Anthony P. Evanoff UCM Contributor
August 1st 2013
The Disappearance of Business Ethics and Recommendations for Change in a Post-Enron Era
The following contains my research as well as my thoughts on the current state of our U.S. corporate business environment, post Enron, as it pertains to the ethical behaviors, or lack thereof, and the necessity for change in the status-quo of financial reporting. Change is seldom easily accomplished, especially on such a grand scale as what we are attempting to do: alter the accounting and ethical behaviors of the largest, most powerful publicly traded U.S organizations. First, allow me to discuss change itself.
“Much past scholarly work has centered on the origins of change. It seems equally important to understand how change attempts are planned and implemented, how they are received, how they are resisted, and what factors contribute to success or failure of such attempts”(Zaitman, 1980 P. 148). Critical to the success of our recommended change is understanding our target group and the egos at play within the chief executive officers (CEOs) and chief financial officers (CFOs). “The overall conceptual design viewed legislation as the external impetus to the initiation and implementation of change within particular installations. This process of change was viewed as being influenced by community characteristics, and union characteristics and support, organizational characteristics, and various key actors such as the director of the installation, policy facilitators, and supervisors’”(Zaitman, 1980 P. 148).
Process of Change:
Implementing policy change is a process that involves the following steps:
1. Sensing of unsatisfied demands on the system;
2. The search for possible responses;
3. The evaluation of alternatives;
4. The decision to adopt a course of action;
5. The initiation of action with the system;
6. The implementation of the change;
7. The institutionalization of the changes(Zaitman, 1980);
Left to their own, CEOs and CFOs, will pursue their own policies which do not coincide greatly with formal federal policy. “Apparently the implementation of externally imposed innovations conflicts with a sense of autonomy high level officials possess as a partial consequence of professionalism. This induces a form of passive resistance. At best, considerable ambivalence is created at the top and communicated to lower level supervisors” (Zaitman, 1980, p. 149).
Change is Needed, Too Much Pressure to Cheat:
The Enron accounting scandal, which broke in October 2001, and subsequent accounting scandals led to a loss of investor trust in integrity of financial statements, which lead to the creation and passage of the Sarbanes-Oxley Act(SOX) 2002, and likely changed both investor and managers reactions to financial disclosures (Koh, Matsumoto, Rajgopul, 2008). Researchers Graham, Harvey, and Rajgopul (GHR) 2005, are of the opinion that in the post-scandals period, capital markets continue to be obsessed with meeting or beating analysts’ earnings per share (EPS) targets, and CFOs take potentially value-destroying actions to meet such expectations(Koh, Matsumoto, 2008). Jensen, Murphy, and Wruck (2004) argue that (a) the pressure to meet analyst expectations was the driver behind the deceptive accounting practices of the early 2000’s and (b) SOX cannot effectively improve financial reporting transparency unless managers de-emphasize earnings guidance to equity analysts, as pressure to meet such guidance leads to earnings management. (Koh, Matsumoto, 2008).
Earnings Management; Process or Problem?
Earnings management may be defined as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”. Earnings management is not to be confused with illegal activities to manipulate financial statements and report results that do not reflect economic reality. These types of activities, known as “cooking the books”, involve misrepresenting financial results. Many executives face a lot of pressure to cross the line from earnings management to cooking the books. “A 1998 survey at a conference sponsored by CFO Magazine found that 78 percent of the CFOs in attendance had been asked to cast financial results in a better light, though still using generally accepted accounting principles. Half of them complied with the request. Worse, however, 45 percent of the group attendees reported that they had been asked to misrepresent their company’s financial results-and 38 percent admit with complying”. A large number of companies are using earnings management either to maintain steady earnings growth or to avoid reporting red ink. “The intense pressure to report better earnings was confirmed by a similar survey at a Business Week CFO conference. It found that 55 percent of the CFOs had been asked to misrepresent financial results, and 17 percent complied”.
