Creative Accounting and

Financial Statements Frauds

How to Detect It?

Roles of Accounting
Improve problem solving / decision making
Manage risks
Trust, Assurance
Educational - learn about organisations
Language of business
Construct, define, measure success/failure
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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
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Hierarchy of Accounting Qualities

Decision Makers and their characteristics
Benefits > Costs
Understandability
Decision-Usefulness

Relevance
Predictive
value

Reliability

Timeliness

Feedback
Value

Verifiability
Comparability &
consistency

Representational
Faithfulness

Neutrality

Materiality

You will discover

That accounting is subjective, partial and potentially
misleading
Accountants use language / numbers in a highly technical
way
Accounts are a highly stylised story, representation,
description of organisational events
The tribe of accountants takes many forms and lives within
all organisations
Problematic nature of accounting numbers
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However.

Accounts are main source of systematically produced

regulated information
Good as it gets
Usually reliable 3rd party verified
Follow the same basic rules
Most of the information is there (in the small print)
You can never eliminate the risk of fraud / criminal
misrepresentation

Roles of Accountants
Assisting 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 it
is possible for two companies in the same
industry to follow entirely different accounting
principles and both get a true and fair audit
report?
M. Lafferty
Every company in the country is fiddling its
profits.
I. Griffiths

Fair Presentation VS Creative

Accounting
Fair 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 Accounting
Using the flexibility within accounting to manage the
measurement and presentation of the accounts so that they
serve the interests of preparers.

Definitions

The 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)

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What do we want to create?

More profit?
More assets?
More liabilities?

Less profit?
Fewer assets?
Fewer liabilities?
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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)

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Accounting Scandals
Enron collapses, 7th biggest US company

US largest energy wholesaling company

October 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 sheet
Treats loans as sales
Swops assets and treats them as sales
Creative accounting and fraud
End 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.

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Accounting Scandals

Parmalat
Run by charismatic Calisto Tanzi
Creates fictitious sales
e.g., double counts sales
e.g., fictitious subsidiaries
Has dubious loans treated as equity
Fake Bank of America account worth 5 billion dollars

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History of Financial Shenanigans

1963 - Great Salad Oil - fictitious inventory

1970s - Equity Funding Corporation fic. sales
1987 - MiniScribe Corporation fill disc box w
bricks
2006 - PT Bank Global Tbk.- reksadana
2006 PT Great River Garment Tbk. - bonds

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The Seven Shenanigans

1.

Recording revenue too soon or of Questionable Quality

Before shipments or before customers acceptance

Selling to affiliated party

2.

Recording bogus revenue

Cash received in lending as revenue

Sales that lack of economic substances

3.

Boosting revenue with One-Time Gains

Sell 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

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The Seven Shenanigans

4.

Shifting current expenses to a later or earlier period

5.

Failing to record or improperly reducing liabilities

6.

Failing to record expenses/liabilities

Reducing liabilities by changing accounting assumption

Shifting current revenue to a later period

7.

Capitalizing normal operating cost

Failing to write down/off impaired assets

Creating reserves and releasing them into income

Improperly holding back revenue just before an acquisition

Shifting future expenses to the current period as a

special charge

Inflating amounts included as special charge

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Searching for Shenanigans

Auditors report

Proxy statement

Footnotes

Absence of opinion or qualified report

Reputation of auditor
Litigation
Executive compensation
Related-party transaction

Accounting policies/changes in those policies

Related-party transaction
Contingencies or commitments

Presidents letter

Forthrightness

MD&A

Specific concise disclosure

Consistency with footnote disclosure

Registration statement/
prospectus

Past performance
Quality of management and directors

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Techniques for Detecting

Shenanigans
Quantitative Screening

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

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Techniques for Detecting

Shenanigans
Qualitative Screening

Change in accounting estimate or

principle
Offering customers financing or
extended credit terms
Changes in accounting policies
Changes in account classification
Change in auditors
Extended 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

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Analyzing FS - Balance Sheet and Statement of Operations

Warning Sign
1.

2.

3.

4.

5.

