Page 702 - Accounting Principles (A Business Perspective)

This book is licensed under a Creative Commons Attribution 3.0 License

proper identification of other risks. The quality of earnings will continue to be of paramount importance. There
have been too many situations where companies have had to restate their earnings for prior years because they did
not properly disclose material facts or properly implement the revenue recognition and/or expense recognition

principles that were covered in Chapter 5.

An accounting perspective:

Business insight

The Enron situation was the focus of a massive investigation that led to significant changes in
corporate governance, accounting rules, and auditing procedures. Enron was formed in 1985 and
became a major player in the energy industry. Its stock reached a high of about USD 90 per share
in August 2000. Top executives began selling stock shortly thereafter, while at least for a short
period during the ensuing fall in the stock's price, employees were prevented from doing so. In
October of 2001, the disclosure of off-balance sheet partnerships, with attendant liabilities for

Enron, resulted in a USD 1.2 billion write-off in stockholder's equity. In November of 2001, Enron
revealed that it had overstated earnings by USD 586 million since 1997. In December 2001, Enron
filed for bankruptcy. Enron stock became almost worthless, selling for under USD 1. Employees of
Enron not only lost their jobs, but many also lost their retirement savings because they consisted
largely of Enron stock. Individual and pension fund investors as a group lost billions of dollars. The
state of Florida's pension fund lost about USD 340 million. Enron's external auditor, Arthur
Andersen & Co., was accused of shredding documents pertaining to Enron after the US Justice
Department confirmed its investigation and was indicated in March of 2002 for that action. (For
more information about the Enron situation see, for instance: U.S. News & World Report, March

18 2002, pp, 26-36)

External auditors, internal auditors, audit committee members, and members of Boards of Directors are likely to
ask much tougher questions of management. They are also more likely to investigate questionable transactions.
Audit committees may be required to publicly disclose their activities that were performed to carry out their duties.
Management's letter to the stockholders contained in the annual report, and usually signed by the CEO, contains
the views of management regarding current operations, operating results, and plans for the future. This letter is
likely to become even more important in the future than it is now. There could be financial penalties if this letter is
purposely misleading in that its contents are not supported by the financial statements or they misrepresent

significant facts. To the extent these letters are more conservative rather than being unrealistic, individuals
analyzing financial statements will be able to rely on their content to a greater extent in the future. The Sarbanes-
Oxley Act of 2002 in the US sets more stringent standards for financial reporting for public companies and their
managers. Boards, and independent auditors, along with strict penalties for non-compliance.
Financial statement analysis is going to have increasing importance. There will be more focus on the cash flow
statement, covered in Chapter 16, and its "cash flow from operating activities", since this amount is considered by
some to be "cash earnings". Some consider this amount to be less susceptible to manipulation than is net income.

Accounting Principles: A Business Perspective 703 A Global Text