Creative Accounting, Fraud and Accounting Scandals

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Creative Accounting, Fraud and Accounting Scandals

• By
• Mike Jones
• Cardiff Business School

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Overview

• Introduction
• Definitions
• Managerial Motivation
• Methods of Impression Management
• Creative Presentation
• Research Evidence
• Accounting Scandals
• Impact of Creative Accounting and Fraud
• Controlling Creative Accounting and Fraud

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Creative Accounting
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• Two Quotes
• How do you explain to an intelligent public that
  it is possible for two companies in the same
  industry to follow entirely different accounting
  principles and both get a true and fair audit
  report?
• M. Lafferty
• Every company in the country is fiddling its
  profits.
• I. Griffiths

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Definitions

• Fair Presentation
• Using the flexibility within accounting to give
• a true and fair picture of the accounts so
• that they serve the interests of users.

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Definitions

• 2. Creative Accounting
• Using the flexibility within accounting to
• manage the measurement and presentation
• of the accounts so that they serve the
• interests of preparers.

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Definitions

• 3. Impression Management
• Using the flexibility of the accounts
• (especially narrative and graphs) to convey
• a more favourable view than is warranted of
• a companys results serving the interests of
• preparers.

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Definitions

• 4. Fraud
• Stepping outside the Regulatory Framework
• deliberately to give a false picture of the
• accounts.

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Definitions
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Managerial Motivation

• Managers may wish to
• Boost profits to benefit from
• i, Profit related pay
• ii, Shares and share options
• Manage gearing
• Profit-smooth

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Managerial Motivation

• Which company would you invest in A or B?
• Company Year 1 Year 2 Year 3 Year 4
• A 1m 2m 4m 8m
• B 4m (1)m 15m (3)m

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Methods of Creative Accounting 1

• Innumerable, but managers can, for example,
• manipulate income, expenses, assets and
  liabilities
• 1. Income Recognition
• 2. Interest payable e.g., capitalisation
• 3. Stock
• 4. Depreciation
• 5. Goodwill and Intangibles
• 6. Off balance sheet financing

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Methods of Creative Accounting II Stock

• Only one asset, stock, worth say 10
• million Euros. If capital is 5 million Euros and
  this years
• profit is 5 million Euros, then balance sheet A

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Methods of Creative Accounting III Depreciation

• Business Profit 10,000 Euros
• Fixed Assets 100,000 Euros
• Depreciation straight line 10 years
• If company adopts 20 year asset life will this
  affect
• profit?
• Yes
• Original
  policy New policy
• Euros
  Euros
• Profit before depreciation 10,000 10,000
• Depreciation (10,000) (5,000)
• Profit after depreciation -
  5,000
• Profit increases by 5,000 Euros

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Methods of Creative Accounting IV

• Simple off balance sheet financing scenario
• Company wants to acquire new premises
• Merchant bank sets up a special purpose company
  to acquire clients properties. Loans secured on
  properties
• Ownership spread over clients
• Company leases properties
• Rents pay loan interest
• End of initial lease, clients can
• i, buy leased properties or
• ii, sell properties and repay

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Methods of Creative Accounting V

• Financing Scenario
• Banker
• 10 year secured loan
• Receives rental
• Capital Guaranteed
• Client
• Immediate access
• If property appreciates will gain
• ? Effective ownership without having to borrow
• ? No need for loan on financial statements

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Methods of Impression Management

• 1. Graphs may be used
• 1. Selectivity
• 2. Deliberately to exaggerate trends
• 2. Accounting Narratives
• 1. Selectivity
• 2. Spin and bias
• 3. Emphasise good news not bad news

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Research Evidence

• Revsine (1991) Research evidence is consistent
• with the notion that managers use latitude in
• existing financial reporting to benefit
  themselves.
• In Regulated Industries Managers will lobby for
  and choose accounting policies which reduce their
  regulatory visibility
• Earnings management linked to variables such as
  size, risk, managerial compensation
• County Natwest Woodmac (1992) find that
• 1. 29 out of 45 UK companies which failed
  reported a rise in EPS
• 2. 3 out of 45 were qualified

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Real Life
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Research Evidence
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Accounting Scandals

• Perennial
• South Sea Bubble to Enron and Parmalat
• Mixture of fraud and creative accounting

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Fraud

• Individuals use businesses as own private bank
  account to plunder at will.
• Fictitious transactions.
• Transactions which break accounting rules.

