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The quality of financial statement

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Date added: 17-06-26

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1. Introduction:

The purpose of this assignment is investigation how credit crunch issues is widespread in the world and what is the quality of financial statement. This will be shown by analyzing the fraud in financial statement of Enron and WorldCom.

2. Methodology

Analysis based on a review of the academic auditing literature, audit reports, together with articles from financial journal.

3. Background:

3.1. The collapse of Enron and WorldCom

3.2. The financial statement Enron Corporate and The methods of Enron Corporation that used to the fraud of the financial statement

From the tables above we can see clearly that without LJM1, JEDI, Chewco and the “Four Raptors” partnership. In Enron were considerable numbers of partnerships which leads to Enron hided a significant debt. This is one of the methods of Enron primarily used to cover debt. We can see from table 4, Enron's prior-year reported debt amounts are increased by both JEDI's and Chewco's borrowings. In addition, Enron's net income is reduced for specific JEDI revenues previously allocated to Chewco, relating to appreciation in value of Enron stock held by JEDI, wich eliminates upon consolidation. This, in effect, reduces Enron's share of JEDI's earnings. The net effect reduces Enron's prior-years' reported net income and shareholders' equity amounts. In brief, Enron did not announced adequate information in financial statement in order to reduce tax payments and blow-up income and profits and to raise the price of share (the high stock price was vital issues to the survived of Enron corporation (Peter 2002: 91) and credit rating. Furthermore, Enron created many partnerships and used partnerships to hide debts.

       Partnership of Enron Corporation

  • The financial activities of Chewco Investments, L.P. (Chewco), a related party which was an investor in Joint Energy Development Investments Limited Partnership (JEDI), should have been consolidated into Enron's consolidated financial statements beginning in November 1997;
  • The financial activities of JEDI, in which Enron was an investor and which were consolidated into Enron's financial statements beginning in the first quarter of 2001, should have been consolidated beginning in November 1997; and
  • The financial activities of a wholly-owned subsidiary of LJM Cayman, L.P. (LJM1), a private investment limited partnership for which the general partner's managing member was Andrew S. Fastow, former Executive Vice President and Chief Financial Officer of Enron (see Note 4), should have been consolidated into Enron's consolidated financial statements beginning in 1999.

3.3.1. The system of operation to product the financial statement of Enron

Looking first at how Enron can cheat in their financial statement. This will be explanation by analyzing their process of making financial statement (Peter 2002: 41-2) in the graph below in order to have clearly understanding. The culture of Enron Corporation was concentrate profit and how to create greater profits (Peter 2002: 47). Thus, every individual in Enron need do like what Directors want do including accountants and the another firms have the same benefit.

3.3.2. The methods of Enron Corporation that used to the fraud of the financial statement

One of the methods that Andrew Fastow used on financial statement fraud is he set up the use of Special Purpose Entities(SPEs) so that to finance the purchases and take out of accounting report. In 1997, there are arguments in SPE issue which known like Chewco (Peter 2002: 61).

     Some summary about SPEs:

  • Original had a good business purposes
  • Really a joint venture between sponsoring company and a group of outside investors.
  • Cash flows from the SPE operations are used to pay investors.

     However, Enron had used SPEs to:

  • Hide bad investments and poor-performing assets (Rhythms Net connections). Declines in value of asset would not be recognized by Enron (Mark to Market)
  • Hide debt (borrowed money was not put on financial statements of Enron)
  • Quick execution of related-party transactions at desired prices. (LJM1 and LJM2)
  • To report over $1billion of false income.
  • Many SPE transactions were timed ( or illegally back-dated) just near end of quarters in order to income could be booked just in time and in amounts needed, to meet investor expectations.
Mark-to-Market accounting means that it is re-assessed in the valuable in each asset and changes in value are reflected in balance sheet and income statement in the company.
  • Forced sales in illiquid markets set prices
  • Drive asset values to insolvent levels ( despite the absurdity that mark-down of liabilities increase profits)
  • Risk of facing an insolvent counter-party generates runs: wholsesale and quasi-retail

Table 5: The different in financial statement frauds between 2 company WorldCom and Enron

WorldCom     Enron Overstating Asset Frauds Understating Liability/ Expense Frauds The frauds was simple  The frauds was very complicated: many complex transactions and accounting issues

3.4. Credit crunch and quality of financial statement

     3.4.1. Credit crunch

There is undeniable that credit crunch reveal in the recent global recession. For find out that reason, this quite appropriate to looking at why and how credit crunch occurs. There are number of reason why this financial crisis happened (credit crunch). The credit crunch started in 2007 with the bankrupt of Lehman Brothers, which is one of the most important in the US institutions. When looking at accounting practice, some author have argued that when using fair value accounting, this led to the credit crunch has been getting worsen. This will be difficult to value what is fair value have; thus, many people who control stock market and politicians have arguments for these issues with excessive political preventive in the worldwide (Emerald 2009). On the other hand, in the collapse of Enron and WorldCom, auditors play the important role in the credit crunch occur, which received limited information with opaque reporting. In addition, auditors have change audit report and the role of banking, business and the ever more compound financial instruments (Emerald 2009).

3.4.2. Quality of financial statement

This wills obsever who is the person that responsibility for quality of financial statement. There is no doubt that with good quality of financial statement leading to do not occur credit crunch. Because financial statements include income statement, balance sheet, and so on that is open information (Jorion 2003).Therefore, How to avoid financial statement frauds is essential. One of the reason is there are an increa.e in the size and number of financial statement frauds.

4. Solution


Emerald (2009) Global credit crunch: the role of the auditors [online] available from http://info.emeraldinsight.com/learning/management_thinking/articles/credit_crunch.htm?PHPSESSID=brqmbrv5134rc5p7g9k9dskmr2& [ April 2009] Enron corp (2000) Annual Report 2000 [online] available from www.enron.com [2000] Jorion,P.(2003) Investing in a Post-Enron World. United States: McGraw-Hill Trade Peter,F (2002) What went wrong at Enron. Canada: John Wiley & Sons http://www.sec.gov/Archives/edgar/data/1024401/000095012901504218/h92492e10-q.txt
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