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Accounting scandals

Accounting and corporate governance scandals have been a growing problem in the recent years. Many believe that the blame for those scandals should be borne on two groups of people. Those responsible for managing a company and those whose duty is to provide assurance on the accounts prepared by the directors (auditors), both of whom failed to perform their jobs adequately. Our report aims to seek how true this general opinion is. We shall examine examples of such scandals, explaining the matter of those scandals, similarities/differences between them as well as reasons for and consequences arising from them.

So what are the accounting/corporate scandals? Wikipedia (2010) outlines accounting/corporate scandals as “political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations. Such misdeeds typically involve complex methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of corporate assets or underreporting the existence of liabilities, sometimes with the cooperation of officials in other corporations or affiliates.

“ BPP in its ACCA F8 Study text (2012) states the meaning of fraudulent financial reporting, which in fact leads to corporate scandals as activity that “involves intentional misstatements, including omissions of amounts or disclosures in

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financial statements, to deceive financial statement users. This may include:

* Manipulation, falsification or alteration of accounting records/supporting documents

* Misrepresentation (or omission) of events or transactions in the financial statements * Intentional misapplication of accounting principles

Such fraud may be carried out by overriding controls that would otherwise appear to be operating effectively… Management fraud is harder to detect because management is in a position to manipulate accounting records or override control procedures. ” Below we take a closer look at high profile examples of corporate scandals that played some role in forming corporate governance landscape. We will analyse the scandals of Tyco (US) and Anglo Irish Bank (IE)- companies from opposite sides of Atlantic, operating in jurisdictions using different models of regulation (principles vs. rules-based).

We cannot talk about the corporate scandals without first explaining the concept of corporate governance, as poor corporate governance often gives grounds to those scandals. The first part of our report focuses therefore on illustrating what corporate governance is all about, what system of corporate governance was in each country at the time of the scandals and what changes were introduced as a response to those scandals. The important role of an audit in relation to corporate governance will also be highlighted.

Second part of our report will give detailed description of the scandals, outline the corporate governance weaknesses found and discuss the consequences of the scandals on the shareholders, potential investors and the public in general. The conclusion section of this report will talk about the main reasons behind Tyco’s and AIB scandals, differences/similarities between them. It will also include our opinion on whether the steps taken afterwards will deter similar events happening in the future.

CORPORATE GOVERNANCE

“Corporate governance is the system by which companies are directed and controlled. Good corporate governance is important because the owners of a company and the people who manage the company are not always the same. As it is the directors that manage the company, the burden of good corporate governance falls on them. ” (ACCA Paper F8,p. 35) There are various codes of corporate governance across the globe with those most influential including OECD Principles of Corporate Governance, UK Combined Code and US Corporate Governance.

For the purpose of this report we are most concerned with the two latter ones as they directly influence the jurisdictions we are analysing.

CORPORATE GOVERNANCE IN IRELAND

Influences on Irish Corporate Governance SOX EU Recommendations Common Law Companies Act Irish GAAPs UK Combined Code Corporate Governance in Ireland IFRs OECD EU Directives ISAs Direct influences Indirect influences Corporate Governance System in Ireland at the time of Anglo’s Scandal From all factors influencing corporate governance in Ireland, the UK Combined Code is the most significant.

“As in other countries, the development of corporate governance in the UK was initially driven by corporate collapses and financial scandals. The UK’s Combined Code (1998) embodied the findings of trilogy of codes: the Cadbury Report (1992), the Greenbury Report (1995) and the Hampel Report (1998). ” The Combined Code was reviewed in 2005 and 2007 resulting in small number of changes. (Mallin 2010) The UK Code sets out standards of good practice regarding board leadership and effectiveness, accountability (including audit), remuneration and relations with shareholders.

(ACCA F8 2014) The Code contains broad principles and more specific provisions. Listed companies have to report how they have applied the principles, and either confirm that they have applied the provisions or if they have not, to provide an explanation (comply or explain concept). “Corporate governance codes address a wide range of structural and behaviour elements including board accountability, shareholder rights (e. g. the one-share-one-vote-one-dividend principle), financial disclosure and internal controls, executive remuneration and board structure and functioning. ” (Maier 2005, p. 5)

* Every company should be headed by board of directors, which is collectively responsible for the long-term success of the firm.

* There should be a clear division of responsibility at the head of a company between the chairman and the chief executive.

