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The best work not only describes and summarises theories and findings but also critically interprets them. When an author's views are simply declared as part of evidence and argument, this is known as an 'appeal to an authority': you need to critically evaluate such views. The task is not to 'criticise' the work of experienced professionals on the basis of your own knowledge of the topic or of research methodology but to show that you are capable of thinking critically and with insight about the issues raised. Relate different studies to each other. Compare and contrast different approaches and identify their strengths and limitations. What questions do they leave unanswered? Try to be as balanced and impartial as possible.
Reasons for manipulating numbers (financial crimes):
Given the current financial crisis, the use of aggressive accounting to manipulate the numbers is rising. This is due to the pressure to inflate earnings to please investors and to meet compensation incentives.
Investors expectation for good information are high and are very sensitive to 'bad news'. This put pressures on senior managers to make the numbers look good in fear of the negative consequences of reporting 'bad news'. Reasons: Inflate earnings prior to an issue of shares to attract investors or to sell personal held shares held with the company. Lakis, V. (2008). INDEPENDENT AUDITING DEVELOPMENT TENDENCIES. Technological & Economic Development of Economy, 14(2), 171-183. doi:10.3846/1392-8619.2008.14.171-183.
In a study by Audit Integrity (2008, as cited in Corporate Board, 2009) it reveals that US corporations with lucrative compensation performance schemes (e.g. share options and share repurchase) offered to top managers tend to use more aggressive accounting practices. Of those companies whose accounting Audit Integrity considered "very aggressive", 50% offer generous stock options. In contrast, only six percent of companies with conservative accounting offer share repurchase programs. (2009). Aggressive accounting tied to heavy use of option pay. Corporate Board, 30(175), 26. Retrieved from Business Source Premier database.
Several studies have shown that the extend to which executives benefit from stock options is positively related to the likelihood of misreporting. There was significant evidence of greater option exercises by those firms who intentionally select aggressive accounting.
A study by Burns & Kedia to determine the extend to which managers actually realized the potential gains from misreporting. It was based on the idea that if managers "deliberately adopt aggressive accounting practices, then anticipating a future drop in stock price, they should exercise significantly more options in the misreported period." It was concluded that "executives of firms likely to have deliberately adopted aggressive accounting practices exercise significantly more options in the misreported years in comparison to non restating firms. It states that corporate executives may achieve private wealth gains when they increase option exercises during a time of misreported earnings." Burns, N., & Kedia, S. (2008). Executive Option Exercises and Financial Misreporting. CFA Digest, 38(4), 5-7. Retrieved from Business Source Premier database.
Findings - "The misstatement that lead to earnings restatements are driven by a variety of forces, the most often studied and discussed being deceptive accounting practices by managers. The results of these restatements include a decline in the market value of the firm, an increase in the cost of capital, a loss of reputation for the firm and managers and an overall loss of confidence from investors."
Enron understated its debt by nearly 40% and overstated its cash flows by almost 50% in the year 2000 alone. WorldCom which overstated earnings by more than $7 billion over a three year period. ( Rezaee, 2002)
"High quality financial reporting enables markets to function properly. Furthermore, the value of high quality financial reporting goes beyond investors. Managers making strategic decisions, employees making career decisions, governments making regulatory decisions or tax revenue forecast and researchers analyzing company performance all rely on quality financial reports.
High quality financial reports means that the financial report of a company is transparent (i.e. easily understood), complete and truthful in terms of financial performance. When companies have to restate their financial statements, it means that the originally issued financial report was not transparent, complete and/or truthful, which may lead users of financial reports to make inappropriate decisions."
"The three most frequent reasons for restatements identified were revenue recognition, cost or expense and restructuring assets or inventory collectively accounting for 75.84% of the dataset. Revenue recognition restatements (42.33 %) occur primarily because of questionable reported revenue or revenue recognised in the wrong time period (i.e. reporting revenue that actually pertains to the next fiscal period). Cost or expenses restatements (19.91 %) include improperly capitalizing items that should be expensed and improperly classifying tax liabilities. Restructuring assets or inventory restatements (13.60 %) pertain to inaccurate timing of assets write-downs and inappropriate inventory valuation or quantity issues."
