Creative Accounting Fraud and Accounting Scandals - PowerPoint

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					Creative Accounting, Fraud
 and Accounting Scandals
         Mike Jones
   Cardiff Business School
 Introduction
Managerial Motivation
Methods of Impression Management
Creative Presentation
Research Evidence
Accounting Scandals
Impact of Creative Accounting and Fraud
Controlling Creative Accounting and Fraud

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

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.

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.

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

4. Fraud

Stepping outside the Regulatory Framework
deliberately to give a false picture of the

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

           Managerial Motivation
Managers may wish to:

 Boost profits to benefit from
     i,     Profit related pay
     ii,    Shares and share options

 Manage gearing

 Profit-smooth

          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

  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

  Methods of Creative Accounting II
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
                   Euros m                   Euros m
        Capital    5.0            Stock      11.5
        Profit     6.5
                  11.5                       11.5

   Methods of Creative Accounting III
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
                           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
   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
    Methods of Creative Accounting V
                  Financing Scenario
10 year secured loan
Receives rental
Capital Guaranteed

Immediate access
If property appreciates will gain
 Effective ownership without having to borrow
 No need for loan on financial statements
        Methods of Impression
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

           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
                                       Real Life
High 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
                  Research Evidence
 Ranking of Creative Accounting Practices used by 185
                 Major UK Companies

TYPE                       NO    %         RANKING

Provisions                 105   57        1
Non-trading profits         63   34        2
Extraordinary costs         54   29        3
Pension funds               52   28        4
Capitalisation              50   27        5
Low tax charge              24   13        6
Off balance sheet debt      23   12        7
Depreciation                17    9        8
Currency mismatch           16    9        9
Brand names                 14    8        10
Earn outs                    9    5        11
Phillips and Drew (1992)
         Accounting Scandals
 Perennial

South Sea Bubble to Enron and Parmalat

Mixture of fraud and creative accounting

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

Fictitious transactions.

Transactions which break accounting rules.

                            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
                     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
           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,       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

          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   than   interest   payable
therefore P & L Gains!!                                   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
        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

           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

         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

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”
   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

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

 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.
Controlling Creative Accounting and