Ethical Issues in Finance and Accounting

Ethical Issues in Finance and Accounting

Ethics in finance deals with various ethical dilemmas and violations in day-to-day financial transactions. An example of ethical violations is data fudging in which enterprises present a fabricated statement of accounts and other records, which are open to investigation.

The following are some ethical practices in finance:

• Following truthfulness and authenticity in business transactions
  
  
• Seeking the fulfilment of mutual interests
  
  
• Getting economies and financial units freed from greed-based methodologies

In this way, ethics in finance and accounting determine how to make moral decisions regarding the preparation, presentation and revelation of financial information. Finance and accounting are two of the most important business functions accountable to act in the public interest instead of satisfying the needs of an individual or an organisation.

Therefore, it becomes imperative for finance and accounting professionals to adhere to certain ethics to achieve individual, organisational and societal objectives all at the same time.

However, during the past few years, several accounting scandals have occurred that put a serious question mark on the accountability of finance and accounting professionals.

Several organisations such as Enron, Tyco, Global Crossing, Quest, Xerox, Adelphia, etc., were involved in unethical practices by using wrong and manipulative accounting information.

Unethical Issues in Finance and Accounting

Fraudulent Financial Reporting

It refers to representing false statements regarding the financial status of an organisation. It is usually done by the management of an organisation. It aims to mislead investors and uphold the organisation’s share price. Such financial reporting may increase the organisation’s stock price for a short period. However, in the long run, it proves to be very harmful to the organisation’s brand equity. Apart from this, it is unethical to mislead stakeholders by providing wrong information about the organisation’s financial status.

Enron Corporation, an American energy company based in Houston, Texas, went through a huge scandal revealed in October 2001. The scandal was cited as the biggest audit failure and led the company to bankruptcy. Enron was using an accounting method known as ‘mark to market’, a technique mostly used by brokerage and trading companies. This technique records the value of a security on daily basis for calculating profits and losses.

Enron used this technique to show projected earnings from long-term contracts as current revenue. Though in reality, this money could not be claimed for many years. The company used this technique to expand revenue by manipulating future revenue projections. It made it difficult for the auditors to see the exact sum of money the company was making in reality. The numbers were high in the record books as well as in the stock market. It encouraged more and more investors to invest in the company.

However, by April 2001, a number of market analysts started questioning about the lack of transparency in Enron’s disclosures. Around October 2001, the company announced its first quarterly loss. Slowly, all the fraudulent activities of Enron started emerging on the ground. By November 30, the stock of the company closed at 26 cent per share, leading the company to file for bankruptcy protection by December 2001.

Misuse of Assets

It denotes one of the most common ethical issues in finance and accounting. It involves using an organisation’s assets for any other purpose apart from its interests. Assets can be misused at any level of an organisation and to any extent.

For example, a senior-level executive may show family dinner expenses as a business expense and may charge for it from the organisation. This is an example of serious unethical issue that involves misusing the organisation’s assets.

Disclosure

Violation of disclosure is one of the most common unethical issues that organisations usually face. It involves recording transactions in a manner that is not in accord with usually accepted accounting norms.

Therefore, it is considered fraudulent financial reporting that aims to mislead investors by hiding information that could change their decisions about investing in the organisation. It is unethical for management to hide necessary information from investors.

Insider Trading

It is a malpractice where the trade of an organisation’s securities is undertaken by people with access to non-public information about the organisation. The people involved in insider trading are generally key employees or executives who have access and control over the strategic information of the organisation.

For example, suppose a member from the board of directors knows that within the succeeding day, the company is going to announce a merger that may help the company’s stock to go up. In such a case, he buys 500 shares of the company’s stock in his brother’s name to make a profit after the share’s prices go up. Here, the member from the board of directors took advantage of his/her insider knowledge to make profit. This is a case of illegal insider trading.

This type of malpractice is highly unethical as it promotes unfair trading practices. It is highly discouraged by the Securities and Exchange Board of India (SEBI) for the benefit of the common investor.

Budgetary Slack

It is another malpractice in finance and accounting, which deliberately under-estimates the budgeted revenue or over-estimates the budgeted expenses. Budgetary slack may occur at times when there is no certainty regarding possible results to be expected in future.