The auditors job is to make sure that the financial statements are fairly stated in accordance with GAAP. Every country has its own version of GAAP standards. It is important to note that, in most countries the GAAP is not a set of laws generated by the government. Rather, GAAP is a set of guidelines set up for the accounting profession, usually by an independent standard setting body. The GAAP guidelines provide standards but also acknowledge that accounting in a complex and ever changing business world is often more art than science. Flanagan, D., Muse, L., & O'Shaughnessy, K. (2008). An overview of accounting restatement activity in the United States. International Journal of Commerce & Management, 18(4), 363-381. doi:10.1108/10569210810921979.
Could you elaborate on the boundaries of creative accounting, particularly when it crosses the line from generally accepted accounting principles to not-so-GAAP?
Mulford: Because GAAP is a rules-based system, for most transactions there is a rather clear line between transactions accounted for within the boundaries of GAAP and those accounted for beyond the boundaries. It gets gray in cases where GAAP permits a particular accounting method, but that method is abused by an overzealous management. For example, one of the requirements for revenue recognition is delivery. A firm may have fulfilled the delivery requirement, but by adding other contingencies to the sales agreement in the form of a side letter (open return, postpone payment, other services provided), the revenue in question is effectively not earned. As another example, costs that benefit future periods may be capitalized. But some firms stretch the definition of what constitutes a future benefit and capitalize costs that should have been expensed. What these transactions have in common is that other firms in the industry are likely not accounting for them in the same manner.
Mulford: They would be 1) premature revenue recognition--recognizing actual revenues early before being earned; 2) aggressive cost capitalization--capitalizing costs that other firms routinely expense; 3) extended amortization periods--depreciating fixed assets over periods that extend beyond their useful lives; 4) overstated assets--failure to address asset impairments, for example, receivables, inventory, investments, fixed assets, or goodwill, in a timely manner; and 5) understated operating liabilities--under-accrual of operating expenses that require judgment, like warranty obligations or insurance reserves such as workers' comp. Mulford, C. (2009). Financial Warnings. RMA Journal, 92(3), 14-17. Retrieved from Business Source Premier database.
"With a certain mind-numbing frequency, users of financial statements - investors and creditors - find themselves buffeted with announcements of accounting irregularities. These irregularities are called many things, including aggressive accounting, earnings management, income smoothing, and fraudulent financial reporting (collectively referred to as creative accounting). While they may vary in the degree to which they misreport financial results, they have similar effects - financial statements that serve as a foundation for important investment and credit decisions are incorrect, improper, and worse, misleading."
"Every one of the above examples entails, in one form or another, participation in the financial numbers game. The game itself has many different names and takes on many different forms. While the financial numbers game may have different labels, participation in it has a singular ultimate objective - creating an altered impression of a firm's business performance. By altering financial statement user's impression of a firm's business performance, management that play the financial numbers game seek certain desired real outcomes. Common labels, which depend on the scope of the tactics employed, are summarized:
Aggressive accounting: A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with GAAP or not.
Earnings management: The active manipulation of earnings towards a predetermined target, which may be set by management, a forecast made by analyst, or an amount that is consistent with a smoother, more sustainable earnings stream.
Income Smoothing: A form of earnings management designed to remove peaks and valleys from a normal earnings series, including steps to reduce and "store" profits during good years for use during slower years.
Fraudulent Financial Reporting: Intentional misstatement or omissions of amount or disclosures in financial statements, done to deceive financial statements users, that are determined to be fraudulent by an administrative, civil, or criminal proceeding.
Creative accounting practices: Any and all steps used to play the financial numbers game, including the aggressive choice and application of accounting principles, fraudulent financial reporting and any steps taken toward earnings management or income smoothing.
