Table of Contents
Accounting is governed by several standards to ensure that professionalism is maintained. These standards ensure that the accounting activities are harmonized all over the world. In absence of these standards, different firms would have different ways of accounting and these would call for the people interested in the companies to familiarize themselves with the different accounting practices that each company applies (United States & Valukas 2010).
Accounting standards are set by international accounting bodies, which govern the accounting practice. These principles are referred to as Generally Accepted Accounting Principles (GAAP). They are generally accepted by the accounting profession since they are set by an authoritative accounting body. These principles are elaborated below.
One of the principles is the accrual concept. This principle states that transactions should be recorded when they occur and not when the cash is exchanged. This means that revenues, regardless whether its earned on credit or cash basis, should be recorded when it is earned. Liabilities should also be recorded according to the period they are incurred (Finney, Miller & Johnson 1970).
Another principle is known as the consistency concept. This concept states that once a firm chooses a certain accounting technique, it should apply it all through its operations, unless there is a valid reason not to do so.
Another principle is the going concern principle. It states that an accountant should put into consideration that the firm is healthy to remain in business upto the foreseeable future. This will depend on the leverage ratio of the firm. A high leverage ratio means that the firm is not a going concern whereas a low leverage ratio means that the firm is a going concern. In case the accountant finds that the company is not healthy enough to grow into the future, he should give evidence to support such claims.
Another one is the conservatism principle. This principle states that liabilities should be accounted for even if they are not likely to occur. This means that any liability that the accountant anticipates that it might occur should be recorded even before it occurs. However, this does not apply to revenues. Revenues are only accounted for when occur. If they are recorded before they take place, the total earnings might be overstated beyond the actual amount that is actually collected in a given period.
Materiality is another accounting principle. This principle requires that only material facts, which have a monetary value, are recorded. This means that only the transactions that bear monetary information are put into the financial records (Finney, Miller & Johnson 1970). The materiality of the item or transaction in question is based on how the monetary valuation of the product. Non-monetary information is included in the notes of the financial statements if it is considered relevant to the investors. Therefore, they guide the readers of the financial statements on the non-monetary aspects of the firm.
Any accounting practice that is beyond these principles is considered unethical. Basically, they act as guidelines to be followed by the accountants across the globe in their activities. They provide uniformity in the accounting practice all over the world since they are made by governing bodies that govern accounting.
Repo 105 is an accounting trick in which short-term liabilities are referred to as sales. A company raises funds using short-term liabilities. Proceeds received are subsequently used to offset some of the company’s liabilities. In a Repo market, a company gains access to the extra funds from other companies for short durations and in return they give collateral, referred to as a bond. The company offers to repay the short–term liability with an interest. However, the collateral never changes hands from the borrower to the lender.
Lehman Brothers’ used Repo 105 to help them resettle a large amount of liabilities. They used this accounting manoeuvre to resettle a long-term liability amounting to $50 billion so as to lower their leverage on the statement of financial position before the earnings of the company were announced (Needles et al. 1990). This portrayed a picture of them as not reliant on external debt as what was the actual picture. The company was having a high leverage before them selling bonds to cover the large amount of liabilities.
According to the generally accepted accounting principles, Repo 105 should not be legally accepted as an accounting technique. Since the practice tends to assign to a firm funds which they actually do not have. The image portrayed after this practice does not reflect the true financial position of the firm. Thus, it ends up giving wrong information concerning the firm and thus investors, who rely on the financial position of the firm, make wrong investment decisions and might end up incurring losses. Also, as it happened to Lehman Brothers, the company might end up failing to repay its debts, which results to bankruptcy.
Illegality of ‘Repo 105’ can be demonstrated by going concern principle. This principle states that a firm should be considered to be healthy enough to remain in business to the foreseeable future. However, whenever the accountant of a company finds that the company is not capable of remaining in business for a long period, then he/she should, with reasons make it known to the stakeholders of the company (Duska & Duska 2003). ‘Repo 105’ denies the possibility of determining whether a company is a going concern or not depending on the lowered leverage that it generates thus changing the actual image of the company’s financial position. It, therefore, compromises the decision making by directors.
Lehman Brothers’ failed to record the Repo 105 transaction as a loan. As a result, they failed to meet the conservatism principle, which requires that liabilities should be accounted for even though they have not occurred. The funds obtained through this technique are not referred to as long-term debts or liabilities. Therefore, they are not recorded as liabilities to the company, which is inconsistent with the generally accepted accounting principles. This shows that ‘Repo 105’ is unethical and thus illegal in operation.
