Comments on Financial Statement Scandal

The so-called "financial statement scandal" involving Enron, the 7th biggest company in the U.S., not only represented an enormous loss to its investors, but also resulted in the disintegration of Arthur Andersen, one of the world's top 5 accounting firms. The scandal had a serious impact on the securities market as well as the accounting system, and for a while the market was inundated with books and articles on how to analyze financial statements, uncover financial statement frauds, or see through accounting tricks. As these articles contained detailed discussions relating to means of "window dressing" financial statements, this issue will not be discussed here. Instead, the author will provide a few comments concerning the so-called "accounting scandal" from the point of view of a practicing accountant and auditor.

Comment 1: The Real Cause of Financial Statement Scandals is Human Greed

Since the first Accounting Research Bulletin (ARB) was published in 1939, financial accounting standards have guided the profession for over 60 years.  Since then there have been substantial advancements in human technology and culture, but there has been no structural change to accounting theories and principles. For this reason, some people have queried and even doubted the value of traditional financial reporting. The answer is still very much in the affirmative; financial statements are still the most objective and reliable source of information in evaluating financial circumstances, operating results, and changes in financial status of a business. However, we must also admit that financial reports generated on the basis of prevailing accounting principles have the following limitations:

1. Financial statements present information in units of currency, and are not able to directly disclose information about intangible assets and management quality of a company;
2. Evaluations based on historical cost do not accurately reflect current values of a business (net value≠share price);
3. Financial statements contain only historical information, while users of financial statements (especially investors) are more interested in the future of the business;
4. Restrictions on accounting estimates and judgments may affect the quality and comparability of financial statements;
5. Giving businesses the choice of accounting methods under general accounting principles may enable those preparing the statement to manipulate "book" assets, liabilities, profits and losses, and thereby twist the truthfulness of the statements.

However, for the most part, adopting other measures, such as increasing disclosures in notes to the financial statements, or providing other supporting information of value can overcome the above limitations. Furthermore, due to the following recent additions and revisions to accounting principles, the accounting profession and system have fully kept up with financial trends and innovations. The series of international accounting scandals was not created overnight, nor caused by the aforementioned limitations of financial statements. It was caused by human greed. Therefore accounting is not useless, and the proper exercise of its functions depends on whether persons involved in financial reporting possess proper concepts of accounting.

Comment 2: Accounting is a Science, not Magic!  It Should not be Too Creative!

The objectives of preparing financial statements is to "truthfully" report the financial circumstances, operations and results, and changes in financial circumstances of a business, so that users of such information may rely on them in making investments, loans, and other economic decisions. Investors can also use them as a reference in evaluating the responsibilities and performance of management of the business in utilizing resources.  In order to achieve the above objectives, the preparations of financial statements not only contain the basic assumptions of accountability and continuous operations, they should also possess the qualities of: (1) comprehensibility; (2) relevance; (3) reliability; and (4) comparability. In terms of reliability, those preparing financial statements should not merely strive for compliance in form during any certain accounting period, but should always remember and abide by these principles: faithful and accurate presentation of information, substance over form, care in judgment, integrity of information. For example, in recognizing assets of acquisition goodwill and deferred income tax, businesses should not merely comply in form to Taiwan's Financial Accounting Standard 25 ("FAS 25") concerning "Accounting Policies for Business Mergers & Acquisitions" and FAS 22 concerning "Accounting Standards for Income Tax"). Instead, businesses should refer to the true meaning of an asset - "a resource controlled by the business, which is created from a past transaction, and is expected to result in inflow of future economic benefits". Members of the accounting profession must also remember that Time is the strictest, as well as cruelest, test of accounting judgment.

Comment 3: Accountability for False Financial Statements Lies in the Group of Related Parties, and Not in Accounting Principles

If after the test of time certain financial statements are proven to be false and inaccurate (and not due to changes in economic circumstances), the innocent financial statements users (who may be investors or creditors) are the biggest victims.  Who should be held accountable for substantive losses of these innocent parties as a result of untruthful financial statements?  The parties responsible should be the following, and not the accounting principles themselves:

1. Management of the business (including directors): those preparing the financial statements should be held primarily responsible;
2. Company supervisors and external accountants:  they must pay the price for failing to fulfill their duties of due care and good faith (but should not be dragged down because of their position if they are innocent of fraud)
3. Competent authorities:  may incur public blame for failure of adequate supervision.
4. Accounting principles should not become the scapegoat.

Comment 4: Should Profits be "Managed"?  Financial Statements Should be Truthful, Not Manipulated

"Faithful representation" is a global and unchallengeable standard in preparation of financial statements. Where operating results of a business fluctuate as a result of economic cycles or special circumstances, it should be truthfully reported in the financial statements.  Profits must not, and should not be "managed" or even "manipulated" because of: (1) attempts to achieve certain budgetary targets; (2) evasion of tax liabilities; (3) compliance with terms of bank loans; (4) attempts to raise funds; or (5) any other reason, such as bonuses for management.

Although the generally applicable accounting principles permit businesses to adopt different accounting methods, the purpose of such freedom is not to permit businesses to manage their profitability.  Instead, it is to enable a business to choose the most appropriate accounting method for its nature of business, so that its financial statements will more accurately represent its financial circumstances, operating results, and changes in financial circumstances.  Therefore, the adoption of an accounting method should be: (1) made in advance; (2) applied consistently; (3) be objective and consistent with economic facts; (4) be comparable with the general industry trend.

