The Failures of SEC and FASB

In the US, the legal and regulatory framework ensuring the reliability of accounting information has been around since the establishment of the AICPA and its predecessors dating back to 1887. The AICPA committee began by formally establishing accountancy in the United States as a profession through educational requirements, a code of professional ethics, licensing status and, most importantly, setting generally accepted accounting principles for financial statement accounting. 

Until the 1970s, the AICPA held a virtual monopoly in this field. In the 1970s, however, it transferred its responsibility for setting generally accepted accounting principles (GAAP) to the newly formed Financial Accounting Standards Board (FASB). Though widely used, the lack of enforcement of AICPA was deemed to be it's major drawback,  as the Wall Street Crash has been attributed to wide-spread accounting fraud, insufficient disclosures and false information. This lead to the creation of the SEC in 1933. 

The goal of the SEC in financial accounting was to ensure improved disclosure and protect investors. However, with the collapse of Enron and WorldCom,  the legal framework faced intense pressures for redevelopment. This resulted in the passage of the Sarbanes-Oxley law that established increased securities regulation and the Public Company Accounting Oversight Board (PCAOB) to maintain audit independence, enforce compliance and regulate the auditing environment. In response to Arthur Andersen shredding implicating documents, tampering was recorded as a criminal offence and  auditing firms were required to maintain seven years of records relevant to their audits. Furthermore, internal controls were mandated to promote enhanced disclosures of off-balance sheet transactions
and pro-forma figures, such as with the use of SPEs and mark-to-market accounting in Enron , with senior executives taking individual responsibility for the accuracy of financial reports.

The developments in the legal and regulatory frameworks are commendable, however several limitations pose a threat to the effectiveness of the the SEC and FASB. These threats consequently transpire into large-scale accounting fraud, such as the AIG Scandal in 2005, Lehman Brothers Scandal in 2008 and Autonomy Scandal in 2012. The main limitation of the legal system stems from timeliness and adequacy of investigations, insufficient persecution and lax protection for whistleblowers. Though, the SEC budget has doubled since the SOX act was enacted the
investigation process has remained fairly constant, relying primarily on informal inquiry and witness testimonials. 

While tips are vital towards the timely uncovering of  financial statement frauds, the subpar witness protections fails in providing an incentive for compelling witnesses, particularly those not involved in the fraudulent reporting. For example, executives , Timothy Belden and Ken Rice, both involved in the accounting scheme avoided jail time and gained protection for their unethically earned fortune while neutral whistleblower, Sherron Watkins of Enron and Cynthia Cooper of WorldCom, were publicly shamed. Therefore, the SEC should seek to provide adequate compensation and/or protection to whistleblowers or divert the majority of funding towards technical forensic investigation such as data-mining, artificial intelligence and latent semantic indexing. In addition, the benefits derived from fraudulent accounting to the perpetrators, often outweighs the cost. For example, the SEC failed to prosecute Lehman Brothers citing lack of evidence and the CEO of AIG faced no criminal charges with the proceedings focused mainly on negotiating monetary fines. 

The main limitation of the regulatory system stems from the flexibility within GAAP and the effects of politics in the standard-setting process. As a principle-based accounting standard, US GAAP tends to be more susceptible to aggressive reporting decisions, in comparison to rule-based accounting standard. This is evident in the choices in accounting for goodwill, recognition of special purpose entities, treatment of loans and conditions for capitalization that were extensively manipulated by Enron and WorldCom towards the interest of the executives. The interaction of private-interest groups in the accounting standard process also dilutes the true-and-fair notion that FASB frameworks claims to uphold. For example, Enron and its auditor, Arthur Andersen, were given permission to use mark-to-market accounting in 1992 after extensive lobbying efforts.

The SEC and FASB claim to be responsible for protecting investors from mishaps in the capital markets. However, numerous studies and evaluations indicate limited improvements in investor protection particularly with regards to the increase in regulation and compliance cost. The points above provide a non-exhaustive summary of the limitations of the legal and regulatory organizations in the US, further improvements include educating the public about securities markets , warning investors of fraud and stock market scams and limiting the relationship between publicly-traded companies and Wall Street. 

The Financial Number Game: The Enron and Worldcom Story

Creative accounting is the measurement and presentation of the accounts using the flexibility within the rules of standard accounting practices, so that they serve the interests of preparers (Mulford, 2002). Fraudulent accounting , in contrast,  deliberately steps outside of the regulatory framework in order to deceive financial users. (Singleton et al. 2006)  The main features of creating accounting are increasing assets by aggressive capitalization and extended amortization policies , inflating revenues by recognizing premature or fictitious revenue, decreasing liabilities by off-balance sheet financing , decreasing expenses by tax evasion and provision accounting and maximizing operating cash flow. (Jones, 2011).Fraudulent and Creative accounting can be driven by multiple factors for simplicity these drivers may be categorized into three circumstances; pressure, rationalization and opportunity

The Enron and WorldCom story was a story not just of the failure of the accounting firm, but also the traditional gatekeepers: the board, the audit committee, the lawyers, the investment bankers, the rating agencies. (Levitt, 2002). A key feature used by both companies was to be particularly optimistic in their revenue recognition approaches in order to inflate profits. Enron's approach in inflating profits were by recording fictitious sales through use of merchant-model rather than "agent-model" in booking trades and by employing mark-to-market accounting , where current revenues were based on estimates of present value of net future cash flow for volatile contracts (Lambert ,2006). Worldcom's approach for inflating profits were to recognize fictious revenue through corporate unallocated revenue accounts and capitalize long-distance line cost expenses as prepaid capacity.

