Business Failure and Unethical Accounting Practices

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Introduction

One of the current trends in business management within most corporate organizations is the implementation of extrinsic methods of motivation in order to encourage better performance among employees. Extrinsic motivators take the form of external rewards provided by the company for meeting and exceeding the set metrics that were established. Aside from employees, companies themselves also happen to possess extrinsic motivators in the form of financial statements that indicate improved performance on the part of the company which resulted in more profits. The extrinsic motivator in this case comes in the form of greater levels of investor interest in the company resulting in access to more external sources of cash flow as well as the potential to lower interest levels on incurred debt. It is based on this that the upper management of a company often “maneuver” numbers to a certain extent so as to present the company in a good light (Ruderman, 1-6). This comes in the form of a variety of accruals, use of reserves, and other such instruments so as to create a more flattering image of the company’s earnings. Accountants are well aware of this and there is an assortment of methods that can be implemented to do so in a factual and above all ethical way. Some examples of this come in the form of releasing some of the company’s reserve funds that were set aside for “rainy days” (i.e. work stoppages, natural disasters, etc.) or even by accountants recognizing revenues from products before actual sales are made (a tactic often seen in large retailers). It is only when the company enters into a good quarter that a “restructuring charge” is often added in so as to make up for the money that was utilized to increase the company’s earnings in a previous quarter. Various studies explain that among CFOs such practices are prevalent among most industries to the extent that nearly 20 to 30 percent of companies within various sectors utilize such practices in order to present their financial statements in a better light (Matar, 194-204). As a result, such practices do have an impact on earnings misrepresentation to around 10% of earnings per share that is under the company’s name. The reason behind such actions which can be considered as “barely” ethical is related to an endemic problem among many of the largest corporations which is the pressure to meet the quarterly expectations of their earnings on Wall Street. However, at times companies take this form of “fact fudging” too far resulting in what can only be described as instances of corporate fraud wherein the accountancy department is complicit in providing a means to “cook the books” resulting in the presentation of falsified business data to fool outsiders into thinking that there is nothing wrong or that the company is making more money than it actually is (Spathis, 509-535). Instances such as these can be described as a form of business failure since it in effect falsifies the performance, cash flow, and profitability statements of the company to cast it in a better light. Such actions are unethical due to the potential for investors or banks to invest in a failing company resulting in a significant loss of investments. Examples of this can be seen in cases involving Enron, WorldCom, and Adelphia wherein these companies “cooked the books” to such an extent that they listed several billion dollars in assets that in reality were not there. Taking such factors into consideration, this paper will examine the various warning signs that are indicative of business failure wherein unethical accounting practices are being utilized as well as examine why such practices continue to be implemented despite the proliferation of supposedly ethical workers. It is expected that through this paper, better business ethics practices can be implemented resulting in a greater level of awareness over what can be done to prevent business failure due to unethical accounting.

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Accelerating Revenues within Financial Statements

One process that has been utilized in various companies is to show a lump sum payment for services that will be implemented over a period of several years as a single payment for that particular year alone. For example, if a company were to provide a security service to another company over a period of 5 years with the contracting company paying for the 5-year terms of service upfront, it would normally be the case that the amount for services rendered should appear based on the required monthly payments (i.e. it should be amortized over the service period of the contract). Instead, what occurs is that the services company would record that single payment as a profit for that year alone despite the costs that would come about by providing the necessary services to the contracting company. Other methods of implementing an accelerating revenue stream in company accountancy reports come in the form of “channel stuffing” which is a method of accountancy wherein a company records all shipments of products to a distributor as sales instead of classifying them as a type of inventory. The problem with this method of accountancy is that it does not take into consideration the amount of time that would be required to make a sale or if all the products could even be sold. There are even instances where products could be returned due to any manner of possible defects. As a result, the information in the financial reports could be grossly misleading with the company incurring losses that are not recorded at all. This is a form of business failure due to the manner in which the actual sales of the company are falsified and any losses are in effect hidden. Losses due to product returns or a lack of sales should appear on a balance sheet since they act as markers to possible problems within the company’s operational status and supply chain. Without these markers in place, it becomes possible to hide internal operational problems which show high levels of sales despite the reality being high levels of returns and low sale outputs.