* The Code requires ‘an appropriate combination’ of executive and non-executive directors on the board and recommends that at least half the board should comprise non-executive directors (to ensure objective judgement).

* The chairman and non-executive directors meet the same independence criteria i.e. neither of them should be a former chief executive of the same company.

* The board should be a subject to evaluation reviews.

* It is recommended that sub-committees of the board are set-up to deal with sensitive areas (audit committee, nomination committee, and remuneration committee).

* Need for business to maintain good systems of internal control to manage the risks the company faces (internal audit). (ACCA F8 2012)

It will be interesting to discover if Anglo Irish Bank complied with the principles of the Combined Code at the time leading up to the scandal.

RESPONSE FROM REGULATORS TO THE MOST RECENT SCANDALS IN BANKING SECTOR

“Financial crisis in 2008 and 2009 prompted the Financial Reporting Council to undertake an extensive review in 2009 and a revised code, the UK Corporate Governance Code, was published in May 2010 (subsequently updated in September 2012). This code incorporates recommendations made by Sir David Walker in a report on his review of the governance of banks and other financial institutions. ” (ACCA F8 2012, p. 36) Since 2010 Irish listed companies must adhere to the updated UK Corporate Governance Code and also comply with the additional requirements in the ISE’s Irish Corporate Governance Annex. For financial services companies, the compliance requirement is even more onerous with the publication of the Central Bank’s Corporate Governance Code for Credit Institutions and Insurance Undertakings. Grant Thornton (2011) describes the significant changes introduced in the new code. Those include the introduction of annual rotation for directors, and a requirement to take into account the diversity and gender balance on the board as well as the creation of a new Stewardship Code to regulate the conduct of institutional investors.

The Irish Annex focuses on the quality of the disclosures, emphasising the need for meaningful disclosures and explanations and calls for companies to “move away from the practice of recycling descriptions that replicate the wording of the 2010 code or Irish Annex provisions. ” It also requires some significant additional disclosures in relation to the rationale for board composition, the board appointments process, board evaluation, the work of the audit committee, and remuneration policy.

In relation to financial institutions The Central Bank’s Code added a number of new innovations particularly the introduction of specific quantitative limits, such as a maximum number of boards a director can serve on, and minimum numbers of boards meeting. The compliance with the Central Bank Code is not on a ‘comply or explain’ basis. It is mandatory for all credit institutions and insurance undertakings to act as per scope of the code. Therefore breach of any requirement in the code could result in a criminal prosecution.

US CORPORATE GOVERNANCE at a time of Tyco scandal “Like the UK and Ireland, the USA has a well-developed market with a diverse shareholder base including institutional investors, financial institutions, and individuals. It also has many of the agency problems associated with the separation of corporate ownership from corporate control. The US is somewhat unusual in not having had a definitive corporate governance code in the same way that many other countries do. Rather there have been various state and federal developments over a number of years. “(ACCA F8 2012, p. 43)

At the time of Tyco scandal “corporate governance in the US was comprised of multifaceted legal and institutional mechanisms designed to safeguard the interest of corporate shareholders”. The United States had several layers of corporate governance regulations. Edwards (2003) recognises three lines of defence in U. S. Corporate governance mechanism. “A first line of defence is our basic legal structure consisting largely of state-based corporate law and federal securities laws…Corporate law is a second line of defence which attempts to better align the interests of managers and directors with those of shareholders by imposing various obligations on manages and directors and then penalising them if they fail to meet those obligations. A third governance mechanism is executive compensation increasingly tied to the company’s stock performance by granting managers either stock options or restricted stock. ” There are two fundamental models of regulation (principles and rules-based) in any field where regulation is necessary. U. S. takes the “rules-based” approach to accounting (US GAAP, GAAS) and corporate governance.

There are several advantages and disadvantages of this model. Detailed rules remove the scope for judgment and therefore the risk of manipulation. A rule can be quickly issued in an accounting abuse or loophole becomes apparent. Changing principles has deep implications as it can affect the interpretation of several matters. On the other hand it is virtually impossible to develop a set of rules comprehensive enough to cover every eventuality. It is often possible to distort reality while still complying with the letter of the rules.

It is likely that creative individuals will devise way to avoid rules by literal interpretation (aggressive accounting practices) and that is exactly what happened in case of Tyco International. RESPONSE FROM THE REGULATORS -SARBANES-OXLEY ACT 2002 There have been a number of significant corporate scandals in early 2000s that resulted in subsequent failure of companies such as Tyco International, WorldCom and Enron. These resulted in the Public Company Accounting Reform and Investor Protection Act (Sarbanes Oxley) in the US to try and prevent further corporate fraud.

