Creative Accounting Updated

Creative AccountingCreative Accounting

ByBy

Nitin Malhotra – 09PT2-72Nitin Malhotra – 09PT2-72

Sameer Rawal – 09PT2-84Sameer Rawal – 09PT2-84

Sanjeev Kumar – 09PT2-89Sanjeev Kumar – 09PT2-89

Saurabh Gulati – 09PT2-90Saurabh Gulati – 09PT2-90

Sumit Kumar Sharma – Sumit Kumar Sharma – 09PT2-9909PT2-99

2

OverviewOverview IntroductionIntroduction DefinitionsDefinitions Managerial MotivationManagerial Motivation Creative AccountingCreative Accounting Methods of creative AccountingMethods of creative Accounting Research EvidenceResearch Evidence Accounting ScandalsAccounting Scandals Impact of Creative Accounting and FraudImpact of Creative Accounting and Fraud Controlling Creative Accounting and FraudControlling Creative Accounting and Fraud Comprehensive checklist of warning signsComprehensive checklist of warning signs

3


4


Two QuotesTwo Quotes

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

M. LaffertyM. Lafferty

““Every company in the country is fiddling its profits”.Every company in the country is fiddling its profits”.I. GriffithsI. Griffiths

5

DefinitionsDefinitions

1. Fair Presentation1. Fair 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.

6


2.2. 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.

7


3.3. 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.

8


4.4. 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.

9


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

10

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 pay

ii,ii, Shares and share optionsShares and share options

Manage gearingManage gearing

Profit-smoothProfit-smooth

11

Managerial MotivationManagerial Motivation

Which 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 4Year 4

AA £1m£1m £2m£2m £4m£4m £8m£8m

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

12


What do we want to create?

More profit? Less profit?

More assets? Fewer assets?

More liabilities? Fewer liabilities?

13

Creative Accounting PracticesCreative Accounting Practices Income smoothing – move profit from one year to

another

Changing accounting policies, particularly depreciation, asset valuations

Overstating costs, particularly in regulated industries

Making expenses into Assets - ‘capitalisation’

14

Creative Accounting PracticesCreative 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 – ACCOUNTING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs……...

15

Methods of Creative AccountingMethods of Creative AccountingInnumerable, but managers can, for example, Innumerable, but managers can, for example, manipulate income, expenses, assets and liabilitiesmanipulate income, expenses, assets and liabilities

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

16

Methods of Creative AccountingMethods of Creative AccountingStockStock

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

17

Methods of Creative AccountingMethods of Creative Accounting

DepreciationDepreciation

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

18

Methods of Creative AccountingMethods of Creative Accounting

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 company to acquire Merchant bank sets up a special purpose company to acquire

clients properties. Loans secured on propertiesclients properties. Loans secured 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

19

Methods of Creative Accounting Methods of Creative Accounting VV

Financing ScenarioFinancing Scenario

BankerBanker

10 year secured loan10 year secured loan

Receives rentalReceives rental

Capital GuaranteedCapital Guaranteed

ClientClient

Immediate accessImmediate access

If 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

20

Methods of Creative Accounting Methods of Creative Accounting VIVI

21

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

22

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)

23

Accounting ScandalsAccounting Scandals

PerennialPerennial

South Sea Bubble to EnronSouth Sea Bubble to Enron

Mixture of fraud and creative accountingMixture of fraud and creative accounting

24

FraudFraud

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

Fictitious transactions.Fictitious transactions.

