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Earnings Management, Window

Dressing, Forensic Accounting and


Corporate Governance
Earnings Management
 EARNINGS MANAGEMENT occurs
when managers use judgment in financial
reporting and in structuring transactions to
alter financial reports to either mislead
some stakeholders about the underlying
economic performance of the company, or
to influence contractual outcomes that
depend on reported accounting numbers.

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Earnings Management

Important to understand: More often the problem is not the


flexibility of the reporting rules, but the fact that the watchdogs
are not doing their job!!!

– Audit failure

– Poor corporate governance

– Shareholder involvement

– SEC / SEBI enforcement

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Common Earnings Management Practices

1. Shifting income between periods:


Revenues Expenses
Borrowing 1. Premature 2. Capitalization of
earnings from recognition of expenses
the future revenues Example: WorldCom
Example: Xerox
Postponing 3. Deferring 4. Exaggerating
earnings to the recognition of current
future revenues expenses/losses to
Example: Microsoft create cookie jar
reserves
Example: Microsoft

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Common Earnings Management Practices (cont’d): J.E.
Actual J.E. Proper recognition J.E.
1. Borrowing DR CR DR CR
revenues from the Cash revenue cash def. revenue
future later: def. revenue revenue

2. Deferring DR CR DR CR
expenses to the Asset cash expense cash
future later: Expense asset
3. Deferring DR CR DR CR
revenue to the cash def. Cash revenue
future revenue
later: def. revenue revenue

4. Exaggerating DR CR DR CR
current loss No journal entry
expenses/losses liability/Asset later: loss cash
to create cookie 5
later: liability cash
jar
Common Earnings Management Practices (cont’d)

2. Classification of gains and losses:


– Classifying one-time gains as earnings from continuing operations
– Classifying losses from continuing operations as one-time items
3. Hiding Debt in unconsolidated subsidiaries
– Example: Enron

Legitimate Earnings Violation of GAAP or


Management (Within SEC rules
GAAP)
Manipulation of accruals to:
I. smooth earnings - Income smoothing
II. Turn permanent expenses into temporary losses
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Example of Scope of Manipulations and
Incentives: Xerox Case
 Xerox sells/leases copy machines, and related service to be
provided for several years after sale.
 Recorded service revenue at the time of sale.
 According to the SEC investigation, “accounting tricks”
boosted pretax profit by 1.5 billion from 1997 through
2000.
 In November 1999, CFO told management:
"When accounting actions were stripped away, Xerox had
essentially no growth through the late 1990s.”

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Xerox Case: what were the incentives?
 Without the accounting scheme the company would have
missed Wall Street's consensus per-share earnings targets
in 11 of 12 quarters from 1997 to 1999.
 Accounting scheme helped keep Xerox's stock price
artificially high in the late 1990s so executives could cash
in $5 million in performance-based compensation and
more than $30 million from stock sales.

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Satyam – Rs.7000 crore scam
 The 2008 balance sheet comprised faked and
inflated figures of revenue, profit, interest
and debt. The list includes Rs 5,040 crore of
non-existent cash and bank balances, non-
existent accrued interest, understated
liability of Rs 1,230 crore on account of
funds raised by Mr Raju and overstated
debtors position of Rs 490 crore (as against
Rs 2,651 crore).
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Window Dressing
Ways of Window Dressing
 Premature recognition of Income
 Non-operational Income
 Non-provision of diminution in LT
investments
 Capitalisation or deferment of revenue
expenses
 Revaluation of fixed assets
 Extension of accounting year
 Reducing from Reserves & Surplus
Ways to Window dress
 Advancing bills of customers to inflate the
bottom line or top line
 Inadequate or no provision for doubtful
debts
 Increase estimated useful life to charge
lower depreciation
 No separate disclosure for prior-period
adjustments / extra-ordinary items
Forensic Accounting
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Forensic Accounting Defined

Forensic accounting is the action of


identifying, recording, settling, extracting,
sorting, reporting, and verifying past financial
data or other accounting activities for settling
current or prospective legal disputes or using
such past financial data for projecting future
financial data to settle legal disputes.

