliance. The FASB also has drafted concepts statements that are supposed to provide a conceptual framework under which new accounting rules are proposed and promulgated. CON 1 published in 1978 states that: "a Statement of Financial Accounting Concepts does not.... justify either changing existing generally accepted accounting and reporting practices or interpreting pronouncements .... based on personal interpretations of the objectives and concepts." (FASB, 1978) In other words, accountants are strictly prohibited from exercising any judgment about whether an accounting rule presents the economic substance of a transaction or applying their own interpretation to an accounting situation based on the conceptual framework. They are limited to merely attesting to whether the rules were followed correctly.
There are many GAAP rules that permit or specifically require that information be presented in a manner that seems "unfair", in the sense that it doesn't correspond with the underlying economic reality of the business activity. Current GAAP requires that all Research & Development (R & D) expenditures (FASB, 1974) and most advertising costs (AICPA, 1993) shall be charged to expense when incurred. In today's economy intellectual property and the rights inherent in intangible assets are an increasing portion of the value of a firm. This accounting rule requiring the immediate expensing of R & D expenses or advertising costs based on the premise that it is difficult to measure future economic benefits does not represent economic reality. Clearly many of these outlays result in valuable assets that will make significant contributions to stockholder value. Do we want auditors permitting the capitalization of these types of expenditures based on the judgment that they represent economic assets? …