One study estimates that operating profits for the Standard & Poor’s 500 stocks “have been inflated by at least 10 percent per year for the past two decades, thanks to a mix of one-time write-offs and other accounting tricks”. Since it is widely accepted that operating profits are highly correlated to stock prices over the long term, this means that the prices of S & P 500 stocks, some of the best companies in the world, have consistently been enhanced by earnings management techniques. The practice of earnings management is indeed pervasive.
GAAP-Part of the Problem:
Accounting choices should be made within the framework of General Accepted Accounting Principles (GAAP). GAAP are the set of rules, practices, and conventions that describe what is acceptable financial reporting for external stakeholders. The main source of GAAP for public companies are the Financial Accounting Statements (FAS), although there are also several other sources. Many people find it surprising that a single, normal, everyday accounting choice may either be legal or illegal. The difference between a legal and an illegal accounting choice is often merely the degree to which the choice is carried out. Combine the flexibility of choice with the extreme pressures placed upon organizational CEOs and CFOs to meet or beat forecasted earnings and what is created is Enron, Tyco, Health South, and other large organizations immersed in accounting scandals.
Publically traded companies must adhere to a different set of accounting principles governed by congressional over-site committees whose members understand the accounting principles and requirements better than those preparing the financial reports. Easier said than done, but this must happen in order to effect change in a corrupt area of corporate America. The Securities and Exchange Commission(SEC) is a key player in promoting GAAP, making their use mandatory for the annual reports and financial statements of the 14,000 or so U.S. public companies. Managers whose financial statements reflect any of the following activities may be committing fraud even if they do not think their actions are fraud. This statement further highlights the heart of the problem; there is far too much grey area within the accounting regulations. If there are accounting professionals that aren’t aware of their fraudulent claims, there are many, many more who know that their claims are indeed fraudulent, they just happen to be smarter than those who are responsible for reviewing the financial documents, not to mention that the SEC is under-staffed in its effort to police 14,000 plus U.S. public companies.
A Change in Philosophy:
Three points of interest for governance and regulations have surfaced post-Enron. First, the proportion of small EPS beats has fallen since the scandals, and the propensity to engage in income-increasing earnings management to meet or beat earnings benchmarks has declined (Koh, Matsumoto, 2008). Second, this decline has led to meeting or beating being a stronger signal of future operating performance (Koh, Matsumoto, 2008). Third, the stock market premium assigned to small beats has disappeared in the post-scandals period (Kuh, Matsumoto, 2008). This decline could reduce the pressure on CEOs and CFOs to meet analyst expectations. Evidence suggests that expectations management to meet/beat analyst-set targets has increased in the post-scandals period (Kuh, Matsumoto, 2008). Expectations management is defined as “a formal process to continually capture, document, and maintain the content, dependencies, and sureness of the expectations for persons participating in an interaction, and apply the information to make the interaction successful”.
Mentioned earlier in this memo, a key legislative response to the Enron and other accounting scandals is the passage of the SOX (2002). Congress intended to restore investor confidence in the financial reporting system and to protect shareholders from fraudulent financial reporting practices (Kuh, Matsumoto, 2008). Sox instituted a number of provisions including improving the format and function of audit committees, CEO and CFO financial statement certification, restrictions on non-audit related work by the company’s auditors, mandatory audit partner rotation and annual report on internal controls(Koh, Matsumoto, 2008). Since the passage of SOX, more lawyers and financial experts are members of corporate boards, which should assist in providing legitimate financial reporting. Also, the increased severity of civil and criminal penalties that convicted CEOs and CFOs have received should be a strong motivator in correcting past unethical behaviors.
History of the Problem: What Happened?
The obvious question is, of course, how did Enron transform itself from one of America’s paragons to one of its chief pariahs (Gini, 2004)? How can it be that Enron, the sixth largest energy corporation in the world, wind up being vilified in the press as running a “Ponzi-watts” scheme on its customers and stockholders? Clearly Enron’s conduct, as well as its fellow-traveler in crime, Arthur Anderson, wasn’t the result of a simple lack of ethical rules and legal guidelines and requirements (Gini, 2004). To the contrary. Next to the Hippocratic Oath, the accounting profession claims the second oldest code of ethical standards (Gini, 2004). The American Institute of Certified Public Accountants (AICPA) claims that its code of professional conduct applies to all CPAs in both public and private sectors.
