Accounting Fraud (Creative Accounting)

Abstract

Accounting fraud has become a universal issue, affecting virtually every country and industry in the world. The terms accounting fraud and creative accounting are often used interchangeably. However, some scholars and investigators argue that there is a fine line between traditional accounting fraud and creative accounting. They contend that the former is always illegal, but the latter may use legal, if dishonest, accounting practices. During some of the major financial scandals of the late twentieth and early twenty-first centuries, investigators delayed legal action while they determined whether the line between creative accounting and criminal fraud had been crossed.

Overview

Accounting fraud has been a constant in business throughout history. In the United States, Congress reacted to the stock market crash that caused the Great Depression of 1929–1941 by passing the Securities Act of 1933 and the Securities and Exchange Act of 1934. Those acts assigned fraud detection to auditors, charging them with the responsibility to recognize and report incidents of fraud. Auditors who fail to do so may be sued in civil courts by businesses that have been brought down by scandal. Furthermore, auditors may face punishment and fines if they fail to report fraud once it has been discovered. Accounting fraud always involves the willful presentation of misleading financial information, but those who define creative accounting as a distinct concept suggest that practitioners have learned to take advantage of flexible regulations and standards. However it is defined, there are many ways to commit accounting fraud and engage in creative accounting.

In 1987, the National Commission on Fraudulent Financial Reporting declared that fraud was perpetrated through both intentional acts of misrepresentation and through concealing pertinent facts in financial reports. The issue of accounting fraud has become so pervasive that it is being researched not only by academics within the field of business but also by sociologists, criminologists, and law school professors. Those found guilty of accounting fraud are likely to find themselves facing disgrace, bankruptcy, heavy fines, and even prison time. Since those who engage in creative accounting may not have broken actual laws, they may face lawsuits in civil courts.

The Association of Certified Fraud Examiners (ACFE) was founded in Austin, Texas, in 1988 to investigate fraud within the United States. ACFE began publishing the Report to the Nations on Occupational Fraud and Abuse in 1996. By 2010, the focus of the report had shifted to dealing with fraud on a global basis. In the poorest nations of the world, accounting fraud and creative accounting are considered responsible for swelling the bank accounts of "the few" while the masses continue to live in poverty. In industrialized nations, accounting fraud and creative accounting cheat the government, investors, employees, banks, and the public out of billions of dollars each year.

W. Steve Albrecht, Chad Albrecht, and Conan C. Albrecht (2008) suggest that the major elements of deceptive accounting practices are pressure, opportunity, and rationalization. Some of the conditions they describe as taking place during the economic boom of the 1990s created a "perfect storm," setting the stage for numerous accounting frauds. Their first requirement is that perpetrators do not believe they will be caught and punished. The Albrechts also argue that instead of crediting the booming economy of the period, executives, board members, and stockholders claimed responsibility for successful business tactics. Another condition that contributed to the "perfect storm" was the alignment of executive pay with company performance, which led to hundreds of millions of dollars being awarded in stock options and restricted stocks. They note that in 2002, the same year that many major accounting scandals broke, 186 public companies filed for bankruptcy after incurring $368 billion in debt.

Creative Accounting. First identified in 1980, creative accounting, which is also known as window-dressing, financial engineering, aggressive accounting, earnings management, impression management, and profit smoothing, may involve inflating or deflating profits or assets, falsely claiming lower-than-actual liabilities, or reporting higher-than-actual shareholders’ equity. Charles W. Mulford and Eugene Comiskey (2002) discuss five categories of creative accounting practices. The first of these is a strategy in which companies engage in reporting false or premature revenue by recording goods that have been ordered as completed shipments, reporting orders that they expect to get as orders received, or even making up fictitious orders.

