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Creative Accounting: Interpreting Financial Statements in a Post-Enron World

By

Steve Fortin, PhD, CA

Associate Professor

Accounting Fears Hit Computer Sciences

Wed Apr 2, 8:22 PM ET

NEW YORK (Reuters) - Shares of Computer Sciences Corp. (NYSE:CSC - news) tumbled more than 12 percent on Wednesday after an analyst said there was a "major need" for the computer services firm to be more open about its accounting.

Alternative Accounting Doubles Deficit

Mon Mar 31, 4:10 PM ET

By JEANNINE AVERSA, Associated Press Writer

WASHINGTON - The federal government, if it used an accounting method preferred by Federal Reserve (news - web sites) Chairman Alan Greenspan (news - web sites), would have turned in a deficit of $365 billion in 2002..

That's twice as big as the figure recognized as the official budget deficit number for last year: $158 billion.

IFRSs — A Done Deal! If you’ve heard that International Financial Reporting Standards (IFRSs) are coming to Canada but still don’t know what all the fuss is about, it’s time to get on the bus — the “omnibus” that is!In February of this year, the AcSB confirmed that Canada is moving to IFRSs in 2011, and on April 7, it released its omnibus Exposure Draft of the international standards that will soon replace Canadian GAAP. “Adopting IFRSs in Canada” (available at www.acsbcanada.org/download.cfm?ci_id=44313&la_id=1&re_id=0) gives Canadians the opportunity to comment, by July 31, 2008, on a number of aspects of the conversion to IFRSs. More importantly, it serves as a reminder that if you haven’t started getting ready for IFRSs, you’d better start now!Publicly accountable enterprises must prepare their interim and annual financial statements in accordance with IFRSs for fiscal years beginning on or after January 1, 2011.

U.S. Maneuvers to Avoid Debt Ceiling

Fri Apr 4,11:53 AM ET

By JEANNINE AVERSA, Associated Press Writer

WASHINGTON - Treasury Department (news - web sites) debt managers intend to soon carry out an accounting maneuver that would free billions of dollars on paper to prevent the government from breaching the $6.4 trillion ceiling on the national debt.

The step, announced Friday, is the latest in a series of moves Treasury has taken to prevent the government from defaulting on the national debt.

How Not to Solve the Credit CrisisBy Bill Mann (…) One idea that some are pressing the Securities and Exchange Commission to adopt is for it to suspend mark-to-market accounting, essentially overriding the Financial Accounting Standards Board (FASB), which is tasked with setting accounting standards in this country.

It's not just a bad idea. It's a bad idea that sets a bad precedent.

Mark-to-market accounting forces companies to value the securities on their books at the going market rate. In normal times, this gives investors an accurate view of what a company's assets are worth.

Many people are pointing to mark-to-market accounting (also known as "fair value" accounting) as being part of the problem in keeping the American financial system in turmoil. Banks, insurance companies, and other financial institutions have statutory capital requirements, which are being harmed since the market for so many securities is essentially glued shut. If the last sale of some esoteric, asset-backed security for government of Iceland general obligation bonds trade today at $0.05 on the dollar, then every financial institution holding that security must value it on their balance sheets at $0.05, even if they're pretty sure that the Icelanders are going to catch enough cod to pay their bonds in full.

SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value AccountingWashington, D.C., Sept. 30, 2008 — The current environment has made questions surrounding the determination of fair value particularly challenging for preparers, auditors, and users of financial information. (…)

Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.

How should the use of "market" quotes (e.g., broker quotes or information from a pricing service) be considered when assessing the mix of information available to measure fair value?Broker quotes may be an input when measuring fair value, but are not necessarily determinative if an active market does not exist for the security. In a liquid market, a broker quote should reflect market information from actual transactions. However, when markets are less active (…)

Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?The results of disorderly transactions are not determinative when measuring fair value.

Can transactions in an inactive market affect fair value measurements?Yes. A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment). Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative.

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Creative Accounting

• What is creative accounting?• Using the flexibility within the accounting process

to present a preferred picture of the firm at a point in time

• Can be done through:• Accounting induced operational and financial

decisions• Choice of accounting policies• Manipulation of accounting estimates• Fraudulent transactions

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Causes of creative accounting

• “True” accounting numbers, in a world of uncertainty, do not exist• Mutual funds• Financial assets• Tangible non-financial assets• Intangibles

• Generally Accepted Accounting Principles are an acceptable compromise between imperfect alternatives

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Generally Accepted Accounting Principles

• Set of rules, more or less specific, that dictates the preparation of financial statements• Many alternatives often acceptable under GAAP• Different from country to country• Different from time period to time period

• Acceptable alternatives, from a set of less than perfect accounting treatment available

• Conforming to GAAP does not mean that the information provided is good

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Accounting for Pension at Domtar

