The IFRS standard was introduced in 2001 in order to standardize accounting processes and guidelines across different nations and international boundaries. IFRS standards are issued by the IASB and the IFRS foundation (Landsman et al, 2012, p. 35). IFRS standards have different provisions. However, the main provisions reviewed in this article are IFRS 3 and IFRS 10. IFRS 3 and IFRS 10 are accounting standards that complement each other as they address accounting within the context of business combinations. These accounting provisions precisely address the accounting guidelines that business combinations must follow in conducting financial reporting. Precisely, IFRS 10 requires controlling entities to develop consolidated financial statements in order to prevent accounting fraud perpetrated through Special Purpose Entities (SPEs). Even though IFSR 3 and 10 have faced criticism based on the disadvantages of consolidated balance sheets, the standards are important as they not only protect investors from accessing wrong financial information and thereby making wrong investment decisions, but also assist controlling entities to keep track of their true financial performance hence prevent sudden collapse or bankruptcy. This paper is subdivided into three sections. The first section describes the IFRS 3 and IFRS 10 standards and their provisions. The second section critically assesses the importance of these two standards in contemporary accounting. The third section addresses the consequences of failing to comply with the IFRS 3 and IFRS 10 standards using the Enron scandal as a case study.
IFRS 3 specifies financial reporting guidelines for corporations that have merged with or acquired other corporations (IFRS Foundation (1), 2008, p. 3). The main objective of implementing the standard is to expand the reliability, comparability, and relevance of the financial information issued by a corporation about its association with business combinations. In order to accomplish this objective, IFRS 3 provides a detailed framework which assists the reporting institution (which is the acquirer in this case) to recognize and measure identifiable assets acquired, the liabilities associated with the acquired business, and the controlling interests in the acquired business (IFRS Foundation(1), 2008, p. 3). The framework also assists the reporting institution to recognize and measure the amount of goodwill acquired during the acquisition process. Precisely, goodwill arises when the market price of the acquired business is less than the actual cost incurred by the acquirer in the acquisition process. The remaining amount must be clearly indicated on the acquirer’s balance sheets as goodwill (IFRS Foundation (1), 2008, p. 3).
Lastly, IFRS 3 assists corporations to determine the kind of information to disclose to the public and the kind of information to keep confidential (IFRS Foundation (1), 2008, p. 3). In particular, IFRS 3 perfectly balances the need for public disclosure and the need for maintaining loyalty to the employer. The disclosures section requires the reporting entity to assess the nature and quality as well as the effect of the financial information being disseminated into the public domain. The acquirer must not disclose any information that it consciously knows will mislead its audience and potential investors. Other types of disclosures include the company’s controlled entities as well as the dates and costs of acquisitions. The financial statements disclosed must also clearly indicate the amount of goodwill for each entity.
IFRS 3 conceptualizes a business combination as any large entity that is formed as a result of a combination of various smaller entities that individually qualify to be businesses (IFRS Foundation (1), 2008, p. 3). If the entities that merge to create larger entity are not businesses, then the larger entity does not qualify to be a business combination, hence its financial reportage is not subject to the IFR3 business combinations standard (IFRS Foundation (1), 2008, p. 3). IFRS 3 requires that the reporting entity initially determine whether a corporate event or transaction qualifies to be called a business combination by following the acquisition method. In the acquisition method, the reporting entity must identify the acquirer and the acquisition date.
The principal objective of IFRS 10 is to provide guidance to reporting entities on how they should develop consolidated balance sheets whenever they directly control one or many other entities (IFRS Foundation (2), 2008, p. 3). This implies that all assets and liabilities associated with the controlled entities must be included in the final consolidated financial statements reported by the parent business. The principle of control is the basis upon which reportage of consolidated financial statements should be conducted.
The onset of IFRS 10 saw an elimination of almost all the provisions that existed in the IASB 27 standard (IFRS Foundation (2), 2008, p. 3). As of 2018, the only remaining provision in the IASB 27, and has been included in the modern IFRS 10, is the requirement for subsidiary corporations and other controlled entities to also develop and disclose their own balance sheets within the scope of their operations.
