1.2 Importance of Accurate Financial Information

From 2008 to 2013, the world was faced with the most severe recession since the Great Depression. At the beginning of the recession the stock market crashed, businesses such as Lehman Brothers and other organizations went bankrupt, and unemployment throughout the world reached highs not seen for over 50 years. This financial meltdown revealed numerous cases of fraud, including the massive $50 billion Ponzi scheme by Bernie Madoff, financial statement frauds at Satyam (termed as "India's Enron"), and consumer frauds, such as those committed by accused Texas billionaire Sir Allen Stanford. While economists are still trying to identify the exact causes of the economic downturn, there is common agreement that sub-prime mortgage loans and other risky financial instruments were a root cause of the problem.

Even with these financial challenges, America's capital markets are the envy of the world, known for their efficiency, liquidity, and resiliency. Financial statements prepared by organizations play a very important role in keeping America's markets efficient. They provide meaningful disclosures of where a company has been, where it is currently, and where it is going. Most financial statements are prepared with integrity and present a fair picture of the financial position and results of operations of the organization issuing them. These financial statements are based on generally accepted accounting principles (GAAP) that guide the way in which transactions are to be accounted. While GAAP is a set standard for accounting, GAAP also allows for flexibility to account for innovative transactions and changing circumstances. Within this flexibility, standards of objectivity, integrity, and judgment must always prevail.

Unfortunately, financial statements are sometimes prepared in ways that misrepresent the financial position and financial results of an organization. Misstatement of financial statements can result from such acts as manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared; misrepresentation in, or intentional omission from, the financial statements of events, transactions, or other significant information; or intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure. Misleading financial statements cause serious problems in the markets and the economy. They often result in large losses by investors, lack of trust in the market and accounting systems, or litigation and embarrassment for individuals and organizations associated with the financial statements.

For example, the Enron scandal received significant media attention in the early 2000s and caused substantial embarrassment for the audit profession. Enron's officers manipulated the financial statements by hiding liabilities in off-balance-sheet partnerships (Variable Interest Entities or VIEs, formally called Special Purpose Entities or SPEs), hiding losses in these VIEs, and artificially inflating revenue by entering into buy-and-sell (wash sale or round trip) transactions with other trading companies that allowed Enron to substantially overstate its revenues and income. Enron's auditor, Andersen LLP, was "tried and convicted" in the media and was charged with obstruction of justice (for supposedly shredding documents) by the U.S. government. The criminal trial and negative press led to the demise of Andersen, one of the most respected and largest CPA firms in the world. In the wake of the Enron scandal, the AICPA issued the following statement:

Certainly, Enron (and its fallout effect on Andersen, several law firms, financial institutions, and others) has raised awareness among the public about financial statement fraud. However, Enron is only one of over 600 financial statement frauds that have been investigated by the Securities and Exchange Commission (SEC) alone.

It is the SEC's position that auditors are the public's watchdogs in the financial reporting process. According to the SEC's past Chairman Leavitt, "the SEC and others rely on auditors to issue audit opinions which put something like the Good Housekeeping Seal of Approval on the financial information investors receive" (Leavitt, September 28, 1998).

Because of this "watchdog" role, and because accountants often provide investment and other financial advice to their clients, it is very important that accountants understand as much as possible about financial statements and financial statement fraud. By improving their knowledge, accountants can be more discriminating in the kinds of audit engagements they accept, can better advise their clients, and can save themselves considerable grief, embarrassment, and litigation exposure.