Managing Finance and Budgets

Lecture 12

Ethical & Legal Issues

Session 12 – Ethical & Legal Issues

KEY CONCEPTS

Accounting Rules Auditor responsibilities Creative Accounting Whistle blowing Corporate Social Reporting Accounting for the environment

Ethical & Legal Issues

A Accounting: Regulatory Frameworks

B Creative Accounting

C Ethical Accounting

Section A:

Accounting:

Legal and Regulatory Frameworks

Accounting Rules

There are three distinct Sources of Accounting Rules for PLCs:

1. Company Law

2. Accounting Standards

3. Stock Exchange Rules

Company law

Accounting standards

External accounting

rules

Stock exchange rules

Sources of accounting regulations for a UK limited company listed on the Stock Exchange

Company Law

Company Law as embodied in the Companies Acts 1985 & 1989 requires that Directors are responsible and accountable for their actions in respect of their management of the company’s assets:

1. To maintain appropriate accounting records2. To prepare an annual profit & loss account, a

balance sheet that shows a true and fair* view of accounts as well as a Directors’ Report and to make these available to all shareholders and the public at large.

*The term “true & fair” is not clearly defined in the legislation

Accounting Standards

• Accounting Standards or Financial Reporting Standards are the rules established by the Accounting profession that should be followed in the preparation of the annual accounts of companies.

• These rules are not legally binding, however they do define more clearly what is meant by “true and fair”

• Different standards are concerned with:• how an item should be treated• presenting information• disclosing information• valuing assets and measuring profits.

Stock Exchange Rules

• These rules extend the accounting rules for those companies listed on the Stock Exchange.

• These rules require:• Summarised interim (I.e. half-yearly) accounts in

addition to the annual accounts.• A geographical analysis of turnover• Details of shareholdings in other companies where

the investment is greater than 20%

The Audit Process

• Shareholders are required to elect a qualified independent person to act as Auditor.

• The role of this person (or firm) is to report on whether or not the company’s financial statements are “true and fair”, and whether they comply with the regulatory frameworks.

• In order to do this, auditors must not only scrutinise the statements, but the evidence on which the statements are based.

• Their report is sent to the Registrar of Companies.

Auditors

• Shareholders elect the directors to act on their behalf.• The directors account for the financial performance

and financial position of the company.• The shareholders elect an auditor to check that the

statements made by directors are accurate• The auditors report to the shareholders.

Shareholders

elect

account

review

Directors

Auditors

elect

The relationship between the shareholders, the directors and the auditors

Section B:

Creative Accounting

Deviant Accounting Practice

The Collapse of ENRON, the investigations into Xerox in 2002 and other high-profile events has raised questions about the effectiveness of the Regulatory Frameworks.

The accounting methods used by Anderson Associates for example seem to have successfully persuaded the corporate community that certain companies were profitable, when in reality those companies were in deficit.

Many of the accounting practices used, while not exactly illegal, do not abide by the spirit of the regulations. They are sometimes euphemistically termed “Creative Accounting”

Creative Accounting

“ Every company in the country is fiddling its profits. Every set of published accounts is based on books which have

been gently cooked or completely roasted.”

Ian Griffiths – Creative Accounting (1985)

“Much of the apparent growth in profits which had occurred in the 1980s was the result of accounting sleight of hand

rather than genuine economic growth.”

Terry Smith –Accounting for Growth (1992)

Creative Accounting

“ The accounting process consists of dealing with many matters of judgement and of resolving conflicts between competing approaches to the presentation of results of

financial events and transactions. This flexibility provides opportunities for manipulation, deceit and

misrepresentation”

Michael Jameson

A Practical Guide to Creative Accounting (1988)

Creative Accounting - Methods

Selection of accounting policies Using judgement to give an optimistic or pessimistic

view as required Using artificial transactions to manipulate balance sheet

entries or to move profits between periods Timing transactions to move profits to required time

frame

Creative Accounting - Example

REAL Balance Sheet:

Fixed Assets £25m

Current Assets

Stock £10m

Debtors £5m

Current Liabilities -£10m

LT Liabilities -£15m

£15m

Capital £20m

LOSS -£5m

£15m

CREATIVE Balance Sheet:

Fixed Assets £25m

Current Assets

Stock £15m

Debtors £5m

Current Liabilities -£10m

LT Liabilities -£10m

£25m

Capital £20m

PROFITS £5m

£25m

Old stock re-valued upwards by £5m

Old stock re-valued upwards by £5m

£5m Loan taken out in final part of year; 1st payment not yet due.

£5m Loan taken out in final part of year; 1st payment not yet due.

Creative Accounting - Motivation

Hide volatility of profits thereby reducing perceived risk in organisation

Delay tax burden Increase personal rewards where linked to profits Improve perceived wealth of company Deceive stakeholders Move blame for poor results onto predecessor (or

successor)

Monitoring

Given the existence of a multiplicity of frameworks, one question which needs to be asked is: “How is it that these anomalies are not picked up during the auditing process”?

One answer to this may be that in many cases the firm appointed to do the auditing has close links with the firm which does the accounting.

The Role of Auditors

Role conflict – should be objective but are also a supplier Often unable to detect fraud Frequently reluctant to report fraud Suffer from lack of accountability and independence Insist on self-regulation Subject to competitive pressures

Auditors’ unprofessional behaviour

Allocating insufficient time due to budget restraints Accepting weak client explanations Focusing on completion deadlines instead of

thoroughness Excluding awkward items from samples Accepting doubtful evidence from clients Conflict of interests

How is Deviant Practice Uncovered?

If the movements of money are a one-off, simple shift from one reporting period to another, this may never be detected. This is the primary motivation.

However, invariably when this has been done once, it needs to be repeated. This creates a downward spiral from which it is difficult to recover.

In many cases, it is employees who are required to construct or falsify records who alert the press or authorities .

Such people are called “Whistle blowers”

Whistle blowing

Financial management provides privileged view of the organisation’s dealings

Deviant managerial procedures may become apparent E.g. Use of company assets for personal use

Hiding income from tax or vat authorities

Breaking of reporting regulations

Over-valuing (or under-valuing) of stock Damages for whistle blower could be loss of reputation;

personal liability; dismissal

Section C:

Ethical Accounting Practice

Corporate Social Reporting

Organisations ought to be answerable to stakeholders Currently, regulations only relate to financial reporting Other information is only given selectively or for PR Suggested five elements of CSR:

Environmental reporting

Fair business practices (e.g. to employees/suppliers)

Community involvement

Products – safety and impact

Social policy

Accounting for the environment

Adopting environmental policies Carrying out environmental audits Controlling energy costs and waste Packaging and recycling Life cycle analysis Ethical borrowing and investment Social audits Incorporating sustainability in organisational priorities

Managing Finance and Budgets

EVALUATION

There is a short questionnaire to fill in on the module. The purpose behind the questionnaire is to examine

correlations between your academic experience on the module and other factors.

These factors may include gender, country of origin, previous experience of finances, time allocated to study, etc.

I aim to make changes to the module for next year. This will allow me to focus energy precisely where it is needed.

Managing Finance and Budgets

THE END!

GOOD BYE, THANKS AND GOOD LUCK

MAY SEE YOU NEXT TERM

for

SPREADSHEETS IN FINANCE & FORECASTING