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Accounting and Financial Reporting is a rather board topic being defined in many ways. This report will refer to accounting and financial reporting as the way companies record their business transactions and report that information to their investors through Financial Statements. The topics covered will demonstrate how laws affecting accounting and financial reporting play a key role society today and the ethics behind these decisions. With the recent changes being made to the accounting profession, it is important to understand the new laws being enacted with the Sarbanes-Oxley Act of 00, the new role of the SEC, and AICPA Rule 101 on independence. There are many ethical issues arising due to the behaviors of companies; especially in the way they display information to their investors and the rest of the public stakeholders.

GAAP Accounting Foundations

The main guidelines for accounting and financial reporting are contained in the GAAP Hierarchy. The SEC has allowed various private-sector organizations to come up with these accounting standards for the United States. The resulting standards make up the generally accepted accounting principles, or GAAP. GAAP is not a definite rule but rather it is a Hierarchy, which is made up of varying degrees of authority. The highest authority is FASB Statements and Interpretations, APB Opinions, and CAP Accounting Research Bulletins. The second group of authority is FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides, and AICPA Statements of Positions. The third grouping of authority is the Consensus Positions of EITF and AICPA Practice Bulletins. The lowest level of authority is AICPA Accounting Interpretations, FASB "Question and Answer" guides, and other widely recognized industry practices (Skousen, 16). These guidelines help structure how accounting and financial reporting should be preformed to ensure completeness and accuracy. Stakeholders must realize the importance of standards because they are "essential to the efficient functioning of the economy because investors, creditors, auditors, and others rely heavily on credible, transparent and comparable financial information" (www.fasb.org/news/nr0140.shtml).

Importance of Accurate Financial Statements

John M. Foster, a Financial Accounting Standards Board (FASB) member, explains the significance of neutral, high quality financial reporting. Investors and other stakeholders must believe the information found in financial statements is credible. It is evident that stakeholders believe "financial statements prepared under GAAP, are reliable, relevant, consistent, and comparable" (Foster). Ultimately, stakeholders must trust auditors to make sure that information is being properly presented.

Additionally, the numbers contained in financial statements must be useful and credible. To achieve this, the numbers must record all economic activities of a company and its subsidiaries, not just selective activities that make the company "look good". Credible financial statements are ones that do not omit information nor print a better picture of a company's activities. Having financial statements that stakeholders and investors alike can have faith in fuel our economy. To further ensure useful and credible information in the financial statements, FASB "[strives] to establish neutral accounting standards that provide a picture of a company's financial position and its results of operations in a way that is unbiased and as complete and faithful as possible" (Foster).

Sarbanes-Oxley Act

On July 0, President Bush signed into law the Sarbanes-Oxley Act of 00. The Act radically redesigns federal regulation of public company corporate governance and reporting obligations. It also significantly tightens accountability standards for directors and officers, auditors, securities analysts and legal counsel. The act has impacted the accounting community to a great extent. Specifically, Title III Corporate responsibility, Section 0 Corporate responsibility for financial reporting; and Title IV Enhanced Financial Disclosure, Section 404 Management Assessment of Internal Controls.

• Sec. 0. Financial Responsibility

Section 0 of the Sarbanes-Oxley Act of 00 covers the corporate responsibility for financial reports. It states that the CEO and CFO of each issuer shall prepare a statement to accompany the audit report to certify the appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in all material respects', the operations and financial condition of the issuer. This also includes responsibility of the signing officer over internal controls and any recent changes within the company. A violation of this section must be knowing and intentional to give rise to liability. Certifying officers will face penalties for false certification of $1,000,000 and/or up to 10 years' imprisonment for "knowing" violation and $5,000,000 and/or up to 0 years' imprisonment for "willing" violation (www.aicpa.org/info/sarbanes_oxley_summary.htm).

• Sec. 404. Management Assessment of Internal Controls

This section requires that each annual report has to contain an internal control which shall state the responsibilities of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. It also must contain an assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Each issuer's auditor has to attest to, and report on, the assessment made by the management of the issuer. An attestation made under this section has to be in accordance with the standards for attestation engagements issued of adopted by the Board (www.AICPA.org).

