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Creative Accounting

By Nitin Malhotra 09PT2-72 09PT2Sameer Rawal 09PT2-84 09PT2Sanjeev Kumar 09PT2-89 09PT2Saurabh Gulati 09PT2-90 09PT2Sumit Kumar Sharma 09PT2-99 09PT2-

Overview
         

Introduction Definitions Managerial Motivation Creative Accounting Methods of creative Accounting Research Evidence Accounting Scandals Impact of Creative Accounting and Fraud Controlling Creative Accounting and Fraud Comprehensive checklist of warning signs

Creative Accounting

Creative Accounting
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

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.

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.

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.

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

Definitions
No exibi ity exibi ity to give a true and fair view exibi ity to give a creative view exibi ity to give a fraudu ent view

Regu atory framework e iminates accounting choice

Working within regu atory framework to ensure users interests

Working within regu atory framework to serve preparers interests Outside regu atory framework

Working outside regu atory framework

Within regu atory framework

Managerial Motivation
Managers may wish to:


Boost profits to benefit from


i, ii, Profit related pay Shares and share options

Manage gearing ProfitProfit-smooth

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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

4m

(1)m

15m

(3)m

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Creative Accounting

What do we want to create?

More profit?

Less profit?

More assets? More liabilities?

Fewer assets?

Fewer liabilities?
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Creative Accounting Practices


 Income smoothing another

move profit from one year to

 Changing accounting policies, particularly depreciation, asset valuations  Overstating costs, particularly in regulated industries

 Making expenses into Assets - capitalisation

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Creative Accounting Practices


 Off-balance sheet financing , e.g leasing, Sale and buyback, special purpose vehicles  Recognising profits that aren t really there foreign exchange rates affecting values of assets and loans  Corporate takeovers ACCOU TING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs ...

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Methods of Creative Accounting


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


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:
B l ce Capital o it to k 10 5 5 10 10 o pa y: 1 adopts a o g o s sto k val atio poli y i as s sto k by 5 illio os 2 do s a pa ti la ly t o o g sto k k i as s os W ow av bala sto k by 1 0 illio t B. s B l ce eet B

                               

Capital o it

5.0 6.5 11.5

to k

11.5

os

os 11.5

 

eet A os os

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Methods of Creative Accounting


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


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 Creative Accounting VI

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Real Life
High S res in Health Che k unting te hniques in Phillips and Drew s C mpanies using the m st reative a Health Che k Comp y Britis Aerosp e M xwe Burton Group Dixons Cab e and Wire ess Blue Circle TI Group Bookers Asda Granada Next Sears LEP Laporte British Airways Tiphook Ultramar

Se tor E gineering Media Stores Stores Te ep one networks Building materials Engineering Food manufacturing Food retailer Leisure Stores Stores Business services Chemicals Transport Transport Oils

Freq e 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, Fe ruary, . 22

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Research Evidence
R a n in rea iv e a cc n in r K O ra c ice s a n ie s % 7 se d E r v isi n s n ra d in r i s E ra rd in a r c s s e n si n nds a i a isa i n a ch a r e O a a n ce sh e e d e e re cia i n rre n c is a ch Bra n d n a e s s E a rn
hi i s and re

7 7 7

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Accounting Scandals
 Perennial


South Sea Bubble to Enron 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 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 reditanstalt reuger & Toll Ladbroke Group

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Accounting Scandals
Leasco Lemont & Hauspit Levitt Group Lockheed London & county Securities London Capital Group Lonrho Lucent Maxwell Communications Mc esson &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 RollsRoyal 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

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Accounting Scandals
1. Maxwell Communications
i, ii, iii,
   

Worldwide global communications Net debts 1.5bn vs net assets 1bn 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
2. 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
3. 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

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Impact of Creative Accounting and Fraud


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, 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


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

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Checklist of Warning signs


Balance Sheet and Statement of operations Warning Sign Cash and equivalents decline relative to total assets Receivables grow substantially faster than sales Receivables grow substantially slower than sales Bad debt reserves decline relative to gross receivables Unbilled receivables grow faster than sales or billed receivables Inventory grows substantially faster than sales, cost of sales, or accounts payable Inventory reserves decline relative to inventory Prepaid expenses shoot up relative to total assets Other assets rise relative to total assets Gross plant and equipment increases sharply relative to total assets Problem Indicated Liquidity issues; may need to borrow Perhaps aggressive revenue recognition-recording revenue recognitiontoo soon or granting extended credit terms to customers Receivables may have been reclassified as another asset category Under reserving and inflating operating income A greater portion of revenue may be coming from sales under the percentage-of-completion method percentage-ofInventory may be obsolete, requiring a write-off; company writemay have failed to charge the cost of sales on some sales Under reserving and inflating operating income Perhaps improperly capitalizing certain operating expenses Perhaps improperly capitalizing certain operating expenses Perhaps improperly capitalizing certain operating expenses
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Checklist of Warning signs