Implementation of IRFS 10 ensures that business do not engage in aggressive accounting practices that would perpetrate fraud. The inclusion of the IASB 27 section is necessary because, businesses associated with accounting fraud normally take advantage of subsidiary independence to perpetrate fraud. For instance, businesses with numerous subsidiaries might use in-sourcing strategy to perpetrate fraud.
The concept of control is an important factor in determining whether a corporation is the controlled entity or the controlling entity. In the former IASB standards, there were some inconsistencies associated with this concept (IFRS Foundation (2), 2008, p. 3). IASB underwent numerous revisions in order to clearly conceptualize the aspect of control without creating practical inconsistencies. However, IFRS amended IASB and defined control based on three aspects. First, the investor must have control over the investee. Second, the investor must be exposed to variable returns from the investee. Third, the investor must be able to use his power to manipulate returns (IFRS Foundation (2), 2008, p. 3).
Critical Assessment of IFRS 3 and IFRS 10 standards
Reporting of consolidated financial statements is advantageous in many ways. IFRS 3 and IFRS 10 have been particularly important in eliminating fraud associated with SPEs as businesses are required to provide consolidated financial statements. In consolidated financial statements, the resultant figures are a true reflection of a company’s financial performance and position. The balance sheets pull together financial figures from all subsidiaries such that any abnormal losses in any one of the subsidiaries would translate into reduced profit margins for the entire corporation. Hence, the controlling entity does not have an incentive to engage in misleading reportage.
However, there are chances that consolidated financial statements could also perpetrate accounting fraud. One of the most obvious loopholes in un-consolidated financial statements is the possibility of the controlling entity to use one or more of the controlled units as a haven for hiding losses associated with the parent company (Sainati et al, 2017). Precisely, the controlling entity treats some of its subsidiaries as other businesses, hence engages in transactions as if it were engaging in business with a non-affiliate corporation (Cornford, 2006, p. 2). When it comes to reporting, the financial information to the special purpose entity (business unit) is not included in the controlling entity’s balance sheets.
According to some scholars, the IFRS 10 and IFRS 3 standards do not completely eliminate corporate fraud since corporations might only include financial information from some of the entities in their consolidated balance sheets (Sainati et al, 2017). For a corporation with hundreds of SPEs, it would be difficult for an auditor to follow through and ascertain the relationship between the parent entity and every other entity it has transacted with. For instance, an entity with more than 500 SPEs may decide to include financial information from only 400 SPEs in its consolidated financial statement and use the remaining 100 as SPEs for risk and debt transfer. It would be quite difficult for an auditor to establish the relationship between the parent company and the other 100 corporations. This implies that other auditing mechanisms must be used apart from a review of the company’s consolidated balance sheets. Nevertheless, continued reliance on risk and debt transfer does not guarantee a corporation’s success in the long run (Sainati et al, 2017). If the corporation continues transferring risk and debt in order to boost public perception, it will definitely go bankrupt since it is still within the debt and risk’s influence. Therefore, IFRS 3 and IFRS 10 are also focused on assisting corporations to perfectly manage assets and liabilities, hence prevent going bankrupt.
Adoption of the IFRS 10 standard could be disadvantageous because, it conceals the financial performance of the parent company, hence making it difficult for investors to make accurate investment decisions. A consolidated financial statement, as necessitated by IFRS 10, only displays the financial performance of the parent entity and the controlled entities as a single economic unit. Other than failing to illustrate the financial performance of the parent entity, consolidated financial statements also make it difficult for investment managers to identify the non-performing controlled entities. For a corporation that only has a few controlled entities, tracking the financial performance of individual subsidiaries might not be a complex task. However, for a corporation with hundreds of controlled entities, tracking the individual performance of each of these entities might not be realistic. Therefore, identification of the high risk entities might be complex. On the contrary, a consolidated financial statement works perfectly in this case because, financial information of hundreds of controlled entities does not have to be included in the final balance sheets of the parent entity. Nevertheless, to illustrate the effectiveness of IFRS and IFRS 10 standards, it is worth considering the Enron scandal, which was the largest accounting scandal that has ever been recorded in American accounting history. However, the Enron scandal occurred at a time when the IFRS 3 and IFRS 10 had just been put into effect hence had not gained much traction and adoption in the United States. Nevertheless, the corporation consciously breached the standards leading to the exposure of its corporate fraud and subsequent downfall.
