Creative accounting 101: Fudge, bilk, steal

Nearly two years on, the spectacular collapses at Enron and WorldCom are still causing the international business community to engage in a mixture of incredulity, hand wringing and buck passing.

While this goes on, banks still need to assess companies for their suitability for lending purposes; investors and institutional funds need to decide where to put their money; and brokers need to make their recommendations to clients. In other words, ordinary business professionals need to reassure themselves as to the soundness of businesses large or small, international or local. If your starting point for looking into a company’s performance is its published accounts, you need to begin with a health warning. Auditors sign off on accounts and reports which give a “true and fair view” of  companies’ financial positions. If managers have engaged in creative accounting — successfully manipulating financial reporting procedures so that debts or liabilities are disguised or transferred or earnings overstated — you won’t easily find evidence of that in the published accounts. Remember too that big financial meltdowns like Enron and WorldCom have been met with disbelief precisely because the accounts and reports looked whiter than white and the companies looked like strong performers.

While there are risk factors to look for in accounts, some warning signals will not be there. You may need to look beyond the numbers at issues such as leadership culture, motives for fraud and company structure. So what kind of indicators can you look at within company accounts? If in doubt, it is hard to beat the old fashioned approach of crunching the numbers. Calculating the return on total capital employed gives a profit picture before tax, interest and dividend payments (which an analyst might well consider to be a reflection of the business climate and so beyond the control of companies’ managers). Total capital includes debt, as well as shareholdings, and it is this calculation which gives an indication as to the soundness of companies’ capital foundations. As with any performance indicator, the return on capital employed should be compared with an equivalent figure in the previous year’s accounts and/or against an industry benchmark. It is only by looking at companies in context that we can reach an assessment as to whether an exceptional performance is realistic or not. If it looks too good to be true, it probably is.

Along with other profitability and liquidity tests this kind of calculation will not necessarily point to any specific creative accounting ruses, but it will provide a means of comparing one company with others in the same industry or of similar sizes and structures. Furthermore, such ready reckoners will only prove reliable if the figures entered in company reports can themselves be trusted. And, as we have seen, trust has become a rather old-fashioned virtue. These days, the numbers in published accounts are being approached with caution. What is more, the size and sheer complexity of the modern conglomerate provides managers and executive teams with plenty of places to hide. Enron’s fault lines eventually showed up through complex energy trades and the — now notorious — special purpose entities (SPEs). Any indication, found within the notes to the accounts or via the business media, that these kind of complex trades and vehicles have been employed should sound warning bells and prompt closer scrutiny.

Former US Securities and Exchange Commission chairman, Arthur Levitt, identified five specific areas of concern: acquisition accounting, big bath charges, aggressive revenue recognition, “cookie jar” reserves and materiality.
*Acquisition accounting has long been regarded as a potential context for creative accounting. If a company has made an acquisition and its figures show a large write-down of assets as an exceptional item — beware. This may be a way of showing increased non-exceptional profits in later periods. The earlier overstatement makes the later profits look artificially strong by comparison.
Acquisition accounting also has the potential for distortion due to differences in accounting standards. The international standard allows an acquiring company to take control of the shares of the company it is buying as a subsidiary at the time the deal is announced. The length of time between the announcement and the deal’s completion can cause a bigger write-down than under UK rules, for instance, where share ownership is only transferred once the deal is complete. In a falling stock market, the price of those shares could go down considerably and the write-off required will be even greater under the international standard.
*“Big bath” charges are generally employed at times of company restructuring. The accounts will overstate the charges associated with closing down or consolidating parts of the company’s operation, for instance, while saying that the charges are “conservatively estimated.” The charges are subsequently used to bolster shortfalls in future earnings.
*The practice of aggressive revenue recognition — booking income before a sale is completed — has proved fatal to some companies. The earnings look real but, in fact, payment has not yet been made. According to the SEC, nearly one third of the 51 forced financial restatements between 1992 and 1998 were the result of improper revenue recognition.
*“Cookie jar” reserves occur when companies over-estimate liabilities for things like sales returns and expenses to do with warranties as well other ad hoc losses. This practice creates a stash which can be raided in leaner times.
*In the context of creative accounting, materiality is the process of rounding errors up within a percentage ceiling. Managers will often justify this on that basis that the difference is too small to make an impact on the overall profit.

These five areas are by no means the only causes for concern. The running mate of creative accounting is, of course, “off balance sheet” debt; the trouble with this kind of liability is precisely that you will not find it listed in company accounts. Many commentators blame investment analysts for the drive to transfer debt from the balance sheet and into leases or the SPEs mentioned earlier. According to this interpretation, markets can be over-concerned with gearing ratios, which are improved if debt is removed from the balance sheet. Of course, the motive to remove liabilities from the balance sheet might come from within the company. If its financial position is poor, and/or if it has reached its borrowing limits, directors might be tempted to move liabilities into leases or into SPEs, joint ventures or other entities. The Association of Chartered Certified Accountants (ACCA) is the largest professional accountancy body operating on an international basis, with over 300,000 members and students in 160 countries.
www.accaglobal.com or email emile.valere@accaglobal.com