Creative Accounting and Earnings Management

Prof. Lakshman R Watawala

President

CMA Sri Lanka

Creative Accounting and Earnings Management

Creative accounting and earnings management are expressions referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.

References

Griffiths Creative accounting Fox J Learn to play the earnings game Investopedia Justin Kuepper Articles Merchant K A and Rockness J The ethics of

managing earnings: an empirical investigation

Jameson M Practical guide to creative accounting

Creative Accounting and Earnings Management

They are characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes used.

"Creative accounting"

The term as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations. "Creative accounting" is at the root of a number of accounting scandals, and many proposals for accounting reform -usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added.

Earnings Management

Earnings management usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics. Aggressive earnings management is a form of fraud and differs from reporting error.

Earnings Management

The main forms of earnings management are as follows:

Unsuitable revenue recognition Inappropriate accruals and estimates of liabilities Excessive provisions and generous reserve

accounting Intentional minor breaches of financial reporting

requirements that aggregate to a material breach.

Creative Accounting and Earnings Management

Credit crunch, Worldcom, Enron, Parmalat, Satyam...The succession of financial scandals which have made the front page news in recent times has meant that terms such as 'creative accounting' and 'stock options' have now become part of everyday vocabulary for people half the world over.

stock options

One commonly accepted incentive for the systemic over-reporting of corporate income which came to light in 2002 was the granting of stock options as part of executive compensation packages. Since stock prices reflect earning reports, stock options could be most profitably exercised when income is exaggerated, and the stock can be sold at an inflated profit.

stock market downturn of 2002

Newspaper and television journalists have hypothesized that the stock market downturn of 2002 was precipitated by reports of accounting irregularities at Enron, Worldcom, and other firms in the United States

ENRON

Enron, a Houston-based energy trading company was, based on revenue, the seventh largest company in the U.S.

By the use of shell companies, Enron was able to keep hundreds of millions worth of debt off its books.

Doing so fooled investors and analysts into thinking this company was more fundamentally stable than it actually was.

ENRON

Additionally, the shell companies, run by Enron executives, recorded fictitious revenues, essentially recording one dollar of revenue multiple times, thus creating the appearance of incredible earnings figures.

. Eventually, the complex web of deceit unraveled, and the share price crashed from over $90 to less than $0.70.

Enron

As Enron fell, it took down with it Arthur Andersen, the fifth leading accounting firm in the world at the time. Andersen, Enron's auditor, basically imploded after David Duncan, Enron's chief auditor, ordered the shredding of thousands of documents.

The fiasco at Enron made the phrase "cook the books" a household term once again.

WorldCom, 2002

Not long after the collapse of Enron, the equities market was rocked by another billion-dollar accounting scandal.

. Telecommunications giant WorldCom came under intense scrutiny after yet another instance of some serious cooking the books".

WorldCom recorded operating expenses as investments.

Worldcom 2002

. Apparently, the company felt that office pens, pencils and paper were an investment in the future of the company and therefore capitalized the cost of these items over a number of years. In total $3.8 billion worth of normal operating expenses - which should all be recorded as expenses for the fiscal year in which they were incurred - were treated as investments.

Worldcom 2002

This little accounting trick grossly exaggerated profits for the year the expenses were incurred;

in 2001, WorldCom reported profits of around $1.3 billion. In fact, its business was becoming increasingly unprofitable.

Who suffered the most in this deal? The employees - tens of thousands of them lost their jobs.

Worldocm 2002

The next ones to feel the betrayal were the investors who had to watch the gut-wrenching downfall of WorldCom's stock price, as it plummeted from more than $60 to less than $0.20.

Investment scams

Ponzi Scheme - A type of pyramid scheme, this is where money from new investors is used to provide a return to previous investors. The scheme collapses when money owed to previous investors is greater than the money that can be raised from new ones. Ponzi schemes always collapse eventually.

Madoff investment scandal

The Madoff investment scandal broke in December 2008, when former NASDAQchairman Bernard Madoff admitted that the wealth management arm of his business was an elaborate Ponzi scheme.

Madoff said that his firm had "liabilities of approximately US$50 billion Prosecutors estimated the size of the fraud to be $64.8 billion,

Madoff investment scandal

Madoff had 4,800 clients as of November 30, 2008

Alerted by his sons, federal authorities arrested Madoff on December 11, 2008.

On March 12, 2009 Madoff pleaded guilty to 11 federal crimes and admitted to operating what has been called by The Market Oracle the largest investor fraud ever committed by an individual.

Madoff investment scandal

On June 29, 2009, he was sentenced to 150 years in prison with restitution of $170 billion.

Satyam scandal

On 7 January 2009, company Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India (SEBI) that Satyam's accounts had been falsified [1][2][3].

Raju confessed that Satyam's balance sheet of 30 September 2008 contained:

inflated figures for cash and bank balances of 5,040 crore (US$1.12 billion) as against 5,361 crore (US$1.19 billion) reflected in the books.

an accrued interest of 376 crore (US$83.47 million) which was non-existent.

an understated liability of 1,230 crore (US$273.06 million) on account of funds was arranged by himself.

an understated debtors' position of 490 crore (US$108.78 million) (as against 2,651 crore (US$588.52 million) in the books).

