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Cash flow accounting follows the method in which accounting data are recorded as per the date of receipt of payment for sale rather than the date on which the sales was made and similarly purchases are recorded as on the date on which payment was made for purchases rather than purchase date. This kind of accounting does not match the revenues to the time period during the revenues were earned or match the expenses to the time period during which income was generated.
In accruals basis revenues are recorded as and when the sales takes place and it matches revenues to the time period during which the revenue were earned. Similarly purchases are recorded when it was made rather than during the period when the payment was made.
Impact of both accrual and cash flow on accounting statement:
Recording of revenues take place as and when received, which can be both before and after they are earned
Recording of revues takes place when they are earned which can be before or after they are received
Financial Statement reflects shows revenues and expenses on the basis of recording of transaction rather than when they are earned
Financial Statement reflects the result of operations.
No receivables are recorded
Receivable recorded when payments are not received at the point of sale
No payables are recorded
Payables are recorded when payments are made at the point of purchase
Partial payment cannot be tracked
This shows partial payment
Tyco scandal – A case analysis
About the company:
Tyco Laboratories started its operations in 1960. The company went public in 1964 and expanded into various divisions. Most of the expansion was by way of acquisitions and mergers. Dennis Kozlowski joined the company in 1975 as an assistant controller. The diversified company was brought under three focus areas - fire protection, electronics, and packaging. Kozlowski came on Board in 1987 and became COO in 1989. (Eric, May 16, 2012)
He later on went on to become the CEO in 1992 and Chairman of the Board in 1993. The company diversified into healthcare as well. After 40 and odd acquisitions, the company was rechristened as “Tyco International”.
About the fraud:
This was a management fraud. CEO and CFO stole $150 million and inflated company income by $500 million. They paid moneys to themselves without approval of the Board.
How the fraud happened:
The former CEO, Dennis Koslowski and CFO, Mark Swartz gave themselves loans which were free of interest. These were, however, not recorded as interest-free loans. They were given as bonuses and other benefits. Since they were the top management, it was easy to approve and siphon off the money. The officers also sold stock of the company without telling the investors which is a requirement under SEC.
How the fraud was discovered:
There were many factors which led to the discovery of the fraud. The CEO was leading a very lavish lifestyle which raised suspicions. The stock price was restated which was questioned by the Securities and Exchange Commission (SEC) in 1999. In 2002, many questionable accounting practices had been raised: (Obringer, 2013)
The fraud had impacted a wide variety of stakeholders. Some of them are discussed below: (Alicia Andrew)
The employees undergo an emotional pressure of either having been party to the fraud or not being able to act as a whistle blower considering the fact that they knew about the fraud or fear of being removed from the organization.
Some employees may resign by themselves, some may be removed. Many may feel insecure about their position in such a company especially when there is a lot of uncertainty about the capability of the company to continue. In the case of Tyco itself, many employees chose to quit and many employees were removed.
The employees who were left over continued with the management. The company needs to introduce programs to enlighten the employees of the facts of the case, how important ethical behavior is and what are the consequences of unethical behavior.
The top management itself was involved in the fraud which comprised the CEO, CFO and the Senior General Counsel. They faced penalties and are serving imprisonment of 8 – 25 years.
The board of directors
In case of Tyco, the Board were not informed about the “Loan” transactions and hence not approved by the entire Board. The CEO and CFO, being directors themselves, approved all the unethical transactions and the other members were kept in the dark. The CEO was also the Chairman of the Board which was an added advantage.
The other members of the Board would have been shocked by the mere fact their trust that they had placed on their senior executives was betrayed. The Board would now need to take steps to hold the company together and salvage whatever little they can. They need to do all that they can to stabilize the stock price and regain the trust of the investors. The Board may also look at any possible mergers or takeovers.
The Board should look at introducing Independent directors who will review the process of the companies in a scheduled manner. Also, key payments to the Directors should be compulsorily authorized by the Board.
Internal auditors are those who report to the management on the existence and efficiency of internal controls in an organization. In this case, the internal auditors would have been the best whistleblowers to the external auditors who in turn would have reported to the SEC. The Internal auditors and key executives also breached their duty of care (fiduciary duty) to shareholders and the other key stakeholders by allowing the misappropriation of funds or at least turning a blind eye to the activities which were going on over the 5 year period.
The Internal auditors should have questioned the validity of such payments. If the CEO and CFO (who were probably the people the audit team was reporting to) did not take any action, the auditors should have taken it to the Board directly so that they will get recognized and action would have been taken. The company will also need to strengthen its own internal controls by not giving complete authorization to the CEO and CFO.
The SEC was the first organization to raise questions about the validity of the stock price. This fraud had a huge impact on the SEC. It caught the attention of the Commission and ensured that they exercise caution with every other balance sheet.
The worst affected are the shareholders. They are the backbone of the company as they have invested in the company expecting returns and trusting the company with their money. The CEO and CFO who held positions in the nature of a fiduciary breached the trust placed on them. In this case, the CEO and CFO misrepresented to the investors about the financial position of the company thereby misleading the investors to believe about the prosperity of the company. The stock price was also highly overrated.
The Board of the company needs to consolidate the impact of the fraud and appraise the shareholders about the same. They need to know the facts from the company itself and not through the grapevine.
The Board should also reassure the shareholders and discuss on what the future plans will be. They should be able to regain the trust of the shareholders. A detailed plan to revive the company’s place in the market and its stock price should be brainstormed with the shareholders.
The external auditors are responsible to the shareholders. They express their opinion in the audit report which is relied upon by many stakeholders like the shareholders, banks, financial institutions, etc. In this case, the external auditor issued qualified statements on the financial reports without applying the appropriate level of professional skepticism. He was aware of some of the accounting policies that did not comply with GAAP and he did not conduct his audit in accordance with GAAS.
To resolve this, a second partner, rotation of the audit firm will help in reducing the collusion with the management.
Role of Corporate Governance and Ethics:
Corporate Governance from the viewpoint of an investor is that the company is able to provide a comfort that the proceedings of the company are ethical and legal. (KPMG Singapore, 2010)
A good team of Board of Directors is required to ensure that the company is run well. For this a thorough well documented due diligence needs to be in place covering the following three crucial areas:
The is also the concept of Audit committee. The Board and the Audit Committee have independent directors. The role of the independent directors is to scrutinize the affairs of the company independently.
The removal of independent directors is often very hostile. This is because, in most cases, they will be the whistle blowers. In the Singapore context, the removal typically follows one of two patterns:
(1) Being asked by the board to resign and then doing so, citing personal reasons; or
(2) Being unceremoniously removed from the board. (KPMG Singapore, 2010)
This, by itself, is an indicator of fraud. A good Board should pay heed to the independent directors and must arrange to conduct regular training to the employees stressing the importance of ethics. For the company to be good, firstly, the head should be good. Only then the followers can be trained!
Alicia Andrew, L. B. (n.d.). Tyco. Retrieved oct 03, 2013, from Cases: https://sites.google.com/site/504cases/tyco
Eric, J. (May 16, 2012). Tyco Scandal Business Case analysis. Yahoo.
KPMG Singapore. (2010). Corporate Governance, The investors' perspective and expectations. Singapore: KPMG.
Obringer, L. A. (2013). How cooking the books works. Retrieved Oct 03, 2013, from How Stuff Works: http://money.howstuffworks.com/cooking-books10.htm