Enron also inflated revenues through round-trip trading, this is essentially done by transferring an asset to another company through sales while buying back the same asset for about the same price and recognizing the trade as revenue (Bond, 2000). Enron achieved this through establishing special purpose entities  such as JEDI, Chewco and Whitewing these entities were also used to hide debt through off-balance sheet financing, this was also a common approach for other energy and telecommunications company such as AOL, CMS Energy and Duke Energy(Forbes, 2002)

Both companies where pressured by declining profits due to the downturn of the economic climate after the dot-com bubble, huge focus on meeting analyst estimates and unrealistic internal earnings targets from , the CEOs, Bernie Ebbers and Jeffrey Skilling. An SEC Investigation found handwritten notes in Worldcom premises that calculated the difference between “act[ual]” or “MonRev” results and “target” or “need[ed]” numbers, and identified the entries necessary to make up that (SEC,2002).

The opportunity for fraudulent accounting was fostered by the company culture in both firms and the relationship with Arthur Andersen. An auditor upholds principles such as independence, objectivity, integrity and competency , due diligence and professional skepticism.  However, most the principles mentioned above weren’t observed by Arthur Anderson. There were obvious signs of cooking the books in both companies, however, the auditors failed to detect any fraud and issued unqualified audit report for years. The company culture of both Enron and Worldcom were shaped by rewarding high-risk taking, unquestionable compliance with seniority,  subpar emphasis on professional ethics and arbitrary rank-and yank approaches to hiring and firing employees.

Several methods could be adopted to mitigate fraud and the losses as a result of fraud. These primarily includes proper corporate governance, auditor independence and persecution. Some significant measures for corporate governance include confidential hotlines, fraud awareness training, management reviews and data mining. Studies show that 51% of fraud were detected by tips from confidential hotlines. Fraud awareness trainings are particularly effective in establishing the company code of conduct and a suitable company culture. Management reviews are used to assess internal controls , frequency of control override and establish the right tone at the top. Data mining is an effective forensic accounting tool that helps in the early detection of fraud . It includes using trend analysis in susceptible accounts such as accounts payable, latent semantic analysis and address geocoding.

While external auditors have been proven to be rather inefficient in detecting fraud , steps need to be taken to establish standards for external auditor independence and limit conflicts of interest. The Sarbanex-Oxley act , that was introduced after the crackdown of Enron and Worldcom, addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It also restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients (Roebuck,2012).

Finally, the legal process in mitigating financial statement manipulation needs to be strengthened. The benefits of gambling on accounting fraud appear to outweigh the potential costs of being caught for committing this fraud. Fines are deemed by the unscrupulous as a price worth paying in return for much lucrative gains from share price manipulation and fraudulent reporting. (Leng, 2006) This suggests that current U.S. civil and criminal penalties for committing accounting fraud are not strong enough to deter this type of behavior (Wharton, 2002)

A Review of Capital Market Research

Capital market research in accounting is based on the relationship between the capital market and financial statement. CMR emerged in accounting literature during the 1970's. Prior to that majority of accounting literature deemed it futile to expect a fairly presented financial position if the aggregates are represented by varying components such as historical cost, actual value, depreciated historical cost, LIFO (Chambers, 1976) Therefore a lot of researchers at the time were focused on advocating for a paradigm shift from historical cost accounting with replacement cost, realizable value, discounted present value and historical index costing(Hendriksen ,1965) citing pathological cases such as bankruptcies, accounting scandals, takeovers or subsequent asset revaluations.

Balls and Brown (1968) on the other hand deemed it necessary to support accounting theory with empirical research and consideration of selection bias. In their research paper 'An Empirical Evaluation of Accounting Income Numbers' they assessed the information content of accounting disclosure by evaluating the aggregate effect of unexpected earnings on abnormal returns and found that 80-90% of earnings is anticipated by inventors due to multiple sources of  financial information. This indicates that annual accounting numbers are not a particularly timely source of information to the capital markets. This research strongly relies on the semi-strong form of market efficiency which asserts that the market reacts swiftly to impound all publicly available information into the share price (Fama,1969).

Beaver (1968) circumvents the problem of specifying an earnings expectation model by examining the variability of stock returns and trading volume around earnings announcements. Beaver hypothesizes that the earnings announcement period is characterized by an increased flow of information compared to a non-earnings announcement period. He uses return volatility to infer the flow of information. The evidence supports Beaver's hypothesis.

The principles of capital market research holds that earnings are oriented toward the interests of shareholders and information about earnings and its components is the primary purpose of financial reporting.The capital market research topics of primary interest to researchers currently appear to be tests of market efficiency with respect to accounting information, fundamental analysis and value relevance of financial reporting  (Watts, 2001).

The belief that “price convergence to value is a much slower process than prior evidence suggests” ( Frankel and Lee, 1998). The accounting literature draws inferences about market efficiency from two types of tests: short- and long-horizon event studies and cross-sectional tests of return predictability or the anomalies literature. Event studies, which constitute the bulk of the literature, include the post-earnings-announcement drift literature

The studies were important in refuting the then prevailing concern that the historical cost earnings measurement process produces meaningless numbers. Second, these studies introduced positive empirical methodology and event study research design to the accounting literature. The early capital markets research amply demonstrated the benefits of incorporating the developments from, and contributing to, the economics and finance literature. Finally, the studies helped dispel the notion that accounting is a monopoly source of information to the capital markets.

Some of the arguments against the importance of capital market research indicate that a majority of the findings are neither novel nor useful to the accounting profession. In addition critics assert that there is mounting evidence of capital market anomalies, which suggests that capital markets might be inefficient and that early research did not perform statistical tests comparing alternative performance measures.