Rewards of the Game:
Expected rewards earned by those who play the financial numbers may be many and varied. Often the desired reward is an upward move in a firm's share price. For others, the incentive may be a desire to improve debt ratings and reduce interest costs on borrowed amounts or create additional slack and reduce restrictions from debt covenants. Finally, for high-profile firms, the motivation may be lower political costs, including avoiding more regulation or higher taxes.
Share price effects:
Firms that communicate higher earning power will tend to see a favorable effect on their share prices. For the firm, a higher share price increases market valuation and reduces its cost of capital. For managers of the firm with outright equity stakes or options on equity stakes, a higher share price increases personal wealth. Playing the financial numbers game may be one way to communicate to investors that a firm has higher earning power (sustainability of earnings and potential of growth), helping to foster a higher share price.
Borrowing Cost Effect:
Higher reported earnings, and the higher assets, lower liabilities, and higher shareholders equity amounts that accompany higher earnings, can convey an impression of improved credit quality and a higher debt rating to a lender or bond investor. As a result, the use of creative accounting practices to improve reported financial measures may lead to lower corporate borrowing costs.
Bonus Plan Effect:
Incentive compensation plans for corporate officers and key employees are typically stock option and/or stock appreciation rights plan. With such plan, employees receive stock or the right to obtain stock, or cash, tied to the company's share price. When structured properly, such plans successfully link the officers and employees interests with those of other shareholders...When such bonus schemes are tied to reported earnings, officers and employees have an incentive to employ creative accounting practices in an effort to maximize the bonuses received.
Political Cost Effect:
Large and high-profile firms may have the motivation to manage their earnings down-ward in an effort to be less conspicuous to regulators. Few readers old enough to have experienced firsthand a strong Organization of Petroleum Exporting Countries (OPEC) and the price effects of the oil embargoes of the 1970s will forget the term obscene profits as it was applied to the earnings of the oil companies during that period. The earnings of those companies were viewed as sufficiently high that Congress enacted a special "windfall profits tax" in an effort to rein them in. Oil prices moved so quickly during that period that likely there was very little these companies could have done to mitigate the positive earnings effect. Given time, however, they might have been encouraged to take steps, such as deferring revenue or accelerating expenses, in an effort to lower reported income.
The financial numbers game is played by actively altering reported financial results (i.e. the income statement and statement of cash flows) or reported financial position (i.e. the balance sheet) in some desired amount and/or some desired direction. A company can achieve this end through policy choice, accounting policy application, or outright fraudulent financial reporting.
Accounting Policy Choice and Application:
One way that the financial numbers game is played is through a firm's selection of the accounting policies it employs in the preparation of its financial statements or in the manner in which those accounting policies are applied. The companies involved are simply using available flexibility in accounting principles.
Flexibility in Financial Reporting:
The selection and application of GAAP is flexible, leaving much room for judgement in certain areas. As a result, through their choice and application of accounting policies, companies in similar circumstances may report dissimilar results. Consider the flexibility available in three areas common to modern financial reports: inventory cost determination, software revenue recognition, and goodwill amortization.
It is through the presence of this flexibility that managements can get creative in the preparation of financial statements and play the financial numbers game. Of course, the natural question is, why does flexibility exist? Why do accounting regulators permit companies to have such flexibility? Would it not make sense for regulators to require all companies to report their financial transactions in the same way? Unfortunately, it is not that simple. Financial transactions and the economic conditions surrounding them are not sufficiently similar to warrant use of identical accounting practices, even by companies within the same industry. For valid reasons, flexibility in financial reporting exists. It will and should remain as long as circumstances and conditions across companies and industries vary. The existence of flexibility in the choice and application of accounting policies, however, should not result in misleading financial statements. Rather than using that flexibility to mislead financial statements users, companies should employ it to provide a fair presentation of their financial results and financial position.
Aggressive Application of Accounting Principles
When the financial numbers game is played, however, rather than using reporting flexibility for fair presentation, companies select accounting principles and apply them in an aggressive manner. They push the envelope and stretch the flexibility of GAAP, sometimes beyond its intended limits. The purpose of this aggressive application of accounting principles is to alter their financial results and financial position in order to create a potentially misleading impression of their firm's business performance. The ultimate objective is to achieve some of the games reward that may accrue to them.
