W1 L1 Accounting and Corporate failure
1. Appreciate the role accounting can play in corporate failures corporate collapse or failure
Accounting and Corporate Collapse
-Large corporations collapsed, costing investors huge sums of money to repay, ever since
commercial corporations came into existence
-In many cases accounting disclosure (or lack thereof) has been cited as the causes of the collapse
unlikely that accounting failure has ever singularly caused an otherwise healthy business to collapse
-Accounting can be used to mislead.
E.g. accounts can be manipulated to mislead investors and others as to the health of the business in
the years prior to the ultimate business failure
How can this happen?
-Accounting requires judgement to be used
e.g. estimating depreciation, bad debts
1. Judgements may simply be incorrect (e.g. forward estimates of prices), or events may happen that
could not have been accounted for (e.g. markets can change rapidly)
2. Or, this allows scope for manipulation to occur, and when accounts are used to make decisions
(e.g. invest in a company, work for a company), decision-makers can be misled
2. Understand some particular accounting practices/decisions that are often associated with
corporate collapse
1. Accounting for investments in subsidiaries
Three possible accounting treatments:
1. Consolidated Accounting
Essentially aggregates the accounts of the parent and subsidiary companies after eliminating internal
balances and transactions
2. Equity Accounting
The acquiring company records the investment as an asset whose value increases when the investee
makes a profit and decreases when dividends are remitted
3. Cost Method
The investment is recorded at cost and not adjusted until sold
Judgement
'Control' and 'Significantly influence'
-if I own 60% of shares then I CONTROL a business
Accounting standards provide some guidance
-e.g. can the investor company 'dictate the operating and financing decisions of the investee'?
BUT this assessment is usually a judgement, it can be subjective
,So What?
Consolidated and Equity Accounting should yield the same group profit
BUT: Consolidated Balance Sheet will include all of the subsidiary’s asset and liabilities
(fewer inter-company balances)
Equity Balance Sheet include only parent's proportionate interest in the net assets of the
investee
(cost adjusted by subsequent profit an dividends)
If Cost Method used, subsequent debt raised by the investee will not be recorded in any way in the
books of the investor
The choice of these methods affects almost all ratios of performance and position (which are
commonly used by investors, analysts, banks to make decisions)
What did Enron do?
1. used Special Purpose Entities (SPEs) to account for many of its subsidiaries/investments
(in order to avoid disclosing their true liabilities)
2. utilized over 500 SPEs to conduct many of their ‘acquisitions’ of interests in other businesses
Enron argued it did not control these SPEs, and they were accounted for using the Cost Method
But was this an appropriate accounting treatment?
Enron’s SPEs
97% held by Enron (financial capital)
3% held by ‘independent’ third parties, who would be assigned ‘controlling voting interest’ in the
SPE
→ Because Enron did not hold these voting rights, it claimed it did not control or significantly
influence the SPEs
→ Because it claimed it did not control or significantly influence the SPEs Enron accounted for them
using the cost method (i.e. the net initial cost of its contribution to the SPEs owners equity)
Were these SPEs really independent?
In many instances, the independent 3rd parties were Enron employees acting under the direction of
senior Enron managers (allegedly)
Øused the SPEs to borrow money to finance further acquisitions / investments
Øguaranteed the debt of the SPEs
But , subsequent borrowings by the SPE did not affect Enron's disclosed level of debt
Enron’s investment continued to be accounted for at cost, and it was effectively shielded from the
future transactions of its investees
Why did Enron not have to consolidate SPEs?
• Because control did not technically exist
• The majority of voting rights in the SPEs were held by individuals (usually Enron employees but
below the level at which they would be deemed an officer of the company)
• To some extent Enron’s use of SPEs was legal (and approved by the SEC), but even in these
cases the financial information published by Enron was capable of misleading a reasonable
and competent investor
• In many cases the 3% independent equity requirement was (subsequently) deemed not to
have been met
Intra-Group Transactions
• In many cases of surprise corporate collapses, the failure to consolidate has meant that many
transactions with related parties have been treated as arms-length transactions
– E.g. combinations of loans, guarantees and equity holdings across corporations
• These have the potential to greatly distort the riskiness of an equity investment in such firms
,2. Capitalization decisions
Firms spend money all the time (CR Cash)
The nature of the accounts we debit depends on the nature of what we spent the money on:
1. Did we pay for benefits which we expect to receive in the future over which we have control?
Asset
2. Did we simply pay for benefits that we have already consumed? Expense
WorldCom
One of the biggest telecommunications companies in the US, collapsed in 2002.
Spent $ on rental costs to lease local phone lines
ØShould have been expensed in current-year
ØInstead, was capitalized into an asset (by attracting customers today they would get their business
in the future)
Was able to hide $US 3.85 billion in expenses
3. Under provisioning
• Provisions are funds set aside for probable future obligations (i.e. a future liability)
– Example: Allowance for doubtful debts might be 5% of all sales
• The amount of provisions is estimated, but are unknowable (as they relate to future events)
• Judgement is required to determine the size of a provision.
