Consequences of Fraudulent Transactions and Managing the Risks - Free Essay Example

Sample details Pages: 9 Words: 2689 Downloads: 8 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? Management teams, who are believed by shareholders to operate their assets and are trusted by other stakeholders to act as a custodian for their money, have been blamed being one of the financial criminals who destroy the world economic system, especially this is the main reason for the collapse of the Wall Street banking system in 2008 which continued to be the worst world financial crisis since the Great Depression (The Guardian, 2010). In September of 2008, Lehman Brothers, the fourth most famous mid-size Wall Street investment banker in the US known as the owner of credit card, American Express, went bankrupt according to Chapter 11 bankruptcy protection from the Federal Reserve Bank of New York. Don’t waste time! Our writers will create an original "Consequences of Fraudulent Transactions and Managing the Risks" essay for you Create order This caused Dow Jones stock exchange market to close down at just over 500 point, which has been accounted as the largest fall since 2001 and it was the direct reason of depreciation in the price of commercial estate in the US. Not only real estate business but the banking system also was affected by this situation. Merrill Lynch and AIG, who are the main creditor of Lehman Brother, subsequently were taken over by Bank of America since they lost their money from the poor. Moreover, this economic collapse in the US also demonstrated its impact to threaten financial system around the world which could be seen from decrease of stock price in major stock exchange market; such as Japan, UK and Canada (The Guardian, 2010). Many people believe that financial manipulation by management is the direct cause of world economic depression. However, it could be argued that some financial corruption lead to improve accounting and financial regulation including to give more attention for corporate governance and social responsibilities of management. This project will mainly demonstrate how management financial manipulation could be beneficial. Firstly, the definition of financial manipulation including kinds and its characteristic will be explained. Then it will address the current economic problems which resulted from management intention. In the final part, this article will illustrate the advantages which arise from financial frauds by management. Definition of Management Financial Manipulation The significant function that financial statement plays is to present the companys performance by performing an analysis of figures such as net income (the bottom line) and other intermediate levels of measurement of earnings such as percentage of gross margin or earning per share. It is therefore influence for managements and companies to maintain their financial report to consist with their expectation at the end of each period (Stolowy and Lebas, 2006). According to important role of financial statement being a main appearance to reflect a companys performance, the management, whose incentive is normally dependent on such figures, has intended to threaten or control the result from their operation which present in the financial statement by using the weaknesses of accounting and financial standard. This dishonest behavior seems to be defined as financial management manipulation. The financial statement has been comprised of three main components which are accounting methods, accounting estimates and classification of extraordinary items. Through these factors, management could encompass such figures to present in the way that they want. According to Copelands statement, it mentioned that manipulation is an ability to increase or decrease reported net income at will (quoted in Stolowy and Lebas, 2006: 580). From this quotation, it could be seen that the method of manipulation might be executed by three patterns which are to maximise income, to minimise income or to maintain income. However, some experts claim that accounts manipulation seems to have more comprehensive features than the meaning that was given by Copeland in 1968. By Barnea and Ronen, since 1975-1976, income statement classification has been included as meaning of the accounts manipulation (Barnea, 1975-76 and Ronen and Saden, 1975) and in 1998, presentation of balance sheet subsequently has be en demonstrated as a method of the manipulation by management (Black, 1998). And lastly, a selection of preferred accounting treatment has been represented as the latest tool for accounting artifice as well. These methods illustrate that there are various approaches initiated by management in order to arrange their financial results to coincide with investors expectation, which mostly are extreme earnings or efficient financial ratio (Stolowy and Lebas, 2006). Although there are varieties of accounting manipulation, it could be categorised into four main methods. Firstly, a term of practices which the firms officers artificially manage earnings to achieve or meet some pre-established level of expected earnings might be defined as earnings management (Stolowy and Lebas, 2006: 580). Next theory is income smoothing (Stolowy and Lebas, 2006: 580). This refers to a scheme which tends to generate a stable growth of income or profit to consist with prior period by postponing the recognition of income or cost to future. This form can be, for instance, the reversal of provisions, kinds of estimated expenses, or the selection of revenue recognition points which could be obviously beneficial to maintain certain profit through a long-term contract without consideration whether it is fair presentation (Stolowy and Lebas, 2006). Thirdly, big bath accounting is a procedure that new management regularly use to clear up all pending or outstanding balance which could not be explained or find any supporting idea. This term was initially explained by Moore (1973) as: New management has a tendency