(Foundations in accounting 2011) Changes embodied in the Sarbanes-Oxley Act included: * Requirement for CEOs and CFOs to certify that quarterly and annual reports are fully compliant with applicable securities laws and present a fair picture of the financial situation of the company. * Listed companies must have an audit committee comprised only of independent member and at least one of them must be ‘audit committee financial expert’. * Establishment of new regulatory body- the Public Company Accounting Oversight Board (PCAOB)- with which all auditors of US listed firms have to register, including non-US audit firms.

* SEC issued separate rules that encompass the prohibition of some non-audit services to audit clients (e. g. book-keeping, financial information system design and implementation, internal audit), mandatory rotation of audit partners and auditors’ reports on the effectiveness of internal controls. * The auditor is required to report to the audit committee various information including all critical accounting policies and practices, and alternative accounting treatments. (Mallin 2010)

AUDIT

“Many of the requirements in relation to corporate governance necessitate communication between the directors and the shareholders. ” (ACCA Paper F8 2012, p. 8) Financial statements produced by directors is an example of such communication. But how will the shareholder know whether information included in those statements is accurate and represents a fair picture of company’s financial situation? One way of dealing with this problem is seeking assurance from a practitioner. “Assurance services include a range of assignments, from external audits to review engagements. ” (ACCA Paper F8 2012, p. 10)

Assurance services may be provided by an independent outsider who provide an opinion on financial information (external auditors) or by people employed as part of an organisation’s system of controls (internal auditors).

EXTERNAL AUDIT

The annual accounts of most limited liability companies are required to be audited by law, but some small companies are exempt. The need for an external audit in the case of companies arises primarily from the existence of separation of ownership from control.

ISA 200 states that, in conducting an audit of financial statements, the overall objectives are: “To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respect, in accordance with an applicable financial reporting framework; and to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings. ” (ACCA Paper F8, p. 105)

For the external audit function to be effective, it must be independent of management. Auditors must report to shareholders, not to company management. This can be difficult when management negotiate the audit and other fees paid to the auditors. There are a number of perceived threats to external audits, in particular those that affect auditor independence. These include:

* Non-audit fees

* Lengthy relationships with auditors

* Large fee income (and consequent dependency) from a single client

* Relationship between auditor and client

* Non-audit services (Brennan, 2003)

The organisation and structure of the auditing profession vary from country to country. However, there is a clear movement towards harmonisation of both auditing and accounting standards throughout the world. INTERNAL AUDIT “Internal audit assists management in achieving the entity’s corporate objectives, particularly in establishing good corporate governance. ” (ACCA Paper F8, p. 83) Internal audit can form a part of organisation’s system of controls.

It is not required by the law; therefore a company has the right to decide whether or not to establish internal audit function. It is not regulated in the same way as statutory external auditing. The scope nature of internal audit’s work is more likely to be set by company policy than by any external guidelines. Internal audit is an appraisal or monitoring activity including examining, evaluating and reporting to management and directors on the adequacy and effectiveness of the accounting and internal control system. There are some limitations of the internal audit function, e. g.

* Internal auditors are employed by the organisation and this may influence their independence and objectivity as well as the ability to report fraud/error because of perceived threats to their continued employment within the company.

* Internal auditors are not required to be professionally qualified and so there may be limitations in their knowledge and technical expertise. (Foundation in Accountancy 2011)

The two scandals described in this report illustrate how important it is for companies and their shareholders that auditing and other assurance engagements are carried out effectively. Read also about sources of accounting standards

INTRODUCTION TO ANGLO IRISH BANK

Anglo Irish Bank was set up in 1963, its headquarters were in Dublin. It was one of Ireland’s smallest banks until 1978 when it was acquired by the City of Dublin Bank. In 1986, Sean Fitzpatrick was appointed the Chief Executive Officer. In 1988 Anglo saw a 54% growth in profits and following this, the corporation started to expand its business to the US, Austria as well as taking over other banks such as Royal Trust Bank, Smurfit Paribas Bank and the Credit Lyonnais Bank of Austria.

