Creative Accounting, Fraud Creative Accounting, Fraud and Accounting Scandalsand Accounting Scandals

ByBy

Mike JonesMike Jones

Cardiff Business SchoolCardiff Business School

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OverviewOverview IntroductionIntroductionDefinitionsDefinitionsManagerial MotivationManagerial MotivationMethods of Impression ManagementMethods of Impression ManagementCreative PresentationCreative PresentationResearch EvidenceResearch EvidenceAccounting ScandalsAccounting ScandalsImpact of Creative Accounting and FraudImpact of Creative Accounting and FraudControlling Creative Accounting and FraudControlling Creative Accounting and Fraud

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Creative AccountingCreative Accounting

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Two QuotesTwo Quotes

““How do you explain to an intelligent public How do you explain to an intelligent public that it is possible for two companies in the that it is possible for two companies in the same industry to follow entirely different same industry to follow entirely different accounting principles and both get a true accounting principles and both get a true and fair audit report?”and fair audit report?”

M. LaffertyM. Lafferty““Every company in the country is fiddling its Every company in the country is fiddling its

profits”.profits”.I. GriffithsI. Griffiths

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DefinitionsDefinitions1.1. Fair PresentationFair Presentation

Using the flexibility within accounting to giveUsing the flexibility within accounting to give

a true and fair picture of the accounts soa true and fair picture of the accounts so

that they serve the interests of users.that they serve the interests of users.

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DefinitionsDefinitions2. 2. Creative AccountingCreative Accounting

Using the flexibility within accounting to Using the flexibility within accounting to

manage the measurement and presentation manage the measurement and presentation

of the accounts so that they serve the of the accounts so that they serve the

interests of preparers.interests of preparers.

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DefinitionsDefinitions3. 3. Impression ManagementImpression Management

Using the flexibility of the accounts Using the flexibility of the accounts

(especially narrative and graphs) to convey(especially narrative and graphs) to convey

a more favourable view than is warranted ofa more favourable view than is warranted of

a company’s results serving the interests ofa company’s results serving the interests of

preparers.preparers.

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DefinitionsDefinitions4. 4. FraudFraud

Stepping outside the Regulatory FrameworkStepping outside the Regulatory Framework

deliberately to give a false picture of thedeliberately to give a false picture of the

accounts.accounts.

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DefinitionsDefinitions No Flexibility to Flexibility to Flexibility to Flexibility give a “true give a creative give a fraudulent and fair” view view view Regulatory framework Working within Working within Working outside eliminates accounting regulatory framework regulatory framework regulatory choice to ensure users’ to serve preparers’ framework interests interests Within regulatory framework Outside regulatory framework

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Managerial MotivationManagerial Motivation

Managers may wish to:Managers may wish to:

Boost profits to benefit fromBoost profits to benefit fromi,i, Profit related payProfit related payii,ii, Shares and share optionsShares and share options

Manage gearingManage gearing

Profit-smoothProfit-smooth

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Managerial MotivationManagerial MotivationWhich company would you invest in: A or B?Which company would you invest in: A or B?

CompanyCompany Year 1Year 1 Year 2Year 2 Year 3Year 3 Year Year 44

AA £1m£1m £2m£2m £4m£4m £8m£8m

BB £4m£4m £(1)m£(1)m £15m£15m£(3)m£(3)m

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Methods of Creative Methods of Creative Accounting 1Accounting 1

Innumerable, but managers can, for example, Innumerable, but managers can, for example, manipulate income, expenses, assets and manipulate income, expenses, assets and

liabilitiesliabilities

1.1.Income RecognitionIncome Recognition2. Interest payable e.g., capitalisation2. Interest payable e.g., capitalisation3.3.StockStock4.4.DepreciationDepreciation5.5.Goodwill and IntangiblesGoodwill and Intangibles6.6.Off balance sheet financingOff balance sheet financing

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Methods of Creative Methods of Creative Accounting II StockAccounting II Stock

Only one asset, stock, worth say 10 Only one asset, stock, worth say 10

million Euros. If capital is 5 million Euros and this year’smillion Euros. If capital is 5 million Euros and this year’s

profit is 5 million Euros, then balance sheet A: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

Euros m Euros m Capital 5.0 Stock 11.5 Profit 6.5 11.5 11.5

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Methods of Creative Methods of Creative Accounting III DepreciationAccounting III Depreciation