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Forensic Accounting vs. Fraud Auditing

Fraud Auditor: An accountant especially


skilled in auditing who is generally engaged
in auditing with a view toward fraud
discovery, documentation, and prevention.

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Forensic Accounting vs. Fraud Auditing
Forensic Accountant: A forensic accountant
may take on fraud auditing engagements and
may be a fraud auditor, but he or she will also
use other accounting, consulting, and legal
skills in broader engagements. In addition to
accounting skills, he or she will need a
working knowledge of the legal system and
excellent communication skills to carry out
expert testimony in the courtroom and to aid
in other litigation support engagements.
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Defining Fraud

 A representation
 About a material point,
 Which is false,
 And intentionally or recklessly so,
 Which is believed
 And acted upon by the victim
 To the victim’s damage

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What Drives Fraud
 Key drivers
– Confidence earned
– Pressures
– Greed

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Accountant’s Role in Fraud Detection
 In the early 1980s, companies began to use
computers to perform their record keeping
 Intense competition caused auditing fees to fall
as much as 50% from the mid-1980s to the mid-
1990s.
 Auditors cut costs by reducing the process of
reviewing hundreds of corporate accounts. They
grew more reliant on internal controls.

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Accountant’s Role in Fraud Detection
 Top executives were able to circumvent internal
controls and manipulate the records.
 This lead to situations such as Enron,
WorldCom, Xerox, Adelphia Communication,
and the fall of Arthur Andersen in the early
2000s.

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Forensic Accounting
 Two parts:
– Investigative accounting
– Litigation support
 Treats all figures as suspect until proven
otherwise

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Investigation
 Is the act of determining whether criminal
matters such as employee theft, securities
fraud (including falsification of financial
statements), and insurance fraud have
occurred.
 Also includes searching for irregularities
associated with civil matters, such as a
search for hidden assets in divorce cases.

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Litigation Support
 Is the factual presentation of economic
issues related to existing or pending
litigation.

 The forensic accountant quantifies damages


sustained by parties involved in legal
disputes and assists in resolving disputes,
even before they reach the courtroom.

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Litigation Support
 Arbitration assistance
 Business valuation for divorce, stockholder disputes
 Computation of damages resulting from personal injuries,
wrongful death, breach of contract, casualty, and fidelity
losses
 Determination of lost profits due to business interruption
 Testifying as an expert witness
 Financial review of contractual obligations
 Investigative services related to fraud and other illegal acts

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Red Flags
 No Company Policy Manual  Handwritten checks
 Feeling of disorganized  Extensive fund transfers
bookkeeping, purchasing, receiving,  Unusual transactions (inconsistent)
and/or warehousing departments  Deficient hiring policies and procedures
 Missing documents  Employees’ lifestyles inconsistent with
 Unrecorded transactions salaries
 Employees who don’t take vacations
 No bank reconciliations
 SPEs
 Subsidiary ledgers out of balance  Excessive insider sales of stock
 No physical inventory counts  Unexplained resignations of upper
 Checks written to cash management
 Large related party loans  Excessive debt/equity ratio
 Excessive other revenue  CPA switching
 Negative operating cash flow  Strange account titles
 Downward earnings trend

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The Fraud Triangle

Motive / Pressure

Rationalization Opportunity

[Source: Michael Kurland, How to Solve A Murder: Macmillan, 1995, pp. 7-8]
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Perceived Pressure
Employees, managers, and owners can feel
pressure to commit fraud as a result of

 Greed or preoccupation with being successful


 Living beyond means
 High personal debts
 Unexpected financial needs
 Expensive vices
 Family-imposed pressures
Source: Carl Pacini, J.D., Ph.D., CPA

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Perceived Opportunities
Opportunities to commit fraud exist when
levels of trust in an organization are reached
or when controls are weak.

 Inappropriate segregation of duties


 Ineffective supervision
 Transaction authorization not required
 Lack of physical controls
 Lack of adequate audit trail
Source: Carl Pacini, J.D., Ph.D., CPA

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Rationalization
Individuals usually don’t commit fraud unless
they can justify their actions in relation to
their own code of ethics.