The second creative accounting practice concerns aggressive capitalization and extended amortization policies. One example of this is America Online’s inflating subscriber costs in order to claim higher-than-actual earnings and assets in the mid-1990s. The third method deals with misreporting assets and liabilities by overvaluing accounts receivable, inventory, and investments in order to suggest that expenses and losses were lower than they actually were. The fourth strategy involves creative income statements or manipulated financial reports that create new classifications of operations that fall under different accounting regulations. The final method identified by Mulford and Comiskey deals with the manipulation of cash flow statements to make it appear as if cash flow is at its highest possible level.

Dhanesh Kumar Khatri (2015) describes three major methods used in creative accounting. The first involves liquidity, which deals with delaying payment of expenses on a temporary basis or holding on to cash that rightfully belongs to others. A second method deals with profitability as firms manipulate profit-sharing information. The earnings management method concerns manipulation of a firm’s earnings.

Khatri insists that firms engaged in creative accounting are likely to use aggressive accounting by misstating financial statements for the purpose of making a firm appear more stable than it actually is. Reasons for employing creative accounting methods include attempts to meet limits established by owners, improving opportunities for raising capital, fulfilling listing requirements, facilitating negotiations during mergers, reducing taxes, hiding ineptness, and smoothing out income (Khatri, 2015). Creative accounting is made possible by firms’ setting up multiple trading identities to make it more difficult to identify the activities of a single entity and to reduce taxes, establishing offshore businesses that are not bound by the same regulations as other firms, and manipulating inventory valuations to impact prices and affect closing inventories (Khatri, 2015).

Accounting Fraud. Some frauds are easily detected once auditors or investigators began to look closely at a firm’s activities. Common signs of fraud that might be discovered through an internal audit include evidence of duplicate payments, excessive credits, long-term outstanding receivable accounts, continuous stock increases, excessive cash and bank balances, external auditor warnings, excessive customer complaints, documents that have been altered, cash shortage, and the presence of a lot of common names and addresses that suggest fictitious business dealings (Agarwal & Medury, 2014).

Accounting fraud may occur in various ways, including misrepresentation of financial statements and accounts, through either overvaluing or undervaluing closing stock, reporting fake sales, neglecting to record actual sales, or not reporting returns. A second method of committing accounting fraud is by providing untruthful information due to overstating or understating costs, liabilities, expenses, and income. Accounting fraud may also occur through the misrepresentation of assets. This representation may be the result of using forged checks, embezzling cash or tax withdrawals, stealing stock, selling scrap and waste, altering bank deposits, claiming assets that are not in stock, claiming discounts that were not given, failing to record credit sales, and fake reporting of bad debts (Agarwal & Medury, 2014). Another way is through timing. Firms may overstate accounting income at the same time they understate taxable income, enabling them to pay outside investors lower profit shares (Lennox, Lisowsky & Pittman, 2013).

Further Insights

Some observers suggest that creative accounting grew in response to loopholes in laws passed in the 1990s that exempted performance-related pay from limits placed on the taxation of salaried employee expenses. The loophole encouraged firms to manipulate reports of employee earnings in order to avoid paying higher taxes. One common example of creative accounting involves the practice of ignoring employee stock compensations when reporting expenses. Some firms discovered that such misleading reports made them look better to investors. Such practices have also been blamed for exacerbating inequalities between the haves and the have-nots as the United States began to recover from the recession of 2007–09.

Income smoothing is a reporting strategy that allows firms to manipulate or delay financial reports in order to cover up fluctuations in earnings. Information gained from income smoothing may cause investors to pay higher prices for stocks. Management benefits from income smoothing because it allows managers to earn higher salaries, bonuses, and stock increase options.

Charles W. Mulford and Eugene Comiskey (2002) note that creative accounting has also changed the ways in which acquisitions are made. After paying out large sums in borrowed cash in the 1980s, most companies switched to purchasing companies with stock options in the 1990s. Therefore, it became necessary for firms to make themselves appear as profitable as possible in order to drive the price of stock upwards and improve credit ratings.