Comment 5: Accountants are the Last Line of Defense for Truthfulness of Financial Statements

The reason financial statements of a business are required to be audited by an external accountant is that by having objective professionals examine the statements, the credibility of financial statements can be enhanced.  Where there is financial statement fraud, the accountant and business will typically begin pointing fingers at each other. A certain major accounting firm in Taiwan recently published a solemn and extremely visible statement in the financial newspapers, dissociating itself from its client XX Technology Company that was accused of raising funds illegally. It appears that the general public is still not clear about the role of an accountant, which is to audit financial statements, rather than to "manipulate the accounts".  After the Enron scandal and a series of financial statement frauds in the U.S., on July 30, 2002 the U.S. President Bush signed an "Enterprise Reform Bill" proposed by Senator Paul Sarbanes and Congressman Michael G. Oxley. A certain part of the bill is dedicated to enhancing the independence of accountants: (1) an accountant may not provide its audit client with audit and other non-audit services at the same time; (2) a person may not be the engagement partner (or concurring partner) of a listed client for more than 5 years, but there must be instead regular rotations; (3) the auditor of a listed company may not join the management team of any of his/her audit clients within 1 year of leaving the accounting firm (the so-called "revolving door" provision; and (4) accountants must provide a review opinion concerning management's evaluation of the company's internal control systems.

The Taiwan Securities & Futures Commission has also been actively engaged in amending the Accountant Law and other relevant laws and regulations, in cooperation with the "Taskforce for Promoting a Sound Business Accounting System" created following EDAC last year. The direction of these reforms is also to reinforce the independence and capabilities of accountants, so that accountants may enhance their positive function: providing assurance as to the accuracy and truthfulness of financial statements.

Accountants are also confronted with changes in the economic environment, but the greatest impact on the profession does not come from reduction in the number of clients due to independent requirements, because an economic society will also need objectively certified financial statements. Instead, the greatest challenge comes from realizing the role that accountants play in the economy: they are the last line of defense in ensuring the truthfulness and accuracy of financial statements.

Comment 6: It is Difficult to Assess an Auditor's Competence in Auditing Financial Statements Within a Short Time; Accountants Must Have a Conscience

Accounting firms are professional, profit-seeking business organizations.  However, although they are not charitable associations, from certain perspectives they are still businesses that require following one's conscience:

1. Unless there has been some problem related to a company's financial statements, it is difficult to assess the auditor's competence within a short period of time;
2. An auditor of financial statements differs from other professionals, such as architects, doctors or lawyers, whose clients are very much aware of the processes and outcomes of services provided. Users of financial statements almost always see only the standard form audit opinion issued by an accountant, and the public is not completely aware of the auditing process;
3. Article 20 of Taiwan's Company Law provides that the board of directors of a company shall appoint an auditor of financial statements. Article 228 of the same Law also requires the board of directors to prepare financial statements.  Since the board is at the same time the preparer of the statements, as well as the appointer of auditors, it is easy for the board to compromise the two roles. In the U.S., the audit committee of the board of directors appoints the company auditors. The Taiwan Company Law does not yet have the mechanism of an audit committee. It may be more appropriate for the auditors to be appointed by the supervisor examining the company's financial statements, or by the shareholders' meeting which ultimately approves the financial statements.

The responsibility of preparing a company's financial statements lies in the company's management. If there are no problems arising from a company's financial statements, there is then relatively lower risk for its accountant. Also, it is also difficult to assess the auditor's competence within a short period of time. However, the accounting profession is one that provides services based on "trust", and only by maintaining a good "reputation" will the financial statements it certifies possess the necessary credibility.  Therefore, an accountant must give due care to each and every financial statement he/she audits, so that the good reputation built up over a lifetime is not destroyed by a certain case overnight.

Comment 7: Price Competition is Inevitable for Auditors:  Specialization is the Trend

Although the legislative trend for enhancing independence of accountants will pose certain restrictions on an accountant's provision of consulting services to businesses, nonetheless audit services are for the most part quite standardized, with very limited differentiation from one auditor to another. In these circumstances the fees chargeable by an accountant also are confronted with price competition.  It then becomes a great challenge for an accounting firm to ensure its business survival as well as audit quality.

1. Under the precondition of complying with independence requirements, an accounting firm's best strategy is to develop valuable management consulting services.  However, audit work is the foundation of an accounting firm, and the firm must avoid having audit work become the stepping-stone to getting management consulting contracts.
2. An accountant must not only possess auditing skills, but also other specialized skills relating to specific industries and management.  If accountants are unable of providing more valuable services, the accounting profession will soon lose its own value, and it will be difficult to attract talented people to the profession. Even accounting education will be faced with serious challenges.

Comment 8: Honesty & Integrity are an Accountant's Biggest Assets; It is the Accountant's Responsibility to Choose Law-Abiding Clients

The problems described above are ones confronting accountants both in Taiwan and overseas, after years of development, and they await the members of the profession and general public to provide structural solutions.  However, as the last line of defense to truthful financial reporting, accountants must possess certain professional guidelines and ethics that are beyond challenge and are followed from the heart, irrespective of changes in the law or environment:

1. The accountant's truthful examination of financial statements is not only a professional obligation, but also a responsibility to the general public.
2. Honesty and integrity are characteristics expected of an accountant by the general public, as well as professional ethics that an accountant may not ignore.
3. Price competition cannot ever be used as an excuse for an accountant's lowering of audit quality and disregard of independence requirements.
4. What should and can a doctor say when a patient dies during medical treatment?  Although a business failure is not equivalent to an audit failure, it is also one of an accountant's responsibilities to choose only clients that are honest and law-abiding.