Creative accounting and off-balance-sheet activities
By Armaghan Ul Haq
Global Capital Markets Group
Recent reports of high-profile company failures has cast the spotlight on creative accounting and renewed the call for published financial statements that show a full and accurate picture of a company's performance and position. If a company fails to provide meaningful disclosure to investors about where it has been, where it is and where it is going, the value of the company may be eroded, and shareholders will lose confidence in the company
Prevalence of creative accounting
The problem of creative accounting is not new, primarily due to the market that is unforgiving of companies that miss their estimates. I recently read of one major US company that failed to meet its so-called "numbers" by one penny, and lost more than 6 percent of its stock value in one day.
These pressures to "make the numbers" often result in earnings management and a consequent decline in the quality of financial reporting. Companies try to meet or beat expectations of analysts in order to grow market capitalisation.
The Korean Times of 15th March 2002 carried a front cover story about companies (which were named) punished for manipulating accounting books. The Korean Financial Supervisory Commission (FSC) had taken powerful punitive actions against 13 companies suspected of having been involved in dubious accounting practices, the so-called "accounting fraud'' or "window-dressing'' settlements, during the 1999-2000 fiscal year. In the story, a senior FSC official expressed his anxieties over the illegal practices, saying, "The Korean fears of an Enron type scandal have become a reality. They tried to boost their corporate value through offshore funds and derivatives in the process of account settlements in the fiscal years of 1999 and 2000,'' he explained.
Common techniques of creative accounting - on balance sheet
Arthur Levitt, former chairman of the US Securities and Exchange Commission, identified five of the more popular creative accounting techniques - "big bath" restructuring charges, creative acquisition accounting, "cookie jar reserves," "immaterial" misapplications of accounting principles, and the premature recognition of revenue.
"Big bath" charges
Companies sometimes set up large charges associated with companies restructuring. These charges help companies "clean up" their balance sheet -- giving them a so-called "big bath."
Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes - analysts will look beyond a one-time loss and focus only on future earnings. Consequently, these charges are "conservatively estimated" with extra cushioning. The so-called conservative estimates then miraculously end up as income when future earnings fall short.
When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. It is important to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs -- and maybe a little extra -- through the financial statements.
Creative acquisition accounting
In recent years, whole industries have been rationalised through consolidations, acquisitions and spin-offs. Some acquirers, particularly those using stock as an acquisition currency, have used this environment as an opportunity to engage in "Creative Acquisition Accounting."
So what do some companies do? In the purchase price allocation procedures, they classify a large portion of the acquisition price as "in-process" Research and Development, which can be written off in a "one-time" charge -- removing any future earnings drag. Sometimes, large liabilities for future operating expenses are created to protect future earnings.
Miscellaneous "cookie jar reserves"
A third trick played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in "cookie jars" during the good times and reach into them when needed in the bad times.
There was this one U.S. company, which took a large one-time loss to earnings to reimburse franchisees for equipment. That equipment, however, which included literally the kitchen sink, had yet to be bought. And, at the same time, they announced that future earnings would grow an impressive 15 percent per year. Magic!
Another rabbit in the magician's hat is the word "materiality". Some companies misuse the concept of materiality. They "intentionally" record errors within a defined percentage ceiling. This is justified on the basis that the effect on the profit is too small to matter. When the management is questioned about these clear violations of accounting principles, they answer sheepishly, "It doesn't matter. It's immaterial." Have you heard the story of a Fortune 500 company which had recorded a significant accounting error, and the auditors told them so. But they still used a materiality ceiling of six percent earnings to justify the error. Materiality is not a bright line cut-off of three or five percent. It requires consideration of all relevant factors that could impact an investor's decision.
Finally, some companies try to boost earnings by manipulating the recognition of revenue. Think about the "birds nest soup". You wouldn't eat it before it was ready. But some companies do this with their revenue -- recognising it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.
Common techniques of creative accounting - off balance sheet
The last few years have seen a number of attempts by companies to remove assets and liabilities from balance sheets through transactions that may obscure the economic substance of the company's financial position. There are three areas that warrant mention here, each of which has the potential to obscure the extent of a company's assets and liabilities.
A company that owns an asset, say an aircraft, and finances that asset with debt, reports an asset (the aircraft) and a liability (the debt). Under existing accounting standards in most jurisdictions (including US, Singapore and International standards), a company that operates the same asset under a lease structured as an operating lease reports neither the asset nor the liability. Imagine a balance sheet that presents an airline without any aircraft - not a faithful representation of economic reality!
This matter is being addressed internationally, and there is a distinct possibility that the companies will be required to recognise assets and related lease obligations for all leases, both finance and operating.
A company that transfers assets (like loans or credit-card balances) through a securitisation transaction recognises the transaction as a sale and removes the amounts from its balance sheet. Some securitisations are appropriately accounted for as sales, but many continue to expose the transferor to many of the significant risks and rewards inherent in the transferred assets and should not be removed.
Creation of unconsolidated entities
A company that transfers assets and liabilities to a subsidiary company must consolidate that subsidiary in the parent company's financial statements. However, in some cases (often involving the use of an SPE), the transferor may be able to escape the requirement to consolidate.
Common Techniques of Creative Accounting � Off-income Statement
A company may pay for goods and services through the use of its own stocks or options on its stock, and may not record any cost for those goods and services in the income statement. The most common form of this stock-based transaction is the employee stock option.
Addressing the peril of creative accounting
The recent technical rule changes by the regulators and standard setters has improved the transparency of financial statements and have gone a long way in addressing the creative accounting techniques addressed here. Developments in the International Standards - some finalised, others in-process (such as lease accounting referred to above) - when filtered through to Singapore, will further close the gate for this form of manipulative accounting. Whilst tightening the technical rules does go a long way, it is not the only answer to this problem.