3 Manipulating reports and creative accounting

Manipulation of financial statements and creative accounting

For as long as entities are required to produce accounts for specified periods, there will be the problem of inter-period allocation of transactions and economic activity. In the UK, accounts are required to show a true and fair view. It is ‘a’ not ‘the’ because there is no such thing as the unique set of numbers for that period for that company. What is ‘true and fair’ is in the eye of the beholder.

As a result, management will always have the ability to move profit from one period to another depending on their view of corporate transactions. In pejorative terms, this is called ‘income smoothing’. It is all about the judgement allowed within the rules to portray a complex set of transactions and events. To complicate matters further, inadvertent wrong presentation is an error, but deliberate wrong presentation is fraud. Establishing the mens rea to distinguish the latter from the former can be very difficult.

Jones1 uses the following definitions and we have added a distinction between creative (borderline acceptable) and aggressive accounting (likely to be sanctioned by the FRC) though this is a spectrum and the lines between these concepts are blurred and may be movable:

1 Fair presentation is using the flexibility within accounting to give a true and fair picture of the accounts so that they serve the interests of users. This is the aim of most entities being reported on. It is, after all, the law, and the requirements of accounting standards. Audit firms regard a client demonstrating this clear objective as ideal as it minimizes their exposure. Users might not be just actual or potential shareholders but a wider community, sometimes called stakeholders. 2 Creative accounting on the other hand uses the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of preparers. It may be within the flexibility allowed by regulators and does not give rise to

26 Manipulating reports, creative accounting sanctions. That said, it is on the cusp of acceptability and sometimes extends beyond any red line (see Box 3.1). Creative accounting is not altogether bad. It can encompass ways of presenting the information to provide a better understanding of a firm’s activities. Creative accounting as described operates within the regulatory framework and is not usually illegal or in breach of FRC rules. 3 Aggressive accounting (also Box 3.1) goes that bit further than creative accounting and might be considered for sanctions by the FRC and may even lead to prosecutions by the SFO and actions by the

FCA (if the company is listed) – as with Tesco (see Chapter 5). Jones only makes the distinction between creative accounting and fraud.

We add aggressive accounting which we define as one step on the cusp or over the red line of breaching FRC rules and regulations, and accounting standards. Normally aggressive accounting would lead to an FRC investigation and sanctions, perhaps even an FCA action and a prosecution by the SFO (as for Tesco).2 Such prosecutions by the

SFO are notoriously difficult in terms of achieving a guilty verdict by a jury not well versed in accounting or financial reporting. Frequently in the US and less frequently in the UK (for example

RBS [discussed later]), such financial activities can give rise to litigation. It is, however, a commonly used term which lacks an agreedupon definition and in the US is frequently associated with fraud3 while in the UK it is not normally so associated. This is a source of some confusion. Aggressive accounting as defined above may well be classified as fraud in the US – as demonstrated by Autonomy discussed in Chapter 5. 4 Fraud is deliberately stepping outside the regulatory framework to give a false picture of the accounts. This big step has to be outside the inherent flexibility and must be deliberate. Usually it is significantly beyond aggressive accounting, but again this is a spectrum, so where the line is drawn, at the cusp, may be arbitrary.

Box 3.1 Main methods of creative or

aggressive accounting4

The difference between creative (acceptable) and aggressive (possible sanctions) accounting is the extent of the change and any justification.

• Timing of income • premature or deferred sales recognition

• especially contracts bundling goods and services and/ or spanning accounting periods • misuse of sale and leasebacks

• Timing of expenses • judgemental use of provision accounting • acquisitions • receivables • goodwill • pensions • uncertain liabilities

• improper capitalization of interest • Increase of assets

• enhanced goodwill • enhanced brands and other intangibles • increased closing inventory • flexibility in overhead allocation methods • over-estimation of net realizable values

• lengthened depreciation lives • revalued fixed assets • flexibly assessed market values • Decrease of liabilities

• off balance sheet financing • reclassification of debt as equity

Source: Partially modified from Jones5 and related papers

Alternative methodology

Schilit et al.6 included many of the examples we explore in this chapter and the next, and classified the manipulations as different types of “financial shenanigans”. Their classification is shown in Box 3.2. and reads almost like an instruction manual of how to manipulate the financial statements, except it is aimed at the auditors and professional investors who want to spot the manipulation.