• Deliberately under-stating a provision allows liabilities to be decreased, effectively
strengthening a balance sheet
HIH
Was Australia's second largest insurance company.
Was placed into provisional liquidation on 15 March 2001.
– Failure to provide adequately for future claims (under-provisioning), resulting in the
understatement of liabilities
– The estimated HIH's under-provision totaled up to $4.44 billion
4. Valuation
• Placing a dollar figure on a company’s assets and liabilities
• A key piece of information for acquisitions and mergers
• Valuation of companies often incorporates intangible assets (such as goodwill) which are
extremely hard to value, particularly on an on-going basis
• Valuing intangibles requires judgement
ABC Learning
Australian company of childcare centers
pursued an aggressive expansion strategy prior to collapsing in 2008.
ABC Learning expanded through many acquisitions of different independent child care centers.
It chose to capitalize large intangibles from each of these acquisitions, including treating ‘goodwill’
and ‘childcare licenses’ as assets, and failed to fairly write them down over time.
This inflated its financial position and masked its cash flow problems.
, 3. Consider the role of the auditing profession in corporate collapses, and the broader regulatory
implications
Auditors play a role in improving the confidence external users have on financial accounts.
They are meant to assess if judgements have been made fairly.
However, auditors were implicated in each of these corporate collapses... (and three of these were
audited by the same firm, Arthur Anderson)
Arthur Andersen
• Engaged Enron as a client since 1986.
• Enron’s transactions, based on Arthur Andersen’s risk assessment, were risky; however,
Andersen’s audit procedures and audit opinions did not reflect consideration of this risk.
• Some auditors were aware of, and actively engaged in, setting up the SPEs.
• Andersen provided Enron (and HIH) with external and internal auditing, as well as consulting
services.
Advisory services and auditors
Arthur Andersen provided an increasing amount of consulting (i.e. advisory) services to Enron,
WorldCom and HIH, as well as being their auditors.
This presents a conflict of interest:
Implications for Profession
• Some behavior of the auditors may have been legal (or not provable to be illegal)
BUT most reasonable people would find it unethical
• Why unethical?
– The auditors are alleged to have knowingly signed-off on
reports that they knew to be misleading in their substance
• One factor affecting the likelihood of unethical behavior is
the dependence of audit firms on the business of big clients
(particularly via non-audit services)
• The permissible nature of, and disclosure requirements
regarding non-audit services are the subject of regulatory response in both Australia and the
USA
1. Appreciate the role accounting can play in corporate failures corporate collapse or failure
Accounting and Corporate Collapse
-Large corporations collapsed, costing investors huge sums of money to repay, ever since
commercial corporations came into existence
-In many cases accounting disclosure (or lack thereof) has been cited as the causes of the collapse
unlikely that accounting failure has ever singularly caused an otherwise healthy business to collapse
-Accounting can be used to mislead.
E.g. accounts can be manipulated to mislead investors and others as to the health of the business in
the years prior to the ultimate business failure
How can this happen?
-Accounting requires judgement to be used
e.g. estimating depreciation, bad debts
1. Judgements may simply be incorrect (e.g. forward estimates of prices), or events may happen that
could not have been accounted for (e.g. markets can change rapidly)
2. Or, this allows scope for manipulation to occur, and when accounts are used to make decisions
(e.g. invest in a company, work for a company), decision-makers can be misled
2. Understand some particular accounting practices/decisions that are often associated with
corporate collapse
1. Accounting for investments in subsidiaries
Three possible accounting treatments:
1. Consolidated Accounting
Essentially aggregates the accounts of the parent and subsidiary companies after eliminating internal
balances and transactions
2. Equity Accounting
The acquiring company records the investment as an asset whose value increases when the investee
makes a profit and decreases when dividends are remitted
3. Cost Method
The investment is recorded at cost and not adjusted until sold
Judgement
'Control' and 'Significantly influence'
-if I own 60% of shares then I CONTROL a business
Accounting standards provide some guidance
-e.g. can the investor company 'dictate the operating and financing decisions of the investee'?
BUT this assessment is usually a judgement, it can be subjective
,So What?
Consolidated and Equity Accounting should yield the same group profit
BUT: Consolidated Balance Sheet will include all of the subsidiary’s asset and liabilities
(fewer inter-company balances)
Equity Balance Sheet include only parent's proportionate interest in the net assets of the
investee
(cost adjusted by subsequent profit an dividends)
If Cost Method used, subsequent debt raised by the investee will not be recorded in any way in the
books of the investor
The choice of these methods affects almost all ratios of performance and position (which are
commonly used by investors, analysts, banks to make decisions)
What did Enron do?
1. used Special Purpose Entities (SPEs) to account for many of its subsidiaries/investments
(in order to avoid disclosing their true liabilities)
2. utilized over 500 SPEs to conduct many of their ‘acquisitions’ of interests in other businesses
Enron argued it did not control these SPEs, and they were accounted for using the Cost Method
But was this an appropriate accounting treatment?
