Creative Accounting

Creative Accounting and Financial Statements FraudsHow to Detect It?

Roles of AccountingImprove problem solving / decision makingManage risksTrust, AssuranceEducational - learn about organisationsConstruct, define, measure success/failureLanguage of business

Power of Accounting

Accounting provides a very selective but powerful representation of the corporate identity..The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary .Accounting provides the categories through which organisational participants perceive both themselves and the organisation.Mike Powers

Hierarchy of Accounting QualitiesDecision Makers and their characteristicsBenefits > CostsUnderstandabilityDecision-UsefulnessRelevanceReliabilityPredictive valueFeedback ValueTimelinessComparability & consistencyVerifiabilityNeutralityRepresentational FaithfulnessMateriality

You will discoverThat accounting is subjective, partial and potentially misleading

Accountants use language / numbers in a highly technical wayAccounts are a highly stylised story, representation, description of organisational eventsThe tribe of accountants takes many forms and lives within all organisationsProblematic nature of accounting numbers

However.Accounts are main source of systematically produced regulated informationGood as it getsUsually reliable 3rd party verifiedFollow the same basic rulesMost of the information is there (in the small print)You can never eliminate the risk of fraud / criminal misrepresentation

Roles of AccountantsAssisting the internal management of organisations

Complying with external financial reporting, controls and with taxation regulations

Expert consultants on financial and organisational performance

Two Quotes

How do you explain to an intelligent public that itis possible for two companies in the sameindustry to follow entirely different accountingprinciples and both get a true and fair auditreport?M. LaffertyEvery company in the country is fiddling itsprofits.I. Griffiths

Fair Presentation VS Creative AccountingFair Presentation Using the flexibility within accounting to give a true and fair picture of the accounts so that they serve the interests of users.

Creative AccountingUsing the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of preparers.

DefinitionsThe term 'creative accounting' can be defined in a number of ways. Initially we will offer this definition: 'a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business'.

Kamal Naser, presenting an academic view, offers this definition:Creative accounting is the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing rules and/or ignoring some or all of them. (1993:2)

What do we want to create?More profit?Less profit?More assets?Fewer assets?More liabilities?Fewer liabilities?

Financial Shenanigan Financial shenanigans are actions that intentionally distort a companys reported performance and financial conditions. They range from benign (changes in accounting estimates) to egregious (fraudulent recognition of bogus revenue)

Accounting ScandalsEnron collapses, 7th biggest US company US largest energy wholesaling companyOctober 2001 shocking US$618 million quarterly loss (mysterious & hidden related party partnership)November 2001 falsely claimed US$600 million earning. Restatement of 4 years FS.uses special purpose vehicles to keep debts off balance sheetTreats loans as salesSwops assets and treats them as salesCreative accounting and fraudEnd 2001- Enron bankrupt. The biggest corporate collapse in American History

John Dingell US Congressman:What we are looking at here is an example of superbly complex financial reports. They didnt have to lie. All they had to do was to obfuscate it with sheer complexity

Later, Enrons auditors faced a flurry of attacks, class action lawsuits and a criminal conviction that ultimately led to the firms demise.

Accounting ScandalsParmalatRun by charismatic Calisto TanziCreates fictitious salese.g., double counts salese.g., fictitious subsidiariesHas dubious loans treated as equityFake Bank of America account worth 5 billion dollars

History of Financial Shenanigans1963 - Great Salad Oil - fictitious inventory1970s - Equity Funding Corporation fic. sales1987 - MiniScribe Corporation fill disc box w bricks2006 - PT Bank Global Tbk.- reksadana2006 PT Great River Garment Tbk. - bonds

The Seven ShenanigansRecording revenue too soon or of Questionable QualityBefore shipments or before customers acceptanceSelling to affiliated party

Recording bogus revenueCash received in lending as revenueSales that lack of economic substances

Boosting revenue with One-Time GainsSell assets that have appreciated price above their cost (or book value) Creating income by reclassification of balance sheet account - held for sale to trading securities

The Seven ShenanigansShifting current expenses to a later or earlier periodCapitalizing normal operating costFailing to write down/off impaired assetsFailing to record or improperly reducing liabilitiesFailing to record expenses/liabilitiesReducing liabilities by changing accounting assumptionShifting current revenue to a later periodCreating reserves and releasing them into incomeImproperly holding back revenue just before an acquisition Shifting future expenses to the current period as a special charge Inflating amounts included as special charge

Searching for Shenanigans

Techniques for Detecting ShenanigansQuantitative Screening

The steepest decline in cash flow from operations (CFFO) relative to net incomeThe greatest year-over-year sales growth, followed by declining or negative sequential growthThe greatest growth in receivables relative to salesThe largest bulge in inventory relative to sales and to cost of salesThe biggest or smallest deterioration in gross marginsBig increase in soft assetsBig increase in deferred revenue

