Importance of Financial Statements for Users

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Introduction

The term “fraud” refers to the conscious act of one or more managers, those charged with governance, employees, or third parties, using a scam to gain an unfair and illegal advantage. Although it is a broad legal definition, the accountants consider fraud that causes a material misstatement in the financial statements for inspection purposes. There are numerous methods to manipulate financial statements, depending on goals, motives and objects. However, auditors do not provide a standard description of the actual occurrence of fraud.

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The US Securities and Exchange Commission (SEC) prioritizes investigations related to misstatement of financial statements and accounting fraud. One of the most critical cases is the HealthSouth scandal in 2003. During the trial on fraudulent financial reporting, fifteen top managers, including five former HealthSouth CFOs, signed frank confessions (Werhane et al., 2008). The scandal occurred due to a misstatement of reporting $ 2.7 billion in HealthSouth Corp (Werhane et al., 2008). It has led to a series of litigations and control strengthening of adherence to accounting principles.

Summary of the Area of Accounting

At present, companies prepare financial statements following the international financial reporting standards (IFRS) or generally accepted accounting principles (US GAAP) standards. One of the main objects of preparing such reports is to attract additional financing through company shares or depositary receipts on leading stock exchanges (Darmawan & Saragih, 2017). Companies tend to assess the counterparty’s reliability based on the financial statements they submit (Darmawan & Saragih, 2017). However, there is a high uncertainty that constant financial statements prepared under international or American standards can contain false data (Darmawan & Saragih, 2017). In most cases, companies’ financial accounts are subject to sanctioned audits, but the latter cannot ensure the absence of accounting data falsification.

A Detailed Case Discussion

Fraudulent Financial Reporting at HealthSouth

HealthSouth is the largest publicly traded healthcare company in the United States. The corporation’s clinics and hospitals are located in 28 US states (Werhane et al., 2008). The company started to misrepresent its financial statements from the end of the 20th century. Several methods were used, such as manipulating accounting estimates, such as a reserve for doubtful debts, capitalization of operating earnings, and overestimating the insurance indemnity amount (Werhane et al., 2008). The company managed to meet shareholders’ expectations for 40 consecutive quarters through accounting fraud and outright misrepresentation of financial statements.

The scandal led to severe consequences for the company’s financial standing. There was a drop in the company’s market capitalization by approximately $ 6 billion (Werhane et al., 2008). According to Werhane et al. (2008), the HealthSouth revenues were artificially overvalued by $ 1.4 billion to stay consistent with investors’ expectations. In 2003, the company’s CEO Richard M. Scrushy sold shares in the company for $ 75 million the day before the company reported a significant loss (Werhane et al., 2008). This raised suspicions in the SEC; Scrushy was forced to pay an $81 million SEC fine to pay for the fraud costs (Werhane et al., 2008).

During the trial, 15 top executives, including five former CFOs, signed confessions and received various sentences (Werhane et al., 2008). This resulted in a serious economic failure and destroyed the reputation of the company in the long-term.

SEC and PCAOB’s Position

The SEC has indicted HealthSouth for illegally overstating its revenues. The latter confirmed that an extra USD 300 million was paid in taxes (Agrawal & Cooper, 2017). This case provokes the ensuing investigation; the SEC announced the beginning of a formal investigation into the Swiss investment bank UBS AG (Agrawal & Cooper, 2017). It is suspected of misreporting with the financial statements of the medical corporation HealthSouth. The SEC reorganized its anti-accounting fraud task force to include units that track investment firms, market manipulation, and Foreign Corrupt Practices Act violations (Agrawal & Cooper, 2017). For example, since then, companies such as Pfizer, Oracle, Aon, Johnson & Johnson, and Tyson Foods have paid fines to settle allegations of bribes received abroad.

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The Public Company Accounting Oversight Board (PCAOB) is governed by the Sarbanes-Oxley Act of 2002. It establishes auditing and related expert practice standards for registered government audit firms to prepare and issue audit reports (DeFond et al., 2018). In 2003 PCAOB conducted a limited inspection of Ernst & Young as HealthSouth’s auditor company (DeFond et al., 2018). The audit company required consideration of the case in a court and intended to inquire about compensation for legal costs incurred during the process.

Other Companies Participated in Financial Reporting Fraud

Several other companies engaged in financial reporting fraud, such as the WorldCom and Tyco scandals in 2002. In July 2002, the world was shocked by the bankruptcy of the telecommunications company WorldCom. It had the second-largest share in the US telephony market and provided more than half of the US’s Internet traffic; however, as a result of the failure, investors lost $ 180 billion (Petra and Spieler, 2020).

On June 25, 2002, WorldCom management acknowledged that the data on profits in 2001 and the first quarter of 2002 were overestimated by $ 3.9 billion (Petra and Spieler, 2020). Unlike the HealthSouth scandal, WorldCom shares fell to less than a dollar per stock, so the NASDAQ management was required to stop trading (Petra and Spieler, 2020). The SEC has registered fraud statements against the company; the result was a severe blow to the telecommunications sector and the stock market in the United States and abroad.