 Feeling underpaid or overworked


 Desire to seek revenge
 Belief that taking the assets is a loan
 Belief they are helping others (family, employees)
Source: Carl Pacini, J.D., Ph.D., CPA

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Factors affecting occupational Fraud
 Financial condition of the  Personal traits and
organisation characteristics of
 Pressure to show profits in executives and employees
the marketplace  Reward systems for
 Internal accounting ethical behavior
controls  Organisation culture and
 The state of the economy dynamics
 Integrity level of corporate  Peer pressure
leaders and employees  The perception of
 Commitment to detection
organisation’s value  The swiftness, cnrtainty
system and severity of
punishment

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How do Forensic Accountants
Search for Fraud?

 Proactive fraud detection


 Reactive fraud detection

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Proactive Fraud Detection

Inductive approaches
Use of Data-mining software
Digital analysis of company data
Deductive approach
Determine what kinds of frauds can
occur. Search for symptoms of these
frauds.

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Data-mining Softwares
 Excel
 ACL
 IDEA
 Microsoft Access

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Deductive Approach to Detecting Fraud
Involves a 5-step process:
 Understanding the business environment
 Understanding the kinds of fraud that can occur in
this environment
 Determining the most likely symptoms
 Using databases and systems to search for the
fraud symptoms
 Following up on discoveries to determine
likelihood fraud exists
Source: Albrecht, W. S. 2003. Fraud Examination. Mason, OH: Thomson South-Western

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Reactive Fraud Detection

Fraud accountants are often engaged after


someone in the entity suspects that fraud
has been committed.

Usually the area in which fraud has been


committed is known. Often, the entire area
is examined.

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Corporate Governance

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What is Corporate Governance?
 A set of procedures and policies by which corporations are directed and
controlled.. Cadbury Report (UK) – 1992
 “…to do with Power and Accountability: who exercises power, on behalf of
whom, how the exercise of power is controlled.”…. Sir Adrian Cadbury
 As per OECD, Corporate Governance deals with “… the distribution of rights
and responsibilities among different participants in the corporation, such as,
the board, managers, shareholders and other stakeholders, and spells out rules
and procedures for making decisions on corporate affairs “
 Corporate governance deals with the ways in which suppliers of finance to
corporations assure themselves of getting a return on their
investment….Journal of Finance, Shleifer and Vishny
 Corporate governance is about promoting corporate fairness, transparency and
accountability
An Indian Definition
 “…fundamental objective of corporate
governance is the ‘enhancement of the
long-term shareholder value while at the
same time protecting the interests of other
stakeholders.”

 SEBI (Kumar Mangalam Birla) Report on


Corporate Governance, January, 2000
A Gandhian Definition

 Trusteeship obligations inherent in


company operations, where assets and
resources are pooled and entrusted to the
managers for optimal utilisation in the
stakeholders’ interests.
What is good Corporate
Governance?
 Systems and procedures adopted and followed that ensure that all
shareholders share equally in the success (or failure) of a firm

 “The Foundation of any structure of Corporate Governance is


disclosure. Openness is the basis of public confidence in the corporate
system, and funds will flow to the centers of economic activity that
inspire trust.” Sir Adrian Cadbury
EXECUTIVE COMMUNITY
MANAGEMENT VENDORS
INTERNAL CONTROL
NCE ST CREDITORS
RISK MANAGEMENT A AK
E RN EH CUSTOMERS
STRATEGY/PERFORMAN OV OL SHAREHOLDE
G DE
CE RD CORPORATE VALUES & RS RS
BOA
COMMUNICATIONS REPUTATION
VALUES
AVAILABLE EVALUATION TOOLS
BALANCED SCORECARD/TRIPLE BOTTOMLINE/GLOBAL REPORTING
INITIATIVE
BUSINESS PERFORMANCE

TRANSPARENCY &
COMMUNICATION
RESPONSIBILITY

PHILANTHROPY

CITIZENSHIP
INTEGRITY

GIVING -
SOCIAL
TRUST

ETHICS

GUIDING TENETS
CAUX / SULLIVAN / GLOBAL COMPACT / MILLENIUM DEVELOPMENT GOALS /
INDIAN TRADITIONS