L1 The role of accounting in corporate failure Flashcards
(22 cards)
What has been a common cause of corporate collapse?
Accounting disclosures (or lack thereof)
Accounting failures can mislead investors about the health of a business.
True or False: Accounting failure can singularly cause a healthy business to collapse.
False
Accounting failure can mislead but is unlikely to be the sole cause.
What are key areas of accounting practice that can misrepresent a firm’s position?
- Consolidation decisions
- Capitalisation decisions
- Under-provisioning
List the three methods of accounting for investments in other companies.
- Consolidated Accounting
- Equity Accounting
- Cost Method
What must happen if a subsidiary is controlled?
Their accounts must be consolidated into the group accounts.
What is the impact of using the Consolidated Balance Sheet?
It includes all of the subsidiaries’ assets and liabilities (less inter-company balances).
What does the Equity Balance Sheet include?
Only the parent’s proportionate interest in the net assets of the investee.
How can the determination of control be subjective?
Control may exist with ownership significantly less than 50%.
Why would one want to deliberately bias the decision of whether control or significance exists?
A company may choose to manipulate financial statements by choosing the accounting method that makes its financial ratios look better.
What happens to the Debt Ratio when equity accounting is used?
It remains unaffected by the investee’s subsequent debt.
What was a significant issue in the Enron crisis?
The use of Special Purpose Entities (SPEs) to hide debts.
What was the role of independent third parties in Enron’s SPEs?
They held a controlling voting interest despite often being Enron employees.
What did Enron’s use of SPEs allow them to do?
Avoid disclosing their true liabilities.
What does FIN 46 require regarding SPEs?
Consolidation if a primary beneficiary holds more than half of the residual returns.
What significant change occurred after the Enron collapse?
The FASB issued regulations for greater consolidation of SPEs.
What was Worldcom’s controversial accounting decision?
Recording current year bandwidth fees as an investment (asset).
What was the result of Worldcom’s accounting practices?
Hiding $4 billion in expenses.
Which company was Australia’s second-largest insurance firm that collapsed?
HIH Limited.
What led to HIH’s collapse?
Failure to adequately provide for future claims (underprovisioning).
What ethical concerns arose regarding Arthur Andersen’s audits?
Potential conflict of interest due to dependence on non-audit services.
What regulatory changes were made in response to corporate collapses?
- CEOs and CFOs must attest to financial statement truth
- Mandatory audit committees for listed companies
- Compulsory rotation of auditors after a significant role
Fill in the blank: The Cost Method records the investment at _______ until sold.
[cost]