Repo 105 is used as a contingency technique to assist shield the firm from effects of a high leverage. It is, however, not part of the initial techniques applied during the inception of the firm. Thus, it compromises the consistency principle, which requires firms to be consistent with the accounting techniques that they apply. This shows that the technique cannot be legally accepted.
Reasons for Manipulating Reported Earnings
Some firms engage in the unethical practice of manipulating their reported earnings before they could be announced. However, they bear different reasons for making the manipulations based on each firm. The objectives of this unethical practice, therefore, differ.
One of the motives for manipulating the earnings of a firm is to lure investors to make investments into the firm. A firm can manipulate its earnings such that it reports more earnings than its real income is and thus, helps to create a financial position image that attracts investors into investing into the company based on the given statement of financial position (Duska & Duska 2003). Therefore, the investors are lured to make investments into the firm, which most likely was not a going concern, thus providing it with funds that will help it to continue running. It also helps convince creditors of the creditworthiness of a firm and thus they are able to secure credit from the lending firms. Creditors usually analyze the net income of a firm as a representation of its future stream of incomes. By manipulating the incomes before reporting, they are able to convince the creditors of their creditworthiness, which is not the case. An example is the Lehman Brothers. The company sought funds from short-term sources, where they used their assets as collateral to secure short-term sources.
Another motive for manipulating earnings is to evade tax. Each firm is responsible of remitting a certain percentage of its earnings to the government as a tax. Some firms lower their revenues before reporting so as to reduce the amount of tax burden that a firm owes to the government. Little amounts of income translate to low amount of tax payable to the government. Multinational corporations are fond of manipulating their earnings so as to reduce their reported earnings in order to reduce the amount, which they pay as tax (Duska & Duska 2003). Examples of tax evading multi-national corporations include Apple and Microsoft. These companies shift their intellectual property so as to reduce their revenues generated from within America. They shift these rights to countries that have lower tax or no tax jurisdictions such as Ireland. In this way, the companies report lower sales and eventually lead to reduction in amount of tax owed to the government.
Another motive for manipulating earnings is to influence the decisions of the users of the financial statements. Mostly, the users are mostly the shareholders of the firm who seek to maximize their wealth. Therefore, the managers who seek to maximize their earning in-terms of salary. They are, therefore, charged with the responsibility of ensuring that the firm generates more profits if they are to retain their positions as managers (Weygandt 1996). In case the firm reports low profits, the managers can manipulate them so as to convince the shareholders of their capability to continue the firm and thus demonstrate the need of retaining them. In Lehman Brothers’ company, the company sought to ensure that they maintain a good image in the face of its customers and clients. Since, they feared losing them to other customers when they realize their leverage ratio and start questioning the safety of their money within the bank. Eventually, once it starts losing customers, the profits will continue dwindling till the company closes.
Imposition of More Regulations
Regulations are meant to regulate the conduct of individuals at any field. Accounting regulations are meant to regulate the conduct of individuals in the accounting profession. There are loopholes in which some accountants take advantage of and end up engaging in unethical practices.
Lehman Brothers, with the help of Repo 105 accounting technique, ended up into bankruptcy. This was a result of having more short-term debts, which they failed to meet on maturity of the bonds. They had used the funds collected to settle their long-term liabilities in an attempt to lower their leverage.
Imposing more accounting regulations will assist in preventing accounting scandals like with Lehman Brothers. The going concern principle was compromised by trading long-term debts with short-term debts. A regulation, such as the maximum level within which a firm can make such a trade-off, will help to keep firms from displaying the wrong financial position. If there was a maximum leverage ratio, which prevented firms from entering the securities market, Lehman Brothers could have been saved from bankruptcy before it participated in the trade (Weygandt 1996).
There should be restrictions on who should engage in certain activities. Some ventures are said to have a higher level of risk. Therefore, to prevent firms from the adverse effects emanating from such risky activities, there should be well set regulations to control entry of firms into such ventures. For example, trading in securities should be controlled and restrictions put so as to restrict the entries into a market. This will help to prevent firms such as Lehman Brothers from trading in such securities whereas they have a higher leverage.
The guidelines set as the Generally Accepted Accounting Principles have been applied widely. These guidelines help to create uniformity in undertaking the discipline though it has been faced by unethical practices in practiced by some accountants.
An example of unethical practice is the Lehman Brothers where they traded in bonds so as to lower their leverage. This lead to the increase of the company’s debts and consequently, resulted in bankruptcy of the company. This shows one of the consequences of violating the principles of accounting.
Considering that there exist regulations that govern the accounting discipline, it appears that these principles are not fully followed or suffer from loopholes that lead to mal-practice by some accountants. These mean that these regulations are not enough to monitor the performance of the accountants. Therefore, additional regulations should be added to the already existing ones in order to make accounting practice to be well carried out.