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Xin Yin Lin

ENGL 2201

Professor Timm Hackett

April 21, 2017

Problem Solution Paper

Investors and creditors often encounter issues with financial reports. The law required

public companies to field quarterly and annually financial reports, and those reports need to be

audited and attested by third-party accountants. Investors and creditors use those reports to

decide whether or not to make an investment or to lend the money. When the financial reports

contain information that misrepresents the financial standing of the company, investors and

creditors will face with high risk of financial damages, and the image of accountants as a trusted

profession will be shaken. In order to overcome the issues with unethical financial reporting,

third-party accountants must stay independent.

Financial reports keep the investors informed, but sometimes those reports contain

misleading information. The purpose of financial report is to provide information about the

company to aid the investors and creditors when evaluating the company’s financial standing and

risks (“Standard”). Not all financial reports present the accurate materials, according to Andrew

Ceresney, former Director of the Division of Enforcement at the United States Securities and

Exchange Commission, “in FY2012, we opened 124 financial fraud/issuer disclosure

investigations […] for accounting fraud cases, […] we filed 79 financial fraud/issuer disclosure

actions” (“Financial”). Such fraudulent behavior might cause investors to make an unsuccessful

investing decision and will have a negative impact on the marketplace and the economy

internationally.
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Without accurate information from the financial reports, investors and creditors will face

with high risk of financial damage. Enron scandal, one of the greatest accounting scandals in

U.S., which cause tremendous financial loss to investors, employees, and the market. Enron was

the 7th company on the Fortune 500 list, with employees over 20,000 worldwide. On October

16, 2001, Enron announced a loss of $618 million in the third quarter, and the SEC opens a

formal investigation on Enron’s translation on October 31 (“Enron”). The investigation

discovered many fraudulent actions performed by Enron, which include “violation of the 3% rule

for consolidating special purpose entities, improper front-end loading of revenue, misuse of fair

value accounting, and improper accounting for securitization transactions”. The result of the

violation of the 3% rule was $16 billion debt not shown on the balance sheet (Frecka 50). On

December 2, 2001, Enron filed Chapter 11 bankruptcy for protection. From October 16 until

December 2, only within two months, Enron’s stock price drop from $34.30 per share to $0.45

per share (“Enron”). The bankrupt of Enron caused $70 billion lost in market capitalization,

which is tremendous amount for anyone invested in Enron (Tak 937). The unethical accounting

practice results in misleading information in the financial reports which lead to a significant

financial loss for the investors and the market, and Enron is not the only case of unethical

accounting practice.

WorldCom is another example of unethical accounting practice. WorldCom was once the

second biggest long-distance phone company, and have a stock price of $64.51 in June

1999. The SEC’s annual report stated that WorldCom overstated its income before

interest, taxes, depreciation, and amortization by $3.055 billion in 2001 and $797 million in the

first quarter of 2002. Such fraudulent action increases the cash flow and profit for WorldCom

over the past five quarters (Soltani 262). According to Duska and Duska, WorldCom’s
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fraudulent accounting practice lead to a $9 billion restatement, which was the largest restatement

in U.S. history (29). Investors and creditors depend on financial reports to make a financial

decision, but the $3.8 billion overstated EBITDA will cause investors and creditors to believe

WorldCom is at a good financial standing and with low risk.

HealthSouth, one of the largest providers of post-acute healthcare services, was also

involved with unethical accounting practice. In 2002, HealthSouth experienced great financial

hardship and was accused by SEC in 2003 of “falsifying the earnings, cooking the books,

internal control violations and fraud” (Soltani 263). The estimated overstated earnings by

HealthSouth were $4 billion (Duska and Duska 29). Fraudulent financial reports not only

damage the market but also have a huge impact on the company. While the financial profile of a

company can benefit from manufactured financial reports in the short-run, but eventually the

company will come across to the point where debts and income cannot be balanced.

