Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
Complex Accounting and Auditing Issues and Auditor
Responsibility
Stacey Mirinaviciene
Historical lessons of “creating accounting” applying complicated accounting principles to achieve
desired results in misrepresenting real business condition must be discussed and researched for
the future benefit. The author is focusing on the financial statement fraud risk assessment where
complex transactions are present, and the importance of auditor competence, judgment and due
diligence.
This paper is an attempt to analyze complex accounting issues as it applies to financial
instruments, specifically repurchasing agreements and collateralized debt obligations and the
associated ethical considerations. Accounting for repurchasing agreements has been widely
discussed, especially after Lehman Brothers bankruptcy (see Ong & Yeung, 2011; Dunne,
Fleming, &Zholos, 2011; Tuckman, 2010; Martin, Skeie, &Von Thadden, 2010; Gorton & Metrick,
2011; Fleming, Hrung, & Keane, 2010; Chircop, Kiosse, & Peasnell, 2012; Jones & Presley,
2013; Jeffers, 2011; Chang, Duke, &Hsieh, 2011; Hines, Kruze, & Langsam, 2011). Most of the
authors discussed technicalities of the subject matter, but not so much on the subject of auditor
and management accountant’s ethical concerns. This study is an attempt to fill that gap. The
research in this article is conducted using a literature-based approach, incorporating case
studies and accounting rules analysis. The author collected available peer reviewed articles on
grey areas in accounting and the banking industry’s use of loopholes from the period of 2010 2014. Two of the most interesting financing instruments and their accounting treatment were
selected for this paper: repurchasing transactions and collateralized debt obligations. The study
discusses ethical considerations of the use of accounting instruments to “window dress” financial
statements. The study concluded, that the application of integrity, due diligence, quality control,
and professional knowledge by accounting professionals may be a solution to a lot of corporate
problems. It is most likely impossible to predict all ways “creative accounting” can be used, but it
is possible to prevent or minimize its negative impact on the economy with a help of ethical and
knowledgeable auditors.
The study also proposed topic for the future research.
Field of Research: Accounting
Key words: Repo 105, CDOs, SEC, FASB, AICPA, GAAP, PCAOB
Introduction
The numerous financial fraud cases in 2001 -2003 and global financial crisis of 2007-2009
facilitated discoveries of grey areas in financial presentation of accounting data. The failure
of European and American companies, such as Parmalat, Enron, WorldCom, and later
Lehman Brothers, followed by the financial distress of AIG and other companies lead to
academic debates about the soundness of accounting rules and auditor’s ethics. The
creative abuse of loopholes in US GAAP (Generally Accepted Accounting Principles) as it
relates to the banking industry revealed the lack of effective internal and external controls,
unproductive corporate governance, and ineffective financial reporting.
__________________________________________________________
Stacey Mirinaviciene MBA,CPA, Keuka College, Vilnius University, LT, 141 Central Ave, Keuka Park, NY
14478, smirinav@yahoo.com
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
This study has several objectives. First, the author seeks to analyze a number of
accounting problems associated with banking and capital markets. Second, the author
seeks to discuss auditor responsibility in detecting “grey areas” and “red flags” in financial
reporting. “Grey areas” in accounting are also called “creating accounting”, which means
that financial statement presentation may not accurately portray actual business situation.
“Red flags” in accounting are the areas representing significant risk factors effecting
financial reporting. And third, the author seeks to suggest future research on the subject
matter.
The research in this article is conducted using a literature-based approach,
incorporating case studies and accounting rules analysis. The author collected available
peer reviewed articles on grey areas in accounting and the banking industry’s use of
loopholes from the period of 2010 -2014. Two of the most interesting financing instruments
and their accounting treatment were selected for this paper: repurchasing transactions and
collateralized debt obligations. The study discusses ethical considerations of the use of
accounting instruments to “window dress” financial statements.
Background
This study analyzed two financial instruments used in banking industry: repurchasing
agreements and collateralized debt obligations.
Repurchasing agreements
Accounting for repurchasing agreements was originally addressed by ESP FADS
140-3, Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions (ASC 860-10-05-21A. These pronouncements become effective after
November 15, 2008. FASB addresses the accounting for a transaction that has the
following fact pattern: Party A transfers financial asset to party B, who pays cash for the
asset to party A. The same time party B enters in a repurchase agreement with party A.