Enron was among the largest US companies in the energy services sector. Precisely, Enron was involved in the large scale provision of retail energy services (RES), wholesale energy services, transportation services, and broadband services within the energy sector. However, Enron has gone down in history due to its failures that it manufactured via a series of strategies intended to avoid being downgraded. As Huu Cuong (2011, p. 3) indicates, by Enron filing for bankruptcy at the onset of the 21st century, a new revolution in accounting and corporate governance at large was marked. The new revolution would bring new changes to corporate governance and accounting structures in order to reduce the possibility of large corporations going bankrupt and hence causing innocent investors to count losses (Petrick and Scherer, 2003, p. 52). While the company had been on the limelight as one of the best performing American companies in the 1990s, in real sense, the Enron was engulfed in myriads of problems that arose from its decision to create online energy (Knottnerus et al, 2006, p. 179). The main purpose of creating online energy was to facilitate the execution of energy products supply contracts. The first problem associated with online energy included the need for Enron to gain access to huge lines of credit in order to gain investor confidence; it had to prove to its clients that it had enough credit to handle some contracts as far as supplying energy products was concerned (Huu Cuong, 2011, p. 12).
The second issue that Enron was grappling with was the high earning fluctuations that it was experiencing due to inconsistent business performance (Petrick and Scherer, 2003, p. 53). Even in the midst of these problems, Enron was determined to maintain its investment credit rating in order to continue gaining access to cheap credit both from investors and creditors. In essence, fluctuating business performance causes both investors and creditors to lose confidence in the business. Consequently, Enron employed a number of strategies to increase its performance with respect to its operational and financial aspects. The main strategy employed by Enron was the creation of special purpose vehicles (SPVs), which would be used as havens to hide losses (Huu Cuong, 2011, p. 12).
How Enron breached the current IFRS 10 Standards
Since the company was under pressure to maintain its investment credit rating, strategies were necessary to overcome the problems it was encountering that would cause its downfall. Creation of SPEs was the main strategy employed by Enron (Huu Cuong, 2011, p. 12). Special Purpose Entities are subsidiaries that are created with the core purpose of absorbing risks on behalf of the parent company. However, an SPE can also be a subsidiary established in order to hold a company’s assets and ensure their security especially when the parent company is declared bankrupt. In the previous IAS standards, creation of SPEs was a legal business strategy. As long particular accounting criteria are followed under the IAS, the parent corporation is not obliged to include the financial information of SPE in the consolidated financial statement. However, the current IFRS has made it necessary for the parent company to include financial information of all subsidiaries in its consolidated financial statements (Petrick and Scherer, 2003, p. 52). This is because, IFRS founders felt that corporations were taking advantage of the IASB loophole to make themselves appear more profitable and less risky than they really are.
While creation of SPEs whose financial information was not necessarily included in the consolidated balance sheets, Enron used this legal provision in the IASB to maintain its investment credit rating. Precisely, the company created hundreds of SPEs. By distributing risk across these SPEs, the parent company would completely appear less risky and fit for investment. Even though the parent company appeared to be performing well, the burden of its losses was heaped on investors who had vested their interests in the non-performing SPEs.
Transactional Techniques with SPEs
Enron deployed transactional techniques to get rid of liquid assets from its balance sheets while simultaneously retaining control over the assets (Cornford, 2006, p. 2). These transactional tricks were achieved by systematic sell of liquid assets to Special Purpose Entities, which would not appear on Enron’s balance sheets as controlled entities. Consequently, it would be hard for auditors to determine whether Enron was still in control of the assets it had sold. In essence, auditors wouldn’t bother going into the finer details of who purchased Enron’s liquid assets, and whether the purchaser had any business relationship with Enron. Retaining ownership of the liquid assets obviously implied that Enron as a parent corporation would still get a share of the benefits and risks associated with the assets. In order to prolong ownership and control of the assets, Enron had implemented a technique known as the Total Return Swap. As Cornford (2006, p. 2) indicates, a Total Return Swap is an agreement between two parties in which, one party makes payments based on a fixed rate, while the other party makes payments based on the return of a particular underlying asset. In this case, Enron benefited itself at the expense of subsidiaries. The Total Return Swap implied that Enron would utilize the funds acquired from the sale of liquid assets in order to finance its operations and investments in order to increase its profit margin further (Cornford, 2006, p. 2). However, the company was still within the influence of risks and benefits of the liquid assets. To source funds for the purchase of Enron’s liquid assets, the SPEs would engage in massive borrowing activities. Since their debts would not appear on Enron’s balance sheets, Enron would definitely report huge profits when in real sense the true financial performance was far much below than the reported figures.