Accounting Scandals

Over the last few years, accounting scandals have become apart of our everyday lives. Since the collapse of utility giant Enron, a multitude of other accounting scandals and misstatements have come to light. Large firms such as Tyco, WorldCom, Xerox and Health South have all been charged with some sort of accounting violation. Most, if not all of these frauds have occurred because of unethical decisions made by some member of the upper level management. All of the frauds that have occurred recently have been scrutinized in detail by the media, but there was a fraud that occurred here in Ohio in the mid 10's that didn't receive nearly the attention.

Phar-Mor

Phar-Mor Incorporated was a discount retailer based in Youngstown, Ohio. The company revolved around a purchasing strategy known as power buying. This allowed Phar-Mor to purchase inventory at a great discount compared to competitors. For the first few years, Phar-Mor was extremely profitable, but that would soon change. The Phar-Mor fraud commenced at the desk of President and Chief Operating Officer, Mickey Monus. Monus was an entrepreneur and gambler by nature. He was focused on the rapid growth of Phar-Mor at any cost. He also had a special talent in persuading people to believe in him. Above Monus was the CEO, David Shapira. It's not entirely clear how much knowledge of the fraud Shapira had, but it is obvious that he did turn his head to critical evidence during the fraud. Other important player's included Patrick Finn (CFO), Stanley Cherelstein (Controller), and John Anderson (Accounting Manager).

The fraud began as a small cancer in a rapidly growing company. This cancer quickly metastasized into a 500 million dollar fraud in less than a decade. Phar-Mor's problems began with their corporate strategy to compete with the major player's in the deep discounting retail industry. Under Monus, Phar-Mor refused to be undersold on price, even if they were losing money. This desire to sell at the lowest price, regardless of profit explains how Phar-Mor had an operating loss in spite of tremendous sales revenue. When Patrick Finn was faced with this loss he immediately went to Monus. At this time, Monus was able to convince Finn that the only course of action to take was to change the loss into a profit, as that would give him the time he needed to correct the operating problems. Monus would go out to its vendors and demand exclusivity fees to help cover the losses. In the meantime, the fraudulent financial reporting was simple, change the internal financial reports to numbers that agreed with what people wanted to see. The weekly losses became profitable numbers and John Anderson would keep the real numbers in a subsidiary ledger. As long as Shapira was seeing good numbers in black ink, he let Monus run the operations. These losses compounded over time, and when Coopers and Lybrand came to audit, Phar-Mar was 1 million dollars short. Phar-Mor would continue to knowingly provide fraudulent financial data on a weekly basis, even as the fraud grew into the hundreds of millions of dollars.

Phar-Mar was not only providing fraudulent financial statements, but there was also gross misappropriation of assets. Monus was living an extravagant and lavish lifestyle on the deceitful success of Phar-Mor. He built a new wing on his house, financed community events, and took frequent trips to Las Vegas where executives would gamble away Phar-Mor money. He then started his own basketball league and embezzled over ten million dollars to keep it afloat. He continued to demand exclusivity fees from his vendors as well. Monus worked a five year exclusivity fee with Coca-Cola worth ten million dollars alone, the revenue was used to cover-up existing losses. Even with all the exclusivity fees, Phar-Mar was hemorrhaging too fast to stop.

The Phar-Mor fraud was spearheaded by one man, Mickey Monus, but there were also several key players who could have made strong ethical choices to stop the fraud. Mickey Monus perpetuated the fraud for one main reason, money. Monus' employment contract was incentive laden, so he had substantial interest in the performance of the company. The nature of his contract added extra pressure to misstate financials. Other executives like C.F.O. Pat Finn didn't have the same incentives in his contract as Monus. However, Finn along with other upper level managers was easily persuaded by the manipulative nature of Monus. Monus was able to manipulate the key players in the fraud to make them a victim of groupthink. Finn and the other managers knew what they were doing was wrong, but yet nobody stopped.