SATYAM SCANDAL

On 7 January 2009, company Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India (SEBI) that Satyam's accounts had been falsified

Raju confessed that Satyam's balance sheet of 30 September 2008 contained:

inflated figures for cash and bank balances of 5,040 crore (US$1.12 billion) as against 5,361 crore (US$1.19 billion) reflected in the books.

Satyam scandal

an accrued interest of 376 crore (US$83.47 million) which was non-existent.

an understated liability of 1,230 crore(US$273.06 million) on account of funds was arranged by himself.

an understated debtors' position of 490 crore(US$108.78 million) (as against 2,651 crore(US$588.52 million) in the books).

Satyam scandal

Satyam's shares fell to 11.50 rupees on 10 January 2009, their lowest level since March 1998, compared to a high of 544 rupees in 2008. In New York Stock Exchange Satyam shares peaked in 2008 at US$ 29.10; by March 2009 they were trading around US $1.80.

SATYAM SCANDAL

Satyam's shares fell to 11.50 rupees on 10 January 2009, their lowest level since March 1998, compared to a high of 544 rupees in 2008. In New York Stock Exchange Satyam shares peaked in 2008 at US$ 29.10; by March 2009 they were trading around US $1.80.

SATYAM SCANDAL

On 22 January 2009, CID told in court that the actual number of employees is only 40,000 and not 53,000 as reported earlier and that Mr. Raju had been allegedly withdrawing INR 20 crore rupees every month for paying these 13,000 non-existent employees

SATYAM SCANDAL

Chartered accountants regulator ICAI issued show-cause notice to Satyam's auditor PricewaterhouseCoopers (PwC) on the accounts fudging. "We have asked PwC to reply within 21 days," ICAI President .

It was also reported that Satyam's auditing firm PricewaterhouseCoopers will be scrutinized for complicity in this scandal.

SATYAM SCANDAL

SEBI, the stock market regulator, also said that, if found guilty, its license to work in India may be revoked.

Satyam was the 2008 winner of the coveted Golden Peacock Award for Corporate Governance under Risk Management and Compliance Issues, which was stripped from them.

Recent Sri Lankan Experiences

Collapse of a credit card company engaged in deposit taking

Not approved by the Central Bank for Deposit Taking.

Fundamentals rights case filed in the Magistrates Court and Supreme Court.

Directors unable to submit proposal for repayment of depositors.

SL Experience

Central bank investigation carried out. All directors taken into custody. The parent company and many subsidiary

companies stopping operations.

Supreme Court appointed a Committee of 3 member Chartered Accountants to assist in the repayment of Depositors.

This committee is referred to as the Committee of Chartered Accountants.

SL Experience Committee has the Central Bank as the

Secretariat which has court appointed COO and staff.

The committee has regular meetings and todate over a period of 2 years had app. 125 meetings to engage in implementing court decisions regards repayment, sale of assets, preparation of progress reports to court at each sitting, attending to matters relating to Group companies,

SL Experience

Auditors appointed to conduct audit of the company.

The auditor of the company was also in custody and later died while in prison.

There were many doubts in the audited figures which are now been verified.

The Attorney General represented the Central Bank and works closely with the committee.

SL Experience

Matters of concern was the confirmation of deposit figure of Rs 26.0 B (US $ 230 M)

This has now been confirmed by the auditors. The correctness of the previous accounts are

now been verified due to differences in the figures in the accounts and the General Ledger.

This included the verification of deposits, income, expenditure, assets and liabilities.

SL Experience

The payment of interest to depositors were very much higher than the normal rates paid by banks and finance companies.

The generation of income has not been sufficient for the repayment of the interest and the deposits.

This resembles a Ponzi scheme where payments have been made to existing depositors from new deposits.

SL Experience

Directors personal assets as ordered by the Supreme Court have been taken over and used to repay the depositors.

Payment schemes submitted by the Directors included the 1st one for Rs 13 B (US $ 130 M) and not realised. A statement later prepared by other directors estimated a realisable amount of Rs 2.2 B (US $ 20 M).

Later Directors have submitted another estimate for Rs 7.5 B (US $ 68 M)

SL Experience

The directors have proposed that they be reappointed to the Board to manage and add value to the company with 3 outside directors and supervision by the depositors.

The other proposal is for the creditors to take over the company which includes the depositors, other creditors, two specialists one in financial restructuring and another commercial lawyer.

SL Experience

The depositors now have to consider these proposals and come back to court at the next hearing.

Conclusion

There are many lessons that we can take from the various experiences.

With the US bankruptcies the audit and controls have been strengthened and this has resulted in Sarbanes Oxley Act put in place, Public Company Accounting Oversight Board (PCAOB) to control the accopunting professions, more powers to SEC, Corporate Governance strengthened.

Conclusion Audit committees, independent directors,

directors disclosures

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) a voluntary private sector organization dedicated to provide guidance to executive management and governance entities on critical aspects of Organizational Governance, business ethics, internal control, enterprise risk management, fraud and financial reporting.

Conclusions Financial organisations that accept deposits

from public to come under closer scrutiny of the Central Banks.

Public to be educated on investing in high risk ventures promising attractive rates of interest.

The auditing and accounting profession to be strengthened to maintain quality of audits and the integrity of its members.

CPD should play a major role in all professional accounting bodies.

Conclusion

Strict controls to be exercised to ensure that all members comply and not only a few. If the professional bodies cannot do it then the government will step in similar to in the US.