Managers usually follow this practice when they do not have historical records to rely upon. However, this strategy prevents budgets from working accurately. This is unethical in cases, when managers deliberately distort budget figures to achieve certain accounting objectives.

Today, penalties for violating ethics have increased manifold with increase in unethical practices. There are harsh penalties for manipulating financial records and information, providing protection to wrongdoers and misleading the investigation. However, it is better for organisations to have safeguards that may reduce the chances of the occurrence of unethical behaviour.

Such safeguards may fall into two categories, which are:

Safeguards Created by Law

They may include corporate governance regulations, professional standards, regulatory monitoring and disciplinary procedures.

Safeguards Created by Organisations

They include employing competent staff, ethical programmes, strong disciplinary processes, solid leadership and robust internal control, and monitoring the quality of employee performance and encouraging employee communication with senior levels.

All these practices can help an organisation to imbibe ethical practices with much ease. An ethical audit is one such practice that follows a thorough formal examination of the labour practices of a specific organisation. The audit works as a verifiable process that helps an organisation to comprehend, measure, and improve its social and environmental performance.

Scam of Satyam Computer Services

Satyam Computer Services, the fourth largest IT outsourcing organisation in India, was incorporated on 24 June 1987. Mr. Rama Raju and Mr. Ramalinga Raju were the promoters of the organisation. Satyam achieved a tremendous amount of success within a very short period of its inception.

The organisation established two technology parks in Secunderabad and Qutuballapur in its initial years of operation. Satyam’s Initial Public Offer (IPO) was over-subscribed by 17 times in 1991. When Satyam announced its offshore software project with John Deere and Co., Satyam’s revenue reached $2 billion mark in 2008.

In the same year, Satyam had its operations in 65 countries around the world. The organisation had been offering consulting, outsourcing and system integration services to more than 20 industries. However, the true picture of Satyam came to light in 2008. It was when Mr. Ramalinga Raju, one of the promoters of the organisation, disclosed all the fraudulent practices and fabrication of the accounting books to the board of directors.

On 30 September 2008, Mr. Raju admitted that the balance sheet of the organisation contained inflated cash and bank balances. He also admitted that the organisation had been showing inflated profit figures for the last several years.

According to the confession made by Mr. Raju, the extent of the fraud was ₹7,800 crores. The Satyam scam is the biggest accounting fraud in India.The scam attracted the attention of the international business community to the corporate governance practices in India. In addition, the suspicious role of the independent directors and dubious auditing practices was also exposed.

ENRON Scandal

Enron Corporation was an American energy, commodities and services corporation with its headquarters located in Houston, Texas. It was listed as “America’s most innovative company” six years in a row by Fortune and yet it filed for bankruptcy in late 2001 under Chapter 11 of the United States Bankruptcy Code.

Enron projected itself as a financially stable and profitable company, but this was an illusion as most of its profits were only on paper. It was entrenched in debt and was hiding its losses from the American public. We will discuss the rise and fall of Enron in the following sections.

Switch From Energy to Trading

In the early 1990s, the sale of natural gas was deregulated along with the sale of electricity in the free market, which was supported by Kenneth Lay, the CEO of Enron. The deregulation of the energy market was instrumental in Enron earning higher revenues.

This was the turning point that paved way for Enron becoming a trading company from an energy company. It started making huge investments in different parts of the world to tap new markets.

As Enron was one of the biggest companies in the US during this period, it was a popular choice for many ambitious graduates as a place of work. The employees were partially paid in stocks, which acted as a motivating factor to increase the stock price of the company.

Mark-to-market Accounting

Jeffrey Skilling, who was appointed the CEO of Enron Corporation in 1997, pushed to change the accounting system of the company to mark-to-market accounting. Earlier, Enron used to record actual revenues and costs of supplying gas. However, when it turned to mark-to-market accounting method, the future incomes were being taken into account when a long-term contract was signed. These valuations were built on future net value of the cash flows.

Due to this, it was difficult to predict the actual costs of the contract. This led to the adverse consequence of including estimated incomes in Enron’s accounting books, even though the money hadn’t been received yet. So, any loss or additional income would have no effect on the projected valuations of the company’s income. Enron provided misleading information to its shareholders even as there were deviations in the projected and actual revenues of the company.