Business ProfitBusiness Profit 10,000 Euros10,000 EurosFixed AssetsFixed Assets 100,000 Euros100,000 EurosDepreciation straight line 10 yearsDepreciation straight line 10 yearsIf company adopts 20 year asset life will this affect If company adopts 20 year asset life will this affect profit?profit?Yes:Yes: Original policyOriginal policy New policy New policy EurosEuros Euros EurosProfit before depreciationProfit before depreciation 10,000 10,000 10,00010,000DepreciationDepreciation (10,000)(10,000) (5,000)(5,000)Profit after depreciation Profit after depreciation - - 5,0005,000

Profit increases by 5,000 EurosProfit increases by 5,000 Euros

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Methods of Creative Methods of Creative Accounting IVAccounting IV

Simple off balance sheet financing scenarioSimple off balance sheet financing scenario Company wants to acquire new premisesCompany wants to acquire new premises Merchant bank sets up a special purpose Merchant bank sets up a special purpose

company to acquire clients properties. Loans company to acquire clients properties. Loans secured on propertiessecured on properties

Ownership spread over clientsOwnership spread over clients Company leases propertiesCompany leases properties Rents pay loan interestRents pay loan interest End of initial lease, clients can End of initial lease, clients can i, buy leased properties; ori, buy leased properties; or ii, sell properties and repayii, sell properties and repay

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Methods of Creative Methods of Creative Accounting VAccounting VFinancing ScenarioFinancing Scenario

BankerBanker10 year secured loan10 year secured loanReceives rentalReceives rentalCapital GuaranteedCapital Guaranteed

ClientClientImmediate accessImmediate accessIf property appreciates will gainIf property appreciates will gain Effective ownership without having to borrowEffective ownership without having to borrow No need for loan on financial statementsNo need for loan on financial statements

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Methods of Impression Methods of Impression ManagementManagement

1. 1. Graphs may be usedGraphs may be used

1.1. SelectivitySelectivity

2.2. Deliberately to exaggerate trendsDeliberately to exaggerate trends

2. Accounting Narratives2. Accounting Narratives

1. Selectivity1. Selectivity

2. Spin and bias2. Spin and bias

3. Emphasise good news not bad news3. Emphasise good news not bad news

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Research EvidenceResearch EvidenceRevsine (1991) “Research evidence is Revsine (1991) “Research evidence is

consistent consistent with the notion that managers use latitude inwith the notion that managers use latitude inexisting financial reporting to benefit existing financial reporting to benefit

themselves”.themselves”.

In Regulated Industries Managers will lobby In Regulated Industries Managers will lobby for and choose accounting policies which for and choose accounting policies which reduce their regulatory visibility reduce their regulatory visibility

Earnings management linked to variables Earnings management linked to variables such as size, risk, managerial compensationsuch as size, risk, managerial compensation

County Natwest Woodmac (1992) find that: County Natwest Woodmac (1992) find that: 1.1. 29 out of 45 UK companies which failed 29 out of 45 UK companies which failed

reported a rise in EPSreported a rise in EPS2.2. 3 out of 45 were qualified3 out of 45 were qualified

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Real LifeReal LifeHigh Scores in Health Check

Companies using the most creative accounting techniques in Phillips and Drew’s ‘Health Check’

Company Sector Frequency British-Aerospace Engineering 7 Maxwell Media 7 Burton Group Stores 7 Dixons Stores 6 Cable and Wireless Telephone networks 6 Blue Circle Building materials 5 TI Group Engineering 5 Bookers Food manufacturing 5 Asda Food retailer 5 Granada Leisure 5 Next Stores 5 Sears Stores 5 LEP Business services 5 Laporte Chemicals 5 British Airways Transport 5 Tiphook Transport 5 Ultramar Oils 5

Source: M.J . Jones (1992), Accounting for Growth: Surviving the Accounting Jungle, Management Accounting, February, p. 22

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Research EvidenceResearch EvidenceRanking 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)

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Accounting ScandalsAccounting Scandals PerennialPerennial

South Sea Bubble to Enron and ParmalatSouth Sea Bubble to Enron and Parmalat

Mixture of fraud and creative accounting Mixture of fraud and creative accounting

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FraudFraud

Individuals use businesses as own private Individuals use businesses as own private bank account to plunder at will.bank account to plunder at will.

Fictitious transactions.Fictitious transactions.

Transactions which break accounting Transactions which break accounting rules.rules.