Box 3.2 Manipulations as financial shenanigans

(Schilit et al.)7

Earnings manipulation shenanigans

Recording revenue too soon

Recording bogus revenue

Boosting income using one-time or unsustainable activities

Shifting current expenses to a later period

Employing other techniques to hide expenses or losses

Shifting current income to a later period

Shifting future expenses to the current period

Cash flow shenanigans

Shifting financing cash inflows to the operating section

Moving operating cash outflows to other sections

Boosting operating cash flow using unsustainable activities

Key metric shenanigans

Showcasing misleading metrics that overstate performance

Distorting balance sheet metrics to avoid showing deterioration

Acquisition accounting shenanigans

Artificially boosting revenue and earnings

Inflating reported cash flow

Manipulating key metrics

Fraud

Fraud has many meanings and can be used in many situations. It occurs in various forms in failures and/or scandals, and covers a wide range of activities. We should clarify this definition.

Specific examples of fraud include misappropriating assets, for example:

• Stealing cash; • Stealing inventory.

Manipulating reports, creative accounting 29 Or something akin to fictitious transactions, for example:

• Inventing a ghost creditor and logging fictitious purchases with a view to be rewarded for doing so; • Enhancing the value of the same with a view to being rewarded; • As above, but with a debtor where the purpose is to underpay or create fictitious returns; • Sometimes this ghost can be an employee on the payroll or this fictitious action can result in the creation of entire subsidiaries.

Example: Theranos

Theranos, a private US start-up based in Silicon Valley, ran into problems in 2013. The founder, Elizabeth Holmes, claimed a revolutionary blood test, promising immediate results for a wide range of conditions. She has agreed to settle charges that she raised over $700 million (£500 million) fraudulently. The US SEC said Elizabeth Holmes and Theranos deceived investors about the firm’s technology. The SEC also said that the firm had falsely claimed that its products had been used by the US Army in Afghanistan. Theranos’s proprietary analyzer could complete only a small number of tests, and the company conducted the vast majority of patient tests on modified and industry-standard commercial analyzers manufactured by others.

Holmes will lose control of the firm and be fined $500,000. The SEC plans to bring a case against the president, Ramesh Sunny Balwani.

Falsifying claims about the product and then about its use by the US military in order to raise funds was, in our view, a clear case of fraud even though the settlement did not specify liability – though the original SEC charge was for fraud. The fact that this was not for personal gain but for raising funds to pay for the research and development to produce a novel product, claiming it was already working (when it was not), is still a fraud in our view. The motives, however altruistic, misled the investors in the company. Meanwhile, the company will shut labs and reduce staff. It may or may not survive. Holmes had control despite raising equity funds through the use of dual class shares.

Announcements

Any announcements including pre-close trading statements, profit warnings, profit updates and preliminary announcements are governed by

30 Manipulating reports, creative accounting various regulations. We should mention briefly the Financial Services and Markets Act (FSMA). Under this:

The Regulations provide that an issuer of securities to which the regime applies is liable to pay compensation to a person who acquires, continues to hold or disposes of the securities in reliance on published information to which the regime applies and who suffers loss in respect of the securities as a result of either (i) any untrue or misleading statement in that published information, or (ii) the omission from that published information of any information required to be included in it.

A Regulatory Information Service (RIS) is defined as a primary information provider, or an incoming information society service, established in an EU country, that disseminates regulated information in accordance with the minimum standards.

The difference in approach between the US and the UK stems from the liability regime. The UK regime has fraud at the centre of liability and is difficult to prove – the SFO has a record of failures. In the US, stakeholders’ litigation class actions normally have to get over a fraud hurdle, but this hurdle is far lower than in the UK.8

Impression management

In addition to using creative accounting to affect the numbers themselves, there is a further method of influencing the reader – impression management. (This seems to have been used extensively by Integrated Reporting, which we discuss later.) Impression management uses the flexibility within wider financial reports and uses narrative, tables, diagrams, drawings and graphs to convey a particular view to serve the interests of preparers and management.