Cash and equivalents decline

relative to total assets
Receivables grow substantially
faster than sales
Receivables grow substantially
slower than sales
Bad debt reserves decline relative
to gross receivables
Unbilled receivable grow faster
than sales or billed receivables

Problem Indicated or Shenanigan Used

Liquidity issues; may need to borrow
Perhaps aggressive revenue recognitionrecording revenue too soon or
granting extended credit terms to
customers
Receivables may have been reclassified
as another asset category
Underreserving and inflating operating
income
A greater portion of revenue may be
coming from sales under the
percentage-of-completion method

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Balance Sheet and Statement of Operations (Continued)

6.

7.

8.

9.

10.

Warning Sign

Problem Indicated or Shenanigan Used

Inventory grows substantially faster

than sales, cost of sales or account
payable
Inventory reserves decline relative
to inventory
Prepaid expenses shoot up relative
to total assets
Other assets rise relative to total
assets
Gross plant and equipment
declines sharply relative to total
assets

Inventory may be obsolete, requiring a

write-off; company may have failed to
charge the cost of sales on some
sales
Underreserving and inflating operating
income
Perhaps improperly capitalizing certain
operating expenses
Perhaps improperly capitalizing certain
operating expenses
Perhaps capitalizing maintenance and
repair expense

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Balance Sheet and Statement of Operations (Continued)

Warning Sign
11.

12.

13.

14.

15.

Gross plant and equipment

declines sharply relative to total
assets
Accumulated depreciation declines
as gross plant and equipment rises
Goodwill rises sharply relative to
total assets
Accumulated amortization declines
as goodwill rises
Growth in accounts payable
substantially exceeds revenue
growth

Problem Indicated or Shenanigan Used

Failing to invest in new plant and
equipment
Failing to take sufficient depreciation
charge inflating operating income
Perhaps tangible assets were
reclassified to goodwill to avoid
expensing them in future periods
Failing to take sufficient amortization
charge inflating operating income
Failed to pay off current debts for
inventory and supplies-will require
larger cash outflow in future period

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Balance Sheet and Statement of Operations (Continued)

Warning Sign
16.

17.

18.

19.

20.

Accrued expenses decline relative

to total assets
Deferred revenue declines while
revenue increases
Cost of goods sold grows rapidly
relative to sales
Cost of goods sold grows rapidly
relative to sales
Cost of goods soled fluctuates
widely from quarter to quarter
relative to sales

Problem Indicated or Shenanigan Used

Perhaps company released reservesinflating operating income
Either new business is slowing or
company released some reserves to
inflate revenue
Pricing pressure results in lower gross
margins
Company may have failed to transfer the
entire cost of the product from
inventory
Unstable gross margin could indicate
accounting operating expenses

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Balance Sheet and Statement of Operations (Continued)

21.

22.

23.

24.

25.

26.

Warning Sign

Problem Indicated or Shenanigan Used

Operating expenses rise sharply

relative to sales
Operating expenses rise
significantly relative to sales
Major portion of pretax income
comes from one-time gains
Interest expense rises materially
relative to long term debt
Interest expense declines
materially relative to long term debt
Amortization of software costs
grows more slowly than capitalized
costs

Perhaps improperly capitalizing certain

accounting irregularities
Company may have become less
efficient, spending more of each unit
sold
Core business may be weakening
Perhaps improperly capitalizing certain
operating expenses
Perhaps improperly capitalizing certain
operating expenses
Perhaps improperly capitalizing certain
operating expenses

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Statement of Cash Flows

Warning Sign
1.

CFFO materially lags behind net

income

2.

Company fails to disclose details of

cash flow from operations
Cash inflows come primarily from
assets sales, borrowing, or equity
offerings

3.

Problem Indicated or Shenanigan Used

Quality of earnings may be suspect or
expenditures for working capital may
have been too high
Company 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

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Narrative: Footnotes, Management Discussion, Proxy,

Auditors Letter
Warning Sign
1.
2.
3.
4.
5.
6.
7.

8.
9.
10.

