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