to be very pessimistic about the value of certain assets or about the future profitability of current engaged contracts. They, then, often adjust downward, more than necessary, the value of these questionable assets or underestimate the profitability of ongoing contracts by taking the losses now and keeping the possibility of profit as a possible happy surprise if it ever happens. This type of behavior is colloquially know as taking a bath (quoted in Stolowy and Lebas, 2006: 580). Lastly, due to arguments or confusions on some accounting standards, this gap leads managements to use improper standard intentionally to present their result in the way that they expect to see which this term might be defined as creative accounting. The main purpose of this behave is to misguide shareholders or investors through such invented presentations. The forms of creative account which mostly perform, for example, are change in accounting policy during fiscal period without reasonable reason or misclassification of balance sheet and income statement (Stolowy and Lebas, 2006). According to possibility of performing these manipulations by management, this could be essential factors misleading stakeholders such as investors, bankers or, even though, government to be assured that the company is stable and has capabilities to generate the advance performance. A consequence of this misunderstanding is stakeholders might not protect themselves and be persuaded to continually invest or spend their funds for such company and then when the company collapses, its affect would be dramatically pervaded to its creditors, investor and every parts of economic system and finally enlarges itself rapidly to be the world economic crisis. Situation of World Economic Crisis in 2008 In the 1990s, according to the US government, they launched policy to pressure investment bank to acquire more loans which were borrowed by person considered as risky person, having low credit rate and potential uncollectable which this kind of people, generally, could be defined as sub-prime by bankers. The aim of this policy was to increase home ownership rate in the US. Such policy, eventually, provided effective result to increase home ownership rate from 66% to 70% (Holmes, 1999). According to its effectiveness, such policy has been embraced by the US governments for a decade that lead to increase in home ownership rate and, also, low income borrowers. Owing to (AR) rapid rise in unqualified borrowers, this caused many banks fell into liquidated problem but such problem could not be noticed to society for retreat because it was hidden by outstanding performance rate which was called as debt rating, assessed by famous debt rating companies such as Moodys and Standard Poors. It m ight be believed that this issue could be kept in secret since the investment banks, which faced with a large number of doubtful debts, intended to manipulate their financial statement, both balance sheets and income statements, to present distinguished financial ratio, especially debt ratio. A good illustration of this point is Lehman Brother, a famous medium size investment banker in Wall Street, used the weakness of accounting standard to improve their cash flow and present an acceptable proportion between liabilities and assets, debt ratio. However, Lehman could not, no longer, avoid such problem and finally bankrupted in 2008. In addition, another reason that kept the secret was the influence of investment, as significant customers, over the rating agencies (Wikinvest, 2010). As the result, the problem was accumulated increasingly until exposure in 2008. The crisis was started from collapse of Bear Stearns Companies Inc, one of leading investment bank in the US, in March 2008. It was taken over by JP Morgan, under an authorisation from the Federal Reserve Bank of New York. This is a result of sharp declining in value of mortgage securities, especially subprime lending which caused its net profit suddenly fell by almost tenfold from 2006 to stood at 233 million dollars at the end of 2007 and then, eventually, merged itself with JP Morgan Following by Lehman Brothers, whose income declined from 2007 by over 50%, was collapsed by the same reason with Bear Stearns in September 2008. This crisis in the subprime market could be illustrated as the meltdown of the US bank system. For instance, such crisis impacted to increase risk premium on interbank borrowing to 5% while normally it was just 0%-1%. A consequence of high interest rate, other businesses, such as manufacturing and trading companies, could not be financed money from banks in order to expand its production capacity and then collapsing in the US trade business was occurred inevitably (Wikinvest, 2010). Not only in the US but this crisis also affected to global economic system. Many people believed that this was the largest and sharpest drop in global economic activity of the modern era. For example, it obviously caused to decrease in demand both by business and household. As households spent less so imports then fell, and hence someone elses exports fell as well. (McKibbin and Stoeckel, 2009: 4). This situation might be demonstrated that manipulations by some management teams could be regarded as potential factor misleading stakeholders to decide incorrectly. As the result of this misunderstanding, it could impact across the countries and expand itself to be the global problem rapidly. In the next section, the influence of management manipulation in the US over the world economic system will be examined. How does management financial manipulation in the US impact on the world economy As a result of recent meltdown in the US economy, it primary impacted to the US bank system declining in loan issuance which it might be noticed from figure 1. According to the line graph, it could be seen that after reaching a peak at US 700 billion for new lending in second quarter of 2007, the volume of loan issuance decrease significantly throughout of the following year to