Delaying Expenses within the Balance Sheet

Another tactic that companies at times implement is to capitalize on the cost of making and distributing a particular product. This can be done wherein a marketing campaign (i.e. the distribution of various marketing materials in the form of flyers, CDs, brochures, etc.) is listed as a long-term expenditure with the expenses being capitalized in the balance sheet. What should have been the case is that the costs were supposed to appear on the company’s income statement as a loss due to normal operations. By performing actions such as this, companies are able to show positive income and have apparently low operating costs to outside observers. The reason this should be classified as a form of business failure is due to the fact that creating a false image lulls investors into thinking that a company is performing efficiently and effectively when in fact it was merely hiding the costs of its operations towards the long term.

Non-recurring expenses being used to hide low performance

The concept of non-recurring expenses is one-time charges which are often used in accountancy as a means of analyzing a company’s current operating results. However, the main problem with using this particular accounting instrument is related to the fact that companies are apparently implementing them once per year instead of on an infrequent basis. The end result is that when they want to increase the apparent performance of the company during a particularly slow season they happen to find out that they have an excess of funds that have been stored away and place these back into the income sheets of the company. The inherent problem with such a method is the fact that is clearly being utilized to cover up deficiencies in the company’s operations and is being taken out of context from its original function.

Off-Balance Sheet Structuring

One of the strategies implemented by Enron in order to hide liabilities was to create separate legal entities from the company that could incur its various liabilities and expenses that the main company did not want on its own financial statements for investors to see. This can be done due to the way in which subsidiaries are treated as separate legal entities from the parent company and, as such, it is not required that their various expenses and liabilities be recorded in the parent company’s balance sheet. This enables the parent company to in effect hide accelerating expenses and massive debt under the guide of a “clean” and well-organized balance sheet.

Other Income or Expense Appearing on Company Financial Statements

The concept of “other income or expenses” being utilized is due to the assortment of possible expenses or income lines that a company may incur that would fall outside of the normal categories utilized in most financial statements. It is normally the case that it is in categories such as these that companies attempt to hide prior expenses by netting them against income from other sources. Such sources can come in the form of selling property, equipment, or investments that the company had previously. The problem with this is that it enables the company to boost its earnings artificially through the sale of assets. This creates a false image to investors regarding the company’s earnings and makes them believe that it is positive when in reality it is negative.

The “Myth” of Business Ethics at the Present

Based on the information that has been presented so far, it is the assumption of the researcher that the cause of business failure related to unethical accountancy is the continued belief that the people that run companies will continue to utilize ethical methods of conduct despite the pressure to perform that is placed on them by Wall Street and investors. The first myth to be discussed is the assumption of companies that they select and train ethical employees who will always do the right thing. A survey conducted by various prosecuted individuals serving time for white-collar related crime all reveals that the source of unethical behavior is not whether a person is ethical or not in comparison to other employees but rather if the opportunity is there and there are no apparent means of control. As it was seen in the previous sections of this paper, the fact of the matter is so long as the opportunity is present; it is likely that a company may be implementing unethical accountancy practices in order to keep up with investor expectations on company performance.

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In such cases where there is no opportunity and stringent means of control exist even apparently unethical employees have no choice but to conform to an ethical method of doing business. For example, an ethical employee is told to find a method of keeping costs down in order to help the company survive the recession, the employee helps the company lower costs by outsourcing the means of production to China. Everything seems to follow an apparently ethical guideline however a closer examination of the situation reveals that the labor used in the outsourced factory complex is tasked to produce items 18 hours a day, under harsh conditions and minimum safety standards in order to cut down on the cost of production. From an ethical viewpoint, such a situation seems horrid yet it is a part of nearly everyday business operations for various retailers.

While companies may train employees to do the right thing the fact remains that the company itself is still a business. When told to minimize costs in favor of survival one of the first principles to take a hit is the concept of ethicality wherein low-cost production comes at the cost of an abused labor force. The second myth of business ethics is the belief that you will always do the right thing, the inherent misunderstanding from this particular concept is that there are no assurances that a person will always do the right thing, if it were, training classes on business ethics would not be a requirement. The fact is when presented with the opportunity and the necessity to commit certain unethical practices most people in positions do very likely commit questionable acts. The fact is proper business ethics is more of a framework that a person attempts to abide by rather than a belief in one’s own ability to stick to ethical practices. If one believes that they are following proper business ethics under the belief that they will not do wrong without the need for a proper ethical framework then it is very likely that such individuals will commit unethical practices in the near future. One final myth to be examined is that business ethics is based on legal compliance.

