Ethics in Accounting and Reliability

Question: Discuss about the Ethics in Accounting and Reliability. Answer: Introduction Financial failure of a corporation does not affect only its shareholders but the entire economy. The stakeholders other than the owners such as lenders, suppliers, government, society, and the environment are affected adversely at large by the failure of a company. Thus, it becomes crucial to analyze and evaluate the default risk of the firms and take corrective measures timely so that the situation of financial distress could be avoided. In this regards, the analysis of financial statements has been referred to as the essential tool. The analysts have been using financial statements to analyze the default risk of the firm since long (Otalor and Eiya, 2013). However, in the recent years, the discloser of many corporate scandals such as Enron (2001), WorldCom (2002), and the recently one of Wells Fargo (2015), has put the reliability of the financial statements into a questionable situation (Accounting-degree, 2017). The discloser of these scandals reveals that evaluation of the defau lt (bankruptcy) risk through analysis of the financial statements may not reliable. Therefore, there arises a need to perform alternative procedures to measure the default risk of the firms. In this context, the essay presented here analyzes the thesis that, Whether the analysis of financial statements to evaluate the default (bankruptcy) risk is appropriate or not. The default or bankruptcy risk is the risk that the firm may not be able to meet its debt commitments on time leading to insolvency. The insolvency of the firm means end of the business operations of the firm. When the firms debt rises so high that its assets are not able to cover it up, the situation of bankruptcy arises. The firm goes into liquidation after being declared insolvent and sells its assets to pay the debt lenders and creditors. This process brings the entity to an end. Reliability of the Financial Statements in Measuring the Default Risk The information presented in the financial statements is used to analyze the financial performance and financial health of the firm. In measuring the default risk, one requires to closely analyze the debt position of the firm. For the purpose of analyzing, the debt position of the firm, the information pertaining to long term debt, interest expense, supplier dues, total assets, equity, and profitability is important (Lucic, 2014). The information in relation to these items can be extracted from the financial statements of the firm which majorly comprises the statement of income, balance sheet, and the statement of cash flows. However, the information presented in the financial statements is based on the historical data. Thus, the analysis of financial statements provides view of the historical and current financial performance and position of the firm. The analysis of historical trend and the current conditions in regard to financial performance is crucial to measure the default risk (Lucic, 2014). Thus, it could be inferred that the analysis of the financial statements is necessary to assess the default risk and predict the future performance. However, the reliability of the information presented within the financial statements becomes a measure issue in this regard. As has been observed in the many cases of corporate scandals, the financial statements were manipulated (Abdullah, Almsafir, Al-Smadi, 2015). The information presented in the financial statements of Enron was misleading. Further, the accountants also played with the ethical standards in certifying the fake accounts of Enron. The management presented manipulated information in regard to financial performance and position of the company, which laid wrong evaluation of the bankruptcy risk. According to the views of the analysts, the company was financially sound and well versed immediately before being declared involvement (Li, 2010). Kindly refer to the chart given below: A big deviation in the value of assets and revenues could be observed before and after declaration of insolvency. The total assets were $65.50 billion in 2000 that is before declaration of insolvency which dropped significantly to $47.30 billion in 2001 after declaration of insolvency. Further, the revenues dropped from $100.60 billion to $-0.60 billion (Li, 2010). This shows that the company reported fake revenues and assets in the financial statements. The use these fake figures in assessing the default or bankruptcy risk can present only deceptive picture resulting into an inappropriate analysis. Thus, it could be inferred that in order to assess the risk of bankruptcy of the firm, the analysts need to opt for additional measures apart from the analysis of financial statements. The analysis of financial statements alone may not be sufficient to uncover all the aspect related to bankruptcy risk (Li, 2010). Need for Other Approaches to Measure Default Risk It has been observed that the financial statements may not present the true picture of the business of firm. The financial statements may be misleading in certain cases leading to wrong evaluation of the default risk. Thus, it is quite necessary that the analysts use other approaches along with the analysis of the financial statements (Altman and Hotchkiss, 2010). The use of only the financial statements analysis in assessing the default or bankruptcy risk will not be sufficient. Therefore, the analysis of financial statements should be supported by the analysis of other reports, documents, and processes of the firm. In the recent years, there have been observed common trend in the financial market in regard to use of reports of independent body on the borrowing firms financial worth. Further, the lenders also require reports of credit rating agencies to ensure that the borrowing firms are financially capable to pay back the debt (Altman and Hotchkiss, 2010). Further, the other approaches which may involve evaluation of corporate governance of the company and the stewardship of the directors. The lenders are putting much emphasis on the compliance with the corporate governance aspects in considering the lending decisions (Wang and Lin, 2010). In order to control and reduce the risk of default, it is important for every organization to maintain stringent corporate governance environment. The regulators around the world are also taking measures to make the corporate governance a crucial part of the organizations operations. Further, the companies are also required to prepare and submit to the regulators the report on compliance with the corporate governance rules and regulations. The analysis of corporate governance report also plays an important role in assessing the creditworthiness of the borrowers and evaluating the default risk (Wang and Lin, 2010). Conclusion The discussion in this essay resolves around the issues that whether the financial statement analysis is a reliable approach to measure the default or bankruptcy risk and whether is it needed to adopt other approaches to analyze the default risk. From the discussion in this essay, it can be concluded that the assessment of default risk based on the analysis of financial statements alone could be misleading. Therefore, there is a need to adopt other approaches so as to make the assessment of default risk more meaningful and effective. From the revelations of many corporate scandals, it has been observed that the financial statements of the firms may be manipulated and thus, the assessment of default risk based on the manipulated financial statements would be inappropriate. References Abdullah, Z., Almsafir, M.K., Al-Smadi, A.A. 2015. Transparency and Reliability in Financial Statement: Do They Exist? Evidence from Malaysia. Open Journal of Accounting, 2015(4), pp. 29-43. Accounting-degree. 2017. Top 10 Accounting scandals of all times. [Online]. Available at: https://www.accounting-degree.org/scandals/ [Accessed on: 15 March 2017]. Altman, E.I. and Hotchkiss, E. 2010. Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt. John Wiley Sons. Lemus, E. 2014. The Financial Collapse of the Enron Corporation and Its Impact in the United States Capital Market. Global Journal of Management and Business Research: D Accounting and Auditing, XIV(IV), pp. 1-50. 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