In 2004 Sean Fitzpatrick took on the role of Chairman after eighteen years as CEO, David Drumm was appointed CEO. (Wikipedia, 2011) A series of scandals began to unravel from 2008 onwards. The main areas of controversy are Loans to Directors, Mainland Ventures, EMPG Loans and Loans to Sean Quinn & the Quinn Group When these scandals came out, Anglo share price dropped dramatically. The Irish Government made a decision to bail out the bank, at this stage the true state of the bank was unknown.

Anglo Irish Bank was nationalised in 2009 as the Irish government decided that recapitalisation would not be enough to save the bank. In 2011, Anglo Irish merged with the Irish Nationwide Building Society, with the new company being named the Irish Bank Resolution Corporation. Michael Noonan, the Minister for Finance stated that the name change was important in order to remove “the negative international references associated with the appalling failings of both institutions and their previous managements. ” (The Department of Finance, 2011) The Scandals

There are three main parts of this scandal we are going to discuss, firstly; the personal loans to Sean Fitzpatrick (lack of disclosure, misstatement) secondly; the moving, depositing and withdrawing of funds involving Anglo Irish Bank and Irish Life and Permanent (misstatement). Thirdly; the golden circle which involved ten wealthy business men coming together to buy shares in Anglo (apparent breach of company law in relation to dealing in own shares). Loans to Sean Fitzpatrick It all started in 2000, when Sean Fitzpatrick the chairman of Anglo Irish Bank took loans from the bank and then covered them up.

At the year end when Anglo Irish financial statements were about to be published, Sean Fitzpatrick would take out a loan from Irish nationwide Building Society to remove loans from the balance sheet in Anglo Irish, the loans were repaid just before the year end and then re-borrowed immediately after the year end . This loan situation continued for eight years where finally it had grown to a size that was unable to be covered up. This was first noticed in 2008, by financial regulators who were inspecting Nationwide Building Society loan books (not the auditors).

They came across loans to Sean Fitzpatrick amounting to €87 million; these loans were repaid and then repeated themselves. When this news was reported, Sean Fitzpatrick admitted his fraudulent activities and resigned as chairman of Anglo Irish in December 2008. Following this more member of the Board resigned, the total amount of directors loans reported was €179m. (For the year end September 2008, the reported net income before tax was €784m, Materiality €179m / €784m = 22. 8%, this is deemed to be material as greater than 5%) Resignations included: David Dumm – CEO

Lar Bradshaw – Non executive director Willie McAteer – finance director and chief risk officer Michael Walsh – Chairman of Nationwide Building Society The share price of Anglo dropped from €17 to €0. 12. Anglo subsequently ceased trading, in 2009 Irish Government Nationalised the Anglo Irish Corporation. Irish Life and Permanent Depositing Funds Irish Life and Permanent had been depositing funds of approximately €7 billion into Anglo Irish Bank, these funds were borrowed from Anglo Irish and deposited back to Anglo Irish in the last few days leading up to the banks financial year end.

This was to boost the deposit balance in the balance sheet of Anglo Irish Bank to gain support of the investors. These deposits were classified as customer deposits. Days after the financial year end, Irish Life and Permanent withdrew the funds which they had deposited. “Anglo Irish Bank was artificially building up its deposits to give a false picture of its financial health, that would be very, very serious. ” (Financial Times, 2009) “The controversial deposits were included in Anglo’s accounts as “customer deposits”, serving to boost its end-of-year deposit base by 7. 8pc to €51. 5bn when, in fact, its lodgements were down.” (Finfacts, 2009)

The reason for this was to boost the deposit balance in the balance sheet of Anglo Irish in order to gain support and confidence of the investors, deposits were classified as a corporate and commercial deposit rather than an inter-bank loan. When the auditors, Ernest and Young took a “snap shot” of the finances for the annual report in December 2008. The customer deposit base looked healthy and expanding, all talk of a run on the bank.

“The actual fact was that the bank had lost €4 billion in deposits during the international credit crisis during the month of September. Excluding the €7 billion from ILP, Anglo Irish’s loss of deposits could actually have been €11 billion during September 2008. Anglo Irish effectively presented its own deposit base as larger and more stable than it was and used these enhanced figures during a “road show” to the U. S. Seeking new institutional investors.

(Blogspot. avid Drumm, CEO of Anglo Irish stated “the continued strong performance of our customer deposit business reflects consistently competitive rates, transparent products and a strong service ethos – a combination that results in high retention levels” (The Telegraph, 2009), knowing exactly the situation that a large percentage of these deposits would be reverted in the following days.. The intention of Anglo Irish Bank was to cook the books and manipulate the investors this can now be clearly seen.

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