Sheet1

Operating Cash Flows Lagging Behind Net Income

Table 11-1. CFFO versus Net Income (Excluding Nonrecurring Charges)

($ in millions)Q0Q-1Q-2Q-3Q-4

Oxford Health Plan-121.4-57.4-27.3114.097.1

Rite-Aid-158.7-99.882.6206.22.9

Sequential Sales Declining

Table 11-2. CFFO Sequential Sales Growth Slowing

Year-

over-

(Percentage)YearQ0Q-1Q-2Q-3Q-4

Microsoft28.4%-6.6%18.8%-1.7%17.8%5.0%

Cambridge Technology Partners503%0.08.1%13.5%19.0%-

Sheet1

Receivables Growing Faster or Slower Than Sales

Table 11-3. Accounts Receivable Growing Substatially Faster (or Slower) Than Sales

(Days' Sales

Outstanding)Q0Q-1Q-2Q-3Q-4

Sabratek168106104119121

Cambridge Technology Partners73104918981

Wireless Facilities4554322110

Inventory Rising Faster than Cost of Sales (See Table 11-4)

Table 11-3.

(Days' Sales

Outstanding)Q0Q-1Q-2Q-3Q-4

Sabratek407282239273241

Sheet1

Gross Margins Turning Sharply Higher or Lower

Table 11-5. Gross Margins Rising or Declining Rapidly

(Percentage)Q0Q-1Q-2Q-3Q-4

Sunbeam29.4%30.7%25.9%20.9%19.1%

Compaq21.5%22.7%23.5%23.9%23.6%

Big Jump in Soft Assets

Table 11-6. Big Jump in Soft Assests


Cambridge Technology Partners

(prepaid expenses)16.714.22.03.83.3

Baan (prepaid expenses and other

assets)146.772.33.841.835.9

Sheet1

Big Decline in Deferred Revenue (See Table 11-7)

Table 11-7. Change in Deferred Revenue


Microsoft-110.044.0643.0419.0245.0

Microstrategy11.315.212.311.410.0

Wireless Facilities3.49.511.15.22

Techniques for Detecting Shenanigans

Change in accounting estimate or principleOffering customers financing or extended credit termsChanges in accounting policiesChanges in account classificationChange in auditorsExtended payment terms Percentage of completion Unbilled receivables Bill and hold More liberal credit terms Insider stock sales Decline in backlog Layaway sales Non monetary transactions Related-party transaction

Qualitative Screening

Analyzing FS - Balance Sheet and Statement of OperationsCash and equivalents decline relative to total assetsReceivables grow substantially faster than sales

Receivables grow substantially slower than salesBad debt reserves decline relative to gross receivablesUnbilled receivable grow faster than sales or billed receivablesWarning SignLiquidity issues; may need to borrow

Perhaps aggressive revenue recognition-recording revenue too soon or granting extended credit terms to customersReceivables may have been reclassified as another asset categoryUnderreserving and inflating operating incomeA greater portion of revenue may be coming from sales under the percentage-of-completion methodProblem Indicated or Shenanigan Used

Balance Sheet and Statement of Operations (Continued)Inventory grows substantially faster than sales, cost of sales or account payableInventory reserves decline relative to inventoryPrepaid expenses shoot up relative to total assetsOther assets rise relative to total assetsGross plant and equipment declines sharply relative to total assetsWarning SignInventory may be obsolete, requiring a write-off; company may have failed to charge the cost of sales on some salesUnderreserving and inflating operating incomePerhaps improperly capitalizing certain operating expensesPerhaps improperly capitalizing certain operating expensesPerhaps capitalizing maintenance and repair expenseProblem Indicated or Shenanigan Used

Balance Sheet and Statement of Operations (Continued)Gross plant and equipment declines sharply relative to total assetsAccumulated depreciation declines as gross plant and equipment risesGoodwill rises sharply relative to total assets

Accumulated amortization declines as goodwill risesGrowth in accounts payable substantially exceeds revenue growthWarning SignFailing to invest in new plant and equipmentFailing to take sufficient depreciation charge inflating operating incomePerhaps tangible assets were reclassified to goodwill to avoid expensing them in future periodsFailing to take sufficient amortization charge inflating operating incomeFailed to pay off current debts for inventory and supplies-will require larger cash outflow in future period

Problem Indicated or Shenanigan Used

Balance Sheet and Statement of Operations (Continued)Accrued expenses decline relative to total assetsDeferred revenue declines while revenue increases

Cost of goods sold grows rapidly relative to salesCost of goods sold grows rapidly relative to salesCost of goods soled fluctuates widely from quarter to quarter relative to salesWarning SignPerhaps company released reserves-inflating operating incomeEither new business is slowing or company released some reserves to inflate revenuePricing pressure results in lower gross marginsCompany may have failed to transfer the entire cost of the product from inventoryUnstable gross margin could indicate accounting operating expenses