stand at US 150 billion in third quarter of 2008 which accounted for almost fivefold reduction comparing with prior period. This is because of extreme concern about borrower qualification, after the great recession, by the financial institute (Lvashina et.al, 2008). This decrease could have substantial effect on other businesses, especially exporting and financial investment in developing countries by being decelerated its growth rate. Not only business, this crisis also affected to labor suffering from earning deduction (Lin, 2008). According to fundamental cause of economic failure, Rajun, Seru and Vig (2008) draw attention to focus on misleading of credit rating. It is believed that some rating agencies provided poor credit rating to public due to they applied only mathematical model and historical data to assess the value of debts owned by banks, without consideration of possible factor or current situation. This might be a main reason causing investors to misunderstand and made an incorrect decision and finally lead them into trouble when such debts had no ability of repayment. This view contrasts with Murphy (2008) which it contends that the direct cause of economic collapse in the US is management financial manipulation, especially approval for mortgage without obtaining adequate supported documents by management and lobbying the regulator being lenient by some bank investments (Murphy,2008). Similarly, the view is provided by Clark (2010), it claims that the using of accounting deception is a root of this crisis. A good illustration for this point is the artificial accounting by management team of Lehman Brothers who used the imperfection of accounting principle in order to create an increase of balance sheet by US 50 billion presenting the outstanding result of its operation at the end of period. Nevertheless, Lehman Brother finally bankrupted and its management was examined by the US court as a financial criminal causing the collapse of the US bank system in 2008 (The Guardian, 2010). This could be suggested that management manipulating the financial result plays as significant role affecting to occur the world economic recession. However, it could be alternatively argued that management financial manipulation might be one of the best ways to improve a corporate governance and financial regulation also. This positive point will be discussed in the next section of this article. How can management financial manipulation improve corporate governance Many economists believe that there are only negative aspects associated with falsification of accounting records by management which Lehman Brothers and Bear Stearns, who were claimed by the US examiner as financial criminal, could be represented as a classic example of financial manipulation leading to increase problems in the world economic system. Contrastingly, it might be argued that colorable accounting results by management could improve corporate governance, management ethics and financial regulations as well. This section will mainly demonstrate that how can accounting artifice promote corporate governance. After facing with many financial scandals by management which lead the world economic system to collapse recently, stakeholders have begun to suspect that whether the financial statements have adequate fair presentation and request their regulators to take responsibility solving this issue. As a result, governments and regulators have announced more restricted laws of accounting in order to mitigate the occurrence of such behaviors by management and try to improve corporate governance, which may be defined as the process including monitor, assessment and organise to ensure that the company has perform to support in the interests of shareholders and stakeholders (Sherer and Turley, 1997:70). A case in this point is the Sarbanes-Oxley Act in the US which was introduced after bankruptcy of Enron, who was a well-known natural gas company in the US and its management has been convicted regarding to fraud charge (Brickey,2003), in 2001 in order to regulate accounting standard to be more us eful: After the fairly recent series of spectacular bankruptcies or scandals, including EnronÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦Governments and regulators around the world have promulgated appropriate legislation or regulations to prevent occurrence of such scandalsÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦One well-known and exemplary such piece of legislation in the Sarbanes-Oxley Act in the United States. It is a complex piece of legislation but contains three key provisions that are directly relevant to the usefulness of reported account (Stolowy and Lebas, 2006). The Sarbanes-Oxley Act demonstrates as the important example of advantage developed by financial manipulation which attempts to resist fraudulent transaction and monitor corporate governance leading to improve assurance of investors against the financial statements. Although, its capability may not be sufficient to detect all financial artifices due to complexity of current businesses but it could be argued that this amendment represents an admirable beginner supporting the further development. Conclusion In conclusion, it might be believed that the world economic crisis is mainly attributed by management financial manipulation; however, such intentional misstatement might be contributed some advantages to the society, especially upgrading the quality of corporate governance. It is worth recalling that many constructive affords have been introduced in order to prevent such mistake since economic crisis in 2008; nonetheless, such solutions would not be beneficial, if management did not pay attention and recognise to perform for their businesses and it, moreover, could be predicted that the crisis may happen again as a result of ignorance by management. This challenges people in the society to take responsibilities monitoring management behavior in order to protect their economic system from such failure.