HSC Business Studies Revision Notes.
Topic 2: Financial Planning and Management.
Some questionable corporate practices
"The good, the bad and the ugly"
Introduction
Ethical and socially responsible financial management requires managers
to act in good faith and to behave in a morally correct manner in their
financial dealings and records. Without such management, firms and
shareholder’s investments are at risk. Unethical financial management has
recently been exposed in the USA and Australia in a number of large
corporations including Enron, Merck, World.com and Xerox; the HIH
Insurance Group and One-Tel. A number of these large companies have
now collapsed, taking a large number of small businesses and employees
with them.
Andersen and Associates, a respected 90 year old accounting business
that audited the financial records of several of these corporations, was
also exposed for unethical financial practices. This giant business, which
had revenue in 2000–2001 of $9.3 billion, disintegrated and was
swallowed up by other firms. Anderson’s audit clients deserted it when it
was revealed that Anderson employees had shredded documents relevant
to the audit of Enron, a giant US energy company that went bankrupt in
2002.
Overview
What are the types of unethical behaviour in which firms engage?
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There are often inaccuracies and distortions in audited accounts,
and they may not be in accordance with Australian Accounting
Standards. Key information may be omitted or hidden, such as bad
debts, expected losses, or additional liabilities. Operating leases or
pre-purchase agreements may not be included and are sometimes
left “off balance sheet”. Inappropriate cut-off periods may be
used to avoid publication of poor results.
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“Earnings management” may be used to increase or decrease
current period income in order to achieve long-term goals for
earnings. This may be achieved by changing accounting details
through use of different accounting methods, or by changing
estimates or policies that determine earnings. Businesses may
choose to write off big costs during downturns or during
restructurings, often called a “big bath” situation. This strategy
creates greater opportunities for managers thereafter to maintain
consistent and upward growth in earnings. Managers may reduce
reported income by over providing for future liabilities (creating
“slush funds”) for a “rainy day” when profits are expected to fall,
or to avoid excessive government scrutiny or new wage demands.
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Expenses may be inappropriately classified as capital expenditure.
For example,
WorldCom sought bankruptcy protection in 2002 after disclosing
that it had improperly accounted for US$3.8 billion (A$7.1 billion)
in expenses. Investigators later found an additional US$3.3 billion
(A$6.2 billion) in additional accounting irregularities stretching
back to 1999.
In the case of Worldcom, operating expenses should have been
deducted immediately from revenue. Instead, they were spread
over a long period of time, as is appropriate for capital expenses,
and this inflated WorldCom’s reported profits.

Expenses may be shifted to later periods with specific accounting
methods, for example, by holding off paying suppliers to delay
recognising expenses and to increase profits.

Funds may be misused.
In the case of HIH insurance it was the wrong corporate culture.
There was little sense of a separation between private and public
money, and pet employees were treated lavishly. Rita Young, Ray
Williams’ (CEO) secretary, was paid $105 000, just before the
collapse of the business. She ran up a corporate AMEX bill of $102
000, which included charges for three overseas trips. She was paid
an additional $63 000 to fly down to work each week from the Gold
Coast and stay at the luxurious Hotel Intercontinental.
Sydney Morning Herald, August 10–11 2002

Top executives are over compensated or have access to benefits
not available to other employees.
One of the most blatant examples comes from America.
Papers filed yesterday in the divorce of Jack Welch, former CEO of
General Electric, state that GE covered enormous living costs for Welch
and his wife while he led the company. The extent of these benefits has
never been disclosed by the company, although Mrs. Welch says that her
husband gave her support from company funds of US$35 000, which she
accepted under protest.
During his tenure as CEO Welch had free use of a New York City
apartment valued at US$15.2 million, courtside seats at professional
basketball games, satellite TV at his four homes and all costs associated
with the city apartment, such as food, wine and newspapers.
Sydney Morning Herald Weekend Edition September 7–8 2002
Key tips for spotting unethical practices in larger firms include:
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frequent changes are made to accounting policies
reported earnings are consistently higher than operating cash
flows
an audit report is qualified by terms such as “except”, or a report
that contains negative opinions
the firm uses an audit firm which is not one of the well-known
firms
the auditor resigns
strategies are used to beat accounting rules such as operating
leases (off-balance sheet) and sale of receivables (with recourse)
often shown as cash, without indicating a balancing liability on the
balance sheet
Best practice involves:
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preparation of regular financial reports, particularly if revision is
required due to changing circumstances. Listed companies may soon
be required by the Australian Stock Exchange to comment on
rumours that are reasonably specific and credible
disclosure of all relevant information
compliance with Australian Accounting Standards
Firms with ethical practices develop a positive reputation; confident
investors are attracted and rewarded with a higher share price.
Employees are also more likely to be motivated when working for an
ethical company, and there is less temptation for fraud or theft.
Who is responsible for ensuring that the financial planning and
management strategies are ethical and legally compliant?
The Board of Directors is responsible for the supervision of management
and the safeguarding of shareholders’ interests.
An auditor is responsible for expressing an opinion on the fairness of
financial statements in relation to generally accepted accounting
standards.
Revision
1. Using information available to you and the syllabus, explain four
major limitations of financial reports.
2. Describe the possible reasons why firms may be tempted to
“smooth” or adjust their records.
Tip: Consider the impact on managers who are paid performance
bonuses, shareholders’ perceptions, share prices, governments
offering subsidies, or trade unions monitoring a firm’s profitability.
3. If a business was able to reduce both its total assets and liabilities
by keeping a major item off the balance sheet, such as a finance
lease, how might this affect its profitability and its gearing ratios.
Draw up a balance sheet and show how it might look. Now have
some more fun. Substitute a higher value for intangibles such as
the value of goodwill or your brand. How does this affect the
ratios? (This is a popular earnings management strategy so there
must be some benefits!)
4. In the past, famous, or infamous “corporate raiders” such as Alan
Bond, bought businesses whose assets were undervalued, sold off
the assets and made a tidy profit. Assets are often undervalued
(unless adjusted) as they are recorded in the balance sheet at
their historic cost (i.e. what they cost to buy at the time). Which
assets would be of greatest interest to such businessmen?
5. Scan the front section and the business section of your favourite
metropolitan daily newspaper for a week or a fortnight.
Unfortunately, articles of this nature have become increasingly
common in recent years. Summarise the main ideas as in the
example below. You are likely to find your notes useful in
assessment tasks and examination situations.