Techniques used to alter the tone or balance include:

• Stressing the positive and downplaying the negative (for example, mining in South Africa; the accounts painted a rosy picture whereas in reality there had been a series of strikes as well as the Marikana killings, where 34 miners were killed and 78 were wounded by security forces). • Downplaying adverse situations (e.g. strikes, high staff turnover, riots or deaths). • Baffling the readers (Enron famously did this, which we discuss in

Chapter 4). Even today, we would challenge anyone to make sense of the accounts of the major UK listed legacy banks: at several hundred

Manipulating reports, creative accounting 31 pages long, clarity can be lost9 especially when combined with some of the other techniques listed here. • Using difficult to read, ambiguous or technical language; obfuscation. • Taking credit for good news, blaming external factors for bad news. • Using misleading graphs – visual tricks include selectivity, measurement distortion and presentational enhancement. • Using photographs to set the tone or even mislead. Just about everyone does this to some extent. • Creating or talking about initiatives, projects and programmes which have little or no meaning, or possible results. • Emphasizing company-specific jargon. • Using red herrings – introducing non-relevant topics.

Companies with negative results focus on the environment, target markets and emotive words rather than on company and performance indicators.10 Clatworthy and Jones (2006) found that profitable companies focus on past results, whereas unprofitable companies focus on the future.11 Companies reporting success use the active voice whereas companies reporting failure use the passive voice.12 Their overall findings, confirmed by other studies, were:

The results in this paper indicate that the chairman’s statement is subject to impression management techniques as managers’ propensity to associate themselves with company financial results is associated with the firm’s underlying financial performance. There is also some evidence that unprofitable companies focus more on the future, rather than on past performance.

Our current evidence confirmed that not much has changed and, if anything, it has become worse. This is especially true with the expansion of the front half of the annual report which contains the narrative sections.

Motivation for creative and aggressive accounting

The motivation for manipulating accounts is straightforward: if a company collapses, many groups could suffer harm. These include, but are not limited to, customers, suppliers, employees and banks. In general, creative accounting gives financial reporting a bad name and undermines overall confidence in financial statements. However, as long as it remains legal, it will continue to happen. As accounting and auditing are permeated by judgement, there will always be different ways to account for the same transaction, especially if estimates or inter-period allocations are involved. Box 3.3 provides some of the motivations for using creative or (the even more manipulative) aggressive accounting.

Box 3.3 Motivation for creative or aggressive

accounting14

• Personal incentives

• enhancing profit-related pay, bonuses, shares and options • personal satisfaction • Market expectations • meeting analysts’ expectations • profit smoothing or meeting industry norms • Special circumstances • managing leverage of debt (e.g. Lehman Brothers) • new issues • mergers and acquisitions • current regulations are wrong or our competitors are doing it so why aren’t we? • new management team • waiting for a better economic environment • Cover up of misstatement or fraud • the deliberate misstatement or misappropriation of assets

Source: Modified from Jones15

Of course, there may be a fine line between creative accounting, aggressive accounting and fraud. It can be regarded as a spectrum. The popular belief among the auditing profession is that creative accounting is not widespread and represents just a tiny fraction of accounts. In our interviews, we found that professional investors are not quite so sure and two of our team (John and Krish) believe that creative/aggressive accounting is more widespread. Note that not all creative accounting methods are wholly bad: sometimes such procedures may be disclosed, albeit in accounting policy notes or Audit Committee reports.

Many new CEOs will report greater than normal write-offs in their first accounts. This is to provide some flexibility in future years and have a better shot at producing positive results after the first year. During the first year the incoming CEO can always blame the outgoing one. We only have anecdotal evidence of this. Sherman and Young (2016)13 go further.

Manipulating reports, creative accounting 33

Evidence of motivation for creative accounting and fraud

Box 3.3 looks comprehensive but in practice, in trying to pigeon hole different failures or cases, one can run into problems. Jones16 summarized some empirical evidence on the motivation of these actions. For example, improving the share price, for convenience, under personal benefit, companies may also be trying to improve the share price to meet analysts’ expectations, and this could also be classified under covering up bad performance. Jones’s evidence is summarized in Box 3.4.

Box 3.4 Incentives for creative accounting and fraud (older and international cases)

General incentives Frequency

Cover up bad performance 30 Of which, those meeting expectations 2 of market and analysts Personal benefit 35 Of which, those improving share price 12 Meeting listing requirements 5 Other reasons 6

Source: Jones17

Jones divided 76 case studies of the incentives into four broad areas:

1 Covering up bad performance (30 cases), including two meeting managerial or analysts’ expectations; 2 Personal benefit (35 cases), including 12 cases where it was possible to identify improving share price as the main general incentive; 3 Five cases of meeting listing requirements; and 4 Six other cases.