WorldCom

On June 6, 00 U.S. regulators charged WorldCom Inc. with fraud after MCI WorldCom admitted it hid almost $4 billion of costs. Two months after the initial charge, WorldCom revealed a further $. billion of improperly reported earnings. Reaching a total of nearly billion dollars concealed in expenses, and converted into false profits.

Adding fuel to the investigation is the fact that Arthur Anderson was WorldCom's auditor while the inappropriate accounting was taking place. Arthur Anderson has been found guilty of Obstruction of Justice charges in the governments' investigation of another infamous client, Enron. WorldCom switched auditors from Andersen to KPMG at which point the accounting irregularities were discovered.

The SEC said in its civil lawsuit that the scheme was directed and approved by WorldCom's senior management and allowed WorldCom to fraudulently report 001 cash flow of $. billion, rather than its actual loss of $66 million. Also, in the first quarter of 00, WorldCom incorrectly reported cash flow of $40 million, rather than a loss of about $557 million (http//www.securitiesfraudfyi.com/worldcom_fraud.html).

The SEC's investigation into the accounting fraud at WorldCom turned up several key players. The following is a list of high-ranking WorldCom executives and other employees who are involved in the accounting fraud

• Bernard Ebbers former CEO of WorldCom. Ebbers is suspected in the accounting fraud but no charges have been filed against him.

• Scott Sullivan former CFO of WorldCom. Sullivan was indicted on charges of securities fraud, conspiracy, and false statements to the SEC.

• David Myers former controller of WorldCom. Myers is charged with securities fraud, conspiracy, and false statements to the SEC.

• Buford Yates Jr. former director of general accounting. Yates pled guilty to charges of securities fraud and conspiracy.

• Betty Vinson former director of management reporting. Vinson pled guilty to charges of conspiracy to commit securities fraud.

• Troy Normand director of legal entity accounting. Normand pled guilty to securities fraud and conspiracy charges (www.worldcomstockfraud.com).

The WorldCom fraud may have been committed for a number of reasons which may have included The fact that top management did not want to loose the faith of stockholders; simply buying time with the hope of eventually turning a profit; and maybe mast importantly executives wanted to maintain jobs and bonuses.

Securities and Exchange Commission

The Securities and Exchanges Commission (SEC) is the governing body over all securities markets in the US. Its primary mission is "to protect investors and maintain the integrity of the market." (www.sec.gov/about/whatwedo.shtml) The commission oversees a wide variety of stakeholders in the securities markets including the markets themselves, investors, companies traded on the exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies. A board of 5 commissioners, 4 Divisions, and 18 offices make up the SEC. Many laws have been created to aid the SEC in their mission, but one simple concept prevails "All investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it." (www.sec.gov/about/whatwedo.shtml)

Numerous laws have been passed giving power to the SEC throughout the years. However, the three possibly most influential were separated by a span of seven decades. The first law requiring companies to disclose information to the public, the Securities Act of 1, was enabled in response to the stock market crash of 1. The law had two main purposes, the disclosure of financial and other significant information to the public regarding securities, as well as to prohibit deceit, misrepresentation and fraud in the sales of securities (www.sec.gov/about/laws.shtml). The creation of the SEC actually did not come about until the following year when the Securities Exchange Act of 14 was passed. The act gave the SEC the ability to regulate the all markets in the US, define prohibited conduct in regards to security dealings, and require financial reporting of all companies with publicly traded securities (www.sec.gov/about/laws.shtml). Insider trading laws stem directly from this act, as the commission was given the right to define restrictions that keep the market fair, unbiased, and equal. Recently, the Sarbanes-Oxley Act of 00 allowed the SEC to adopt rules that strengthen the integrity of securities traded on the market.

Quality appears to be the most important notion which the SEC basis their organization on. The SEC defines quality as "an encompassing term comprising utility, objectivity, and integrity." (www.sec.gov/about/dataqualityguide.htm) Furthermore, they define the three terms included in the definition as follows

• Utility - refers to the relative usefulness of the information to its intended users.

