Creative Accounting, Fraud and Accounting Scandals

1. Creative Accounting, Fraud and Accounting Scandals By Mike Jones Cardiff Business School

2. 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

3. Creative Accounting

4. 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

5. 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.

6. 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.

7. 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.

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

9. Definitions

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

11. 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

12. 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

13. 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:

14. 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

15. 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

16. 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

17. 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

18. 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

19. Real Life

20. Research Evidence

21. Accounting Scandals • Perennial • South Sea Bubble to Enron and Parmalat • Mixture of fraud and creative accounting

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

23. 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 Int’l Signals and Control Holdings Courtaulds Interpublic Brent Walker Cray Electronics Inyerstate Hosiery Mills Brentford Nylons Dynergy Investors Overseas Britannia Securities Eastern Counties Railway Services British & Commonwealth El paso Kreditanstalt British Aerospace Enron Kreuger & Toll British Airways Authority Equity Funding Ladbroke Group

24. 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 Parmalet Swedish Match Penn Central Texas Gulf Sulphur

25. Accounting Scandals

26. Accounting Scandals v, Currency mismatch

27. 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

28. 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

29. 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

30. 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

31. 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”

32. 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.

33. 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.

34. 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