The Impact of Consolidation
However, in 2002, after a thorough auditing process, Enron was compelled to develop a consolidated balance sheet. Surprisingly, there was a huge reduction in the company’s profitability with a corresponding increase in debt (Huu Cuong, 2011, p. 12). Through this consolidated balance sheet, it became evidently clear that Enron was thriving on manipulated profit rather than profit earned through purchase and re-sale of energy products. The huge debt and negative profitability caused the investment-credit rating of Enron to depreciate significantly such that it could no longer gain access to the cheap credit that it had been used to. Consequently, the corporation could not finance its operations as well as execute its contracts, hence filed for bankruptcy. The United States government enacted the Sarbanes Oxley act in order to accounting fraud that included reportage of wrong financial information (Li, 2010, p. 37). Several other policies and guidelines were put in place in order to prevent such future cases of accounting fraud, hence assist investors in making correct investment decisions (Huu Cuong, 2011, p. 12).
Relation to IFRS Standards
The current IFRS 10 standard requires a business combination to report consolidated financial statements of all the subsidiaries. In evaluating how Enron breached this requirement, it is necessary to determine whether Enron itself, at the time of its collapse, qualified as a business combination (IFRS Foundation (2), 2008, p. 3). According to IFRS 3 and IFRS 10 definitions, a business combination is any business entity that controls one or more entities that are also businesses. Enron established numerous SPEs (IFRS Foundation (2), 2008, p. 3). An SPE is simply a subsidiary or strategic business unit that operates independently from the parent company, but is used by the parent company as a risk absorber. Since Enron had a number of affiliate business establishments, it was a business combination. However, it is prudent to determine whether Enron had ‘control’ over the other entities. First, Enron had the capability to use its power to manipulate returns, which is one of the three requirements for an entity to be regarded as a controlling one (Li, 2010, p. 37). Enron’s ability is manifested through the creation of SPEs and utilization of these SPEs to perform Total Return Swaps in the favor of Enron’s apparent financial performance. By being able to create SPEs and use them as risk absorber, Enron was fulfilled the second requirement for a controlling entity (Li, 2010, p. 37). Precisely, the second requirement requires the controlling entity to have power over the controlled entity. Power could be manifested in many ways such as centralized decision-making.
Critics may argue that Enron did not effect centralized decisions because, its business because it did not report financial information about these alleged subsidiaries. However, Enron’s agenda was quite different from implementing a decentralized system; Enron wanted to establish SPEs to facilitate false reporting. In a nutshell, Enron qualified as a controlling entity, hence was obliged to adhere to IFRS 10 standard regarding consolidated financial statements for controlling entities. However, in its reporting, the Enron developed a tendency of omitting financial information belonging to particular SPEs from its balance sheets (Li, 2010, p. 37). This tactic clearly indicated that Enron was going against IFRS 10 standard that requires a controlling entity to include financial information from controlled entities in its balance sheets (IFRS Foundation (2), 2008, p. 3). Omitting even a single controlled entity amounts to accounting fraud, hence Enron was constantly committing accounting fraud. Second, IFRS 10 requires a controlling entity to develop consolidated balance sheets for all the controlled entities as well as the parent entity (IFRS Foundation (2), 2008, p. 3). On the contrary, Enron only developed balance sheets for itself as a parent company. Enron’s SPEs also developed their individual balance sheets for reporting purposes. Therefore, the corporation engaged in accounting fraud because, failure to develop consolidated balance sheets would provide an incentive for risk transfer.