Enron, WorldCom, and HealthSouth scandals were only the surface of unethical financial

reporting. Adelphia, Cendant, Global Crossing, MicroStrategy, Parmalat, Royal Ahold, and

Xerox were also participants of unethical financial reporting (Frecka 54). The result of fraudulent

financial reports from Enron, WorldCom, Qwest, Tyco, and Global Crossing was a lost in market

capitalization of $460 billion. The Certified Fraud Examiners estimated that the percentage loss

of income of the clients who suffer from such fraud was 7%. If this percentage is applied to

U.S. GDP, the loss is estimated to be $1 trillion. The Association of Certified Fraud Examiners

study indicated that the medium loss for reported fraud was $175,000, and 25% of the fraud

caused losses of more than $1 million (Tak 932-933). The number of accounting scandals and

the loss caused by the scandals leads the users of financial reports to questions the ability of

accountants.
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Accountants have responsibilities to keep the market informed, when accountants fail to

do this job, the reputation of accounting profession will be negatively impacted. Duska and

Duska explain that accountants are the “designated gatekeepers” of the public and have a duty

“to maintain the orderly functioning of commerce” (74). The best way for accountants to keep an

orderly functioning market is to ensure the financial reports are fair and accurate. But when

auditors fail to identify the problems in the fraudulent financial reports, the users of financial

reports will question the integrity of the auditors and the failure will shake the image of CPAs as

trusted professionals (Guy et al. 31). Without the trust from the public, the work of CPAs will be

meaningless.

Fraudulent financial reporting damage the company’s financial standing in the long-run

but it creates a positive performance in the short-run, and the short-run benefits give executives

incentive to manipulate financial reports. Most of the executives and manager’s bonuses are

based on the performance of the company, and the performance of the company depends on the

achievement of the earning goals. When earning goals are not achieved, the linked bonuses gave

executives an incentive to manipulate the financial information. Soltani quotes Desai, ‘‘in 1990

the equity-based share of total compensation for senior managers of U.S. corporations was

20%. By 2007 it had risen to 70%’’. Soltani also states that HealthSouth paid Scrushy, CEO of

HealthSouth, $9.2 million in salary from 1999 to 2001, and about $5.3 million of the salary was

based on company’s performance. Scrushy also benefited from the inflated stock price due to

manipulated financial reports; he sold 7,782,130 shares of HealthSouth’s stock during 1999 to

2001 (259, 263). Yinling Chen, a private accountant with five years of work experience, agrees

that sometimes the manager will ask the team to apply legal accounting treatment on the

financial reports. The benefits of manipulated financial reports gave executives and managers
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reason to create fraudulent financial reports, so the auditors must act in the public’s interest to

audit such report.

To reduce the amount of unethical financial reports, it is important to increase the

independence of external auditors. Human tend to do what’s best for themselves, and since the

decision makers of the company benefit from the manufactured financial results, they will have

an incentive to take such action. The decision of whether to manipulate the financial reports

solely depends on the decision maker’s opinion, and if the incentives are high then the chances

of creating a fraudulent financial report will also be high. If one can’t regulate oneself, then it is

necessary to bring in an outsider who has an objective point of view to regulate the action, which

would be the auditors. But auditors often encounter the situation where they work for the clients

but have to look for the best interest of the public (Duska 415). To stay objective and fulfill the

responsibilities owe to the public, auditors must stay independence, or else the Enron scandal

will happen again. In the Enron scandal, Enron’s external auditors from Arthur Andersen LLP

were in close relation with Enron. When Andersen’s employees attended Enron-sponsored

events, they act in a way that others believed they were Enron employees. Enron also hired many

of the former Andersen employees to hold many of the significant financial and operation

positions. Andersen also performs many of the nonaudit services for Enron, include tax,

consulting, and internal audit (Guy et al. 31-34). It is important for auditors to stay independent

when performing attestation services for clients, if not, the pressures will only be higher for

auditors when the conflict of interest arises.

Professional skepticism is the cornerstone of auditing, and the independence of auditors

impact the level of professional skepticism. Chiang believes the lack of PS can lead to the failure
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to diagnose a problem, or failure to act on the diagnosed problem. With a high level of

PS, auditors can better question the suspicious reports, and can better serve the public (184).