Discourse

David M. Shapiro (2011) identifies four traditional accounting structures. Firms using the business model hire their own auditors. As a result, auditors report findings of any irregularities directly to business leaders. Firms that use the epistemological model engage in self-reporting. Advocates of the industry model depend on external auditors, and proponents of the regulatory model are answerable to the SEC and their own Boards of Directors.

Perpetrators. The majority of individuals convicted of accounting fraud are senior managers. Gopal Krishna Agarwal and Yajulu Medury (2014) maintain that owner/promoter fraud generally occurs when a business is still in its first generation and resources are limited, when political connections are strong, when expansion is highly desired, and when the owner/promoter is ambitious or incompetent.

Agarwal and Medury contend that 95 percent of all employee fraud is the result of an employee needing money, either temporarily or permanently. They argue that accountants and auditors should learn to recognize that certain actions suggest the presence of employee accounting fraud. Actions that call for particular vigilance involve an individual spending outside the limits of his/her income, evidence of drug or alcohol abuse or gambling, higher than normal debt levels, out-of-control ambition, trying to keep up with one’s friends and neighbors, family pressures to make more money, extramarital affairs, feelings that employees are underpaid and insecure, tendencies toward lying and greed, pressure from peers, and strict hierarchies within the workplace.

Employees are more likely to seize opportunities to commit fraud when employee turnover is high, when duties are not segregated, when record keeping is obviously poor, when a crisis is occurring, when access to computers is not restricted, when authorization of transactions is not controlled, and when there are inadequate checks on employee actions. Personal integrity may also be a factor in employee fraud, particularly when employees observe others committing fraud. Employees may not see their actions as stealing, sometimes rationalizing the theft as a loan that they will eventually pay back.

From the mid-1990s until 2001, improprieties in accounting continued to rise at the same time that corporate tax compliance fell significantly. As a result, some experts have posited that aggressive financial reporting may be indicative of tax aggressiveness. However, Clive Lennox, Petro Lisowsky, and Jeffrey Pittman (2013) found that in the United States, public firms that engaged in tax aggressiveness were less likely than those who did not do so to commit tax fraud.

Most accounting fraud is uncovered through tips, but approximately 5 percent is discovered during internal audits. Thus, accountants and auditors are in a prime position to discover fraud in its early stages. Sandra Gates, Cheryl Prachyl, and Carol Sullivan (2016) contend that educators have a major responsibility to instill in business school students an understanding of the extent of accounting fraud, how often it occurs, how to recognize types of fraud, and how to prevent fraud. They, along with other experts on ethics in accounting, recommend that schools create forensic and fraud accounting programs or establish special courses on those subjects as well as integrating both subjects throughout accounting curricula.

Scandals. Entire books have been written about the accounting scandals of the early twenty-first century. The Enron scandal, which became public in 2001, is considered the most pervasive of all. It involved gross overstatement of earnings designed to hide major losses. By the time it was over, Enron had filed for bankruptcy, and its accounting firm, Arthur Anderson, had been convicted of obstructing a federal investigation.

Accounting scandals proliferated in 2002. The accounting fraud perpetrated by WorldCom was called both "brazen" and "unsophisticated" (Giroux, 2008). Reporting $3.8 billion in improper expenses led the company into bankruptcy. Tyco engaged in questionable acquisition practices that resulted in the indictment of both the CEO and CFO. Adelphia, a cable company, overstated its earnings at the same time that the company was being routinely looted by its CEO, John Rigas. Other scandals involved deceptive stock analysis practices at Merrill Lynch, Salomon Smith Barney, Credit Suisse, Goldman Sachs, and J. P. Morgan, resulting in sanctions and fines that totaled $2 billion (Giroux, 2008). Later major accounting fraud scandals included the enormous Ponzi scheme orchestrated by investor Bernie Madoff that came to light in 2008 and the 2015–16 SEC investigation of Valeant Pharmaceuticals.

