Creative accounting, fraud and international accounting scandals

Creative Accounting, Fraud and International Accounting Scandals... 13.3 The Most Important Accounting Fraud in Italy: The Parmalat Case 25913.3.1 Parmalat: Was it a Case of Creative Acc

Creative Accounting, Fraud and International Accounting Scandals

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Creative Accounting, Fraud and International Accounting Scandals

Edited by

Michael John Jones

A John Wiley and Sons, Ltd., Publication

Published in 2011 by John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,

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ISBN 978-0-470-05765-0

Typeset in 11/13pt Times by Aptara Inc., New Delhi, India

Printed and bound in Great Britain by CPI Antony Rowe, Chippenham, Wiltshire

2.2.7 Other Users 27

2.3.2 Division of the Responsibility between Chief Executive

5.2.5 Frank Clarke, Graeme Dean and Kyle Oliver, Corporate

Collapse: Accounting, Regulatory and Ethical Failure (2003, first

5.2.9 Beasley, Carcello and Hermanson, Fraudulent Financial

Report-ing 1987–1997: An Analysis of U.S Public Companies (1999) 81

8 Accounting Scandals in Australia since the Late 1980s 137

Garry D Carnegie and Brendan T O’Connell

8.4 HIH Insurance 147

8.5 Corporate Governance Reforms Following the

9 Corporate Accounting Scandals in China 163

Catherine Huirong Chen, Yuanyuan Hu and Jason Zezhong Xiao

10.5 Examinations of the German Financial Reporting Enforcement

11 Creative Accounting and Fraud in Greece 211

George Kontos, Maria Krambia-Kapardis and Nikolaos Milonas

13.2.3 The Accounting of ‘Creative Gains’ in Football Club

13.3 The Most Important Accounting Fraud in Italy: The Parmalat Case 25913.3.1 Parmalat: Was it a Case of Creative Accounting or of False

13.3.2 Key Accounting Issues at Parmalat: Some Examples of the

13.3.4 The Role of Information Demand-side Actors: Institutional

13.4 The Aftermath of the Parmalat Scandal and its

14.5.1 Revision of Accounting Standards for Consolidated Financial

15 Financial Accounting Scandals in the Netherlands 305

Henk Langendijk

16.3 Investments in Stamps: The Latest Series of Financial Scandals in the

16.3.2 The Nature of the Businesses and the Accounting for

17 Accounting Scandals in Sweden – A Long Tradition 359

Gunnar Rimmel and Kristina Jon¨all

17.2 Fermenta and Prosolvia: Swedish Stock Market

17.2.4 Fictitious Invoices, Invented Agreements and Premature

17.3 Two Scandals in Multinationals that Dominated

18 Creative Accounting – The UK Experience 379

David Gwilliam and Richard H.G Jackson

19 Creative Accounting and Accounting Scandals in the USA 407

Charles W Mulford and Eugene E Comiskey

20 Bank Failures and Accounting During the Financial Crisis

20.4 Financial Instruments Associated with

20.4.1 Collateralised Debt Obligations (CDOs) 433

20.5.4 Lawful Adjustments to Composition of ‘Level 3’ Assets in

20.6 Lehman’s, Madoff and Bear Stearns;

23.3.1 Factors Increasing the Possibilities of Creative Accounting

Appendix 1 Chronological List of Major Instances of Accounting Issues

Across 12 Countries and Beyond 509 Appendix 2 Alphabetical List of Most Important Accounting Scandals

Across 12 Countries and Beyond since about 1980 519

List of Contributors

Michael Jones (editor)

Michael Jones, MA Oxon, is Professor of Financial Reporting at Bristol University.Formerly, he taught accounting for 33 years, first at Hereford Technical College, then atPortsmouth Polytechnic (now University) then at Cardiff Business School (1989–2009)

He has taught financial accounting at all levels from GCSE level to final-year degreeand MSc courses He has published over 140 articles in both professional and academicjournals These articles cover a wide range of topics, such as financial accounting, thehistory of accounting and international accounting He is joint editor of the BritishAccounting Review and serves on two more editorial boards As well as being Director

of the Financial Reporting and Business Communication Unit, he chairs the BritishAccounting Association Financial and Reporting Special Interest Group He has served

on the British Accounting Association Committee and on the Committee for Professors

of Accounting and Finance He has written three textbooks: Accounting, Financial Accounting and Management Accounting (Author, Chapters 1–7, 21–23)

Bhabatosh Banerjee

Dr Bhabatosh Banerjee, MCom, PhD, AICWA, is Professor of Commerce and Co-ordinator,

MBA in Finance, University of Calcutta; Editor, Indian Accounting Review; and President,

Indian Accounting Association Research Foundation A former Dean of Commerce andManagement (1987–89 and 2003–5), Dr Banerjee has 39 years’ postgraduate teachingexperience including two years in the USA (1995–97) The first recipient of the InternationalEducator Award (2006) from the Indian Accounting Association, his numerous research

publications include Contemporary Issues in Accounting Research (ed.) (1991), Accounting Education in India (1994) and Regulation of Corporate Accounting and Reporting in India

(2002) (Author, Chapter 12 on India)

Garry Carnegie

Garry Carnegie is Professor of Accounting in the School of Accounting, RMIT University,Melbourne Prior to joining academe, Professor Carnegie gained experience in IT, publicaccounting and in the financial services industry He has held full-time professorial posts

at Deakin University, Melbourne University/Private University of Melbourne and the