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Accounting ScandalsAccounting ScandalsAdeccoAdecco British PrintingBritish Printing European CommissionEuropean CommissionAdelaid SteamshipAdelaid Steamship BTRBTR Four Seasons NursingFour Seasons NursingAdelphiaAdelphia Burton GroupBurton Group GEC/AEIGEC/AEI CommunicationsCommunications CendantCendant Global CrossingGlobal CrossingAholdAhold CiscoCisco Collins HoldingsCollins HoldingsAlbert FisherAlbert Fisher City Equitable FireCity Equitable Fire Grand MetropolitanGrand MetropolitanAlstomAlstom Insurance Insurance Green Department Green Department

StoreStoreAOL/Time WarnerAOL/Time Warner City of Glasgow BankingCity of Glasgow Banking Green Tree FinancialGreen Tree FinancialArgyll FoodsArgyll Foods ColorollColoroll HalliburtonHalliburtonAshteadAshtead Computer AssociatesComputer Associates HealthSouthHealthSouthAssociated British PortsAssociated British Ports ConsecoConseco HIHHIHAtlantic ComputersAtlantic Computers Consolidated CottonConsolidated Cotton Home Stake ProductionHome Stake ProductionBarchris ConstructionBarchris Construction Duck Duck IBMIBMBarlow ClowesBarlow Clowes Continental VendingContinental Vending ImClone SystemsImClone SystemsBCCIBCCI Corporate Services GroupCorporate Services Group Insull Utility InvestmentInsull Utility InvestmentBond CorporationBond Corporation Court LineCourt Line Int’l Signals and Int’l Signals and

ControlControl HoldingsHoldings CourtauldsCourtaulds InterpublicInterpublicBrent WalkerBrent Walker Cray ElectronicsCray Electronics Inyerstate Hosiery MillsInyerstate Hosiery MillsBrentford NylonsBrentford Nylons DynergyDynergy Investors OverseasInvestors OverseasBritannia SecuritiesBritannia Securities Eastern Counties RailwayEastern Counties Railway Services ServicesBritish & CommonwealthBritish & Commonwealth El pasoEl paso KreditanstaltKreditanstaltBritish AerospaceBritish Aerospace EnronEnron Kreuger & TollKreuger & TollBritish Airways AuthorityBritish Airways Authority Equity FundingEquity Funding Ladbroke GroupLadbroke Group

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Accounting ScandalsAccounting ScandalsLeascoLeasco Pergamon PressPergamon Press TiphookTiphookLemont & HauspitLemont & Hauspit Polly PekcPolly Pekc Trafalfar HouseTrafalfar HouseLevitt GroupLevitt Group PoseidonPoseidon Tyco InternationalTyco InternationalLockheedLockheed Quaity Software ProductsQuaity Software Products US Realty & US Realty &

ConstructionConstructionLondon & countyLondon & county Queens Moat HousesQueens Moat Houses Vehicle & GeneralVehicle & General SecuritiesSecurities QwestQwest VersaillesVersaillesLondon Capital GroupLondon Capital Group Rank hovis McDougallRank hovis McDougall Waste ManagementWaste ManagementLonrhoLonrho Reid MurrayReid Murray WorldComWorldComLucentLucent Rite AidRite Aid WPPWPPMaxwell CommunicationsMaxwell Communications Rolls RazorRolls Razor XeroxXeroxMcKesson &RobbinMcKesson &Robbin Rolls-RoycesRolls-Royces Yale ExpressYale ExpressMicro FocusMicro Focus Royal British BankRoyal British Bank Yale TransportYale TransportMicrostrategyMicrostrategy Royal mail SteamshipRoyal mail SteamshipMinsecMinsec Rush & TomkinsRush & TomkinsNational StudentNational Student Saatchi & SaatchiSaatchi & Saatchi MarketingMarketing SkandiaSkandiaNortelNortel Spring RamSpring RamNvidiaNvidia StorehouseStorehouseOxford Health PlansOxford Health Plans SunbeamSunbeamParmaletParmalet Swedish MatchSwedish MatchPenn CentralPenn Central Texas Gulf SulphurTexas Gulf Sulphur

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Accounting ScandalsAccounting ScandalsCase 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, Brands ii, £405 million stranded in Turkey iii, Delmonte sales overestimated iv, Growth in borrowing 1985 1989 Profit 64m 139m Interest In 0.5 77.4 Out (5.7) (55.6) Cash 30 250 Borrowings 66 1106

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Accounting ScandalsAccounting Scandalsv, Currency v, Currency

mismatchmismatch 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 than interest payable therefore P & L Gains!!

