Accounting Information System and Fraud Prevention

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Table of Contents

Accounting Information System (AIS)
The Enron Scandal: AIS failure to prevent fraud
Third-party accounting systems: implications of fraud
Prevention of fraud at Enron
Effective prevention of fraud through legislation
Recommendations
References

Accounting Information System (AIS)

The AIS is a computer system established in most businesses for purposes of collecting, processing, and storing financial information to track accounting activities and conduct audits. In the past, firms used internal customized accounting systems to cater to the specific needs of the company. However, developing such specific systems proved challenging and time-consuming especially with the development of general-purpose third-party systems such as Sage and Oracle (Romney & Steinbart, 2011).

Reports processed using AIS allow decision-makers to formulate strategic financial policies in addition to giving stakeholders access to information regarding their financial positions. Modern AIS systems comprise three or more tiers separated according to functionality. The most common architectural tiers include user presentation, application processing, and data management. Such separation ensures the manageability of information, accuracy, and consistency during the processing and reliability of subsequent reports, especially for financial managers (Romney & Steinbart, 2011).

Although most modern AIS systems result in reliable financial reports, fraud can occur through the manipulation of information and exploitation of loopholes present during the transfer and storage of information from one tier to another. The fraud may occur in different forms including alteration of information during processing, entering incorrect information into the system to obtain a desirable report, and delays in entering financial data in different processing stages and inappropriate storage methods that result in loss of crucial information. These improprieties make auditing difficult and often lead to loss of money to individuals involved in the AIS operations and sometimes the management officials of a company.

The Enron Scandal: AIS failure to prevent fraud

Enron, which was an American company in the energy sector, was involved in a fraud that eventually led to its bankruptcy after the October 2001revelations. The situation also led to the “collapse of Arthur Andersen, which was an audit and accountancy firm that was one of the five largest firms in the world” (Anand, 2013, p.64). The firm’s financial team failed to detect improprieties during the audit process, thus leading to its prosecution for fraud alongside Enron’s executives.

Although the Supreme Court acquitted the firm of charges against it by Enron’s shareholders, the damage that the lawsuit brought upon the firm’s reputation led to the loss of most of the firm’s clients and its eventual dissolution (Eichenwald, 2005).

One of the main reasons why the company’s customized AIS failed in preventing fraud is because the system existed in such a way that entry of information into the data system regarding sales, purchases, and investments happened internally and manually by people in charge of operating the system. Therefore, the system could not prevent fraud through fraudulent initial data entry. This aspect means that members of a firm’s finance team have to ensure that the initial entry of data into the system is correct for the right reports after data processing. Enron’s main problem was overzealousness in its investment risks.

Aside from dealings in the energy sector, such as deals in natural gas, Enron undertook supplementary deals through offering wholesale trading and risk management services (Eichenwald, 2006). Although this aspect often earned the company substantial additional revenue, some deals resulted in great losses, which the company’s former president and chief executive officer, Jeffery Skilling, hid using unethical practices. The main aim of such behavior was to create the impression that the company was making great progress in stock trading on Wall Street even when revenue was lower than expected.

This strategy ensured that investors viewed the company to be in good standing, and thus they bought more stocks in the investment process. One example of instances where the company tried to cover up losses involved Blockbuster Video, a company in the entertainment industry. Enron took up a contract with Blockbuster Video that required Enron to introduce on-demand entertainment in the US within a year.

However, during the execution of the twenty-year contract, Enron realized that the market demand was lower than pilot projects had estimated, thus leading to losses. Instead of informing investors and shareholders of the loss, the company, through its former president, Jeffrey Skilling, and Chief Financial Officer, Andrew Fastow, hid the loss by entering faulty information into the AIS regarding the project’s success and revenue earnings (Eichenwald, 2005).

Another way in which the accounting system failed in its prevention of the Enron fraud is the complexity involved in processing data, which created loopholes through which the company executives could alter information to create favorable reports for investor attraction and maintenance purposes. Initially, the accounting process was easier as the company used the historical cost accounting method, which was easier to apply as it constituted the listing of actual costs of supply and services coupled with actual revenues that the transactions earned the company at the end of each financial year. The historical cost accounting method was reliable, stable and thus predictable, allowing Enron to manage its finances appropriately and make reliable strategic plans for financial growth (Eichenwald, 2005).

However, when Jeffrey Skilling joined the company in 1990 and eventually attained a promotion to chief operating officer in 1997, he advocated for the adoption of the mark-to-market accounting model. The accounting model involves the estimation and inclusion of future profits in business transactions into the company accounts using their present value. Skilling justified his support for mark-to-market accounting by insisting that the method provided a realistic projection of profits coupled with giving investors a better idea of profits to expect when making their investments (Eichenwald, 2005).