University of Ballarat Professor Carnegie’s expertise embraces financial reporting andaccountability as well as accounting history His published research appears in booksand monographs and also in articles in respected journals in the fields of accounting,accounting history, archaeology, economic history, law, museum management and public

administration He is joint editor of Accounting History, the journal of the Accounting

History Special Interest Group of the Accounting and Finance Association of Australiaand New Zealand (Co-author, Chapter 8 on Australia)

Nieves Carrera

Nieves Carrera has a PhD in Business Administration and Quantitative Methods fromUniversity Carlos III Madrid (Spain) and a degree in Economics (University of Vigo,Spain) Before joining the Instituto de Empresa Business School, she was a lecturer

in accounting at the School of Accounting and Finance (Manchester University) Herresearch interests cover different aspects of auditing and financial reporting, such as therole of women in the auditing profession, the structure of the audit market and the impact

of regulation on the audit market and on financial reporting (Author, Chapter 16 on Spain)

Catherine Huirong Chen

Catherine Chen, PhD, MBA, BSc, is a Senior Lecturer, Business School, MiddlesexUniversity Catherine’s main research interests are in corporate governance and executiveremuneration She obtained her PhD in Accounting and Finance at Cardiff BusinessSchool Her PhD thesis examined the determinants of executive remuneration in China,focusing on the role of the board of directors, ownership structure and market comparisonfactors (Co-author, Chapter 9 on China)

Eugene Comiskey

Eugene E Comiskey is the Fuller E Callaway Chair, Professor of Accounting andAssociate Dean for Faculty and Research at the Georgia Institute of Technology Hereceived his doctorate in accounting from Michigan State University and is a CertifiedPublic Accountant (CPA) Dr Comiskey has co-authored four books with Dr CharlesMulford, as well as about 70 journal articles in a wide range of both professional andacademic journals He has served on a number of committees for the American AccountingAssociation and has also served as its director of research, president of its financialreporting and accounting section, as an editorial consultant and as a member of its editorialboard (Co-author, Chapter 19 on the USA)

David Gwilliam

David Gwilliam is Professor of Accounting at the University of Exeter, UK, having ously held academic posts at the University of Cambridge, London School of Economicsand Political Science and University of Wales, Aberystwyth in the UK, and Monash Uni-versity in Australia He is a Fellow of the Institute of Chartered Accountants in England andWales, having qualified with Price Waterhouse, and was the P.D Leake lecturer at ICAEW

previ-in 2003 David’s research previ-interests previ-include accountprevi-ing and audit regulation, accountprevi-ing andthe law, and corporate governance (Co-author, Chapter 18 on the UK)

Yuanyuan Hu

Yuanyuan Hu, PhD, MAcc, MA, BSc, is a lecturer in accountancy at the School ofAccountancy, Massey University, New Zealand Yuanyuan has research interests in theareas of corporate social and environmental reporting, corporate social accountability andresponsibility, Chinese accounting and corporate governance The prime focus of her PhD,awarded by Cardiff University, was on the willingness of Chinese listed companies toparticipate in corporate environmental reporting (Co-author, Chapter 9 on China)

Richard Jackson

Richard Jackson is Associate Professor of Accounting and Finance and former Head ofDepartment of Accounting at the University of Exeter, UK, having moved from the Univer-sity of Wales, Aberystwyth, UK He is a Fellow of the Institute of Chartered Accountants

in England and Wales, having qualified with Ernst & Young Richard was the Henry Ford

II Scholar at Cranfield University, and later worked with NatWest Group and Accentureprior to his academic career His research interests include earnings management anddynamics, market asset valuation and econometric methodology (Co-author, Chapter 18 onthe UK)

Kristina Jon¨all

Kristina Jon¨all, Ekon Lic (Licentiate of Philosophy), is a doctoral student in the FinancialReporting & Analysis Group at the Department of Business Administration at the G¨oteborgSchool of Business, Economics and Law Her research is in the accountability aspects

of business communication Her licentiate thesis explored how textual analysis can be auseful tool to analyse business communication She is also a participant in the researchprogramme ‘The Role of Trust in Communication of Accounting Information Research’.(Co-Author, Chapter 17 on Sweden)

George Kontos

George Kontos graduated from the Athens University of Economics and Business He hasover 30 years’ experience in the banking industry, of which the last 12 years have been asthe Group Financial Reporting Officer for Alpha Bank SA He is a member of the board

of directors for Alpha Bank Romania, Alpha Bank Srbija and Alpha Bank Skopje AD.Since 2001, he has also been a lecturer in bank accounting at the University of Piraeus.(Co-author, Chapter 11 on Greece)

Maria Krambia-Kapardis

Maria Krambia-Kapardis, PhD, MBus, BEc, ACA, has until recently been Professor

of Accounting and holder of the PricewaterhouseCooper Chair in Applied AccountingResearch, Intercollege, Nicosia, Cyprus She is now Associate Professor of Accounting atthe Cyprus University of Technology She has published books, many articles in academicjournals internationally and presented her work at local and international conferences.Her research interests include forensic accounting, fraud investigation and prevention,Corporate Social Responsibility and Corporate Governance (Co-author, Chapter 11 onGreece)

Henk Langendijk

Henk Langendijk has a Masters degree in Business Economics from the University ofAmsterdam He has practical business experience in accountancy and consulting in theNetherlands with the audit firms Arthur Andersen and BDO He is currently Professor inFinancial Accounting and Reporting at Nyenrode Business University and the University

of Amsterdam His PhD was entitled: ‘The market for statutory audits in the Netherlands’(University Leiden) His recent research is in the field of IFRS-conversions, quality of finan-cial reporting (creative accounting and fraudulent reporting) and corporate governance Hehas published numerous books in the field of accounting and many articles in international

journals, such as the Accounting Auditing Accountability Journal, Corporate Governance:

An International Review, the European Accounting Review, the European Journal of Finance and national Dutch accounting journals He is editor of the Dutch accountancy jour- nal Maandblad Accountancy en Bedrijfseconomie (Author, Chapter 15 on the Netherlands)

Hansrudi Lenz

Hansrudi Lenz has been a Professor of Accounting and Auditing at the UniversityWuerzburg since 1996 He received his doctoral and post-doctoral degrees in BusinessAdministration from the Free University of Berlin in 1986 and 1994, respectively Hismain areas of research are related to accounting and auditing He has published severalarticles in refereed German and international journals Professor Lenz acquired profes-sional experience as an employee in the controlling department of the Treuhandanstalt(former state-owned holding company for all former East German firms) and in amanagement holding in Berlin He is currently chairman of the Accounting Commission ofthe German Academic Association of Business Research (Author, Chapter 10 on Germany)

Andrea Melis

Andrea Melis is Associate Professor of Accounting and Business Economics at the

Department of Ricerche aziendali, University of Cagliari, Italy His Masters degree was

taken at the Nottingham Business School (UK) and he received a PhD from the University

of Rome TRE, Italy His main research interests are financial reporting and corporategovernance He has published two monographs on corporate governance, several chapters

in edited books and articles in international journals such as Accounting, Business and Financial History, Corporate Governance: An International Review, Corporate Ownership and Control, The ICFAI Journal of Accounting Research and other premier accounting and

business journals in Italy (Author, Chapter 13 on Italy)

Nikolaos Milonas

Nikolaos T Milonas, PhD, MPhil, MBA, BA, is a Professor of Finance at the Department

of Economics at the University of Athens He has held academic positions at BaruchCollege (CUNY), the University of Massachusetts at Amherst, the Athens Laboratory

of Business Administration (ALBA) and the University of Wales, Cardiff BusinessSchool He has teaching and research interests in the stock market, institutional investing,derivative markets and energy risk management He is the author of two recent books

on mutual funds and derivative markets and of numerous articles appearing in leading

academic journals, including the Journal of Finance, Journal of Futures Markets, European

Financial Management, Financial Review, Housing Finance Review and Applied Financial Economics (Co-author, Chapter 11 on Greece)

Charles Mulford

Charles W Mulford is Invesco Chair and Professor of Accounting in the College ofManagement at the Georgia Institute of Technology He has a doctorate in accounting fromthe Florida State University and is a Certified Public Accountant (CPA) Dr Mulford has

co-authored four books with Dr Eugene Comiskey: Financial Warnings, published in 1996; Guide to Financial Reporting and Analysis, published in 2000; The Financial Numbers Game: Identifying Creative Accounting Practices, published in 2002; and Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance, published in 2005.

In 2002, he founded the Georgia Tech Financial Analysis Lab, which is dedicated toconducting independent stock market research Dr Mulford has appeared on numerousbroadcast networks, including CNBC, ABC News and Bloomberg TV In addition, he

has been quoted in several business publications, including The Wall Street Journal, The Financial Times, Business Week, Forbes and Fortune (Co-author, Chapter 19 on the USA)

Brendan O’Connell

Brendan has extensive teaching and research experience in leading Australian and US versities including Monash University, Deakin University and the University of Richmond

uni-in Virguni-inia He has published numerous papers uni-in leaduni-ing academic journals, such as the

Journal of Accounting Auditing and Finance, Critical Perspectives on Accounting, Issues

in Accounting Education, the Australian Accounting Review and the Journal of Applied Finance on topics such as earnings management, financial statement fraud, business

ethics, accounting education and securitization Brendan was guest editor of a special

issue of Critical Perspectives on Accounting entitled ‘Enron.con’ and a special issue of Accounting History that provided an historical perspective on accounting and audit failure within corporate collapse He is also a member of the editorial board of the Australian Accounting Review His case studies on the collapses of Enron and HIH Insurance are

now part of the CPA programme in Australia In 2004, Brendan was a recipient of $95 000from the Australian Research Council Discovery Grant Scheme to study ‘Audit Failure

in Corporate Collapse: An Historical Perspective’ Prior to working in academia, heworked in both accounting and the investment banking industry (Co-author, Chapter 8 onAustralia)

Simon Norton

Dr Simon D Norton is a lecturer in the law relating to banking, the capital markets, andfinancial services at Cardiff Business School, Cardiff University His areas of research,and in which he has published, include: corporate governance in the context of financialinstitutions; the impact of banking activities upon the natural environment, including theEquator Principles and the United Nations Environmental Programme; and Islamic financeand financial innovation in the context of Sharia principles Dr Norton gained his doctorate

in shipping finance, and is actively involved in the promotion of professional standardsand training in the ship broking industry (Author, Chapter 20 Creative Accounting and theFinancial Crisis of 2008–2009)

Gunnar Rimmel

Gunnar Rimmel, Ekon Dr (PhD), is Associate Professor and Head of the FinancialReporting & Analysis Group at the Department of Business Administration at theG¨oteborg School of Business, Economics and Law After the public defence of his thesis

‘Human Resources Disclosures’ in 2003, he received a post-doctoral position from theAdlerbertska Research Foundation In recent years, he has been involved in a number ofinternational research projects and has been a visiting research fellow at Kobe University

He was Secretary General of the 25th Annual Congress of the European AccountingAssociation (EAA) and currently is a member of the EAA Conference Committee.(Co-author, Chapter 17 on Sweden)