Enron’s SPEs
97% held by Enron (financial capital)
3% held by ‘independent’ third parties, who would be assigned ‘controlling voting interest’ in the
SPE
→ Because Enron did not hold these voting rights, it claimed it did not control or significantly
influence the SPEs
→ Because it claimed it did not control or significantly influence the SPEs Enron accounted for them
using the cost method (i.e. the net initial cost of its contribution to the SPEs owners equity)
Were these SPEs really independent?
In many instances, the independent 3rd parties were Enron employees acting under the direction of
senior Enron managers (allegedly)
Øused the SPEs to borrow money to finance further acquisitions / investments
Øguaranteed the debt of the SPEs
But , subsequent borrowings by the SPE did not affect Enron's disclosed level of debt
Enron’s investment continued to be accounted for at cost, and it was effectively shielded from the
future transactions of its investees
Why did Enron not have to consolidate SPEs?
• Because control did not technically exist
• The majority of voting rights in the SPEs were held by individuals (usually Enron employees but
below the level at which they would be deemed an officer of the company)
• To some extent Enron’s use of SPEs was legal (and approved by the SEC), but even in these
cases the financial information published by Enron was capable of misleading a reasonable
and competent investor
• In many cases the 3% independent equity requirement was (subsequently) deemed not to
have been met
Intra-Group Transactions
• In many cases of surprise corporate collapses, the failure to consolidate has meant that many
transactions with related parties have been treated as arms-length transactions
– E.g. combinations of loans, guarantees and equity holdings across corporations
• These have the potential to greatly distort the riskiness of an equity investment in such firms
,2. Capitalization decisions
Firms spend money all the time (CR Cash)
The nature of the accounts we debit depends on the nature of what we spent the money on:
1. Did we pay for benefits which we expect to receive in the future over which we have control?
Asset
2. Did we simply pay for benefits that we have already consumed? Expense
WorldCom
One of the biggest telecommunications companies in the US, collapsed in 2002.
Spent $ on rental costs to lease local phone lines
ØShould have been expensed in current-year
ØInstead, was capitalized into an asset (by attracting customers today they would get their business
in the future)
Was able to hide $US 3.85 billion in expenses
3. Under provisioning
• Provisions are funds set aside for probable future obligations (i.e. a future liability)
– Example: Allowance for doubtful debts might be 5% of all sales
• The amount of provisions is estimated, but are unknowable (as they relate to future events)
• Judgement is required to determine the size of a provision.
• Deliberately under-stating a provision allows liabilities to be decreased, effectively
strengthening a balance sheet
HIH
Was Australia's second largest insurance company.
Was placed into provisional liquidation on 15 March 2001.
– Failure to provide adequately for future claims (under-provisioning), resulting in the
understatement of liabilities
– The estimated HIH's under-provision totaled up to $4.44 billion
4. Valuation
• Placing a dollar figure on a company’s assets and liabilities
• A key piece of information for acquisitions and mergers
• Valuation of companies often incorporates intangible assets (such as goodwill) which are
extremely hard to value, particularly on an on-going basis
• Valuing intangibles requires judgement
ABC Learning
Australian company of childcare centers
pursued an aggressive expansion strategy prior to collapsing in 2008.
ABC Learning expanded through many acquisitions of different independent child care centers.
It chose to capitalize large intangibles from each of these acquisitions, including treating ‘goodwill’
and ‘childcare licenses’ as assets, and failed to fairly write them down over time.
This inflated its financial position and masked its cash flow problems.
, 3. Consider the role of the auditing profession in corporate collapses, and the broader regulatory
implications
Auditors play a role in improving the confidence external users have on financial accounts.
They are meant to assess if judgements have been made fairly.
However, auditors were implicated in each of these corporate collapses... (and three of these were
audited by the same firm, Arthur Anderson)
Arthur Andersen
• Engaged Enron as a client since 1986.
• Enron’s transactions, based on Arthur Andersen’s risk assessment, were risky; however,
Andersen’s audit procedures and audit opinions did not reflect consideration of this risk.
• Some auditors were aware of, and actively engaged in, setting up the SPEs.
• Andersen provided Enron (and HIH) with external and internal auditing, as well as consulting
services.
Advisory services and auditors
Arthur Andersen provided an increasing amount of consulting (i.e. advisory) services to Enron,
WorldCom and HIH, as well as being their auditors.
This presents a conflict of interest:
Implications for Profession
• Some behavior of the auditors may have been legal (or not provable to be illegal)
BUT most reasonable people would find it unethical
• Why unethical?
– The auditors are alleged to have knowingly signed-off on
reports that they knew to be misleading in their substance
• One factor affecting the likelihood of unethical behavior is
the dependence of audit firms on the business of big clients
(particularly via non-audit services)
• The permissible nature of, and disclosure requirements
regarding non-audit services are the subject of regulatory response in both Australia and the
USA