The AICPA’s code of professional conduct also emphasizes the importance of

independence. As stated in the Code, “A member should maintain objectivity […] should be

independent in fact and appearance when providing auditing and other attestation services”

(AICPA). When external auditors are not engaged in activities other than attestation, then the

auditors will not have any personal interest in the client’s financial standing, thus can remain

objective and act on questionable part of the financial statement without much pressure. Guy et

al. believes that the auditor’s opinion enhances the reliability of the financial reports presented

by the company. If the auditor were not independent from the company, then the opinion from

such auditor would not have any value (36). The ability for an auditor to stay independent allows

the auditor to be objective and better serve the interest of the public.

Highly independent auditors can reduce the number of unethical financial reports, which

enhance the efficiency of the market. Duska claims that when the financial report accurately

reflects the financial standing of the company, it creates an efficient market (410). With the

accurate information, investors and creditors can better estimate the potential growth of the

company and face will less risk of financial damages.

Financial reports must contain the accurate information about a company’s financial

standing to have an efficient market. But because the managers and executives have incentives to

manipulate the financial reports, the public cannot solely rely on the company to produce those

reports. A third-party auditor will act in the public’s interest and attest the financial reports of the

company, and the auditor must remain independent. The level of independence affects the

objectivity and professional skepticism of the auditor, which affects the work of an auditor.
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Work Cited

“AICPA Code of Professional Conduct.” AICPA Code of Professional Conduct - AICPA,

www.aicpa.org/Research/Standards/CodeofConduct/Pages/default.aspx. 20 Jan. 2017.

Chen, Yinling. Telephone Interview, 18 Apr. 2017.

Chiang, Christina. "Conceptualising the Linkage between Professional Scepticism and Auditor

Independence." Pacific Accounting Review, vol. 28, no. 2, 2016, pp. 180-200, ProQuest

Central,

http://search.proquest.com.jproxy.lib.ecu.edu/docview/1875490402?accountid=10639. 19

Mar. 2017.

Duska, Ronald F. “The Responsibilities of Accountants.” Geneva Papers on Risk and Insurance,

vol. 30, no. 3, 2005., pp. 410-424. ProQuest.

doi:http://dx.doi.org/10.1057/palgrave.gpp.2510042 21 Jan. 2017.

Duska, Ronald F., and Brenda Shay. Duska. Accounting Ethics. Malden, MA, Blackwell

Publishing, 2003. 24 Jan. 2017.

“Enron Fast Facts.” CNN, Cable News Network, 17 Apr. 2016,

www.cnn.com/2013/07/02/us/enron-fast-facts/. 24 Mar. 2017

“Financial Reporting and Accounting Fraud.” SEC Emblem, 19 Sept. 2013,

www.sec.gov/news/speech/spch091913ac. 24 Mar. 2017

Frecka, Thomas J. "Ethical Issues in Financial Reporting: Is Intentional Structuring of Lease

Contracts to Avoid Capitalization Unethical?" Journal of Business Ethics, vol. 80, no. 1,

2008, pp. 45-59, Arts & Humanities Database; ProQuest Central,

http://search.proquest.com.jproxy.lib.ecu.edu/docview/198041972?accountid=10639,

doi:http://dx.doi.org/10.1007/s10551-007-9436-y. 19 Mar. 2017.

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Guy, Dan M., et al. Ethics for CPAs: Meeting Expectations in Challenging Times. Hoboken, N.J,

Wiley, 2003.

Soltani, Bahram. "The Anatomy of Corporate Fraud: A Comparative Analysis of High Profile

American and European Corporate Scandals." Journal of Business Ethics, vol. 120, no.

2, 2014, pp. 251-274, Arts & Humanities Database; ProQuest Central,

http://search.proquest.com.jproxy.lib.ecu.edu/docview/1503750877?accountid=10639,

doi:http://dx.doi.org/10.1007/s10551-013-1660-z. 22 Mar. 2017.

“Standards.” FASB, Financial Accounting Standards Board,

www.fasb.org/jsp/FASB/Page/LandingPage&cid=1175805317350. 24 Mar. 2017.

Tak ISA. “Impacts and Losses Caused By the Fraudulent and Manipulated Financial

Information on Economic Decisions.” Review of International Comparative

Management, vol. 12, no. 5, Dec. 2011, pp. 929-39. 24 Mar. 2017