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

25

AccountingAccounting ScandalsScandals

AdeccoAdecco 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

26

AccountingAccounting ScandalsScandals

LeascoLeasco 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

27

AccountingAccounting Scandals Scandals

1. Maxwell Communications1. Maxwell 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’ index7 out of 10 in creative accounting ‘blob’ index

28


2.2. Enron collapses, 7Enron collapses, 7thth biggest US company. biggest US company.

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

-- Treats loans as salesTreats loans as sales

-- Swops assets and treats them as salesSwops assets and treats them as sales

-- Creative accounting and fraudCreative accounting and fraud

-- Auditors’ position uneasyAuditors’ position uneasy

29


3.3. Other US ScandalsOther US Scandals

i,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

30

Impact of Creative Accounting Impact of Creative Accounting and Fraudand Fraud

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 conflict with the letter of accounting standards, impair the effectiveness of the standards, impair the effectiveness of the system”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 sancrosant ... some of them would be better off driving buses - it would be safer for a lot of off driving buses - it would be safer for a lot of us”us”

31

Impact of Creative Accounting and Impact of Creative Accounting and FraudFraud

ii,ii, Regulatory war of the fittestRegulatory war of the fittest

Griffiths “Rather than eliminate creative accounting the imposition Griffiths “Rather than eliminate creative accounting the imposition of standards appears to have created more and more of standards appears to have created more and more sophisticated forms of financial manipulation”sophisticated forms of financial manipulation”

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

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

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

32

Controlling Creative Accounting Controlling Creative Accounting and Fraudand Fraud

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

Probably notProbably not Part of human naturePart of human nature Best 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 standards Promote good ethical conductPromote good ethical conduct Be awareBe aware

33

Controlling Creative Accounting Controlling Creative Accounting and Fraudand 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

34

Checklist of Warning signsChecklist of Warning signs

Balance Sheet and Statement of operationsBalance Sheet and Statement of operations

Warning Sign Warning Sign Problem IndicatedProblem Indicated

Cash and equivalents decline relative to total Cash and equivalents decline relative to total assetsassets

Liquidity issues; may need to borrowLiquidity issues; may need to borrow

Receivables grow substantially faster than salesReceivables grow substantially faster than sales Perhaps aggressive revenue recognition-recording Perhaps aggressive revenue recognition-recording revenue too soon or granting extended credit terms revenue too soon or granting extended credit terms to customersto customers

Receivables grow substantially slower than Receivables grow substantially slower than salessales

Receivables may have been reclassified as another Receivables may have been reclassified as another asset categoryasset category

Bad debt reserves decline relative to gross Bad debt reserves decline relative to gross receivablesreceivables

Under reserving and inflating operating incomeUnder reserving and inflating operating income

Unbilled receivables grow faster than sales or Unbilled receivables grow faster than sales or billed receivablesbilled receivables

A greater portion of revenue may be coming from A greater portion of revenue may be coming from sales under the percentage-of-completion methodsales under the percentage-of-completion method

Inventory grows substantially faster than sales, Inventory grows substantially faster than sales, cost of sales, or accounts payablecost of sales, or accounts payable

Inventory may be obsolete, requiring a write-off; Inventory may be obsolete, requiring a write-off; company may have failed to charge the cost of sales company may have failed to charge the cost of sales on some saleson some sales

Inventory reserves decline relative to inventoryInventory reserves decline relative to inventory Under reserving and inflating operating incomeUnder reserving and inflating operating income

Prepaid expenses shoot up relative to total Prepaid expenses shoot up relative to total assetsassets

Perhaps improperly capitalizing certain operating Perhaps improperly capitalizing certain operating expensesexpenses

Other assets rise relative to total assetsOther assets rise relative to total assets Perhaps improperly capitalizing certain operating Perhaps improperly capitalizing certain operating expensesexpenses

Gross plant and equipment increases sharply Gross plant and equipment increases sharply relative to total assetsrelative to total assets


35




Gross plant and equipment declines Gross plant and equipment declines sharply relative to total assetssharply relative to total assets

Failing to invest in new plant and equipmentFailing to invest in new plant and equipment

Accumulated depreciation declines as Accumulated depreciation declines as gross plant and equipment risesgross plant and equipment rises

Failing to take sufficient depreciation charge-inflating Failing to take sufficient depreciation charge-inflating operating incomeoperating income