Under this agreement party A lends cash to party B, and party B transfers financial asset as
collateral for the loan to party A (Weiss, 2011). The transactions can be accounted
separately if all of the following criteria are met: 1) the initial transfer and the repurchase
agreement do not contractually depend on each other, 2) the initial transferor has full
recourse to the transferee on default, 3) there is a quoted price in an active market for the
previously transferred financial asset and a repurchase agreement, and 4) the repurchase
agreement must be settled before the financial asset maturity date. If these criteria are not
met, transactions are accounted as linked. The next step is to evaluate if these transactions
meet the definition of sale. If transactions do not meet criteria of sale, financial assets
should remain on the balance sheet of the initial lender and both parties will recognize a
forward contract (Weiss, 2011). As one can see, this pronouncement is quite complicated
and can be easily manipulated. The technicality behind this agreement is that very liquid
financial assets are placed as collateral for short term loan. The accounting of this
agreement does not create off balance sheet transactions. Both the asset and a liability
remain on the books of the borrower and leverage ratios are not affected. Is this the “grey”?
It wouldn’t hurt if you added another statement defining your use of grey, if that’s the case.
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
Repurchasing agreements were common tools used by the large banks to improve
leverage ratios by removing current liabilities at the end of reporting periods. Repo markets
were used by Bank of America Corp., Deutsche Bank AG, Citigroup and others (Chang,
Duke, & Hsieh, 2011). The disclosure of the significant Repo 105 transactions was not a
specific requirement.
The failure of Lehman Brothers firm lead to discovery of an accounting manipulation
which attracted attention of many specialists’. However, Repo 105 transactions created a
different effect. The cash secured from collateralized borrowings was used to retire other
liabilities. This combination of sale and retirement of assets reduced total assets, liabilities,
and leverage ratios (Hines, Kreuze, & Langsam, 2011). In the case of Lehman Brothers
failure, the technical requirements of SFAS No.140 were met: 1) the transaction was a true
sale at law (SFAS No.140.9a), the transferee had an ability to pledge or exchange
transferred assets (SFAS No. 140.9b), and the transferor was considered to relinquish
control of the securities transferred (SFAS No. 140.9c) (Examiner’s Report, 2010, Appendix
17, p.4). The first requirement, to prove a true sale was obtained using the opinion of a
London law firm. While US law does not allow attorney opinions to prove sale, under
English law it was a legal process. The third requirement, securing a confirmation of
borrowings were at least 5% lower than market value of assets relinquished, was attained.
The creative use of Repo 105 to improve the balance sheet and financial ratios at the end
of the reporting periods created a misrepresentative picture of the financial health of
Lehman Brothers. Is this the red flag?
After Lehman Brothers manipulation was discovered, FASB amended FSP FAS
140-3- Accounting for Transfers of Financial Assets and Repurchase Financing
Transactions by issuing FASB ASU 2011-3. According to new requirements to account for
a transfer of the assets as a sale, requirements to be met include: 1) the transferred assets
have been isolated from the transferor, 2) each transferee has the right to pledge or
exchange the assets it received, and 3) the transferee does not maintain effective controls
over transferred assets. The new regulation (ASU 2011-03) also increased disclosure
requirements (Jeffers, 2011). The rule-based standards existing in US GAAP allows CFOs
and accountants to use technicalities in some cases to achieve unethical results, without
disclosure or punitive results. The “substance over form” principle frequently seems to be
ignored (Chang, Duke, & Hsieh, 2011). While most researchers agree that the financial
failures of Lehman Brothers is not a responsibility of inadequate GAAP rules, the
opportunity for creative window dressing of financial statements, including a creative use of
international law differences ( in this case difference between English law and US law) is a
bit disturbing. It is most likely impossible to predict all the ways creative accounting can be
used, but it is possible to prevent or minimize its negative impact on the economy with the
help of ethical and knowledgeable auditors. According to the GAAS and AICPA code of
conduct, auditors are required to follow ten standards. General standards of conduct,
require adequate technical training, proficiency, an independent mental attitude, and
exercise due diligence. Standards of fieldwork require adequately supervising assistants,
understanding the entity and its environment, and obtaining adequate evidence (Jones &
Presley, 2013). Standards of reporting require auditors to state in their reports when
financial statements are in accordance with GAAP, to identify inconsistencies, inadequate
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
information and to express an opinion. In Lehman Brothers instance, the highly qualified
auditors, Ernst & Young, had conducted audits for at least three years prior to the discovery
of the problem. These auditors did have sufficient information, including the report of the
employee about his concerns, pointing on problematic use of Repo 105 (Jones & Presley,
2013). All years auditors did not find any deficiencies in Lehman Brothers financial
statements. The rules were followed, but what about ethics?