Another key feature in the model is that it creates a need for revision of projections as trends in market pricing change within the estimated projection period. Although this provision ordinarily allows financial managers to keep updated information in the AIS database and gives shareholders better management of their shares, it also creates room for unscrupulous dealings such as fraudulent alteration of account amounts.

For instance, in the case of Enron’s contract with Blockbuster Videos, the company estimated profits worth over one hundred million dollars after the contract’s completion, based on the outcome of pilot projects concerning the twenty-year contract. However, after a few years, Enron discovered changes in the market demand that resulted in fewer sales in the entertainment industry, thus causing the company significant losses.

However, to maintain the company’s reputation and the hope of success most investors in the project clung to, Skilling and Fastow maintained the continued recognition of estimated revenue instead of data and records to indicate the new developments (Eichenwald, 2005). Continued recognition of the revenue ensured investor confidence and increased the company’s stock prices by indicating profits while the real situation comprised loses.

Additionally, the complexity of the company’s business model and accounting system made it difficult for the auditor, Arthur Andersen, and shareholders to keep track of the accounting process, thus affording Enron’s management a chance to move money around in various accounts to cover up losses. The unpredictability of the mark-to-market accounting model and difficulties in keeping track of past and present transactions created a scenario in which the Arthur Andersen auditing firm frequently accepted Enron’s excuses for discrepancies in financial reports, even though the firm suspected foul play in the data entry process in Enron’s AIS.

The fact that the United States Securities and Exchange Commission had approved the usage of Enron’s accounting model, thus leading to its adoption by other firms to boost investments, created reasonable doubt in explanations regarding faulty information in Enron’s reports.

Third-party accounting systems: implications of fraud

Third-party accounting systems are essentially accounting software that specific firms develop for sale or lease to other firms for use in their accounting systems. In most cases, such software accommodates various functions to suit various needs, with the most common being data entry into different accounts, data processing to establish amounts such as profits or losses, and creation of records for storage purposes. Some of the most common examples include Oracle, QuickBooks, and Sage.

Although small corporations choose to adopt third party accounting systems as they are, larger corporations often seek certain specifications for some features and resort to modification or alteration of such features to choose company needs (Romney & Steinbart, 2011). For instance, in the case of Enron, it is very likely that if the company chose to utilize features from a third-party accounting system, the company would have made modifications to such software to mitigate the complexity of its business model as well as the mark-to-market accounting model, especially during data processing.

In case of fraud due to the failure of a third-party accounting system by way of the breach, liability depends on the conditions accompanying the accounting system, compatibility with the company’s accounting model, and consideration for any alterations to the system after purchase. The software provider is only liable when fraud occurs due to a malfunction in the software’s operations. For instance, a software provider would be liable if features that the provider expressly states to operate at optimum levels fail, thus creating opportunities for fraudulent interference in the accounting process.

A good example of such a malfunction is one where the software stalls for long periods before processing data despite the provider guaranteeing quick data entry and processing. Additionally, in assessing the liability of a software provider, one has to consider whether the provider was aware of the specific functions that a company intended the software for before making recommendations regarding its use. For instance, if the software provider were aware of the need for Enron to use the mark-to-market model, but recommended a software version that did not support the model leading to fraud, the software provider would be guilty of negligence under common law.

Professionals and other service providers owe a duty of care to their clients and are guilty of breach of such duty if they sell faulty products or provide inadequate services to clients leading to injury or harm. However, in the case that such breach occurred due to the fault of the client in instances where the client tampered with features in the software, thus leading to the malfunction of which fraud was resultant, the software provider would not be liable to the fraud.

Prevention of fraud at Enron

One of the advances in accounting and information technology that would have helped prevent the occurrence of fraud at Enron is the establishment of new legislation governing the functions that auditors and company executives fulfill in their firms about accountability and transparency. During Enron’s hearing, Lay stated that although he was aware of Skilling’s activities in the running of the company, he was not always keen on details, which allowed Skilling to make unethical decisions that led to the company’s bankruptcy. Skilling resigned from his position a few months before the discovery of the fraud at Enron in August 2001.

The Sauternes-Oxley of 2002 was responsive to this loophole by increasing the punishment available to courts for such corporate oversights leading to fraudulent loss of funds for shareholders. This aspect has so far given executives adequate reason to oversee the accounting operations in their companies coupled with enhancing their attention to details even in instances where they delegate duties to subordinate members (Anand, 2013).

Secondly, the development of data encryption has ensured that accounting information is only available to specific members in a firm during specific periods, usually according to the purpose of such access. For instance, a software provider can modify specific features and create a code through which to access specific accounting information at specific periods. This aspect ensures that employees are careful during the initial data entry process and in addition to the reduction of chances for interference in the data processing phase (Romney & Steinbart, 2011).