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Accounting ScandalsAccounting Scandals

2.2. Maxwell CommunicationsMaxwell Communications

i,i, Worldwide global communicationsWorldwide global communications

ii,ii, Net debts 1.5bn vs net assets £1bnNet debts 1.5bn vs net assets £1bn

iii,iii, Dubious methodsDubious methods Pledge assets and then sellPledge assets and then sell Plunder pension fundsPlunder pension funds Share supportShare support 7 out of 10 in creative accounting ‘blob’ 7 out of 10 in creative accounting ‘blob’

indexindex

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Accounting ScandalsAccounting Scandals3.3. Enron collapses, 7 Enron collapses, 7thth biggest US biggest US

company.company.

-- uses special purpose vehicles to uses special purpose vehicles to keep keep debts off balance sheetdebts off balance sheet

-- Treats loans as salesTreats loans as sales

-- Swops assets and treats them as Swops assets and treats them as salessales

-- Creative accounting and fraudCreative accounting and fraud

-- Auditors’ position uneasyAuditors’ position uneasy

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Accounting ScandalsAccounting Scandals4.4. Other US Scandals Other US Scandalsi,i, WorldcomWorldcom

-- Capitalises revenue expendituresCapitalises revenue expenditures

ii,ii, XeroxXerox-- Premature recognition of leasingPremature recognition of leasing

iii, Adelphi Communicationsiii, Adelphi Communications-- Rigase’s “looted company” used it as aRigase’s “looted company” used it as a

““personal piggy bank”personal piggy bank”iv, Global Crossingiv, Global Crossing

-- Swaps of capacity treated as incomeSwaps of capacity treated as income

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Accounting ScandalsAccounting Scandals5. Parmalat5. Parmalat

Run by charismatic Calisto TanziRun by charismatic Calisto TanziCreates fictitious salesCreates fictitious sales

e.g., double counts salese.g., double counts sales

e.g., fictitious subsidiariese.g., fictitious subsidiaries Has dubious loans treated as equityHas dubious loans treated as equityFake Bank of America account worth 5 Fake Bank of America account worth 5

billion dollarsbillion dollars

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Impact of Creative Accounting Impact of Creative Accounting and Fraud Iand Fraud I

i, Erodes currency of accountingi, Erodes currency of accounting““Lawyers and merchant bankers .... [should Lawyers and merchant bankers .... [should

recognise] best long term interests lie in recognise] best long term interests lie in financially prudent practices rather than in financially prudent practices rather than in resort to technical devices that, while not in resort to technical devices that, while not in conflict with the letter of accounting standards, conflict with the letter of accounting standards, impair the effectiveness of the system”impair the effectiveness of the system”

Tweedie “I find it frightening some people are Tweedie “I find it frightening some people are just lifting the numbers and using them as just lifting the numbers and using them as sancrosant ... some of them would be better off sancrosant ... some of them would be better off driving buses - it would be safer for a lot of us”driving buses - it would be safer for a lot of us”

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Impact of Creative Accounting and Impact of Creative Accounting and Fraud IIFraud II

ii,ii,Regulatory war of the fittestRegulatory war of the fittestGriffiths “Rather than eliminate creative Griffiths “Rather than eliminate creative

accounting the imposition of standards appears accounting the imposition of standards appears to have created more and more sophisticated to have created more and more sophisticated forms of financial manipulation”forms of financial manipulation”

Ongoing innovations. Merchant banks develop Ongoing innovations. Merchant banks develop creative compliance schemes.creative compliance schemes.

Succession regulatory activity since 1990s Succession regulatory activity since 1990s regulators strive to curb creative accountingregulators strive to curb creative accounting

Vibrant demand for creative compliance . A Vibrant demand for creative compliance . A creative accounting arms race.creative accounting arms race.

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Controlling Creative Controlling Creative Accounting and Fraud IIIAccounting and Fraud III

Can creative accounting and fraud ever be Can creative accounting and fraud ever be stopped?stopped?

Probably notProbably notPart of human naturePart of human natureBest we can do is set up a sound Best we can do is set up a sound

conceptual framework and sound standardsconceptual framework and sound standardsPromote good ethical conductPromote good ethical conductBe aware.Be aware.

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Controlling Creative Controlling Creative Accounting and FraudAccounting and Fraud

““CREATIVE ACCOUNTING COULD BE CREATIVE ACCOUNTING COULD BE

BETTER CALLED MANIPULATIVEBETTER CALLED MANIPULATIVE

ACCOUNTING BECAUSE IT HAS MORE INACCOUNTING BECAUSE IT HAS MORE IN

COMMON WITH THE MASSAGE PARLOURCOMMON WITH THE MASSAGE PARLOUR

THAN THE CREATIVITY OF THE LITERARYTHAN THE CREATIVITY OF THE LITERARY

SALON”.SALON”.

AUSTIN MITCHELLAUSTIN MITCHELL