Collateralized debt obligations
Another accounting disclosure and information communication problem was
associated with Collateralized Debt Obligations (CDOs). Collateralized Debt Obligations
(SDOs) was an investment tool which failed due to insufficient disclosure to investors about
the composition of these investments. CDOs are investment securities created by pooling
similar credit instruments, such as mortgage backed securities, loans, bonds, asset backed
securities, and more. Risk and interest of these instruments depends on the structure of
collateral. The main problem here is that investors did not necessary know what they
invested in, because sponsor can change structure of this instrument at any time without
notifying them. The pricing of these instruments is complex and frequently estimated
(Michello & Deme, 2012). Bear Sterns, Citigroup, Meryl Lynch, Wachovia, and Morgan
Stanley were selling and promoting CDOs, including equity trenches as stabile
investments. Public pension funds, such as General Retirement System of Detroit, the
Teachers Retirement System of Texas, and Missouri State Employees’ Retirement System
invested millions in these risky instruments (Michello & Deme, 2012). Most of these
investors relied on rating agencies, and did not perform enough due diligence in gathering
information on CDOs. Collateralized Debt Obligations (SDOs) were sold in a short sale
markets initiated by banks without sufficient disclosure to investors. Pricing models of these
instruments were complex, did not factor in sufficient information about risks involved, and
did not disclose its composition to investors. Miscommunication of pricing and risk of these
instruments was affecting not only rating agencies, but underwriting departments of issuing
banks. Apparently financial institutions either did not have enough technical knowledge, did
not perform due diligence, or simply ignored the emerging problem. Some researchers
argued that wide spread securitization of mortgage payments into complex investments,
specifically CDOs, insufficient communication to investors played one of most important
roles in triggering 2008 financial crisis(Michello & Deme, 2012). Insufficient disclosures and
inadequate transparency of financial information as 2008-2009 events proved facilitated
increased financial losses and deepened financial crisis.
The table below illustrates Security and Exchange Commission (SEC) enforcement actions
through September 11, 2104
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
Concealed From Investors Risks, Terms and Improper Pricing in CDOs
Other Complex Structured Products
Key Statistics 2011-2014 (compiled from WWW.sec.gov)
Date
Company
2011 Citigrop
2010-2012 Goldman Sachs
Settlement
$285 million
$550 million
2011 JP Morgan
Securities
$153.6 million
2013 Merril Lynch
$131.8 million
2012 Mizuho Securities
USA
$127.5 million
2011 WachoviaCapital
Markets
$11 million
2012 Wells Fargo
$6.5 million
2013 UBS Securities
$50 million
Violation
Misleading disclosure of
CDOs tied to housing
market
Misleading disclosure of
synthetic CDOs tied to
subprime mortgages
Misleading disclosure of
synthetic CDOs tied to
subprime mortgages
Misleading disclosure of
CDOs tied to subprime
mortgages
Misleading disclosure of
CDOs tied to subprime
mortgages
Misleading disclosure of
CDOs tied to subprime
mortgages
Misleading disclosure of
CDOs tied to subprime
mortgages
Misleading disclosure of
CDOs tied to subprime
mortgages
Discussion
Off balance sheet transactions, revenue recognition manipulations, insufficient
disclosures, or omission of disclosures all together were most commonly used financial
statements manipulation tools by failed companies. Table below summarized worst
accounting scandals 2001-2008. Information was derived from www.sec.org web site
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
Name of the
Year
company
2001 Enron
Losses/Misstateme
Auditors
nts
$74billion losses
Arthur Anderson
2002 WorldCom
$180 billion losses
2002 TYCO
$150 million losses PricewaterhouseCo
opers
$1.4 billion
PricewaterhouseCo
misstatements
opers
$5 billion
PricewaterhouseCo
misstatements
opers
$3,9 billion losses PricewaterhouseCo
opers
2003 HealthSouth
2003
2005 American
International Group
(AIG)
2008 Lehman Brothers
2008 Bernie Madoff
$50 billion
misstatements
Arthur Anderson,
KPMG
Accounting Manipulation
Off balance sheet liabilities,
earnings manipulation,
insider trading
Expense capitalization,
fraudulent accounting
entries
Loan manipulation,
fraudulent stock sales
Fraudulent accounting
entries
Fraudulent accounting
entries
Revenue manipulation
PricewaterhouseCo Off balance sheet
opers
transactions, revenue
manipulation
$64.8 billion losses Friehling &
Horowitz, CPAs,
P.C
Ponzi scheme
Despite alleged inconsistencies between US GAAP and US auditing standards, in all
those cases, “red flags” should have been somewhat apparent to internal and external
auditors. Auditing standards suggest auditor reliance on promulgations from authoritative
bodies, but auditor should also apply “reasonable man” principle (Jones & Presley, 2013).