• Objectivity refers to the security of the Commissions information, i.e., protection of the information from unauthorized, unanticipated or unintentional access or revision, to ensure that the information is not compromised through corruption or falsification.

• Integrity - refers both to (i) presenting information in a proper context to set out that information in a clear, complete and unbiased manner; and (ii) ensuring that the substance of the information is accurate, reliable and unbiased.

www.sec.gov/about/dataqualityguide.htm

With the aid of useful, secure, and accurate information, the SEC attempts maintain fairness and equality in the market. However, when these three elements are compromised by unjust economical gain or criminal activity, the quality of the market diminishes and the SEC is not performing its main function.

A hot topic regarding ethics and security trading is insider trading. When people hear the term insider trading, automatically a negative connotation is applied. However, insider trading is not necessarily illegal. For example an employee of a company is allowed to trade the securities of his/her employer. In fact, it is a sign of good faith in the performance of a particular company when managers purchase the securities of their own firm. Yet, when a person acts upon nonpublic information they are breaking the law. "Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." (www.sec.gov/answers/insider.htm)

When presented with an opportunity to make guaranteed money, anyone with any sense of business will jump at it. Inside information is a gateway to guaranteed money, however it is illegal. Many assert that "money is the root of all evil," and there are those that will trade the chance of being caught for the chance to become rich. Many analyze Becker's Model of the utility from a crime

E[Uj] = pj Uj (Yj fj) + (1 pj) Uj (Yj)

where

E[Uj] = expected utility from the crime

pj = probability of conviction

fj = monetary equivalent of punishment from given offense

Yj = offenders income including monetary and "psychic"

Uj = individuals utility function

The first part is the probability of getting caught times the utility that will be received if caught. The second part is the probability of not getting caught times the utility from the income from the activity. If the expected utility is positive, then the individual would theoretically be willing to commit the crime (Beams 1).

Free money versus ethics comes into play in many situations. A simple suggestion by a friend or an associate to sell or purchase a security can suddenly make an individual a criminal. Drawing the line between a legal and illegal trade is difficult. Managers are allowed to trade the securities of their own firm and are often rewarded with stock options. Four reasons which motivate insider trading have been identified portfolio diversity, corporate control, sentimental reasons, and private information (Ma 68). Often when an employee is rewarded stock options for performance or as a part of a regular salary, he/she will choose to sell them to diversify his/her portfolio. Moreover, when decisions are made in a company by a vote of the shareholders, managers often will purchase stock in order to increase their voting power. Also, when working for a particular company, insiders will purchase stock based on faith in their employer, or sell when they depart. None of the previous mentioned reasons are illegal and some are in fact encouraged. However, when one acts on information not disclosed to the public, they are cheating the so-called "efficient market". In order for the securities market to be truly fair and unbiased, a governing body is needed. "To maintain the integrity of the market" (www.sec.gov/about/whatwedo.shtml) the SEC enforces laws against insider trading and other illegal activities that give advantages to one trader over the next. A security market not overseen by the SEC is like a country with no government, chaos would prevail.

Auditor Responsibilities and Independence

Unbiased, neutral, and credible information found on financial statements leads to the importance of auditors being independent of their clients. With the high level corporate scandals being exposed today, the issue of auditor independence has been brought to the forefront recently. The American Institute of Certified Public Accountants (AICPA) Rule 101 on Independence outlines the importance requirements for auditors to guarantee their independent is not impaired when working with various clients. According to AICPA Rule 101, an auditor becomes subject to independence requirements if he or she is a covered member. Auditors are covered members if they are

1. An individual on the client's attest engagement team

. An individual is in a position to influence the engagement

. A partner or manager provides more than ten hours of non-audit services to the client

4. A partner works in the office where the lead audit partner primarily practices

These factors make auditors covered members and therefore they may have no direct or material indirect financial interest in the client without impairing independence (www.aicpa.org/download/ethics/plainenglish.doc).