Change in accounting principle

Change in accounting estimate
Change in accounting classification
Change in auditor
Change in CFO or outside counsel
Investigation by the SEC
Long-term
commitments/contingencies
Current or potential litigation
Liberal accounting policies
Misguided management incentives

Problem Indicated or Shenanigan Used

Attempt to hide an operating problem
Attempt to hide an operating problem
Attempt to hide an operating problem
Sign of risky client
Sign of risky client
Could lead to accounting restatements
Potentially large drain on cash reserve
Potentially large drain on cash reserve
Financial reports may inflate profits
May lead to some financial shenanigans
to boost profits, bonuses, and share
price

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Narrative: Footnotes, Management Discussion, Proxy,

Auditors Letter (Continued)
Warning Sign
11.

Weak control environment

12.

Auditors concern
Promotional management

13.

14.

15.
16.

Use of percentage of completion

accounting
Use bill and hold accounting
Overrelliance on a few customers

17.

Financial problems at key

customer

18.

Seller finances customer

Problem Indicated or Shenanigan Used

Creates easy opportunities to perpetrate
financial shenanigans
Sign of risky client
May be more likely to use financial
shenanigans than more modest executives
Revenue may be inflated
Revenue may be inflated
Potential business problem if one of them
leaves
Business can be hurt if a key customer files
for bankruptcy
Revenue may have been inflated and
business may be much weaker than you
realized

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Narrative: Footnotes, Management Discussion, Proxy,

Auditors Letter (Continued)
Problem Indicated or Shenanigan Used
Warning Sign
19.
20.
21.

22.
23.

24.

25.

26.

Customer has right of return

Barter transaction
Seller gives customer stock
warrants
Capitalized interest or software
Unrecorded liabilities, such as
stock options
Noncompliance with debt covenant
Absence of unaffiliated directors on
board
Prepayment of future periods
operating expenses

Revenue may have been recorded too

soon
Revenue may have been inflated
Revenue may have been inflated
Operating income may be inflated
Future cash obligations may be greater
than expected and operating income
may be inflated
Bank may call loan, causing a substantial
cash crunch
Weak control environment may create
opportunities for management to
perpetrate financial shenanigans
Leads to inflated operating income in
future periods

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Checklist 1: Possible Signs of Misleading Financial Statements

Choosing accounting policies
Changing accounting policies
Deferring expenses
Income smoothing
Recognizing revenue too soon
Underaccruing expenses
Changing discretionary costs
Low quality controls
Changing auditor

Too liberal
Unjustified
Profits are overstated
Profits are understated
Profits are overstated
Profits are overstated
Manipulating profits
Risk of shenanigans
Risk of shenanigans

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Always bear in mind

Preparers of accounts know how people will interpret their

accounts
Be cynical assume the accounts are the best possible
picture
Analysis only as good as original data
Never just use accounts check from many different
sources
Accounting terms are different from general understandings

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LEADING THE BATTLE TO COMBAT SHENANIGANS

Rule makers
Corporate executives and internal auditors
Outside directors
Independent auditors
Regulators
Educators
Watchdog organizations and independent
commissions
Financial analysts
Financial media
Lawyers representing the inventors
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The Ethics of Creative

Accounting
Regulatory war of the fittest
Griffiths Rather than eliminate creative accounting the
imposition of standards appears to have created more and
more sophisticated forms of financial manipulation
Ongoing innovations. Merchant banks develop creative
compliance schemes.
Succession regulatory activity since 1990s regulators strive
to curb creative accounting
Vibrant demand for creative compliance . A creative
accounting arms race.

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Controlling Creative Accounting and

Fraud
Can creative accounting and fraud ever be stopped?

Probably not
Part of human nature
Best we can do is set up a sound conceptual
framework and sound standards
Promote good ethical conduct
Be aware.

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References

MBA Intensive Seminars 2004 Introduction to Accounting

Howard Schilit Financial Shenanigans: How to Detect Accounting Gimmicks &
Fraud in the Financial Statements
Mike Jones; Cardiff Business School - Creative Accounting, Fraud and
Accounting Scandals
Oriol Amat, John Blake, Jack Dowds

- The ethics of Creative Accounting

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Thank You !

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