Financial shenanigans

Financial shenanigans are, according to H. Schilit, “action(s) that intentionally distort a company’s reported financial performance and financial condition,” (CFA Institute, 2002) and can range from the harmless to outright fraudulent misstatements. These tricks of the trade can cause confusion and, consequently, a loss of confidence among the investing public, but there are some that have serious implications for the investing public, the economy in general, and government-regulators. The case of Enron is one such case wherein accounting shenanigans were utilized to siphon off profits for executives and hide losses.

Analysts were unable to figure the actual business model utilized by the company which helped pull off the accounting fraud, but by the time Enron’s books were scrutinized, the company had grown to be among the largest firms in the United States. As the accounting scandal unfolded, Arthur Anderson, auditing firm of Enron, took a fall right along with it, and so did $60 billion of the investing public’s money (C. B. Thomas, 2002). As a response to the collapse of Enron and the string of accounting scandals occurring in the corporate world, the Sarbanes-Oxley Act of 2002 was introduced and signed into law on July 30, 2002.

The intent of the law is to set more stringent requirements to screen out rogue corporations and help mitigate the occurrence of accounting shenanigans. A significant feature of the Sarbanes-Oxley Act is a provision for off-balance sheet transactions. The Securities and Exchange Act of 1934 has been amended to include the requirement that issuers are obligated to disclose off-balance sheet transactions, arrangements, obligations, and other relationships with unconsolidated entities or other persons that can materially affect the financial or operational condition of the issuer.

This section 401 of the Sarbanes-Oxley act shall mean that the issuer must report on 1) obligations under certain guarantee contracts, 2) retained or contingent interest in assets transferred to an unconsolidated entity, 3) obligations under certain derivative instruments, and 4) obligations under any material variable interest in an unconsolidated entity. An example of guarantee contracts are take-or-pay arrangements in the power industry, wherein excess power generation severely impacts the cost of power and tends to bloat operational expenses either to the detriment of consumers or investors, or both.

The second relates to assets such as a pool of receivables wherein the issuer retains some interest which declines over time. The third requirement is for derivative instruments with material effects that are not transparent for analysts. Lastly, the fourth reportorial requirement relates specifically to issuers that have ownership, contractual, or pecuniary interest in an unconsolidated entity, wherein such interest constitutes the possible partial absorption of losses the unconsolidated entity may incur (SEC, 2003).

Section 401 is an important feature in the law as public companies are forced to supply would-be investors and analysts supplemental information that can help shed light on financial statements and, consequently, the actual financial condition of the reporting firm. A main concern, however, as shared by Marc Siegel of CFRA, is that companies’ behaviors remain unchanged even with the introduction of the Sarbanes-Oxley Act (Bloomberg, 2005).

Public, and even some private corporations, are restating their financial statements to comply with the requirements, while some are benign changes, there are some spectacular restatements in financial results like that of General Motors. Analysts believe that reporting companies are more transparent with the new laws, but Siegel emphasized that issuers are using non-accounting metrics to justify or camouflage financial performance (Bloomberg, 2005).

Now it seems that companies are taking a new approach by significantly increasing the amount of information available to the public through the use of non-accounting metrics, over which the issuer has considerably more control and is currently outside the scope of legislation. Question: How can the public cut across the flood of information, particularly of non-accounting metrics, to see the true financial performance of the issuer, knowing that such metrics can either provide amazing insight or grand deception on the future of the company?

References:

1. Schilit, H. (2002). Financial shenanigans. CFA Program Curriculum: economics and Financial Statement Analysis, II, 723-735. 2. Thomas/Dallas, C. B. (2002, June 18). Called to account. Time. Retrieved October 29, 2006 from: http://www. time. com/time/business/article/0,8599,263006,00. html 3. Bloomberg (November 10, 2005). [Interview with Marc Siegel, Research Director, Center for Financial Research and Analysis]. Are Investors Safer with Sarbanes-Oxley?.

Retrieved October 29, 2006 from: https://www. cfraonline. com/CFRA/newsupdate/11-11-2005_Bloomberg_MarcSiegel. wmv 4. Securities and Exchange Commission (2003). Discussion of amendments. Final Rule: Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations. Retrieved October 29, 2006 from: http://www. sarbanes-oxley. com/section. php? level=2&pub_id=SEC-Rules&chap_id=SEC4