Kazuyuki Suda

Kazuyuki Suda, PhD, BEcon, MCom, is Professor of Accounting at the Graduate School

of Finance, Accounting and Law, Waseda University He has been a Visiting Professor

of Accounting at the University of Alberta (1996–97) and Visiting Research Associate

at the University of Rochester (1987–88) He was a Chair of the Specified Issues StudyCommittee of the Japanese Accounting Association (2004–6) and a Vice President ofthe Japanese Association for Research on Disclosure from 2005 to date He has served

as a member of the Technical Committee of Accounting Standards Board of Japan, theExaminations Committee of Security Analysts Association of Japan, and a Commission

of CPA Examinations of Certified Public Accountants and Auditing Oversight Board inJapan He has published many books in Japanese as well as articles in English (Author,Chapter 14 on Japan)

Jason Zezhong Xiao

Jason Xiao, PhD, MSc, MEcon, ITML, is Director of the Chinese Accounting, Finance andBusiness Research Unit and Professor of Accounting at Cardiff Business School, CardiffUniversity Jason has researched into accounting and corporate governance in China andaccounting information systems He has published over 30 articles in international journalsand over 50 articles in Chinese journals and is a member of five journal editorial boards He

is a member of ACCA’s Research Committee and a board director of the Chinese AuditingAssociation (Co-author, Chapter 9 on China)

Enron, WorldCom and Parmalat are well-known accounting scandals However, what is not

so well known is that every country has its own accounting scandals The basic motivationfor this book is to explore the role of accounting, particularly creative accounting andfraud, in accounting scandals across different countries I therefore approached peoplefrom different countries to see if they would be prepared to help me In almost every casethey did not say ‘what accounting scandals?’ but ‘which accounting scandals would youlike me to write about?’

Accounting scandals, by their nature, are extreme cases They generally involve creative

accounting and fraud The title of the book reflects this: Creative Accounting, Fraud and International Accounting Scandals This book covers 58 high-profile accounting scandals

across 12 countries However, it also deals with many other cases of creative accountingand fraud

Accounting scandals are inherently interesting because they indicate extreme abuse offinancial reporting They show how, in extremis, the accounting numbers can be manipulated

so as to deceive and defraud This book provides an insight into the methods of creativeaccounting and fraud, the motivations that underpin the scandals and the consequences ofthe scandals, both in the short term and the long term

The book aims to inform The information is presented in as accessible a way as possible.There is a focus on presenting the big picture The book should prove very interesting toreaders It provides a global approach to the topic It covers 12 countries with representativesfrom Australasia (Australia), Asia (China, India and Japan), Europe (Germany, Greece,Italy, the Netherlands, Sweden, Spain and the UK) and North America (USA) It thereforerepresents leading global economies, developed and developing countries as well as themajority of the world’s population In addition, there is a chapter dealing with bank failures

in the recent credit crunch

The book is presented in three broad sections In the first section I explore the basicthemes which underpin the book I examine the creative accounting environment, motives,methods and impression management I site this within the academic and largely descriptiveprofessional literature

In the next section, individual authors, all native to their respective countries, provide anin-depth look at the major accounting scandals and instances of creative accounting thathave occurred since the 1980s Each author contextualizes the accounting issues and looks

at the motives, methods and consequences of the creative accounting and the accountingscandals These chapters give a unique insight into the global nature of the problem There isalso a final chapter in this section looking at the consequences of the recent global bankingcrisis.

To write this book I depended upon the expertise of the individual authors This bookwould not have been possible without my reliance on their research and local knowledge

To the best of my knowledge the facts which they have described and on which this book

is based are correct

The authors were given general parameters within which to write their chapter I rely uponthe expertise and factual accuracy of the individual country author chapters to synthesiseand distil the material The material in Chapters 21–23 and Appendices 1 and 2 thus reliesprincipally on these individual chapter contributions Generally, I have not changed theaccounting terminology that they have used Therefore, within the book certain accountingterms are used somewhat interchangeably such as inventory or stock; accounts receivable

or trade receivables or debtors; accounts payable or trade payables or creditors; property,plant and equipment or fixed assets This is because different countries have their ownterminology or use International Accounting Standards Board terminology

In the last three chapters, I draw out some general themes from the chapters I look

at the methods used, the motivations for the creative accounting, fraud and accountingscandals, the role of powerful individuals, and I highlight failures of internal control andexternal auditing Finally, I investigate the long-term impact of accounting scandals on theregulatory environment

This book has several novel and original features:

• An accessible overview of the methods, motives and nature of creative accounting and

fraud drawing on prior literature and past accounting scandals

• For the first time, an in-depth study of international accounting scandals in both developed

and developing countries

• Individual chapters are written by experienced authors native to each country.

• A global synthesis of the motivations, methods, control failings and consequences of

major accounting scandals is provided

• An historical overview of accounting scandals and creative accounting is provided from

the ancient period into the 1980s

• A chapter looking at the banking crisis of 2008/9 from an accounting perspective.