Sybase Inc. (1998) - Its revenue recognition policy was within GAAP for software revenue recognition. It links recognition to shipment and collectability of the amounts due. It was determined, however, that the company's Japanese subsidiary was recording revenue "for purported sales that were accompanied by side letters allowing customers to return software later without penalty." Such open return policies, especially considering the use of side letters and the lack of sufficient estimates of returns recorded in the accounts, clearly pushed the company's practices beyond the intended limits of GAAP.
Sunbeam Corporation (1996) - The company underwent restructuring resulting in a pre-tax special charge to earnings of approximately $337.6 million in the fourth quarter of 1996. According to GAAP the charge should be recorded in the year of the restructuring and should incorporate all anticipated costs of its implementation. On the surface, that is precisely what Sunbeam was doing. However, the company intentionally overestimated the costs of its restructuring, leading to understated results for 1996 and higher results for future years. In so doing, Sunbeam was applying accounting principles aggressively. By recording unusually high restructuring costs, the company was able to effectively move future-year expenses into its 1996 results. For example, among the costs included in the restructuring charge were write-downs of inventory and fixed assets. Such write-downs reduce future-year expenses for cost of goods sold and depreciation. Also included in the company's restructuring charge were reserves or liabilities for future environmental and litigation costs. To the extent that these were normal operating expenses of future years, they should not have been included in a charge taken in 1996. Thus, by recording an overly large restructuring charge in 1996, the company was able to boost its results for 1997 and beyond.
Waste management Inc - It is up to management to determine appropriate useful lives and residual values for property and equipment. When managements use this flexibility in an aggressive manner to artificially boost earnings, by selecting either useful lives that are too long or residual values that are too high, periodic charges for depreciation and amortization expense will be understated. As a result, current earnings will be overstated, as will the book values of the assets in question. If later it is determined that those book value amounts are higher than the undiscounted net cash flows to be realized through their use, a write-down may be in order. Waste Management had played the financial numbers game and artificially boosted earnings with extended useful lives and inappropriately high residual values.
Measures to hinder aggressive accounting
"The importance of high-quality financial reporting became very apparent in 2001 and 2002 when large corporation such as Enron, Global Crossing, and WorldCom were forced to declare bankruptcy when massive accounting and financial reporting irregularities were revealed. To alleviate the public outcry over these scandals, the Congress passed the Sarbanes-Oxley Act. A provision of this act specifically addressed the issue of improving corporate financial reporting. Whereas the new reporting requirements lend themselves to more comfort for investors in relying on audited financial statements, companies are struggling with additional costs, falling stock prices... The primary impact of Sarbanes-Oxley on companies is cost." Flanagan, D., Muse, L., & O'Shaughnessy, K. (2008). An overview of accounting restatement activity in the United States. International Journal of Commerce & Management, 18(4), 363-381. doi:10.1108/10569210810921979.
Explaining aggressive accounting:
A study by Nelson, Elliot & Tarpley (2002, as cited in Scott,2002) of the use of aggressive accounting showed that the most common earning management technique (or aggressive accounting) was reserve transaction (25%) followed by revenue recognition (15%) and business combination (14%). Scott, A. (2002). Aggressive Accounting Practices Examined. Internal Auditor, 59(4), 13. Retrieved from Business Source Premier database.
Used with the intention to get the desired result. Lakis, V. (2008). INDEPENDENT AUDITING DEVELOPMENT TENDENCIES. Technological & Economic Development of Economy, 14(2), 171-183. doi:10.3846/1392-8619.2008.14.171-183.
Impact on users:
Users trust accountants and auditors to ensure that they accurately informed them about business dealings. Violating that trust damages the profession reputation.
"The first line of defence for investors is manned by the nation's auditing firms" Martin ( 2002, as cited in Scot, 2002) Scott, A. (2002). Aggressive Accounting Practices Examined. Internal Auditor, 59(4), 13. Retrieved from Business Source Premier database.