There are some requirements that apply to auditors whether they are covered members or not. The client cannot employ any firm employee without weakening independence. Also, no firm employee can service as a director, an officer, or trustee for the client without impairing the firm's independence with its client. Another requirement that applies to all firm employees is that they may not own more than 5% of the client's outstanding equity securities ("AICPA Rule 101"). The 5% rule includes the auditors the investments of their immediate family members or other people they undergo joint investments with.

The investments and other actions of immediate family members can impair auditor independence. Immediate family members consist of their spouse, or equivalent, and any dependents. The client can employ these family members, as long as they are not in a key position of influence ("AICPA Rule 101"). The family member would be in a key position of influence if they were responsible for significant accounting functions or work with preparing the financial statements. Also, immediate family members may invest in certain employee benefit plans provided the plan is offered equitably to all similar employees. The covered members whose families may invest in this way are

1. Partners and managers who provide only non-attest services to the client

. Partners who are covered members only because they practice in the same office where the client's lead attest partner practices in connection with the engagement ("AICPA Rule 101").

It is important that immediate family members are aware of these requirements to ensure that auditor independence is not impaired.

Recent Issues of Auditor Independence

Auditor independence has been brought to the forefront recently due to the new laws enacted. An example of auditor independence possibly being compromised can be seen through the relationship of Ernst and Young, Sprint PCS, and Sprint's CEO and President. E&Y was the auditor of Sprint and at the same time it was working on tax planning for Sprint's CEO William Esrey and President Roland LeMay. E&Y had been receiving "more non-audit fees than audit fees from Sprint for the last three years," as a result of these non-audit services (PR Newswire). E&Y did not do anything wrong by working for Sprint as well as its top executives. However, many stakeholders felt that these executives could easily influence E&Y during an audit. Since E&Y was receiving higher fees from their non-audit services, they could feel pressured or fear that questioning actions of Sprint could cause them to lose compensation from the tax services. Therefore, E&Y may have decreased its independence with regards to its handling of Sprint. Critics of Sprint include the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO), who voice the concerns of the Communications Workers of American and other unions representing Sprint employees. The AFL-CIO has "called publicly for Sprint to dump Ernst & Young" (Business Journal of Kansas City). In light of these critics, Sprint has decided to keep E&Y as its auditor since E&Y has not shown that its independence has been impaired through the various services it performs for Sprint and its top management.

Another well-known example of auditor independence truly being impaired is through the Enron scandal with its auditors Arthur Anderson. Anderson performed internal and external audit services for Enron as well as many other services. The independence issue arises out of the fact that Anderson received fees from total services in the amount of $5 million, which was made up of $7 million for non-audit services and $5 million for audit services (Indictment of Arthur Anderson). Since Anderson received more money for non-audit services Anderson's objective opinion with regards to its audit procedures could have been compromised and most likely were. If the firm went against Enron's management, it could lose over half its revenue for the client.

Since the independence issue is looked at more closely in the manner Anderson audited Enron financial statements. The three financial reporting issues at hand during this case were the consolidation of Special Purpose Entities, the adjustments previously not made to its 17 financial statements, and the reclassification of $1. billion of stockholders' equity (Indictment of Arthur Anderson). Anderson claimed that these issues arose because Enron withheld important information from them, but it is important to make sure that Anderson should not have been more aggressive in its audit procedures.

The way Anderson dealt with this situation once the SEC started its investigation proves that Anderson's independence was impaired because the firm was aware of the problems with Enron financial statements. Instead of preserving documentation to assist Enron and the SEC, "Anderson employees on the Enron engagement team were instructed by Anderson partners and others to destroy immediately documentation relating to Enron, and [were] told to work overtime if necessary to accomplish the destruction" (Indictment of Arthur Anderson). These actions prove that Anderson knowingly withheld information from the SEC and were directly involved in the unethical actions of Enron.

In the end, Anderson ultimately collapsed due to other clients and stakeholders losing confidence in the firm's services. The public's reaction to this situation shows how once trust is lost in a company's accounting and financial reporting the system ultimately fails. Stakeholders no longer feel confident in what the company stands for and will not support it. This situation exemplifies how important accurate and proper financial reporting is to the success of any company.

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