Goodwill rises sharply relative to total Goodwill rises sharply relative to total assetsassets

Perhaps tangible assets were reclassified to goodwill to Perhaps tangible assets were reclassified to goodwill to avoid expensing them in future periodsavoid expensing them in future periods

Accumulated amortization declines as Accumulated amortization declines as goodwill risesgoodwill rises

Failing to take sufficient amortization charge-inflating Failing to take sufficient amortization charge-inflating operating incomeoperating income

Growth in accounts payable substantially Growth in accounts payable substantially exceeds revenue growthexceeds revenue growth

Failed to pay off current debts for inventory and supplies-Failed to pay off current debts for inventory and supplies-will require larger cash outflow in future periodwill require larger cash outflow in future period

Accrued expenses decline relative to total Accrued expenses decline relative to total assetsassets

Perhaps company released reserves – inflating operating Perhaps company released reserves – inflating operating incomeincome

Deferred revenue declines while revenue Deferred revenue declines while revenue increasesincreases

Either new business is slowing or company released some Either new business is slowing or company released some reserves to inflate revenuereserves to inflate revenue

Cost of goods sold grows rapidly relative to Cost of goods sold grows rapidly relative to salessales

Pricing pressure results in lower gross marginsPricing pressure results in lower gross margins

Cost of goods sold declines relative to Cost of goods sold declines relative to salessales

Company may have failed to transfer the entire cost of the Company may have failed to transfer the entire cost of the product from inventoryproduct from inventory

Cost of goods sold fluctuates widely from Cost of goods sold fluctuates widely from quarter to quarter relative to salesquarter to quarter relative to sales

Unstable gross margin could indicate accounting Unstable gross margin could indicate accounting irregularitiesirregularities

36




Operating expenses decline sharply relative to Operating expenses decline sharply relative to salessales


Operating expenses rise significantly relative to Operating expenses rise significantly relative to salessales

Company may have become less efficient, spending Company may have become less efficient, spending more for each unit soldmore for each unit sold

Major portion of pretax income comes from one-Major portion of pretax income comes from one-time gainstime gains

Core business may be weakeningCore business may be weakening

Interest expense rises materially relative to long-Interest expense rises materially relative to long-term debtterm debt

Higher cash outflow expectedHigher cash outflow expected

Interest expense declines materially relative to Interest expense declines materially relative to long-term debtlong-term debt


Amortization of software costs grows more slowly Amortization of software costs grows more slowly than capitalized coststhan capitalized costs


37


Statement of Cash FlowsStatement of Cash Flows


CFFO materially lags behind net incomeCFFO materially lags behind net income Quality of earnings may be suspect or expenditures for Quality of earnings may be suspect or expenditures for working capital may have been too highworking capital may have been too high

Company fails to disclose details of cash flow Company fails to disclose details of cash flow from operationsfrom operations

Company may be trying to hide the source of the Company may be trying to hide the source of the operating cash problemoperating cash problem

Cash inflows come primarily from asset sales, Cash inflows come primarily from asset sales, borrowing, or equity offeringsborrowing, or equity offerings

Signs of weakness, especially if cash comes exclusively Signs of weakness, especially if cash comes exclusively from asset sales, borrowing, or equity offeringsfrom asset sales, borrowing, or equity offerings

38


Narrative: Footnotes, Management Discussion, Proxy, and Auditor’s LetterNarrative: Footnotes, Management Discussion, Proxy, and Auditor’s Letter Warning Sign Warning Sign Problem IndicatedProblem Indicated

Change in accounting principleChange in accounting principle Attempt to hide an operating problemAttempt to hide an operating problem

Change in accounting estimateChange in accounting estimate Attempt to hide an operating problemAttempt to hide an operating problem

Change in accounting classificationChange in accounting classification Attempt to hide an operating problemAttempt to hide an operating problem