As such, this book provides a rare glimpse into the murky world of accounting scandals Itwill be ideal for the general reader, professional accountant and businessman worldwide

It is also well suited for undergraduate students taking courses in forensic accounting andfraud It may also prove a useful supporting book on more general accounting and financecourses The book is uniquely positioned to support specialised MSc courses in accountingand finance or MBA courses

Michael JonesAugust 2010

I am extremely grateful to the 21 authors who have helped me to write this book Withoutthem, a book of this type would have been impossible They have provided the detailedfactual knowledge of their particular scandals and the national accounting environments inwhich those scandals occurred I have relied upon the factual accuracy of their work whenpreparing the rest of the book

I am very appreciative of the help and unfailing support of my partner, Jill Solomon,whose insightful comments have helped me immensely I should also like to thank SteveHardman, Jenny McCall and the team at John Wiley for their help and support Finally, lastbut certainly not least, I should like to thank Jan Richards for her unstinting patience andhard work in turning my generally illegible scribbling into the final manuscript

Part A

1 Introduction – Setting the Scene

Michael Jones

1.1 INTRODUCTION

Accounting scandals, creative accounting and fraud are perennial They range from ancientMesopotamia to the South Sea Bubble in 1720 to Enron and Parmalat today They occur inall eras and in all countries As accounting forms a central element of any business success orfailure, the role of accounting is crucial in understanding such business scandals Accountingenables businesses to keep a set of records to give investors and other users a picture ofhow well or badly the firm is doing However, sometimes when businesses are doing badlymanagers are tempted to use accounting to enhance the apparent performance of the firm in

an unjustified way In addition, managers may wish to use the flexibility within accounting

to serve a range of managerial interests such as to boost profits or increase assets This can

be done legally by using creative accounting to exploit the flexibility within accounting.Alternatively, in other cases management will indulge in false accounting or fraud In thiscase, management will step outside the rules and regulations that govern accounting Oftenthis will be because management has got into serious financial difficulties and is lookingfor any way to postpone corporate collapse Managers may use prohibited accountingtechniques, falsify records or even record fictitious transactions In some cases, companiesstart with creative accounting, but end up committing fraud

This book aims to explore the role of accounting, particularly creative accounting andfraud, in accounting scandals The terminology of creative accounting is explored first,and I then provide an overview of the three parts of the book In Part A the background andcontext of creative accounting and fraud are explored This part draws upon the establishedacademic and professional literature and thinking about creative accounting and fraud Itprovides an overview of the main terminology, looks at the creative accounting environment,the motivations for indulging in creative accounting and fraud, the methods of creativeaccounting and fraud, the evidence for creative accounting, impression management and,finally, looks at 18 major accounting scams and scandals across time This is from ancienttimes until about 1980

Part B looks at a series of international accounting scandals Accounting scandals in 12countries are investigated, covering Asia, Australasia, Europe and North America Countryspecialists contribute chapters on Australia, China, Germany, Greece, India, Italy, Japan, theNetherlands, Spain, Sweden, the UK and the USA In addition, there is a separate chapterdealing with the global banking crisis of 2008–9 from an accounting perspective As can be

Creative Accounting, Fraud and International Accounting Scandals Edited by Michael Jones

 2011 Michael Jones Published by John Wiley & Sons, Ltd

seen from their biographies, these experienced academics, using their knowledge and rience, provide an informed view of creative accounting, fraud and international accountingscandals in their respective countries Finally, in Part C, I draw out some themes and impli-cations from the country studies In particular, I look at the impact of accounting scandalsand synthesise the country studies using the data available from the individual chapters.

expe-1.2 EXPLORING THE TERMS

The term ‘creative accounting’ came to prominence in a book published by Ian Griffiths in

1986 This book, called Creative Accounting (Griffiths, 1986), written in the UK context,

began with the assertion that:

Every company in the country is fiddling its profits Every set of accounts is based on books which have been gently cooked or completely roasted The figures which are fed twice a year

to the investing public have been changed in order to protect the guilty It is the biggest con trick since the Trojan horse.

Any accountant worth his salt will confirm that this is no wild assertion There is no argument over the extent and existence of this corporate contortionism, the only dispute might be over the way in which it is described Such phrases as ‘cooking the books’, ‘fiddling the accounts’, and ‘corporate con trick’ may raise eyebrows where they cause people to infer that there is something illegal about this pastime In fact, this deception is all in perfectly good taste It is totally legitimate – it is creative accounting.

Since Griffiths’ book there have been many other explorations of creative accounting In

the UK, for example, there have been at least three books Accounting for Growth by Terry

Smith, a city analyst, looked at the reporting practices of 185 UK companies and foundnumerous examples of creative accounting Hardly any companies were immune (Smith,

1991) Trevor Pijper, in Creative Accounting: The Effectiveness of Financial Reporting in the UK, investigated the situation in the UK at the start of the 1990s, finding many companies

that had indulged in creative accounting In particular, Pijper looked in depth at Polly Peck,

a UK company that controversially collapsed in 1990 (Pijper, 1993) Finally, McBarnet

and Whelan, in Creative Accounting and the Cross-eyed Javelin Thrower, explored UK

financial reporting in 1999 They looked at many instances of creative accounting, especiallythose detected by the Financial Reporting and Review Panel, which ‘policed’ UK financialreporting (McBarnet and Whelan, 1999) Meanwhile, in the USA, a very influential book by

Charles Mulford and Eugene Comiskey, entitled The Financial Numbers Game, investigated

the pre-Enron financial reporting in the USA and documented numerous examples of bothcreative accounting and fraud Enron is shown to be only one high-profile example offrequently occurring financial manipulations in the USA (Mulford and Comiskey, 2002).This leads us to the question, what exactly are creative accounting and fraud and howcan they be distinguished from other commonly used terms such as earnings management,income smoothing and aggressive accounting?