Enron was the first non-financial company to be given permission to use the mark-to-market method in the United States by the U.S. Securities Exchange and Commission on 30^th January 1992.

Enron’s New Strategy

Enron became the biggest seller of natural gas in the US by 1992 with gross earnings of US$122 million. It diversified its operations and began trading in pipelines, paper plants, electricity plants, broadband services and water plants. This made Enron an attractive option for investors between 1990 and 1998, and its stock price jumped up by 311 per cent. The stock price increase continued for the next two years at 56 per cent in 1999 and 87 per cent in 2000.

Enron also manipulated energy prices to raise its stock prices and revenues. During the California Electricity Crisis in 2000-01, the company sold natural gas at a rate of $60 per thousand cubic feet, which was earlier being sold for mere $3 per thousand cubic feet.

Enron’s Collapse

Mark-to-market Accounting

Enron’s collapse was due to the mark-to-market accounting method. The company had been overly optimistic about its future profits and revenues, and wasn’t left with any cash by the middle of 2001.

The Enron Culture

In Enron, unhealthy competition rather than cooperation was promoted amongst the employees. As the incentives were mostly paid out in stock options, everyone was in a hurry to close deals because bonuses were distributed on the basis of the number of deals closed rather than following up on them. This proved to be problematic as no follow-up action was being taken on the closed deals.

Enron had a performance committee that conducted the performance appraisals of the employees. It gave out ratings ranging from 1 to 5, with 1 being the highest. As expected, employees with higher ratings got excellent bonuses, while those with the lowest ratings were asked to leave.

Key Players at Enron

There were several people at Enron who were responsible for its collapse. Foremost among them was Jeffrey Skilling who had introduced the mark-to-marketing method of accounting in Enron. He launched EnronOnline, an Internet-based service, to deal with the trading of contracts of energy commodities with other companies. Ultimately, Enron could not cover the costs of capital transactions.

Andrew Fastow, a top executive at Enron, was responsible for the creation of complex financial structures at Enron that were used for concealing the losses and debts of the company. Rebecca Mark, the Vice-Chairman of Enron, spearheaded the failed business operations of Azurix and Enron International (subsidiary companies of Enron), which invested in projects such as the US$3 billion power plant in Dabhol, India, and another costly acquisition of Wessex Water in UK.

Kenneth Lay also played a huge part in Enron’s demise as he neglected his duties as the CEO of the company and preferred to spend his time vacationing around the world using company assets such as the company’s jet for his personal travels. He was also aware about the extent of debts of Enron and played a part in the covering up of this information from the investors.

Effect of Enron’s Bankruptcy

Enron’s bankruptcy led to the loss of jobs for almost 21000 employees. The company’s shareholders lost a combined US$74 billion in the four years leading to the filing of bankruptcy by the company.

The former employees of Enron won a lawsuit against the company in 2004 worth US$85 million, which was in lieu of loss of nearly $US2 billion in pension funds. The employees had the loss of a stable source of income in the form of pensions.Due to the Enron scandal, a new US federal law, known as the Sarbanes-Oxley Act, was passed. The main objective of the Act was to oversee the audits of public companies.

Andrew Fastow and his wife Lea were offered a deal by the prosecutors for pleading guilty and testifying against Lay, Skilling and other top executives of Enron in January 2004. As a result, Fastow’s sentence was reduced from ten years to six years.

Kenneth Lay was convicted of six charges including wire and securities fraud, and sentenced to 45 years in prison without parole in May 2006. He died in July 2006 due to a heart attack in Aspen, Texas. Skilling was found guilty of 19 out of 28 charges filed against him and in October 2006, was sentenced to 24 years and four months in prison.

Conclusion

The collapse of Enron was caused by multiple factors. Among them, the mark-to-market method of accounting, cut-throat working environment and misuse of company assets by senior executives of the company are of special significance.

The story of Enron is as much about the people who chose to mismanage company funds and deceive the US as it is about complex accounting that contributed to the bankruptcy of the company. It is about the decisions that affected not only 21000 Enron employees but the US as a whole.