Hold On To the Revenue Recognition Method and GAAP Principles

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Shady accounting practices are what landed Enron and WorldCom in hot water with the SEC, and although you may be the owner of a small online business or brand new ecommerce company, and not publicly traded, it is probably in your best interest to adhere to the generally accepted accounting practices (GAAP) or international financial reporting standards (IFRS).

Implementing these systems can have some far-reaching benefits for your company, which we will explain later.

Here are two of the biggest accounting scandals in history and ways they could have been avoided:

Enron

Enron’s scandal was the largest of its kind when it broke in 2001. The company’s executives put a lot of effort into creating one of the most complex accounting scandals of all time. The company, which was once the seventh largest in the nation, eventually declared bankruptcy and cost its shareholders $74 billion.

The scam: The company created a slew of partnerships and subsidiary companies that they used to hide debt. One company, Chewco, was named after Chewbacca from the Star Wars franchise and helped the company hide $600 million in debt from the SEC. This made Enron appear much stronger than it really was and lured many unsuspecting investors into the company. Meanwhile, company executives were selling off their stock at premium rates and preparing to tell the public the bad news.

The solution: Ethics. This was a simple case of greed gone wild. Had someone within the company had the courage to stand up to the brass, this could have been avoided. The Enron scandal and its consequences for both company executives and investors should serve as a reminder to everyone working within finance that when in doubt, use the most stringent ethical standards.

WorldCom

Executives of WorldCom, once the second largest long distance provider in the United States, basically helped themselves to billions of dollars. The news broke on June 25, 2002 and the SEC alleged that the company had improperly accounted for $3.8 billion. That number turned out to be closer to $11 billion and the company was eventually forced to declare bankruptcy, which according to a University of Massachusetts-Boston study, resulted in 33,000 lost jobs and about $180 billion of investor’s money down the drain.

The scam: While their business was sagging, WorldCom executives were busy reclassifying line costs (fees paid to rent other companies’ equipment) as capital expenditures (expenses paid to improve your own property or equipment). This created an inaccurate picture of the company’s financial state because capital expenditures are depreciated over a long period, which means they would only show up as expenses over long periods of time.

The solution: Following the GAAP’s direction for expensing line costs and operating at a high ethical standard would have prevented this scandal. No one would have seen jail time, investors would not have been cheated out of their money and innocent people would not have lost their jobs. Simply following the GAAP principles for an accounting method like revenue recognition would have guaranteed no scandal would have ever occurred.

As a small business, you probably won’t have to worry about your CEO lying to investors and lining his pockets with money from the company coffers. Most small businesses would recognize if something as small as a stapler were missing so chances are that this type of accountability is not much of an issue. The fact remains however, that following GAAP for things like revenue recognition and transactions is a good idea whether your company is publicly traded or not. Benefits of following GAAP include the following:

  • Give your books a standardized and well-documented form to follow
  • In the event that you try to gain investors, using GAAP standards can be seen as impressive and as a mark of professionalism.
  • Consistent information about your business’ cash flow and assets and liabilities can help you make well-informed decisions regarding your company’s cash.

If your company has not adopted a standardized accounting practice, whether it’s GAAP or IFRS, you should strongly consider implementing one of these systems. Setting it in place can benefit your company in many ways and can ensure that your accounting department has a clearly communicated set of standards by which they should operate.