Going back to the example of outsourcing to China, while outsourcing to another country is perfectly legal and that employee environment standards are laxer there as compared to countries such as the U.S. it must be noted that knowingly subjecting people to a hazardous production method and at low pay is a violation of numerous ethical standards despite the act being compliant with the country’s legal code. The fact is business ethics is based on the concept of what is perceived to be the right course of action that positively affects a person. Any act that negatively affects an individual yet is legally compliant is still considered an unethical act.

The Necessity of Implementing Standards in Corporate Ethics

There is an old saying that states that “the left-hand doesn’t know what the right hand is doing”, in the case of corporations this takes on a more significant meaning due to the proliferation of various departments, operational sites, and standards of doing business in particular areas. Not all departments actually know what other departments are doing and, as such, this leaves a great deal of ambiguity as to what sort of ethical practices particular departments are or are not engaging in. As such, this presents the necessity of establishing a standard set of ethical practices and procedures across all departments due to the need to ensure that when represented by a particular department in a certain business venture their ethical practices don’t reflect badly on the rest of the company.

What must be understood is that when a particular operation, department, or employee engages in a distinctly unethical practice this makes consumers think of the company as a whole as being unethical despite the action being isolated to that particular instance. It is based on this particular example that there needs to be a certain code of ethics in order to ensure a generalized form of ethical accountability across all departments in order to prevent any action that might jeopardize the company’s image.

Program Implementation

Based on the various facts that have been presented so far it can be seen that there is a need to implement a program in companies where standard ethical practices are implemented on a department-wide basis. This program entitled “Employee Ethics and Integrity” will be a Code of Ethics that shall be strictly enforced by companies by which all employees are expected to conform to the ethical rules and responsibilities outlined in future versions of current company policy manuals.

The value of implementing these particular standards is that it ensures that a company has a proper ethical basis by which it conducts its business. This will reflect in aspects related to financial reporting, corporate social responsibility, adherence to proper ethical methods of accounting and environmental protection as well as generally ensuring that employees within the stick to practices that are to the benefit of the company itself.

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Conclusion

Based on what has been presented in this paper, there are numerous methods by which a company may artificially inflate its earnings through various accountancy practices. Such actions are often the result of the necessity of meeting investor expectations no matter the cost. As such, it is necessary that in order for a company to avoid business failure due to improper accountancy practices, it is necessary to implement a sufficiently capable ethics program to ensure that such practices are not even used as a last resort. It can be assumed that if such a program is properly implemented within the near future, problems related to corporate mismanagement, falsification of data, skirting laws, and government regulations can be avoided with employees taking into consideration the consequences of their actions based on prescribed disciplinary action should violations of the ethical code of conduct be violated. Not only would this adherence benefit the company but it would most likely benefit consumers as well.

References

Matar, Mohammed. “The Disclosure Of Information Required In The Financial Statements Of SMES: Empirical Case Study Of Jordan.” Proceedings Of The International Conference On Information Management & Evaluation (2012): 194-204. EbscoHost. Web.

Ruderman, Susan. “Teaching Non-Specialists About Financial Statements: A Guide To The Resources.” Business Information Alert 16.5 (2004): 1-6. EbscoHost. Web.

Spathis, Chenos. “Detecting Falsified Financial Statements: A Comparative Study Using Multicriteria Analysis And Multivariate Statistical Techniques.” European Accounting Review 11.3 (2002): 509-535. EbscoHost. Web.

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BusinessEssay. (2022, May 5). Business Failure and Unethical Accounting Practices. Retrieved from https://business-essay.com/business-failure-and-unethical-accounting-practices/

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BusinessEssay. (2022) 'Business Failure and Unethical Accounting Practices'. 5 May.

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BusinessEssay. 2022. "Business Failure and Unethical Accounting Practices." May 5, 2022. https://business-essay.com/business-failure-and-unethical-accounting-practices/.

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BusinessEssay. "Business Failure and Unethical Accounting Practices." May 5, 2022. https://business-essay.com/business-failure-and-unethical-accounting-practices/.