Table 3.1 shows how some of the selected cases were finally uncovered. The reasons follow similar lines:

• New management reviews the accounts; • Whistleblower comes forward; • Someone tells someone who informs the authorities;

Table 3.1 Global scandals and how they were discovered

Company Year How discovered

Waste Management1998 New CEO and management went through the books Enron 2001 Whistleblower WorldCom 2002 Internal audit discovered $3.8 billion fraud Tyco 2002 SEC investigation HealthSouth 2003 Share sell-off before big loss Freddie Mac 2003 SEC investigation American Insurance2005 Whistleblower Lehman Brothers 2008 Went bankrupt Bernie Madoff (Bernard L. Madoff

Inv. Sec.) 2008 Madoff told his sons about the Ponzi scheme who reported him to the SEC Saytam 2009 CEO told his colleagues BHS 2016 Went bankrupt Tesco 2014 New CEO and management went through the books HBOS 2007/8 Shareholders Autonomy 2011 HP, the company that bought Autonomy MG Rover 2005 Went bankrupt and sold to the Chinese Carillion 2018 Went bankrupt Steinhoff 2017/18CEO disappeared after share price collapse Conviviality 2018 Share price collapse, then bankruptcy SIG 2018 Whistleblower

• There is a sharp drop in share price; • The company fails; • The authorities investigate; • The purchasing company in a takeover disputes the purchase price; • Internal auditors discover fraud.

What is possible now?

It can be argued that current regulations diminish the possibility of aggressive accounting. But the overstatement of earnings by Tesco of £326 million (discussed in more detail in Chapter 5) shows that it is still possible, even if more difficult.

Some observers believe that auditors are partially in denial of creative accounting practices. Others would agree with Rod that this is not a correct or a true observation. “I believe that creative accounting is not widespread as management are essentially honest and want to provide a true and fair presentation.”

There are many ways to creatively manipulate accounts as we have seen. Often, creative accounting issues relate to the timing of revenue

Manipulating reports, creative accounting 35 recognition or of cost allocation, especially on transactions that span more than one accounting period. Aggressive accounting takes that one stage further. In a system that is still principles based, despite the ever-expanding accounting pronouncements, precedent holds particular sway and preparers and auditors are influenced by what others do. In this environment, it can be a race to the bottom as to who can push the boundaries the furthest while still remaining legal. Too often the argument will be one or both of either “competitor A does this so why can’t we?” or “the standards don’t explicitly state we can’t do this”. Both have failings: the precise circumstances of the first will not be known because disclosed accounting policies are always limited as to practical detail, while in the second excuse it should not be a matter of what is not prohibited, but rather what a first principles analysis of the standard indicates is the proper solution. Moving away from principles to a legal basis simply encourages the second argument.

Normally there is discussion between auditee and auditor as to how a transaction may be accounted for within the permissible limits (as discussed in Chapter 1). This process is sometimes misunderstood and is perceived as assisting companies with creative accounting. Auditors are subject to strict ethical rules about auditing which mitigates this risk but it is a public perception that will not go away. Accusations that accountants are involved in developing tax avoidance strategies ‘on an industrial scale’18 are seen as applying equally in the world of financial reporting where the range of judgements involved are much wider than in the field of tax law.

For as long as preparers of financial statements remain within a permissible spectrum there is little an auditor can do even if their preferred treatment is different. The auditor can raise questions and challenge assumptions, but senior management may be able to justify their figures. However, the precise boundary between this type of creative or aggressive accounting and that which might be defined as fraud is ultimately dependent on both scale and intent.

Notes

1 Jones, M. J., 2011, Creative Accounting, Fraud and International Accounting, University of Bristol, 2011 Paper given at the University of South Australia. Available at: www.unisa.edu.au/Global/business/centres/cags/docs/seminars/creative%20 accounting%20and%20fraud(aus).pdf Accessed July 2018.

See also Jones, M. J., 2010, Creative Accounting, Fraud and International

Accounting Scandals, John Wiley & Sons. Available at: www.wiley.com/en-gb/

Creative+Accounting%2C+Fraud+and+International+Accounting+Scandal s-p-9780470057650 Accessed July 2018.

