1.2 Importance of Accurate Financial Information
The United States has the biggest organized markets for stocks, bonds, and other investments in the world. These markets are known as capital markets because they allow firms to raise money (i.e., capital) by selling financial instruments such as stocks and bonds to investors.
From 2008 to 2013, the world was faced with the most severe recession since the Great Depression. At the beginning of the recession, the capital markets quit functioning, and businesses such as Lehman Brothers and other organizations went bankrupt. Because of this crash, unemployment throughout the world reached highs not seen for over 50 years. This led to a financial meltdown throughout the economy that revealed numerous cases of A generic term that embraces all the multifarious means that human ingenuity can devise to get an advantage over another by false representations. No definite and invariable rule can be laid down as a general proposition in defining fraud, as it includes surprise, trickery, cunning, and unfair ways by which another is cheated. The only boundaries defining it are those that limit human knavery., including the massive multibillion-dollar Ponzi scheme by Bernie Madoff and The intentional misstatement of financial statements through omission of critical facts or disclosures, misstatement of amounts, or misapplication of accepted accounting principles.s at Satyam (termed “India’s Enron”). While economists have identified several causes of the economic meltdown, there is common agreement that risky financial instruments sold on worldwide capital markets that involved risky mortgage loans were a root cause of the problem.
Even with these financial challenges, America’s capital markets are the envy of the world, as they are known for their efficiency, liquidity, and resiliency. Reports such as the balance sheet, income statement, and statement of cash flows that summarize the financial status and results of operations of a business entity. prepared by organizations play a very important role in keeping America’s markets efficient. They provide meaningful information about where a company has been, where it is currently, and where it is going. This information helps investors and analysts gauge the current and future performance of an organization, which allows them to value an organization’s capital offerings such as its stocks and bonds.
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 transactions are to be accounted for. 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 and integrity must always prevail.
Unfortunately, financial statements are sometimes prepared in ways that misrepresent the financial position and financial results of an organization. Misstated financial statements can result from several different acts, such as manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared. Misleading financial statements often result in large losses by investors, lack of trust in the capital markets and An organization of policies and procedures for recording economic transactions., 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 to substantially overstate the company’s revenues and income.
While there are many forms of fraud, the losses from a financial statement fraud—such as that found at Enron—can be tremendous. Financial statement fraud is thought to be a much rarer event than most other forms of fraud but also a much more costly form of fraud relative to other forms of fraud. For example, embezzlements likely take place at many organizations. A large embezzlement may be a few hundred thousand dollars, whereas a large financial statement fraud can cause losses to investors, creditors, and others in the hundreds of millions or even billions of dollars.
Companies that sell stocks and bonds on the capital markets are required to have their financial statements audited by certified public accounting (CPA) firms. Enron’s financial statement auditor, Arthur Andersen LLP, was charged by the US government with obstruction of justice (for shredding documents). The criminal trial and negative press led to the demise of Andersen, one of the largest and most respected auditing firms in the world.
In the wake of the Enron scandal, the American Institute of Certified Public Accountants (AICPA) issued the following statement:
Our profession enjoys a sacred public trust and for more than one hundred years has served the public interest. Yet, in a short period of time, the stain from Enron’s collapse has eroded our most important asset: Public Confidence.1
In the United States, the Governmental organization with responsibility for regulating stock trading and the financial statements and reports of public companies. is given responsibility to regulate the capital markets, including the accounting and auditing of the companies who sell their stocks and bonds publicly through our capital markets (i.e., public companies). The SEC was organized in the 1930s after the stock market crash of 1929, when the economy was in the Great Depression. More recently, massive frauds caused by Enron and WorldCom raised awareness among the public about financial statement fraud and led Congress to pass legislation known as the US legislation passed in 2002 whose goal is to minimize the occurrence of fraud and increase the penalties for perpetrators when it occurs.. SOX required the creation of an organization known as the A nonprofit corporation that reports to the SEC and regulates auditors of companies that have publicly traded stocks., which reports to the SEC and regulates auditors of companies that have publicly traded stocks.
For decades, the SEC has viewed auditors as the public’s watchdogs in the financial reporting process. According to former SEC Chairman Arthur Levitt, “The SEC and others rely on auditors to issue audit opinions which put something like the Good Housekeeping Seal of Approval on the information investors receive.”2 Because of this “watchdog” role, 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.