Tyco is the most considerable diversified American concern operating in the electronics, information technology, medicine and security equipment industry. In 2002, a scandal erupted around the company; its CEO Denis Kozlowski and CFO Mark Schwartz had stolen $ 150 million and inflated the organization’s revenues by $ 500 million (Chen et al., 2019). Investigations conducted by the SEC and the Manhattan District Attorney revealed dubious accounting practices, substantial loans issued by the company to Denis Kozlowski, subsequently written off. Consequently, Kozlowski and Schwartz were sentenced to 8-25 years in prison (Chen et al., 2019). As a result, the shareholders’ class-action lawsuit should have been upheld.

WorldCom, Tyco and HealthSouth have manipulated financial reporting; for these companies, artificial overstatement of assets has become a way to comply with the terms of loan agreements formally, the value of collateral or the criteria for granting extending loans established by the borrower. Considering differences, even though WorldCom and Tyco CEOs were sentenced to imprisonment, Scrushy was acquitted of all counts of financial fraud but was convicted of bribing Alabama’s governor.

Lessons

The Worldcom, Tyco and HealthSouth account scandals have increased the importance of internal controls to companies worldwide. The Sarbanes-Oxley Act requires companies to develop and maintain adequate internal control systems (Darmawan & Saragih, 2017). It focuses on accounting issues that may be justified by shareholders who assume that the company’s earnings are overstated long before accountants and federal authorities know it (Darmawan & Saragih, 2017). Since 2004, all companies listed on the US Stock Exchange and all their subsidiaries are obligated to prove internal controls’ effectiveness in providing financial statements (Darmawan & Saragih, 2017).

CEOs and CFOs should have increased personal responsibility for the accuracy and completeness of financial data. After corporate financial scandals at the beginning of the 21st century, the US legislation of accounting, auditing and liability for financial reporting fraud has undergone significant changes. Sarbanes-Oxley requires the description, testing and monitoring of the entire internal control system for risks affecting financial reporting quality (Darmawan & Saragih, 2017). Therefore, companies face the request of performing a process-oriented audit of their internal administration practices to recognize their deficiencies and continually improve.

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Personal Conclusion

The market value of a company’s shares depends on the amount of financial leverage. The immediate reason for the company’s bankruptcy is not the content of its income statement, but the shortage of money to timely settle accounts with creditors (Darmawan & Saragih, 2017). The difference from accounting standards allows managers to present numbers in the most favorable condition, overstating the number of assets, capitalizing expenses. HealthSouth has overstated asset balance sheets to cover inadequate returns for several years to meet investor expectations.

General Conclusion

Fraudulent financial reporting implies distortion of financial statements. The experience of the large companies’ scandals is useful in terms of recognizing and developing new approaches to prevent it. Considering the HealthSouth case, there are many ways, including overestimating shares’ price, capitalization of operating profits, and overvaluing the insurance reimbursement amount (Werhane et al., 2008). The reliability is evaluated through the financial statements of the companies (Darmawan & Saragih, 2017). Misreporting aims omission of specific numbers or disclosures in financial statements to mislead stakeholders.

To sum up, financial statements are primarily addressed to external users who make individual managerial decisions based on their analysis results. External reporting enables establishing the organization’s financial stability level and characterizing its dynamics, identifying trends, and forecasting the economic situation’s development in the future. Thus, the quality of management decisions primarily depends on the reliability of the information disclosed in organizations’ financial statements, that is, on the level of its transparency.

References

Agrawal, A., & Cooper, T. (2017). Corporate governance consequences of accounting scandals: Evidence from top management, CFO and auditor turnover. Quarterly Journal of Finance, 7(1), 1-41. Web.

Chen, Y. J., Liou, W. C., Chen, Y. M., & Wu, J. H. (2019). Fraud detection for financial statements of business groups. International Journal of Accounting Information Systems, 32, 1-23. Web.

Darmawan, A., & Saragih, S. O. (2017). The impact of auditor quality, financial stability, and financial target for a fraudulent financial statement. Journal of Applied Accounting and Taxation, 2(1), 9-14.

DeFond, M. L., Lennox, C. S., & Zhang, J. (2018). The primacy of fair presentation: Evidence from PCAOB standards, federal legislation, and the courts. Accounting Horizons, 32(3), 91-100. Web.

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Petra, S. & Spieler, A.C. (2020). Accounting scandals: Enron, Worldcom, and Global Crossing. In H. K. Baker et al. (Eds.), Corporate Fraud Exposed (pp. 342-360). Emerald Publishing Limited.

Werhane, P. H., Mead, J., & Collier, C. E. Healthsouth (b). Darden Case No. UVA-E-0273. Web.

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