1.2.1 Creative Accounting

Although creative accounting is a popularly used term, there is much less agreement onits exact definition than might be supposed In essence, there is the wide definition, as

adopted by Mulford and Comiskey (2002, p 15) in the USA and the narrower definition

as practised in the UK I give two representative definitions in Figure 1.1, and also thepreferred definition that I will use in the book

Generally, therefore, the wider US definition sees creative accounting as including fraudwhereas the UK definition sees creative accounting as using the flexibility within theregulatory system, but excludes fraud The preferred definition in this book sees creativeaccounting as excluding fraud It is defined as ‘Using the flexibility in accounting withinthe regulatory framework to manage the measurement and presentation of the accounts sothat they give primacy to the interests of the preparers not the users’ Creative accounting isthus seen as working within the regulatory system It is thus not illegal Companies usingcreative accounting are not breaking the law, just using the flexibility in accounting to servetheir own interests

Creative accounting is thus designed, by exploiting loopholes in the existing regulatorysystem, to serve preparers’ not users’ interests In Europe, the financial statements ofpublished companies, for example, are required to present a ‘true and fair’ view of theaccounts In the USA, a similar phrase ‘present fairly’ is used In these Anglo-Saxoncountries (and in many other countries) there is the overriding notion that accounts shouldfaithfully represent economic reality.1 Users are supposed to be given a set of financialaccounts which reflect economic reality Creative accounting, by contrast, privileges theinterests of the preparers (i.e the managers) It is able to do this because of the fundamentalneed for financial reports to be flexible so as to give a true and fair view of accounts Allcompanies are different and operate in different environments

The flexibility in financial reporting is meant to reflect this However, this flexibility can

be used, and often is, for creative accounting As Figure 1.2 shows, there is a continuumfrom no flexibility to flexibility to give a true and fair view, to flexibility to give a creativeview, to flexibility to give a fraudulent view

Thus, if there is no flexibility, there will be no creative accounting However, there willalso not be a true and fair view This is unacceptable as a fundamental purpose of account-ing is to provide users, generally shareholders, with information so that they can makeeconomic decisions such as whether to buy, sell or hold shares A regulatory framework,which varies from country to country but may include national standards (most countries,e.g the UK and the USA), international standards (widely used), company law (somecountries, such as the UK and Germany) or independent accounting commissions (such asthe Securities and Exchange Commission in the USA) has, therefore, grown up to set upaccounting rules and regulations which companies and other organizations should follow

so as to deliver ‘a true and fair view’ to account users This is the ideal scenario, where thepreparers of accounts use the flexibility in the accounts to deliver ‘a true and fair view’.However, the flexibility within the accounting rules and regulations opens the door for themanagers to use creative accounting In a sense, there is nothing wrong in this as they arenot breaking any rules However, they are departing from the basic purpose of accounting,which is to provide users with a true and fair view When the managers actually go outsidethe regulatory framework, they are not then complying with existing regulations Techni-cally, they may then be indulging in false accounting or in fraud However, this is a difficult

1 For ease of understanding the phrase ‘true and fair’ commonly used in Europe is used in this book to convey the notion

of economic reality.

Narrow definions of creave accounng

“The exploitaon of loopholes in financial regulaon in order to gain advantage or present figures in

a misleadingly favourable light.”

Oxford Diconary of English

“A form of accounng which, while complying with all regulaons, nevertheless gives a biased impression (generally favourable) of the company’s performance.”

Chartered Instute of Management Accounng (2000), Official Terminology

Wide definion of creave accounng

“Any and all steps used to play the financial numbers game, including the aggressive choice and applicaon of accounng principles, both within and beyond the boundaries of generally accepted accounng principles, and fraudulent financial reporng Also included are steps taken toward earnings management and income smoothing.”

Mulford and Comiskey (2002, p 15)

Preferred definion of creave accounng

“Using the flexibility in accounng within the regulatory framework to manage the measurement and presentaon of the accounts so that they give primacy to the interests of the preparers not the users.”

Fraud

“A knowing misrepresentaon of the truth or concealment of a material fact to induce another to act

to his or her detriment.”

Black’s Law Diconary, 7th edn (1999)

“… ‘fraud’ comprises both the use of decepon to obtain an unjust or illegal financial advantage and intenonal misrepresentaons affecng the financial statements by one or more individuals among management, employees, or third pares Fraud may involve:

• Falsificaon or alteraon of accounng records or other documents

• Misappropriaon of assets or the

• Suppression or omission of the effects of transacons from records or documents

• Recording of transacons without substance

• Intenonal misapplicaon of accounng policies

• Wilful misrepresentaon of transacons or of an enty’s state of affairs.”

Auding Standards Board, Statement of Auding Standard, SAS 110

Figure 1.1 Definitions of creative accounting and fraud

Fraudulent financial reporng

”Internaonal misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrave, civil or criminal proceeding.”

Mulford and Comiskey (2002, p 3)

“Internaonal material misstatement of financial statements or financial disclosures or the perpetraon of an illegal act that has a material direct effect on the financial statements or financial disclosures.”

Beasley, Carcello and Hermanson (1999)

Preferred definion of fraud

The use of ficous accounng transacons or those prohibited by generally accepted accounng principles gives the presumpon for fraud which becomes proved aer an administrave or court proceeding

Figure 1.1 Definitions of creative accounting and fraud (Continued)

area False accounting or fraud, in effect, must be proved in a court of law or by a regulatorybody

No

flexibility

Flexibility to give a ‘true and fair’ view

Flexibility to give a creave view

Flexibility to give a fraudulent view

Regulatory framework

eliminates accounng

choice

Working within regulatory framework

to serve users’

interests

Working within regulatory framework

to serve preparers’

interests

Working outside regulatory framework

Within regulatory framework Outside regulatory

framework

Figure 1.2 Flexibility within accounting

Source: Adapted from Jones (2006).