One of the main issues in the lack of ethical behaviors shown by organizations, such as Enron, is the use of GAAP accounting practices, which provide for different interpretations of what is acceptable accounting practices which leaves the door wide open for CEOs and CFOs to create less than accurate financial reports. The driving motivation behind publishing false reports is the pressure and expectations to meet or beat Wall Streets projected earnings. A more clearly defined and acceptable set of accounting rules and regulations, with government over-site, would greatly reduce one’s ability to alter true financial results. By reducing, or eliminating the opportunity to cheat, the unethical behaviors will be changed. The end result will be wide sweeping changes in management and leadership behaviors due to the reduced opportunities to cheat in order to succeed.
John Dobson stated that ethical guidelines are viewed in the same way as legal or accounting rules: they are constraints to be, wherever possible, circumvented or just plain ignored in pursuit of self-interest, or in the pursuit of the misconceived interests of the organization (Gini, 2004). Alan Greenspan agrees, as he pointed out, “It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown enormously” (Gini, 2004).
Connected to the issue of greed, is of course, the game itself, the challenge if you will. Clearly, a large number of key players within Enron were willing to play the game to the furthest limits of logic and accountability. Why? Because they could, motivated by the loop holes that exist within the GAAP accounting protocols. An obvious question that needs to be asked is why? Why would someone making in excess of a million dollars a year risk his sinecure for more? “I think the answer is altogether very, very human, but, not altogether rational. It’s about the thrill of the game. The excitement of risk. The emotion and intellectual pleasure of the challenge. It’s about the need to win, no matter what the odds. It’s about the palpable rush of knowingly breaking the rules. It’s about narcissistic illusions of invincibility. It’s about feeling smugly superior to those who don’t take chances. And, every time you get away with one, it’s about the arrogant certainty of one’s infallibility” (Gini, 2004, P. 13).
Ethical Behavior Must Prevail:
Leaving aside market forces, bad products, and incompetent management, what makes most corporations falter, says Soloman, is a breakdown of ethical standards and the failure of trust(Gini, 2004). Trust and ethical standards are the very ground rules of business, and as such, key to business survival and success. In this equation of ethics and trust, the special role of leadership is critical. Leaders must be those willing to establish the critical agenda, exemplify the art of trusting, and inspire trust in others(Gini, 2004).
In order for the “accounting game” to stop being played, government must take away the motivation of unethical leaders to play the game. Currently, our accounting principles and guidelines, GAAP, allow for too many loop holes to be exploited by those with a win-at-all-cost mentality. The implementation of SOX has helped to slow the most obvious offenders of accounting fraud, however much more needs to be done to protect the interests of the employees, stockholders and stakeholders of organizations that rely on public money for their continued success. The very system used to provide financial results, is the same system used by organizational leaders to lie, cheat, and steal funds from the various stakeholders who support their organizations.
A government over-site committee is recommended and absolutely necessary to work closely with the AICPA to establish a new set of simplified accounting principles that all publically traded companies must adhere to when completing and submitting their financial statements. The cost of the research and implementation of this new set of accounting principles will be but a drop in the bucket compared to the excessive cost associated with accounting scandals such as Enron and the like. Increased government regulation must be present in order to change the gross behaviors that lead to the financial meltdown, which had absolute criminals running some of the largest organizations in the world. Leadership by example will change current behaviors, who better to be the great example of leadership than our government.
Gini, A. (2004). Business, ethics, and leadership in a post Enron era. Journal of Leadership & Organizational Studies, 1(1), 9-15.
Koh, K. Matsumoto, D.A., & Rajgopul, S. (2008). Meeting or Beating Analyst Expectations in the Post-Scandals World: Changes in Stock Market Rewards and Managerial Actions. Contemporary Accounting Research, 25(4), 1067-1098.
Zaitman, G. (1980). Implementing change: Alcoholism Policies in Work Organizations. Administration Science Quarterly, 25(1), 148-152.