3.3 Discussion: Creative Accounting Debate (Initial Post)
Following major scandals at U.S. firms like Enron, WorldCom, Global Crossing, and Tyco, congress passed the Sarbanes-Oxley Act (“Sarbox”) in 2002. Sarbox created the Public Company Accounting Oversight Board to oversee auditors of public companies. It banned company loans to executives and established new protections for whistleblowers. It set higher requirements for the independence of corporate boards. Perhaps most importantly, it made CEOs personally liable not only for the accuracy of publicly issued financial statements but also for the robustness of the financial processes used to create them.
Two decades after the passage of Sarbanes-Oxley, there is reason to believe it has improved internal controls and the reliability of financial statements. However, this has come at a price, and the Act has been subjected to great criticism. There has been some talk of overhauling or even completely repealing the bill. Meanwhile, a new phenomenon has arisen that is causing many to once again question the veracity of public financial statements: the reporting of so-called “adjusted earnings” and other creative measures.
Upon successful completion of this discussion, you will be able to:
- Evaluate the impact of regulatory changes on financial operations.
- Analyze the appropriateness of creative accounting measures.
- Textbook: Analysis for Financial Management
- Textbook: Principles of Accounting: Volume 1, Financial Accounting
- Website: Connect
- File: Higgins Chapter 2 Slides
Prior to Sarbanes-Oxley, corporations were legally responsible for the reliability of their financial statements, but it was very difficult to prosecute executives. The perceived rewards for maleficence thus often outweighed the risks. The passage of Sarbox helped to remove this temptation. However, the cost of this regulation has been high. To avoid these costs, many formerly public companies chose to take themselves private.
In 2010, the Dodd-Frank Act was passed in response to the financial crisis of 2007–2008, adding further regulation to the banking industry in particular. Since that time, the number of publicly traded companies has declined dramatically. Meanwhile, the amount of money raised in the private capital markets has far outpaced the amount raised publicly. Private offerings are only available to institutional investors. Some have argued this trend has limited the opportunities available to average, individual investors and suffocated the growth of the U.S. economy, making foreign investments more attractive.
Before we all jump on the band wagon to repeal Sarbanes-Oxley, however, consider the rise of “adjusted earnings” and other creative measures now being used by executives to report their results to the general public. The definition of adjusted earnings is unclear because each company establishes their own formula, and this formula may change depending on the circumstances. Earnings are adjusted by removing extraordinary or one-time costs that may distort the underlying, core earnings of the company. In the best case, this is done to present a more accurate picture of the company’s ongoing financial circumstances. In the worst case, it is done to present an overly optimistic and misleading view.
Research has shown the number of companies reporting adjusted earnings has steadily increased. Meanwhile, the amount of the adjustments has gotten increasingly favorable to companies and the types of adjustments have become more complex. The Financial Accounting Standards Board, the arbiter of Generally Accepted Accounting Principles (GAAP) has allowed these non-GAAP measures to be reported as long as the company explains how they are calculated. Whether they are helping stakeholders get a better understanding of a company’s financial position or simply misleading the public is up for debate.
- Review the rubric to make sure you understand the criteria for earning your grade.
- In your textbook, Analysis for Financial Management, read Chapter 2, “Evaluating Financial Performance.”
- In your textbook, Principles of Accounting, study Appendix A, “Financial Statement Analysis.”
- Download and review the Higgins Chapter 2 Slides for the assigned chapter above to help you further understand the chapter concepts.
- Navigate to the threaded discussion and respond to the following prompts:
- Has Sarbanes-Oxley been effective at discouraging executives from misleading investors and other external stakeholders? If it has, should it be strengthened? If not, should it be repealed?
- Is it legitimate and appropriate for executives to present adjusted earnings and other creative measures? Are they informative or just misleading?
- Support your position with at least one biblical principle with a specific Bible verse that you feel is relevant to the situation. Explain how and why it applies.
- Your post should be based on the chapters, as well as other resources that can contribute to the discussion. Use OCLS to search for relevant scholarly sources you can use to support your position.
- This initial post should be 200–400 words in length and include at least one academic source that is properly cited. For questions on APA style, go to OCLS APA Writing Styles Guides.
- Your post is due by the end of the workshop.