1.2.2 Fraud

The difference between creative accounting and fraud is, therefore, essentially that creativeaccounting is working within the regulatory framework An exact definition of fraud iselusive; for instance, in the UK there is no legal definition of fraud (Levi, InformationGathering Working Party and Doig, 1999) However, fraud involves working outside the

regulatory framework In each country, the definition of fraud will be slightly different;however, in essence, it involves breaking the law and/or violating the regulatory framework.Fraud can be committed by individuals or management For individuals, accounting fraudwould generally involve theft of, for example, inventory or cash For management, there isalso the crime of preparing false financial statements intended to deceive users When thereare suspicions that fraud is taking place, then we can say there is alleged fraud However,

it is only when there is a proven court case that we have a demonstrable case of fraud.Thus, in Polly Peck, a UK company that collapsed in 1991, Asil Nadir has been accused

of fraud and false accounting by the Serious Fraud Office in the UK but has not yet beenbrought to court The charges remain alleged, with Asil Nadir protesting his innocence.However, in the USA Kenneth Lay and Jeffrey Skilling were both brought to trial andfound guilty of accounting fraud at Enron (White, 2006) Also in the USA, the Rigasfamily who owned Adelphi Communications, a cable operator, were accused of a wholerange of accounting malpractices in June 2002 ‘The Justice Department and the U.S PostalInspection Service charged the five executives with securities, wire and bank fraud, sayingthey “looted Adelphia on a massive scale” and used it as a “personal piggy bank” Rigasprivate funds sloshed with Adelphia’s in the same cash-management system’ (Liebermanand Farrell, 2002, p 3) For their role in the fraud, key members of the founding familywere convicted of financial statement fraud

Financial statement fraud is a subset of fraud in general There have been some attempts

to estimate both the extent of fraud and of financial statement fraud, which is the mainfocus of this particular book The most comprehensive study, particularly of financialstatement fraud, is provided by Beasley, Carcello and Hermanson (1999) in a researchreport commissioned by the Treadway Commission in the USA This is dealt with, indepth, in Chapter 5 I therefore focus here on other indications of the extent of fraud in fourstudies from the UK, USA, Australia and globally

First, in the UK the Fraud Advisory Panel (Levi, Information Gathering Party and Doig,1999) outlined various ranges of the annual cost of major frauds in the UK These rangedfrom £16 billion from the Association of British Insurers; £5 billion from the Serious FraudOffice as well as Ernst & Young; £1–2 billion from benefit fraud and £400–700 millionfrom KPMG The Serious Fraud Office workload of alleged frauds in April 1997 was over

£2 billion and the most common frauds were those on investors and creditors, and on banksand other institutions The number of cases of false accounting ranged from a high of 2106

in 1989 to a low of 1395 in 1995 (from 1986–96) The most frequently occurring type

of fraud was false documentations (£977 000) followed by theft of assets (£640 100) in1997/98

In the USA, the Association of Certified Fraud Examiners in 1996 published a FraudReport (Association of Certified Fraud Examiners, 1996) It collected the experience of 2608Certified Fraud Examiners They studied$15 billion of cases, and established that fraud andabuse cost US organisations more than$400 billion annually Men commit 75 % of frauds,with small businesses being the most vulnerable The most common account affected byfraud was cash, with fraudulent financial statements accounting for about 5 % of cases.Third, in Australia and New Zealand, KPMG carried out a Fraud Survey in 2004(KPMG, 2004) Its main findings were that 45 % of its respondents experienced at least onefraud, with a loss of $456.7 million and 27 657 instances of fraud The typical fraudsterwas male, about 31 years old, with no prior record of dishonesty, in a non-management

position who misappropriated funds of$337 734 and acting alone was motivated by greed.The most common fraud by managers was the theft of inventory/plant, followed by themisappropriation of funds, cheque forgery and false invoicing.

Fourth, Ernst & Young carry out an annual survey of fraud Their 2002 survey found that

85 % of frauds were by insiders on the payroll (Ernst & Young, 2002) Generally, morefrauds happened in less developed regions, such as Africa, than in more developed regions,like Europe The size of more than half the losses was less than$100 000

In general, financial statement fraud can be categorised in two major ways First, it

is when a company uses accounting practices which are outside those permitted by theregulatory framework In other words, they are not allowed by accounting standards oraccounting laws Generally, to be designated as fraud these practices will have been shown

to be fraudulent in a court of law Often, it is difficult to distinguish between creativeaccounting and fraud as it will all be a matter of interpreting the basic assumptions thatunderpin accounting

The second major type of fraud is where transactions have been invented In otherwords, non-existent transactions have been recorded in the books, such as fictitious sales orfictitious inventory For example, in the USA there have been two high-profile fraud cases

in the twentieth century that have involved substantial fraud In McKesson and Robbins afictitious subsidiary had been invented, while in the case of the Equity Funding Corporation

of America a whole edifice of false insurance policies had been constructed

1.2.3 Other Terms

There are many other terms which are used in connection with creative accounting Some

of these are discussed below They are also set out more formally in Figure 1.3

1.2.3.2 Earnings Management

Earnings management is a term commonly used by academics There have been numerousacademic papers written on all aspects of the subject Earnings management is wheremanagers manage the accounts in order to achieve a specific objective So, for example, it

is common practice for analysts to issue profit forecasts for firms trading on the world’sstock exchanges Firms like to meet these forecasts because if they do not, share prices

of the errant companies often fall Firms which are falling short of their targets will,therefore, sometimes seek to manage their profits There are many other examples ofearnings management For example, to ensure that debt covenants are not breached, forprofit smoothing, or to sustain earnings and share price in takeovers A fuller discussion ofthe earnings management literature is given in Chapter 5