Balance Sheet and Statement of Operations (Continued)Operating expenses rise sharply relative to salesOperating expenses rise significantly relative to salesMajor portion of pretax income comes from one-time gainsInterest expense rises materially relative to long term debtInterest expense declines materially relative to long term debtAmortization of software costs grows more slowly than capitalized costsWarning SignPerhaps improperly capitalizing certain accounting irregularitiesCompany may have become less efficient, spending more of each unit sold Core business may be weakening

Perhaps improperly capitalizing certain operating expensesPerhaps improperly capitalizing certain operating expensesPerhaps improperly capitalizing certain operating expensesProblem Indicated or Shenanigan Used

Statement of Cash FlowsCFFO materially lags behind net income

Company fails to disclose details of cash flow from operationsCash inflows come primarily from assets sales, borrowing, or equity offeringsWarning SignQuality of earnings may be suspect or expenditures for working capital may have been too highCompany 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


Narrative: Footnotes, Management Discussion, Proxy, Auditors LetterChange in accounting principleChange in accounting estimateChange in accounting classificationChange in auditorChange in CFO or outside counselInvestigation by the SECLong-term commitments/contingenciesCurrent or potential litigationLiberal accounting policiesMisguided management incentives

Warning SignAttempt to hide an operating problemAttempt to hide an operating problemAttempt to hide an operating problem

Sign of risky clientSign of risky clientCould lead to accounting restatementsPotentially large drain on cash reservePotentially large drain on cash reserveFinancial reports may inflate profitsMay lead to some financial shenanigans to boost profits, bonuses, and share price


Narrative: Footnotes, Management Discussion, Proxy, Auditors Letter (Continued)Weak control environment

Auditors concernPromotional management

Use of percentage of completion accountingUse bill and hold accountingOverrelliance on a few customers

Financial problems at key customer

Seller finances customer

Warning SignCreates easy opportunities to perpetrate financial shenanigansSign of risky clientMay be more likely to use financial shenanigans than more modest executivesRevenue may be inflated

Revenue may be inflatedPotential business problem if one of them leavesBusiness can be hurt if a key customer files for bankruptcyRevenue may have been inflated and business may be much weaker than you realized


Narrative: Footnotes, Management Discussion, Proxy, Auditors Letter (Continued)Customer has right of returnBarter transactionSeller gives customer stock warrantsCapitalized interest or softwareUnrecorded liabilities, such as stock options

Noncompliance with debt covenant

Absence of unaffiliated directors on board

Prepayment of future periods operating expenses

Warning SignRevenue may have been recorded too soonRevenue may have been inflatedRevenue may have been inflated Operating income may be inflatedFuture cash obligations may be greater than expected and operating income may be inflatedBank may call loan, causing a substantial cash crunchWeak control environment may create opportunities for management to perpetrate financial shenanigansLeads to inflated operating income in future periods


Checklist 1: Possible Signs of Misleading Financial StatementsChanging accounting policiesDeferring expensesIncome smoothingRecognizing revenue too soonUnderaccruing expensesChanging discretionary costsLow quality controlsChanging auditor

Choosing accounting policiesUnjustifiedProfits are overstatedProfits are understatedProfits are overstatedProfits are overstatedManipulating profitsRisk of shenanigansRisk of shenanigans

Too liberal

Always bear in mindPreparers of accounts know how people will interpret their accountsBe cynical assume the accounts are the best possible pictureAnalysis only as good as original data Never just use accounts check from many different sourcesAccounting terms are different from general understandings

Rule makersCorporate executives and internal auditorsOutside directorsIndependent auditorsRegulatorsEducatorsWatchdog organizations and independent commissionsFinancial analystsFinancial mediaLawyers representing the inventorsLEADING THE BATTLE TO COMBAT SHENANIGANS

The Ethics of Creative AccountingRegulatory war of the fittestGriffiths Rather than eliminate creative accounting the imposition of standards appears to have created more and more sophisticated forms of financial manipulationOngoing innovations. Merchant banks develop creative compliance schemes.Succession regulatory activity since 1990s regulators strive to curb creative accountingVibrant demand for creative compliance . A creative accounting arms race.

Controlling Creative Accounting andFraud Can creative accounting and fraud ever be stopped?Probably notPart of human natureBest we can do is set up a sound conceptual framework and sound standardsPromote good ethical conductBe aware.

ReferencesMBA Intensive Seminars 2004 Introduction to Accounting Howard Schilit Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in the Financial StatementsMike Jones; Cardiff Business School - Creative Accounting, Fraud and Accounting ScandalsOriol Amat, John Blake, Jack Dowds - The ethics of Creative Accounting

Thank You !

Creative Accounting

Documents

Transcript of Creative Accounting