2 As yet, the Tesco prosecution against three ex-Tesco directors by the SFO and

FCA has not concluded and is still ongoing. The case emanates from actions back in 2014. Another case against Barclays Bank over Qatari loans by the SFO failed, though an appeal may be in progress. 3 Mulford, V. C., and Comiskey, E. E., 2011, The Financial Numbers Game, John

Wiley & Sons, 2002. This book contrasts with Black’s Law Dictionary, which is discussed in: Lawrence, G. M., and Wells, J. T., 2004, ‘Fraud: Basic Legal Concepts –

Beware Insufficient Knowledge of the Law’, Journal of Accountancy, 1 October.

Available at: www.journalofaccountancy.com/issues/2004/oct/basiclegalcon cepts.html Accessed July 2018. 4 Adapted from op. cit. Jones, 2011 and op. cit. Jones, 2010, Chapter 4, Methods of

Creative Accounting and Fraud, pp. 43–68. 5 Ibid. 6 Schilit, H. M., Perler, M., and Engelhart, Y., 2018, Financial Shenanigans: How to

Detect Accounting Gimmicks and Fraud in Financial Reports, McGraw-Hill Education,

New York, fourth edition. Available at: www.amazon.co.uk/dp/B0764LJJH9/ ref=dp-kindle-redirect?_encoding=UTF8&btkr=1 Accessed July 2018. 7 Schilit, H. M., Perler, M., and Engelhart, Y., 2018, Financial Shenanigans: How to

Detect Accounting Gimmicks and Fraud in Financial Reports, McGraw-Hill Education,

New York, fourth edition. Available at: www.amazon.co.uk/dp/B0764LJJH9/ ref=dp-kindle-redirect?_encoding=UTF8&btkr=1 Accessed July 2018. 8 The FRC has put out a discussion paper on auditors and preliminary announcements. FRC, 2017, ‘Discussion Paper – Invitation to Comment: Auditors and Preliminary Announcements’, Financial Reporting Council, 27 April. Available at: www.frc. org.uk/Our-Work/Publications/Audit-and-Assurance-Team/Discussion-Paper-

Invitation-to-comment-Auditors-File.pdf Accessed July 2018. 9 This may be the fault of regulators and Parliament. Whenever either party wants some corporate disclosure that is also to be subject to external scrutiny, the annual accounts are the only practical home. As such, the financial statements now include a large amount of ancillary data. 10 Clarke, F. L., and Dean, G., 2007, Corporate Collapse: Regulatory, Accounting and

Ethical Failure, and Indecent Disclosure: Gilding the Corporate Lily. Cambridge

University Press. Available at: https://scholar.google.co.uk/scholar?hl=en&as_ sdt=0%2C5&as_vis=1&q=Clarke%2C+F.%2C+L.%2C+and+Dean%2C+G.%2

C+2007%2C+Corporate+Collapse%3A+Regulatory%2C+Accounting+and+

Ethical+Failure%2C+and+Indecent+Disclosure%3A+Gilding+the+corporate+ lily%2C+Cambridge+University+Press%2C+2007.&btnG= Accessed July 2018. 11 Clatworthy, M. A., and Jones, M. J., 2006, ‘Differential Patterns of Textual Characteristics and Company Performance in the Chairman's Statement’, Accounting,

Auditing & Accountability Journal, Volume 19, Issue 4, pp. 493–511. Available at: https://doi.org/10.1108/09513570610679100 Accessed July 2018. 12 Ibid. 13 Sherman, H. D., and Young, S. D., 2016, ‘Where Financial Reporting Still Falls

Short’, Harvard Business Review, July-August. Available at: https://hbr.org/pro duct/where-financial-reporting-still-falls-short/R1607F-PDF-ENG Accessed July 2018. 14 Adapted from op. cit. Jones, 2011 and op. cit. Jones, 2010, Chapter 3, Motivations to Indulge in Creative Accounting and Fraud, pp. 31–41. 15 Ibid.

16 Adapted from op. cit. Jones, 2010, Part C, Chapter 21, Identifying Some Themes, pp. 455–478. 17 Ibid. 18 Commons Select Committee: Chair’s comments, 2015, ‘Tax Avoidance: The Role of Large Accountancy Firms Report Published’, Summary and Comments Made by Chair of UK Public Accounts Committee, www.parliament.uk, 6 February.

Available at: www.parliament.uk/business/committees/committees-a-z/com mons-select/public-accounts-committee/news/report-tax-avoidance-the-roleof-large-accountancy-firms-follow-up/ Accessed July 2018.