Accounting profession require auditor to apply common sense, “substance over form”
evaluation, not only rely on technical pronouncements, if they seem to be insufficient.
AICPA Code of Professional Conduct require CPAs to adhere to main principles:
Section 50 – principles of professional conduct, section 90 – specify rules of conduct,
section 100 – independence, integrity and objectivity, section 200 – general standards of
accounting principles, section 300 – responsibility to clients, section 400 – responsibility to
colleagues, section 500 – other responsibilities and practices. Principles of professional
conduct require accountants to accept responsibility to public interest, maintain integrity,
objectivity and independence, exercise due care; maintain internal control and quality
control of their work (www.aicpa.org). Institute of Management Accountants has their own
code of ethics, leading internal auditors, and management accountants. All CPAs are
required to maintain current knowledge of all standards by completing continuing education
courses every year. We have pretty strong set of requirements for CPAs, and due diligence
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
is still a large outgoing problem in auditor’s work. Public’s confidence in financial reporting,
especially after these financial crises suffered huge downfall (Chang, Duke, & Hsieh, 2011).
Sure, large accounting firms are busy, audits require significant amount of time, and
sometimes inexperienced staff is not properly supervised. That is a quality control issue. A
lot of problems could have been prevented if due diligence was applied an analyzing “red
flags”, and taking onto consideration whistleblower’s complains.
US House of Representatives passed Audit Integrity and Job Protection Act H.R.
1564 in July of 2013, prohibiting Public Company Accounting Oversight Board (PCAOB)
from requiring mandatory audit firm rotation. The argument was that no evidence exists that
mandatory audit firm rotation would enhance audit quality, and that board of directors,
management, and shareholders should make that determination (www.aicpa.org). In
opinion of this author such legislation may negatively influence auditor independence,
objectivity, and may be quality problems.
Future Research
One area of concern is a transparency and disclosure of financial information. While
most agree that more disclosure is needed to benefit investors, creditors and other financial
statement users, it may be difficult to find a right balance between adequate transparency
and protection of commercially sensitive information. More research is needed to determine
also the appropriateness of use of nontraditional accounting techniques and evaluation of
“red flags” in financial information.
Another area that needs further investigation is the detailed analysis of causes of
financial crises. Despite the fact that many research studies already exist on this subject
matter, it seems to not be sufficient conclusions how to actually prevent this from
happening. Enterprise –wide risk management process may be an answer and this topic
would require in-depth studies.
Additional research is needed evaluating management accountants and auditors
professional ethics application, evaluating costs and return of implementation and mandate
of strict ethical standards in business environment, as well as application of international
ethics standards.
Conclusion
In light of financial failures of large publicly traded companies in last decade raised
numerous concerns by investors, shareholders, and accountants. Despite established
ethical standards, which, management accountants, internal and external auditors must
adhere, financial statement fraud, misrepresentation of financial data using shady
techniques are still very present, and frequently not detected on a timely manner, especially
in banking industry. In analyzed cases auditors either did not exercise sufficient due
diligence, or simply closed their eyes to the facts. Numerous research studies focused on
GAAP loopholes, eliminating auditor responsibility to detect irregular financial reporting.
Rules are necessary to follow, but common sense and due diligence must be exercised.
Internal and external auditors, management accountants are in the immediate position to
Proceedings of 30th International Business Research Conference
20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
determine and at times to prevent fraud from happening. The application of integrity, due
diligence, quality control, and professional knowledge by accounting professionals may be
a solution to a lot of corporate problems. It is most likely impossible to predict all ways
“creative accounting” can be used, but it is possible to prevent or minimize its negative
impact on the economy with a help of ethical and knowledgeable auditors.
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20 - 22 April 2015, Flora Grand Hotel, Dubai, UAE, ISBN: 978-1-922069-74-0
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