lecture topic 8 earnings management & creative accounting

ATPB 313ACCOUNTING THEORY AND PRACTICE

SEM I 2013/2014(updated October 2013)

TOPIC 8Earnings management/creative

accounting

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Learning OutcomesAt the end of this lecture, students should be able to

discuss:

•the overview of creative accounting

•the incentives to creative accounting

•the techniques of creative accounting

•Malaysian creative accounting cases

•ethics from the perspective of creative accounting

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Overview of Creative AccountingUsing the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of preparers.

(Mike Jones,2003)… 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.

(Healy and Wahlen, 1999)

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Creative Accounting vs. Fraud“Conservative”

Accounting

“Aggressive” Accounting

“Fraudulent” Accounting

•Aggressive recognition of provisions and reserves

•Overstate asset write-offs

• Understate provision for bad debts

• Drawing down provisions/reserves in an overly aggressive manner

• Recording fictitious sales

• Backdating sales invoices

• Overstating inventory

Within GAAP

Violates GAAP

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Five Factors that Influence Fraud

Source: Accountants Today June 2010

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Incentives to Creative AccountingMain Reason: Pressure placed upon management

Agency theory reinforced the idea of seeking to please shareholders

Financial reports are the ‘basis’ of contract

Managers intend to protect the basis of contract

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Incentives to Creative Accounting

Purpose of accounting standards : To regulate financial reporting

Limitation of accounting standards: Vagueness, flexibility, and judgments

Reporting entity tends to choose accounting method ‘that gives their preferred image’.

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Other Incentives to Creative AccountingCG

weaknesses

Questionable ethical values

Political costs

Borrowing costs

etc

Performance

expectation

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The loopholes

lack of effective internal controls

existing supply chain processes

were so complex

the absence of appropriate inventory

management systems

the lack of due diligence on third party

vendors

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The Techniques of Creative Accounting

Extraordinary Items

Income Smoothing

Smoothing Expenses

Fixed Assets Big Bath Cookie Jar

Reserves

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Good Side• Avoid public

attention• Companies in volatile

market• Maintain debt

finance and the financial support of creditors

Bad Side• Mislead investors

through untruthful financial reporting

• The credibility of accounting profession might be tarnished

Creative Accounting

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Malaysian Creative Accounting Cases

PwC’s 2011 Global Economic Crime Survey: Economic crime in Malaysia continues to increase

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Malaysian Creative Accounting CasesKPMG Malaysia Fraud Survey Report 2009 :The number of fraud cases among corporate companies in Malaysia is expected to increase due to the global financial crisis

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Malaysian Creative Accounting Cases

Source: KPMG Malaysia Fraud Survey Report 2009 (only extracted the financial reporting fraud)

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• overstated revenue for financial years 2004 to 2006 by RM622mil.

• irregularities in trade receivables, cash receipts, and property, plant and equipment.

• share price plummeted to below 50 sen from the peak of RM14.40.

Malaysian Creative Accounting Cases

Source: The Star, June 19, 2010

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Megan Media

Holdings Bhd

• “substantial irregularities” in the Memory Tech’s financial statements, a wholly-owned subsidiary.

• fictitious trade creditors and debtors, undisclosed related party transactions, and a bogus deposit payment of RM211mil for production lines.

• failed to submit its regularisation plan to the authorities according to the PN17 timeframe and was delisted in April 2008.

Malaysian Creative Accounting Cases

Source: The Star, June 19, 2010

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SCAN Associates Bhd

• manipulation of earnings and of records of settlement of trade receivables.

• RM1.7mil payment made to a supplier but there was no delivery of items.

• manipulating revenue figures amounting to approximately RM6.8mil in 2005 and 2007 to mislead and defraud the board and shareholders about the company’s underlying performance.

Malaysian Creative Accounting Cases

Source: The Star, June 19, 2010

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Silver Bird Group Berhad

• Furnishing false statements relating to the revenue of Silver Bird in 2010 and 2011 to Bursa Malaysia• false statements contained in

Silver Bird’s eight unaudited quarterly financial accounts for the financial years ended Oct 31, 2010, and 2011

Malaysian Creative Accounting Cases

Source: The Star, September 11, 2013

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Genneva Malaysia Sdn Bhd

• money laundering, making false statements and illegal deposit-taking involving RM5.5bil.

• making a false statement in an advertisement on the company's website, saying its gold trading was in accordance with Islamic law.

Malaysian Creative Accounting Cases

Source: The Star, September 11, 2013

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KPMG Forensic’s 2012 survey The most fraudulent sectors turned out to be the

industrial and consumer market sectors in Sri Lanka.The most common forms of fraud encountered:

Bribery and corruption,IT related fraud,Regulatory non-complianceDiversion or theft of funds or goodsFinancial statement fraud

27% of the perpetrators were from top management, 46% were from the middle and lower levels of management and 27% were either customers or business associates of the organisation

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Methods used for reporting fraud

Internal audits

Whistle-blowing hotlines

Anonymous letters or callers

IT controls

Data analytics.

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Employee red flagsChanges in the lifestyle of an employee

evidenced by unusual purchases of assetssignificant personal debt or credit problemsdrug or alcohol abusehigh employee turnover in areas identified as

particularly vulnerable to fraud, particular reluctance by employees to take vacations

or sick leave and even a lack of segregation of duties in vulnerable areas.

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Management red flagsReluctance to provide information to auditors or

engagement in frequent disputes with themWeak internal controlsThe display by managers of significant

disrespect for regulations and regulatory bodiesThe existence of an excessive number of bank

accountsThe continuous rollover of loansSignificant downsizing in a healthy market

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Prevention Ideas

HOW TO PREVENT FRAUD?

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Ethics & Creative AccountingIs it ethically appropriate for accountants to

practice their training for the benefit of one group in society when others will suffer?

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Ethics & Creative AccountingTeleological Ethics (Utilitarianism)

• concern with the balance between consequences of action.

• greater happiness for the greatest number of people.Deontological Ethics (Deontologicalism)

• Focus on duty or obligation (correctness of the original action) rather than on outcomes.

Ethical Realism

• look within the community that we are part of for the intellectual authority that established the ethical rights and wrongs.

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Summary of Topic 8

Creative Accounting

Overview

Incentives

Techniques

Malaysian Cases

Ethics

Teleologicalism

Deontologicalism Ethical

Realism

Extraordinary itemsIncome

smoothingSmoothing expenses

Fixed assets

Big bathCookie jar reserves

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Tutorial1. Discuss TWO (2) differences between earnings

management and fraudulent accounting.

2. Identify and explain some of the techniques of creative accounting.

3. What are the possible implications of creative accounting?

4. Discuss whether, as an accountant, you should take a higher ethical position than that often found in society and business.

5. Discuss as many as possible Malaysian cases that involve creative accounting.