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Some questionable corporate practices
"The good, the bad and the ugly"

This tutorial was
written by
Cassy Norris
Head Teacher, Social Science
Randwick Boys High School

Introduction
Outcomes
Overview
Revision
More

Introduction

Ethical and socially responsible financial management requires managers to act in good faith and to behave in a morally correct manner in their financial dealings and records. Without such management, firms and shareholder’s investments are at risk. Unethical financial management has recently been exposed in the USA and Australia in a number of large corporations including Enron, Merck, World.com and Xerox; the HIH Insurance Group and One-Tel. A number of these large companies have now collapsed, taking a large number of small businesses and employees with them.

Andersen and Associates, a respected 90 year old accounting firm that audited the financial records of several of these corporations, was also exposed for unethical financial practices. The giant organisation, which had revenue in 2000–2001 of $9.3 billion, disintegrated and was swallowed up by other firms. Anderson’s audit clients deserted it when it was revealed that Anderson employees had shredded documents relevant to the audit of Enron, a giant US energy company that went bankrupt in 2002.

This tutorial outlines some of the kinds of unethical behaviour that can take place and considers some more ethical approaches that firms may use.

HSC Topic 2: Financial Management is covered in the Board of Studies, NSW syllabus (June 1999) on pages 27–29. The specific outcomes for this section are:

Outcomes

The student:

H4.1	critically analyses the social and ethical responsibilities of management
H2.1	describes and analyses business functions and operations and their impact on business success
H4.2	evaluates the effectiveness of management in the organisation and operations of business and its responsiveness to change
H5.1	selects, organises and evaluates information and sources for usefulness and reliability
H5.3	communicates business information, ideas and issues, using relevant business terminology and concepts in appropriate forms.

Overview

What are the types of unethical behaviour in which firms engage?

There are often inaccuracies and distortions in audited accounts, and they may not be in accordance with Australian Accounting Standards. Key information may be omitted or hidden, such as bad debts, expected losses, or additional liabilities. Operating leases or pre-purchase agreements may not be included and are sometimes left “off balance sheet”. Inappropriate cut-off periods may be used to avoid publication of poor results.
“Earnings management” may be used to increase or decrease current period income in order to achieve long-term goals for earnings. This may be achieved by changing accounting details through use of different accounting methods, or by changing estimates or policies that determine earnings. Firms may choose to write off big costs during downturns or during restructurings, often called a “big bath” situation. This strategy creates greater opportunities for managers thereafter to maintain consistent and upward growth in earnings. Managers may reduce reported income by over providing for future liabilities (creating “slush funds”) for a “rainy day” when profits are expected to fall, or to avoid excessive government scrutiny or new wage demands.
Expenses may be inappropriately classified as capital expenditure. For example,

WorldCom sought bankruptcy protection in 2002 after disclosing that it had improperly accounted for US$3.8 billion (A$7.1 billion) in expenses. Investigators later found an additional US$3.3 billion (A$6.2 billion) in additional accounting irregularities stretching back to 1999.

In the case of Worldcom, operating expenses should have been deducted immediately from revenue. Instead, they were spread over a long period of time, as is appropriate for capital expenses, and this inflated WorldCom’s reported profits.
Expenses may be shifted to later periods with specific accounting methods, for example, by holding off paying suppliers to delay recognising expenses and to increase profits.
Funds may be misused.

In the case of HIH insurance it was the wrong corporate culture.

There was little sense of a separation between private and public money, and pet employees were treated lavishly. Rita Young, Ray Williams’ (CEO) secretary, was paid $105 000, just before the collapse of the business. She ran up a corporate AMEX bill of $102 000, which included charges for three overseas trips. She was paid an additional $63 000 to fly down to work each week from the Gold Coast and stay at the luxurious Hotel Intercontinental.

Sydney Morning Herald, August 10–11 2002
Top executives are over compensated or have access to benefits not available to other employees.

One of the most blatant examples comes from America.

Papers filed yesterday in the divorce of Jack Welch, former CEO of General Electric, state that GE covered enormous living costs for Welch and his wife while he led the company. The extent of these benefits has never been disclosed by the company, although Mrs. Welch says that her husband gave her support from company funds of US$35 000, which she accepted under protest.

During his tenure as CEO Welch had free use of a New York City apartment valued at US$15.2 million, courtside seats at professional basketball games, satellite TV at his four homes and all costs associated with the city apartment, such as food, wine and newspapers.

Summarised from the Sydney Morning Herald Weekend Edition September 7–8 2002

Key tips for spotting unethical practices in larger firms include:

frequent changes are made to accounting policies

reported earnings are consistently higher than operating cash flows

an audit report is qualified by terms such as “except”, or a report that contains negative opinions

the firm uses an audit firm which is not one of the well-known firms

the auditor resigns

strategies are used to beat accounting rules such as operating leases (off-balance sheet) and sale of receivables (with recourse) often shown as cash, without indicating a balancing liability on the balance sheet.

Best practice involves:

preparation of regular financial reports, particularly if revision is required due to changing circumstances. Listed companies may soon be required by the Australian Stock Exchange to comment on rumours that are reasonably specific and credible.

disclosure of all relevant information

compliance with Australian Accounting Standards.

Firms with ethical practices develop a positive reputation; confident investors are attracted and rewarded with a higher share price. Employees are also more likely to be motivated when working for an ethical company, and there is less temptation for fraud or theft.

Who is responsible for ensuring that the financial planning and management strategies are ethical and legally compliant?

The Board of Directors is responsible for the supervision of management and the safeguarding of shareholders’ interests.

An auditor is responsible for expressing an opinion on the fairness of financial statements in relation to generally accepted accounting standards.

Revision

Using information available to you and the syllabus, explain four major limitations of financial reports. (outcome H2.1)
Describe the possible reasons why firms may be tempted to “smooth” or adjust their records. (outcomes H3.2 and H4.1)
Tip: Consider the impact on managers who are paid performance bonuses, shareholders’ perceptions, share prices, governments offering subsidies, or trade unions monitoring a firm’s profitability.
If a business was able to reduce both its total assets and liabilities by keeping a major item off the balance sheet, such as a finance lease, how might this affect its profitability and its gearing ratios. Draw up a balance sheet and show how it might look. Now have some more fun. Substitute a higher value for intangibles such as the value of goodwill or your brand. How does this affect the ratios? (This is a popular earnings management strategy so there must be some benefits!) (outcomes H2.1, H3.2 and H4.1)
In the past, famous, or infamous “corporate raiders” such as Alan Bond, bought businesses whose assets were undervalued, sold off the assets and made a tidy profit. Assets are often undervalued (unless adjusted) as they are recorded in the balance sheet at their historic cost (i.e. what they cost to buy at the time). Which assets would be of greatest interest to such businessmen? (outcome H3.2)
Scan the front section and the business section of your favourite metropolitan daily newspaper for a week or a fortnight. Unfortunately, articles of this nature have become increasingly common in recent years. Summarise the main ideas as in the example below. You are likely to find your notes useful in assessment tasks and examination situations. (outcomes H5.1 and H5.3)

Ask your school or local librarian to get you a copy of the July 18–24 2002 issue of Business Review Weekly. Photocopy, but do not rip out the article, “Anderson Ripples Start to Spread”. The article is an easy to read and informative account of some of the problems caused by unethical financial practices employed by Anderson and Associates.