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Accounting Scandals

• Adecco British Printing European Commission
• Adelaid Steamship BTR Four Seasons Nursing
• Adelphia Burton Group GEC/AEI
• Communications Cendant Global Crossing
• Ahold Cisco Collins Holdings
• Albert Fisher City Equitable Fire Grand
  Metropolitan
• Alstom Insurance Green Department Store
• AOL/Time Warner City of Glasgow Banking Green
  Tree Financial
• Argyll Foods Coloroll Halliburton
• Ashtead Computer Associates HealthSouth
• Associated British Ports Conseco HIH
• Atlantic Computers Consolidated Cotton Home Stake
  Production
• Barchris Construction Duck IBM
• Barlow Clowes Continental Vending ImClone Systems
• BCCI Corporate Services Group Insull Utility
  Investment
• Bond Corporation Court Line Intl Signals and
  Control
• Holdings Courtaulds Interpublic
• Brent Walker Cray Electronics Inyerstate Hosiery
  Mills
• Brentford Nylons Dynergy Investors Overseas

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Accounting Scandals

• Leasco Pergamon Press Tiphook
• Lemont Hauspit Polly Pekc Trafalfar House
• Levitt Group Poseidon Tyco International
• Lockheed Quaity Software Products US Realty
  Construction
• London county Queens Moat Houses Vehicle
  General
• Securities Qwest Versailles
• London Capital Group Rank hovis McDougall Waste
  Management
• Lonrho Reid Murray WorldCom
• Lucent Rite Aid WPP
• Maxwell Communications Rolls Razor Xerox
• McKesson Robbin Rolls-Royces Yale Express
• Micro Focus Royal British Bank Yale Transport
• Microstrategy Royal mail Steamship
• Minsec Rush Tomkins
• National Student Saatchi Saatchi
• Marketing Skandia
• Nortel Spring Ram
• Nvidia Storehouse
• Oxford Health Plans Sunbeam

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Accounting Scandals
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Accounting Scandals

• v, Currency mismatch

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Accounting Scandals

• 2. Maxwell Communications
• i, Worldwide global communications
• ii, Net debts 1.5bn vs net assets 1bn
• iii, Dubious methods
• Pledge assets and then sell
• Plunder pension funds
• Share support
• 7 out of 10 in creative accounting blob index

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Accounting Scandals

• 3. Enron collapses, 7th biggest US company.
• - uses special purpose vehicles to keep debts
  off balance sheet
• - Treats loans as sales
• - Swops assets and treats them as sales
• - Creative accounting and fraud
• - Auditors position uneasy

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Accounting Scandals

• 4. Other US Scandals
• i, Worldcom
• - Capitalises revenue expenditures
• ii, Xerox
• - Premature recognition of leasing
• iii, Adelphi Communications
• - Rigases looted company used it as a
• personal piggy bank
• iv, Global Crossing
• - Swaps of capacity treated as income

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Accounting Scandals

• 5. Parmalat
• Run by charismatic Calisto Tanzi
• Creates fictitious sales
• e.g., double counts sales
• e.g., fictitious subsidiaries
• Has dubious loans treated as equity
• Fake Bank of America account worth 5 billion
  dollars

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Impact of Creative Accounting and Fraud I

• i, Erodes currency of accounting
• Lawyers and merchant bankers .... should
  recognise best long term interests lie in
  financially prudent practices rather than in
  resort to technical devices that, while not in
  conflict with the letter of accounting standards,
  impair the effectiveness of the system
• Tweedie I find it frightening some people are
  just lifting the numbers and using them as
  sancrosant ... some of them would be better off
  driving buses - it would be safer for a lot of
  us

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Impact of Creative Accounting and Fraud II

• ii, Regulatory war of the fittest
• Griffiths Rather than eliminate creative
  accounting the imposition of standards appears to
  have created more and more sophisticated forms of
  financial manipulation
• Ongoing innovations. Merchant banks develop
  creative compliance schemes.
• Succession regulatory activity since 1990s
  regulators strive to curb creative accounting
• Vibrant demand for creative compliance . A
  creative accounting arms race.

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Controlling Creative Accounting and Fraud III

• Can creative accounting and fraud ever be
  stopped?
• Probably not
• Part of human nature
• Best we can do is set up a sound conceptual
  framework and sound standards
• Promote good ethical conduct
• Be aware.

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Controlling Creative Accounting and Fraud

• CREATIVE ACCOUNTING COULD BE
• BETTER CALLED MANIPULATIVE
• ACCOUNTING BECAUSE IT HAS MORE IN
• COMMON WITH THE MASSAGE PARLOUR
• THAN THE CREATIVITY OF THE LITERARY
• SALON.
• AUSTIN MITCHELL