Balance Sheet and Statement of operations Warning Sign Gross plant and equipment declines sharply relative to total assets Accumulated depreciation declines as gross plant and equipment rises Goodwill rises sharply relative to total assets Accumulated amortization declines as goodwill rises Growth in accounts payable substantially exceeds revenue growth Accrued expenses decline relative to total assets Deferred revenue declines while revenue increases Cost of goods sold grows rapidly relative to sales Cost of goods sold declines relative to sales Cost of goods sold fluctuates widely from quarter to quarter relative to sales Problem Indicated Failing to invest in new plant and equipment Failing to take sufficient depreciation charge-inflating operating chargeincome Perhaps tangible assets were reclassified to goodwill to avoid expensing them in future periods Failing to take sufficient amortization charge-inflating operating chargeincome Failed to pay off current debts for inventory and supplies-will suppliesrequire larger cash outflow in future period Perhaps company released reserves inflating operating income

Either new business is slowing or company released some reserves to inflate revenue Pricing pressure results in lower gross margins Company may have failed to transfer the entire cost of the product from inventory Unstable gross margin could indicate accounting irregularities
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Checklist of Warning signs


Balance Sheet and Statement of operations Warning Sign Operating expenses decline sharply relative to sales Operating expenses rise significantly relative to sales Major portion of pretax income comes from one-time onegains Interest expense rises materially relative to long-term longdebt Interest expense declines materially relative to long-term longdebt Amortization of software costs grows more slowly than capitalized costs Problem Indicated Perhaps improperly capitalizing certain operating expenses Company may have become less efficient, spending more for each unit sold Core business may be weakening Higher cash outflow expected Perhaps improperly capitalizing certain operating expenses Perhaps improperly capitalizing certain operating expenses

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Checklist of Warning signs


Statement of Cash Flows Warning Sign CFFO materially lags behind net income Company fails to disclose details of cash flow from operations Cash inflows come primarily from asset sales, borrowing, or equity offerings Problem Indicated Quality of earnings may be suspect or expenditures for working capital may have been too high Company may be trying to hide the source of the operating cash problem Signs of weakness, especially if cash comes exclusively from asset sales, borrowing, or equity offerings

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Checklist of Warning signs


Narrative: Footnotes, Management Discussion, Proxy, and Auditor s Letter Warning Sign Change in accounting principle Change in accounting estimate Change in accounting classification Change in auditor Change in CFO or outside counsel Investigation by the SEC LongLong-term commitments/ contingencies Current or potential litigation Liberal accounting policies Misguided management incentives Problem Indicated Attempt to hide an operating problem Attempt to hide an operating problem Attempt to hide an operating problem Sign of risky client Sign of risky client Could lead to accounting restatement Potentially large drain on cash reserves Potentially large drain on cash reserves Financial reports may inflate profits May lead to some financial shenanigans to boost profits, bonuses, and share price

! !

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Checklist of Warning signs


Narrative: Footnotes, Management Discussion, Proxy, and Auditor s Letter Warning Sign Weak control environment Auditor s concern Promotional management Use of percentage of completion accounting Use of bill and hold accounting Over reliance on a few customers Financial problems at key customer Seller finances customer Customer has right of return Barter transaction Problem Indicated Creates easy opportunities to perpetrate financial shenanigans Sign of risky client May be more likely to use financial shenanigans than more modest executives Revenue may be inflated Revenue may be inflated Potential business problem if one of them leaves Business can be hurt if a key customer files for bankruptcy Revenue may be inflated and business may be much weaker than you realized Revenue may have been recorded too soon Revenue may have been inflated

"

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Checklist of Warning signs


Narrative: Footnotes, Management Discussion, Proxy, and Auditor s Letter Warning Sign Seller gives customer stock warrants Capitalized interest or software Unrecorded liabilities, such as stock options Noncompliance with debt covenant Absence of unaffiliated directors on board Prepayment of future period s operating expenses Problem Indicated Revenue may have been inflated Operating income may be inflated Future cash obligations may be greater than expected and operating income may be inflated Bank may call loan, causing a substantial cash crunch Weak control environment may create opportunities for management to perpetrate financial shenanigans Leads to inflated operating income in future periods

# #

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Checklist of Warning signs


Possible Signs of Misleading Financial Statements Choosing accounting policies Changing accounting policies Deferring expenses Income smoothing Recognizing revenue too soon Under accruing expenses Changing discretionary costs Low quality controls Changing auditor Taking a big bath Too liberal Unjustified Profits are overstated Profits are understated Profits are overstated Profits are overstated Manipulating profits Risk of shenanigans Risk of shenanigans Future profits are boosted

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Thank You

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