Effective prevention of fraud through legislation

The Sauternes-Oxley (SOX) Act of 2002 is one of the most notable legislation that the American government enacted after the Enron’s scandal and the Worldcom fraud case the following year. Although the Act has many benefits especially to investors and shareholders, it also carries some limitations that fail to address the fraud issue in its entirety. Some of the most prominent features in the Act include improvement of transparency on financial matters to the public, curbing fraud through the institution of higher penalties to criminal offenses regarding fraudulent dealings by companies, and provision of compulsory rotation of the lead auditor in a firm in a bid to reduce the chances of the occurrence of conflicting interests.

Title II also establishes standards that give external auditors independence in the auditing process while Sec.304 of SOX provides for the individual responsibility of every corporate executive, which ensures that financial reports undergo thorough scrutiny by the executives before they become public knowledge (Anand, 2013). This aspect is especially important in reducing instances where individual executives in public corporations risk the financial health of companies in quests for personal gain.

The Act also allows enhanced financial disclosure by ensuring that corporations document off-balance-sheet transactions, pro forma figures, and stock transactions by corporate leaders in a bid to reduce the risk that moral hazard poses to investors by forcing a higher degree of care in investments on companies (Anand, 2013). The concept of moral hazard suggests that a person is more likely to take a greater risk if a different individual stands to suffer in case of any negative consequences from such risk.

For instance, executives in corporations such as Enron are likely to take a greater risk with money from investors and shareholders than they would take with personal funds. The Act proposes stronger sentencing guidelines for crimes such as failure to certify corporate financial reports in addition to establishing fraudulent alterations to financial reports and such other conspiracies as criminal offenses (Anand, 2013).

Although the above features offer adequate protection for investors and shareholders, some aspects of these provisions stifle the development of small and medium enterprises in addition to making compliance difficult and expensive thus defeating the purpose for the Act’s formulation. For instance, the compliance costs under Section 304 increase with time even during financially turbulent periods, thus creating problems for mid-capital companies and small businesses. Some of the charges that public companies incur include “directors and officers’ insurance, audit fees, legal costs, and board compensation” (Romney & Steinbart, 2011, p.106).

The costs form part of the recurring expenditure that public corporations incur, and thus most companies have to compensate by sourcing for additional capital. Since the inclusion of the charges does not take into account the unpredictability of economic trends, such as the 2007-2009 economic crises, the impact of these changes affects the ability of companies to generate additional capital constantly. Small and medium-sized public corporations are especially vulnerable as compliance charges apply to all corporations regardless of their sizes. Larger corporations bear the advantage of having stronger capital bases, and thus they are more resilient to changes in financial markets.

Kessel (2011) highlights a requirement by the stock exchange rules for biotech companies to seek prior consent from shareholders for the issue of certain amounts in equity securities. This important element furthers corporate governance and protects the interests of shareholders from fraudulent dealings and moral hazard-related situations. However, this aspect also means that the companies have to wait for lengthy periods as shareholders scrutinize the securities, some times leading to the loss of numerous windows of opportunity to make important deals.

This aspect, in turn, means a decline in the market value of the biotech companies together with creating substantial difficulties for SMEs to generate enough capital to gain a competitive edge against bigger public corporations. From this perspective, the Act appears to stifle the development of SMEs in its bid to protect public interests (Kessel, 2011). Also, the Act provides for frequent rotations of the lead auditor to address the issue of conflicting interests, but it does not feature provisions for rotation of auditing firms. Anand (2013) cautions that rotation of the lead auditor of a firm instead of the entire firm still presents a problem regarding conflicting interests for the public corporations as most people in a firm work towards a common goal and they are thus prone to similar dealings.

Recommendations

To prevent a future recurrence of such fraud cases, Enron should establish a strict code of ethics in addition to adopting security measures for the company’s accounting databases. the use of encryption codes for access to accounts, for instance, prevents unauthorized access to such accounts and ensure accountability as such codes reflect individuals accessing accounts as well as the duration of access, thus indicating people responsible for any changes. The best way to implement this strategy is to involve a third-party software provider or monitoring firm for transparency and easier establishment of responsibility in case anything goes wrong.

References

Anand, S. (2013). Essentials of Sauternes-Oxley. Hoboken, NJ: John Wiley & Sons.

Eichenwald, K. (2005). Conspiracy of Fools: A true story. New York, NY: Broadway Books.

Kessel, M. (2011). Sauternes-Oxley Overburdens Biotech Companies. Nature Biotechnology, 29(12), 1081-1082.

Romney, M., & Steinbart, J. (2011). Accounting Information Systems. New Jersey, NJ: Prentice Hall.

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