It also brings into question the reliability of the current standards used for financial reporting and how the companies were able to use loopholes to misrepresent the company’s position and show a better condition than it really is. It further questions the reporting of other companies that employ the same standards and this investor and creditor confidence is shattered, not to mention the effect in terms of bad corporate governance. One such incident was the case of Enron.
The biggest bankruptcy in US history sparked debate about the adequacy of the current standards in place, especially the treatment of the items that Enron was able to use to bolster its profitability outlook (Lorinc 2002). The first of these relates to the treatment of special purpose entities which were at the core of the problem at Enron. These off balance sheet arrangements, in theory, served to isolate financial risk and provide less expensive financing. Such entities may be created by a business for the purpose of pursuing specific transactions for the sponsor.
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