Detailed in-depth notes for the first year 'Financial Management' paper on 'Creative Accounting'. Mainly based on lectures, with summaries of readings (where applicable), learnings from pre-work problems, and personal explanatory notes included where relevant.
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Creative Accounting & Auditing
Overview
Discuss “Creative Accounting” (why and how creative accounting occurs)
Implications of creative accounting (earnings management)
Understand corporate governance
Examine auditing (role of auditors)
Assess success (the extent to which auditing achieves its aim)
Creative accounting
Enron's collapse:
o Auditor: Arthur Anderson
o From a pipeline company in 1980s, became one of the largest energy traders
o Trading margins collapsed from 5.3% in early 1998 to less than 1.7% in Q3 2001, despite
practice of selling fixed assets and booking gains as operating revenues
Creative accounting: in between true and fair view and outright fraud
Red flags in financial statements
o Earnings maintained through acquisitions
o Longer useful lives for non-current assets (reduce depreciation expense)
o High earnings but low cash flow (lots of receivables)
o Accounts receivable and inventory increase more quickly than sales revenue
o Regular non-recurring charges
o R&D or advertising expenses decrease relatively to revenue (not investing in future,
possibly for short term profit maximisation)
(Graham et al, 2006, Financial Analysts Journal)
o Executives view the following as most important measures reported to outsiders:
earnings, revenues, operating cash flow
o If might not meet desired quarterly earnings target, managers responded that they
might: decrease discretionary spending, delay start of a new project even if it entails
some small sacrifice in value, book revenues now rather than later (if justified in either
quarter), provide incentives for customers to buy more product this quarter
Negative effects
o Short-termism
o Use of non-GAAP figures and creative accounting to boost management pay
Good Matching
Only COGS should be matched to sales revenue, not full costs of producing or buying inventory
during the period (so gross margin measures value added from trading with customers)
Costs of buying PPE are not expensed when incurred. Rather, cost is capitalised on the BS and
depreciated over the years as the PPE produce revenues
Employee pension costs are recorded as an expense in the period that employees generate
revenues, not when they are paid (in retirement)
Poor matching due to accounting rules
R&D Development expenditures are expensed when incurred, rather than matched to
(subsequent) revenues they generate
, Advertising and promotion costs are expensed when incurred, rather than matched to
(subsequent) revenues generated.
Poor matching due to firm discretion: earnings management
Estimating too long PPE lives, understating depreciation
Quality of earnings
Quality in information content and relevance
Quality decreases if
o Accounting regulation distorts economic reality (e.g., poor matching) and imposes
restrictions on management (flexibility in accounting rules may increase quality)
o Management uses discretionary choices to manipulate financial disclosure (flexibility
may decrease quality...)
Earnings management: management uses its reporting discretion to produce financial
statements that place management’s performance in a particular light
Fraud: violation of accounting standards, fictitious transactions, misappropriation of assets etc.
Excessive creative accounting can lead to fraud
Manipulations are likely when:
Firm is in the process of raising capital (IPO) or renegotiating borrowing
Management or auditor change
Management rewards tied to earnings
Management is repricing executive stock options
Weak governance structure (management dominates the board, weak audit committee)
Regulatory ratio requirements
Transactions are with related parties rather than at arm's length
Special events such as union negotiations and proxy fights
When it is a takeover target
Firm engages in exotic arrangements (structured off-balance-sheet vehicles)
Change in accounting principles or estimates
Earnings surprise
Drop in profitability after a period of good profitability
Earnings growing faster than sales
Constant sales or falling sales
Very low earnings (might be a loss without manipulation)
Small or zero increase in profit margins (might be a decrease without manipulation)
Firm just meets analysts' earnings expectations
Differences in expenses for tax and financial reporting
Financial reports used for other purposes like tax and union negotiations
Motivations for creative accounting
Market pressure, investor pressure, debt covenants, management renumeration, regulation,
other stakeholders
Corporate Governance
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