• Under GAAP back in 2002, an asset of CDN $114 million is reported on the balance sheet of Domtar, representing a prepaid pension expense as of December 31, 2002

• Analysis of supplementary information reveals that Domtar’s pension plan is under-funded by CDN $217 million as of December 31, 2002• Pension plan asset are $900 million• Pension obligation is $1,117 million

• New rules adopted since recognizing the underfunding as a liability

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General Patterns

• Income maximization• Using “Creative accounting” to maximize reported

income• Most typical of public corporations• Allow companies to look better• May not be true at all points in time

• Income minimization• Using “Creative Accounting” to minimize reported

income• Typical of very large companies, or companies in

special market conditions

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General Patterns

• Taking a bath• If we have a bad year, may as well make it a very

bad year• Done to make future earnings look better (“Creative

accounting” technique often “reverse” in the future)• Typical incentives: bonus plan, change of CEO,

missing earnings forecasts, etc…

• Meeting an Earnings Forecast• Major negative market reactions lately to missed

earnings forecast

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General patterns

• Income smoothing• Using “Creative Accounting” techniques to show a

“smooth” earnings series, thereby hiding the real risk of the firm

• Typical of Bombardier’s program cost accounting policy

• Off-balance-sheet debt• Using “Creative Accounting” techniques to hide

debt away from the balance sheet

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Operational and Financial decisions

• Specific rules under GAAP that must be respected• E.g.: Sales are recognized when delivered, and

collection likely• Manipulate accounting numbers by timing deliveries• Very easy when in the middle of the supply chain• Examples of companies where such opportunities

exist at little cost: Canadian Tire, McDonald’s, Molson• Offer discount or other incentives at year-end to boost

sales: GM, Ford, and Chrysler• “Cherry picking” in financial institutions

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Operational and Financial Decisions

• The more specific GAAP is, the more complex the scheme may become• Enron’s special purpose entities• Very specific rules under U.S. GAAP that dictate

when SPEs must be consolidated or disclosed (less than 3% of external equity holding in 1991)

• Enron appears to have respected these rules, at least at inception

Enron's 'SPE' Transactions Raise More Questions

HOUSTON -- Enron Corp.'s questionable use of off-balance-sheet transactions to hide debt appears to have begun years earlier than previously believed, raising new uncertainties about the company's financial statements going back to the early 1990s, Monday's Wall Street Journal reported.

During the early 1990s, the Enron unit run by former Chief Executive Jeffrey Skilling set up a group of partnerships and trusts operating under the name "Cactus" to buy and sell large amounts of natural gas. Company documents indicate some of these were structured as "special purpose entities," which could serve as a repository for assets and debts that otherwise would have shown up on Enron's balance sheet. In order to be treated as separate, though, an SPE has to have at least 3 percent of its total capital in the form of equity from an outside

venture, according to accounting rules put into place in 1991.

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Operational and Financial Decisions

• Most difficult form of Creative Accounting to solve• “Legal” within GAAP• Auditors and regulators have little power in

protecting investors• May be used positively by firms to convey

information to investors• May be used opportunistically

• Outsiders have little information about the occurrence of such manipulations• Sometimes information disclosed, but often not

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Operational and Financial decisions

• How to deal with this:• Read all available disclosures• Compute trends

• Recent changes?• Too good to be true?

• At least, evaluate the potential for such manipulations to exist in the company/industry

• In case of major doubt, STAY AWAY

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Choice of Accounting Policies

• When presented with an alternative, firms will pick the accounting policies that allow them to present the accounting numbers they want• Inventory valuation using LIFO in the United States• Revenue recognition policy• Depreciation methods

• Potentially serious, but investors are aware of the accounting policies chosen by firms• Can evaluate their aggressiveness/bias• Usually the same year after year

Revenue Recognition Rules Hamper Biotech FirmsA new industry study argues that cumbersome accounting guidelines cause companies in that sector to restate more often.Alan Rappeport - CFO.com | US October 14, 2008

As the Financial Accounting Standards Board wrestles with ways to fix revenue recognition accounting, biotechnology firms say they are facing what one new study calls "unnecessary hurdles" caused by the outdated existing standard. According to a the study — released by the Biotechnology Industry Organization (BIO) and conducted by the research and professional services firm Glass, Lewis, & Co. LLC — revenue recognition rules are leading biotech firms to restate more often and to delay more filings, compared to restatements and delays for most other industries. The rules complicate accounting in biotech because they tend to employ extensive collaborative arrangements with other companies for research and distribution. (…)The study finds that similar types of collaboration arrangements are accounted for in different ways, causing inconsistencies in the timing of when revenues are recognized on income statements. That is particularly problematic for firms such as