IFRS 10 disclosures section requires that a reporting entity assess the quality of the disseminated financial information and its impact on the public (IFRS Foundation (2), 2008, p. 12). Enron breached this requirement by consciously disseminating information that would mislead investors into making wrong investment decisions. In particular, the company’s financial reports did not portray its true financial performance, thus many investors were duped into believing that the company was a perfect investment firm for them. Furthermore, Enron heaped burden on investors who had invested stock in its SPEs. Enron also failed to disclose the identities of the SPEs it had used as risk absorbers in its unconsolidated financial statements. IFRS 10 sets it a requirement that such information be publicized in order to make the audit process easier as well as track the company’s transactions.
Consequences of Breaching the IFRS 3 and IFSR 10 standards
Based on the Enron scandal case, there are consequences associated with a breach of the IFRS standard. The Enron case indicates that breaching the standards only glorifies a corporation for a limited period. Enron was only appeared to be showing exemplary performance between 1995 and 2000 (Li, 2010, p. 37). Beyond 2000, Enron could no longer hide its piling debts, hence was compelled to come out clean and file for bankruptcy in December 2001. The company was finally acquired by another corporation in the energy products retail sector (Li, 2010, p. 37). This downfall came because, Enron was simply piling its risk exposure by transferring debts to SPEs instead of using other strategies to develop effect performance in its subsidiaries. Other than failing due to increased debt burden, the corporation also failed because of negative listing by investment credit rating agencies. Another consequence of breaching the IFRS standard is that investors are placed at a risk of making wrong decisions due to wrong financial information issued to them.
IFRS came into effect in 2001, and is intended to replace the IASB standard. IFRS has various standards that are intended to improve accounting and business financial transparency, hence assist investors to make accurate investment decisions based on financial information provided. While there are many standards codified in the IFRS, this paper focuses on two crucial standards that perfectly complement each other – IFRS 10 and IFRS 3. IFRS 3 focuses on business combinations while IFRS 10 sets out reporting guidelines for business combinations and controlling entities. The paper has shown that even though critics point out potential weaknesses in the IFRS consolidated financial statements approach, the standard is important as it not only cushions investors against rogue accounting practices but also protects businesses from failing due to risky accounting activities. The paper has included the Enron scandal as a case study to illustrate the consequences of breaching IFRS 10 and 3.
List of References
Boddy, C.R., 2017. Enron Scandal. Encyclopedia of Business and Professional Ethics, pp.1-4.
Cornford, A., 2006. Enron and internationally agreed principles for corporate governance and the financial sector. In Enron and World Finance (pp. 19-53). Palgrave Macmillan, London.
IFRS Foundation (1).,2008. IFRS3 – Business Combinations. http://eifrs.ifrs.org/eifrs/bnstandards/en/IFRS3.pdf
IFRS Foundation (2)., 2008. IFRS 10 – Consolidated Financial Statements. http://eifrs.ifrs.org/eifrs/bnstandards/en/IFRS10.pdf
Huu Cuong, N., 2011. Factors Causing Enron’s Collapse: An Investigation into Corporate Governance and Company Culture. Corporate Ownership & Control Journal, 8(3).
Knottnerus, J.D., Ulsperger, J.S., Cummins, S. and Osteen, E., 2006. Exposing Enron: Media representations of ritualized deviance in corporate culture. Crime, Media, Culture, 2(2), pp.177-195.
Landsman, W.R., Maydew, E.L. and Thornock, J.R., 2012. The information content of annual earnings announcements and mandatory adoption of IFRS. Journal of accounting and economics, 53(1-2), pp.34-54.
Li, Y., 2010. The case analysis of the scandal of Enron. International Journal of business and management, 5(10), p.37.
Petrick, J.A. and Scherer, R.F., 2003. The Enron scandal and the neglect of management integrity capacity. American Journal of Business, 18(1), pp.37-50.
Sainati, T., Locatelli, G., Smith, N. and Brookes, N., 2017. How Special Purpose Entities (SPEs) Affect The Governance of Infrastructure Megaprojects.
Let’s block ads! (Why?)