1.2.3.3 Impression Management

Impression management involves managers influencing the financial reports in their favour

It is not fraudulent It is a very wide term and although it includes creative accounting, it isnormally more associated with the presentational aspects of reporting such as accountingnarratives, graphs and photographs Accounting narratives, such as the Chairman’s State-ment in the UK and the Management Discussion and Analysis in the USA, may be subject

to narrative enhancement In other words, management may present news selectively, biasthe news or use attribution (attribute good news to themselves but attribute bad news touncontrollable external influences such as world events)

There are many possible ways in which graphs might be used creatively For example,they may only be used when there is a favourable trend to display Or alternatively theymight be drawn so as to enhance favourable results and downplay unfavourable results.Finally, photographs may be used to present an overall image of the company For ex-ample, many of the high-profile oil companies use nature photographs to try to present agreen image A fuller discussion of the impression management literature is provided inChapter 6

1.2.3.4 Profit Smoothing

The stock market generally rewards companies that produce steady profits, but penalisesthose with erratic profits Companies therefore will prefer to report steady year-on-yeargrowth rather than confront the market with volatile profits Company managers will,

therefore, use various techniques to smooth profits Essentially this means massaging downhigh profits and enhancing poor profits Fortunately for the creative accountant, lots ofopportunities arise for massaging profits The company can, for example, use provision or

‘cookie jar’ accounting This is where a firm may set up a provision for an expense oneyear This will reduce profits The next year it may reverse the provision saying that theexpenses it expected to incur were overestimated Consequently, in year two profits will

be more because of the reversed provision Companies can then save up their profits for arainy day

1.3 STRUCTURE OF THE BOOK

I will now briefly outline the contents of the rest of the book In the rest of Part A, the context

of creative accounting is examined This draws upon existing academic and professionalliterature In Chapter 2, I look at the main actors involved in creative accounting: managers,investment analysts, auditors, regulators, shareholders, merchant bankers and other users.The different interests which these groups have are highlighted Managers may benefit fromcreative accounting as it gives them the flexibility to deliver the results they want Existingshareholders may also gain, unless the company collapses, due to its enhanced share pricescaused by creative accounting For merchant bankers, there may be potentially lucrativefees to be earned by creating complex creative accounting schemes By contrast, othergroups are harmed by creative accounting Regulators dislike creative accounting because

it can be used to bypass accounting rules and undermines the currency of accounting.Shareholders, and other users, may suffer if the company collapses For auditors, creativeaccounting creates a potential conflict with management, and also a potential problem ifthe company collapses as the auditor may be blamed

The motivations to indulge in creative accounting and fraud are varied and are examined

in Chapter 3 There are two sets of general incentives: personal and city The personalincentives relate to the managers They may wish, for example, to try to increase theirsalaries, bonuses, enhance their shares and share options In other words, there are incentivesfor them to manipulate accounting policies in order to maximise their own personal benefit.They also may wish to meet city expectations If the business does not deliver the expectedprofits then its share price may be punished As a result, managers will try to meet analysts’expectations and may indulge in profit smoothing or in other creative accounting techniques.There are also a range of special circumstances For example, managers may wish toincrease net assets so as to stop breaching debt covenants or creative accounting may beused to increase the share price of a company when it is purchasing another through a shareissue In certain circumstances, there may also be incentives to reduce profits For example,

in regulated industries when governments may penalise excessive profits or in situationswhere a new incoming management team may wish to make the current year’s profits worse

so that future profits will look better

There are numerous ways of exploiting the inherent flexibility of accounting so as toindulge in creative accounting In Chapter 4, I look at four main strategies: increasingincome, decreasing expenses, increasing assets and decreasing liabilities

1.3.1 Increase Income

The aim here is to maximise revenues which will feed directly into profit There areseveral main ways Generally, these will involve the premature recognition of sales or themaximisation of other income such as interest receivable or non-operating profit In mostcases, these techniques will exploit the flexibility in accounting regulation However, insome cases completely fictitious sales will be created At its most extreme, as in McKessonand Robbins in the USA in 1931, a wholly fictitious trading subsidiary was set up Morerecently in Germany, as we will see in Chapter 10, at Flowtex, fictitious drilling machineswere ‘manufactured’ and ‘leased’

so that they are recorded as assets not expenses, or (ii) to lengthen asset lives so as to reducedepreciation, or (iii) to reduce bad debts Finally, a good way of decreasing expenses is toincrease closing inventory Closing inventory is taken off cost of sales and thus by increasingclosing inventory, cost of sales is reduced and profits increased

1.3.3 Increase Assets

Many of the strategies that decreased expenses will also boost assets Thus, lengtheningdepreciation levels and capitalising interest will boost fixed assets, while reducing bad debtswill increase accounts receivable However, some other techniques can be used to increaseassets For example, goodwill, brands and other intangible assets can be enhanced in valueand included in the accounts In addition, tangible fixed accounts can be revalued

1.3.4 Decrease Liabilities

Another way of increasing net assets is by decreasing liabilities Two common ways areoff-balance sheet financing and reclassifying debt as equity Off-balance sheet financingattempts to quarantine debt in subsidiary companies which are not then consolidated.Enron, for example, set up numerous off-balance sheet subsidiaries Reclassifying debt asequity seeks to classify outside, third-party debt as insider capital This serves to reducethe apparent levels of debt

There have been many studies into creative accounting, and both descriptive and statisticalstudies are discussed in Chapter 5 The descriptive studies, reports and books discuss andprovide illustrative examples of creative accounting In the statistical studies, large numbers