Cubist Pharmaceuticals, which works with many overseas distributors

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Accounting Estimates

• Preparation of financial statements require many hypotheses and estimates

• Choice may be opportunistic, to show a given picture• Loan loss provision in banks• Restructuring fees in Mergers and Acquisitions• Useful life of assets• Pension assumptions• Asset impairments• Goodwill write-offs

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Accounting estimates

• Some accounting estimates are disclosed• Some accounting estimates are not disclosed• Impact on markets is a function of how much

information is available• Auditor can reduce the potential for

manipulation• Many estimates are hard to audit• Auditors have an asymmetric loss function…

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Accounting Estimates

• Bandwidth capacity at WorldCom• WorldCom signed a 20 year lease contract for

bandwidth capacity• Claimed that they did not need the first 5 years, but

agreed to it because it gave them a bargain price on the last 15 years

• Capitalized the first 5 years as asset

• True that it is not currently used• If it is a bargain, then accounting treatment

may be appropriate

WorldCom accounting scandal

WorldCom has revealed a further $3.3bn in accounting errors, doubling the size of the accounting scandal at America's second largest long distance phone company to more than $7bn. Mark Tran explains Friday August 9, 2002

Any other bad news?WorldCom said it may have to write off $50bn when it restates ifs finances. One of the largest write-offs in corporate history, that would amount to the 2001 gross domestic products of Hungary and the Czech Republic. Only Time Warner's $54bn write-off was bigger.

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Fraudulent behavior

• Most fraudulent transactions involve collusion between at least one or more insiders and usually an outsider

• Often, two transactions that are entered into with the only purpose of manipulating the financial statements

• Each transaction is accounted for following GAAP

• Auditor is of little help

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Fraudulent behavior

• Barter transactions in dot.com company• Let’s exchange banner advertising on our websites• What price for the exchange? Who cares?• What I receive is an asset for me (long-term

advertising contract)• What I give is Revenue this year (little future cost –

Can recognize revenue now)• Total Revenue = Total expense• This year Revenue >>> This year expense

Funny Money Is Alive and Well on Wall Street

(The Bottom Line) Barter Transactions

Companies that rely on non-cash barter deals for revenue growth are getting taken to task.

By Adam Lashinsky, April 03, 2002

(…)

Gemstar-TV Guide International ( (GMST): up $0.59 to $9.60), acknowledges that $20 million of its recent "revenue" actually was the result of a barter transaction in which it traded ad space for intellectual property belonging to a customer.

(…)

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Fraudulent behavior

• Enron’s special purposes entities• Employees created separate legal entity, that

entered into major transactions with Enron• Employees not really independent from Enron, and

did this only because it was good for them and Enron

• By itself, the deal respect the letter of the accounting standards

• But, done to manipulate accounting numbers

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Impact of Creative Accounting

• Creative accounting can be used to signal internal information• Helps outsiders to understand more about the firm

• Creative accounting can be used to “undo” temporary situations, that are not expected to persist• US Government and manipulations

U.S. Maneuvers to Avoid Debt Ceiling

Fri Apr 4,11:53 AM ET

By JEANNINE AVERSA, Associated Press Writer

WASHINGTON - Treasury Department (news - web sites) debt managers intend to soon carry out an accounting maneuver that would free billions of dollars on paper to prevent the government from breaching the $6.4 trillion ceiling on the national debt.

The step, announced Friday, is the latest in a series of moves Treasury has taken to prevent the government from defaulting on the national debt.

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Impact of Creative Accounting

• Creative accounting can be used unethically, to manipulate markets and benefit the preparer• Impact is often a failure of markets• Price protection: Would you buy leather jackets

from the trunk of a car? At what price?

• Intent is what matter!

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Solutions to the Creative Accounting Problem

• Negative impact is based on intent let’s measure intent• Managers’ incentives contract Proxy statement• Debt covenant Footnotes or prospectus• Aggressive Accounting Policies Footnotes• Pressure to meet earnings forecasts

Business press MD&A

• Special situations (change of CEO, big bath incentives, etc.) Business press, MD&A, etc.

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Solutions to the Creative Accounting problem

• Limit the flexibility within GAAP• Transactions can be designed around/within GAAP• May reduce the usefulness of financial statements

in general

• Change performance measure Cash flow is a hard measure• Cash flow is easier to manipulate This is why we

have earnings

• Give accountants an ethics course

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Solutions to the Creative Accounting problem

• Impose legal liability on those who get caught• Securities regulators may not have the resources• How do you define something illegal?• Sarbanes-Oxley Act

• Let the market forces work• Grant firms that commit to full disclosure a lower

cost of capital• Penalize firms that do not through a higher cost of

capital (price protect)• Increase investors’/analysts’ training• “Remove” “bad” managers from the job market

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Conclusions

• No easy solution• Tax authorities have specific rules for the

computation of income loopholes are always found

• Common sense should apply• If it is too good to be true, then it probably is• High return high risk• High uncertainty low price