Change in auditorChange in auditor Sign of risky clientSign of risky client

Change in CFO or outside counselChange in CFO or outside counsel Sign of risky clientSign of risky client

Investigation by the SECInvestigation by the SEC Could lead to accounting restatementCould lead to accounting restatement

Long-term commitments/ contingenciesLong-term commitments/ contingencies Potentially large drain on cash reservesPotentially large drain on cash reserves

Current or potential litigationCurrent or potential litigation Potentially large drain on cash reservesPotentially large drain on cash reserves

Liberal accounting policiesLiberal accounting policies Financial reports may inflate profitsFinancial reports may inflate profits

Misguided management incentivesMisguided management incentives May lead to some financial shenanigans to boost profits, May lead to some financial shenanigans to boost profits, bonuses, and share pricebonuses, and share price

39



Weak control environmentWeak control environment Creates easy opportunities to perpetrate financial Creates easy opportunities to perpetrate financial shenanigansshenanigans

Auditor’s concernAuditor’s concern Sign of risky clientSign of risky client

Promotional managementPromotional management May be more likely to use financial shenanigans than May be more likely to use financial shenanigans than more modest executivesmore modest executives

Use of percentage of completion accountingUse of percentage of completion accounting Revenue may be inflatedRevenue may be inflated

Use of bill and hold accountingUse of bill and hold accounting Revenue may be inflated Revenue may be inflated

Over reliance on a few customersOver reliance on a few customers Potential business problem if one of them leavesPotential business problem if one of them leaves

Financial problems at key customerFinancial problems at key customer Business can be hurt if a key customer files for Business can be hurt if a key customer files for bankruptcybankruptcy

Seller finances customerSeller finances customer Revenue may be inflated and business may be much Revenue may be inflated and business may be much weaker than you realized weaker than you realized

Customer has right of returnCustomer has right of return Revenue may have been recorded too soonRevenue may have been recorded too soon

Barter transactionBarter transaction Revenue may have been inflatedRevenue may have been inflated

40



Seller gives customer stock warrantsSeller gives customer stock warrants Revenue may have been inflatedRevenue may have been inflated

Capitalized interest or softwareCapitalized interest or software Operating income may be inflatedOperating income may be inflated

Unrecorded liabilities, such as stock optionsUnrecorded liabilities, such as stock options Future cash obligations may be greater than expected Future cash obligations may be greater than expected and operating income may be inflatedand operating income may be inflated

Noncompliance with debt covenantNoncompliance with debt covenant Bank may call loan, causing a substantial cash crunchBank may call loan, causing a substantial cash crunch

Absence of unaffiliated directors on boardAbsence of unaffiliated directors on board Weak control environment may create opportunities for Weak control environment may create opportunities for management to perpetrate financial shenanigansmanagement to perpetrate financial shenanigans

Prepayment of future period’s operating expensesPrepayment of future period’s operating expenses Leads to inflated operating income in future periodsLeads to inflated operating income in future periods

41


Possible Signs of Misleading Financial StatementsPossible Signs of Misleading Financial Statements

Choosing accounting policiesChoosing accounting policies Too liberalToo liberal Changing accounting policiesChanging accounting policies UnjustifiedUnjustified

Deferring expensesDeferring expenses Profits are overstatedProfits are overstated

Income smoothingIncome smoothing Profits are understatedProfits are understated

Recognizing revenue too soonRecognizing revenue too soon Profits are overstatedProfits are overstated

Under accruing expensesUnder accruing expenses Profits are overstatedProfits are overstated

Changing discretionary costsChanging discretionary costs Manipulating profitsManipulating profits

Low quality controls Low quality controls Risk of shenanigansRisk of shenanigans

Changing auditorChanging auditor Risk of shenanigansRisk of shenanigans

Taking a “big bath”Taking a “big bath” Future profits are boostedFuture profits are boosted

Thank YouThank You

Creative Accounting Updated

Documents

Transcript of Creative Accounting Updated