Creative Accounting, Fraud and Accounting Scandals By Mike Jones

Creative Accounting, Fraud
and Accounting Scandals
By
Mike Jones
Cardiff Business School
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
2
Creative Accounting
3
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
4
Definitions
1. 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.
5
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.
6
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 company’s results serving the interests of
preparers.
7
Definitions
4. Fraud
Stepping outside the Regulatory Framework
deliberately to give a false picture of the
accounts.
8
Definitions
No
Flexibility
Flexibility to
give a “true
and fair” view
Flexibility to
give a creative
view
Flexibility to
give a fraudulent
view
Regulatory framework
eliminates accounting
choice
Working within
regulatory framework
to ensure users’
interests
Working within
regulatory framework
to serve preparers’
interests
Working outside
regulatory
framework
Within regulatory framework
Outside regulatory
framework
9
Managerial Motivation
Managers may wish to:
 Boost profits to benefit from
i,
ii,
Profit related pay
Shares and share options
 Manage gearing
 Profit-smooth
10
Managerial Motivation
Which company would you invest in: A or B?
Company
A
Year 1
£1m
Year 2
£2m
Year 3
£4m
Year 4
£8m
B
£4m
£(1)m
£15m
£(3)m
11
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
12
Methods of Creative Accounting II
Stock
Only one asset, stock, worth say 10
million Euros. If capital is 5 million Euros and this year’s
profit is 5 million Euros, then balance sheet A:
Balance Sheet A
Euros m
Euros m
Capital
5
Stock
10
Profit
5
10
10
The company:
(1) adopts a more generous stock valuation policy
(increases stock by 5 million Euros),
(2) does a particularly thorough stock-check (increases
stock by 1.0 million Euros).
We now have balance
sheet B.
Balance Sheet B
Capital
Profit
Euros m
5.0
6.5
11.5
Stock
Euros m
11.5
11.5
13
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
14
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
15
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
16
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
17
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
18
Real Life
High Scores in Health Check
Companies using the most creative accounting techniques in Phillips and Drew’s
‘Health Check’
Company
British-Aerospace
Maxwell
Burton Group
Dixons
Cable and Wireless
Blue Circle
TI Group
Bookers
Asda
Granada
Next
Sears
LEP
Laporte
British Airways
Tiphook
Ultramar
Sector
Engineering
Media
Stores
Stores
Telephone networks
Building materials
Engineering
Food manufacturing
Food retailer
Leisure
Stores
Stores
Business services
Chemicals
Transport
Transport
Oils
Frequency
7
7
7
6
6
5
5
5
5
5
5
5
5
5
5
5
5
Source: M.J. Jones (1992), Accounting for Growth: Surviving the Accounting Jungle, Management Accounting,
February, p. 22
19
Research Evidence
Ranking of Creative Accounting Practices used by 185
Major UK Companies
TYPE
NO
%
RANKING
Provisions
Non-trading profits
Extraordinary costs
Pension funds
Capitalisation
Low tax charge
Off balance sheet debt
Depreciation
Currency mismatch
Brand names
Earn outs
105
63
54
52
50
24
23
17
16
14
9
57
34
29
28
27
13
12
9
9
8
5
1
2
3
4
5
6
7
8
9
10
11
Phillips and Drew (1992)
20
Accounting Scandals
 Perennial
South Sea Bubble to Enron and Parmalat
Mixture of fraud and creative accounting
21
Fraud
Individuals use businesses as own private bank
account to plunder at will.
Fictitious transactions.
Transactions which break accounting rules.
22
Accounting Scandals
Adecco
Adelaid Steamship
Adelphia
Communications
Ahold
Albert Fisher
Alstom
AOL/Time Warner
Argyll Foods
Ashtead
Associated British Ports
Atlantic Computers
Barchris Construction
Barlow Clowes
BCCI
Bond Corporation
Holdings
Brent Walker
Brentford Nylons
Britannia Securities
British & Commonwealth
British Aerospace
British Airways Authority
British Printing
BTR
Burton Group
Cendant
Cisco
City Equitable Fire
Insurance
City of Glasgow Banking
Coloroll
Computer Associates
Conseco
Consolidated Cotton
Duck
Continental Vending
Corporate Services Group
Court Line
Courtaulds
Cray Electronics
Dynergy
Eastern Counties Railway
El paso
Enron
Equity Funding
European Commission
Four Seasons Nursing
GEC/AEI
Global Crossing
Collins Holdings
Grand Metropolitan
Green Department Store
Green Tree Financial
Halliburton
HealthSouth
HIH
Home Stake Production
IBM
ImClone Systems
Insull Utility Investment
Int’l Signals and Control
Interpublic
Inyerstate Hosiery Mills
Investors Overseas
Services
Kreditanstalt
Kreuger & Toll
Ladbroke Group
23
Accounting Scandals
Leasco
Lemont & Hauspit
Levitt Group
Lockheed
London & county
Securities
London Capital Group
Lonrho
Lucent
Maxwell Communications
McKesson &Robbin
Micro Focus
Microstrategy
Minsec
National Student
Marketing
Nortel
Nvidia
Oxford Health Plans
Parmalet
Penn Central
Pergamon Press
Polly Pekc
Poseidon
Quaity Software Products
Queens Moat Houses
Qwest
Rank hovis McDougall
Reid Murray
Rite Aid
Rolls Razor
Rolls-Royces
Royal British Bank
Royal mail Steamship
Rush & Tomkins
Saatchi & Saatchi
Skandia
Spring Ram
Storehouse
Sunbeam
Swedish Match
Texas Gulf Sulphur
Tiphook
Trafalfar House
Tyco International
US Realty & Construction
Vehicle & General
Versailles
Waste Management
WorldCom
WPP
Xerox
Yale Express
Yale Transport
24
Accounting Scandals
Case Studies
1. Polly Peck (charismatic chairman: Asil Nadir)
 One of fastest growing UK firms in 1990s
 1990 interim results analysts predict a substantial
increase. 6 days later collapses
 Why?
a, Banks and shareholders shut their eyes
b, Fraud and deception
c, Accounting policies flattering
i,
ii,
iii,
iv,
Brands
£405 million stranded in Turkey
Delmonte sales overestimated
Growth in borrowing
1985
Profit
64m
Interest In
0.5
Out (5.7)
Cash
30
Borrowings
66
1989
139m
77.4
(55.6)
250
1106
25
Accounting Scandals
v, Currency mismatch

Borrows heavily in two strong currencies DM and
Swiss Francs

Deposits in weak currency Turkey

Weak currencies depreciate against strong ones
causing capital losses
Capital Losses (£44.7m) in 1988, and (£170.3m) in 1989
taken direct to Reserves
Interest Receivable greater
therefore P & L Gains!!
than
interest
payable
26
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
27
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
28
Accounting Scandals
4. Other US Scandals
i, Worldcom
Capitalises revenue expenditures
ii, Xerox
Premature recognition of leasing
iii, Adelphi Communications
Rigase’s “looted company” used it as a
“personal piggy bank”
iv, Global Crossing
Swaps of capacity treated as income
29
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
30
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”
31
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.
32
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.
33
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
34