Accounting fraud also takes place in other parts of the world, with the early 2000s again proving a particularly notorious era for such scandals. In 2001 in the Netherlands, Royal Ahold, the world’s third largest supermarket chain, overstated its earnings by $500 million. In 2003, it was discovered that the Italian company Parmalat was missing $8.5 billion in assets. In 2009, the India-based Satyam Computer Services, which employed fifty thousand individuals and provided outsourced services to one-third of Fortune 500 companies, reported inflated earnings amounting to more than $1 billion. Founder and chair Satyam B. Ramalinga was forced to resign, and Satyam prices fell by 85 percent.

Reform and Regulation. As a result of these accounting scandals and the many others that occurred, auditors have been required to become more sophisticated in the techniques used to detect fraud. In the United States, individuals who report to the Securities and Exchange Commission (SEC) include both external and internal auditors, independent experts, and academic investigators (Shapiro, 2011). In the wake of the accounting scandals of 2002, Congress passed the Sarbanes-Oxley Act (SOX). The act mandates internal accounting monitoring of all publicly traded companies and establishes fines and punishments for disregarding the new regulations. In 2010, Congress attempted to fix the problems with SOX and deal with the aftermath of the Great Recession of 2007–09 by passing the Dodd-Frank Wall Street Reform and Consumer Protection Act, which provided increased auditing vigilance.

As a result of these reforms, auditors were required to report findings of fraud to an auditing board instead of reporting to management. When auditing public companies, the lead auditor and the audit reviewer rotate their positions on a five-year basis. An auditor is prohibited from auditing any firm in which the CEO, Controller, CFO, or Chief Accounting Officer has been employed at the accounting firm during the previous twelve months. Whistleblowers have increased protection. Finally, no board member may be paid except what he/she is regularly paid for serving on the company’s board. While the reforms were widely seen as effective in many ways, the Republican-controlled government took steps to roll back some of the Dodd-Frank Act's regulation and oversight provisions in 2018.

Terms & Concepts

Accounting Fraud: The practice of reporting false or misleading information in order to inflate the worth of a business or to hide illegal activities. It is punishable by prison time and stiff fines and often leads to a company’s ultimate destruction.

Amortization: Within the field of creative accounting, amortization usually refers to spreading out intangible assets and capital expenses over time so that a firm appears more profitable than it actually is or as a means of avoiding payment of higher taxes.

Creative Accounting: The practice of manipulating accounting rules and regulations to create a false image of a firm. The term is sometimes considered a synonym for accounting fraud, but creative accounting may be legal if the letter of the law is followed.

Dodd-Frank Wall Street Reform and Protection Act: Passed in 2010 as the United States continued to recover from the recession of 2007–09, the act was designed to give the government increased regulatory authority and increase financial transparency and accountability among publicly traded firms.

Income Smoothing: Frequently described as "cookie-jar accounting" for obvious reasons, income smoothing involves the practice of earnings management. It is designed to make profits appear to be stable over time. Income smoothing is generally considered legal, and is widely practiced among business firms. Many observers and investigators, however, see it as a way of trampling on the law without actually breaking it.

Sarbanes-Oxley Act: Better known as SOX, the Sarbanes-Oxley Act made public companies more accountable to investors, the government, and the public and improved methods for detecting accounting fraud. It also established the Public Company Accounting Oversight Board as a monitoring body.

Securities Act: The 1933 act was intended to prevent another stock market crash from ever again occurring in the United States. The act contained punishment and fines for financial misrepresentation and accounting fraud.

Securities and Exchange Act: Passed in 1934, the act built on the Securities Act of 1933 to promote financial transparency and prevent fraud and manipulation of financial reports. It also created the Securities and Exchange Commission to monitor activities involving stocks, bonds, markets, and securities and oversee financial reporting of all companies involved in these activities.

Bibliography

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Akpanuko, E. E., & Umoren, N. J. (2018). The influence of creative accounting on the credibility of accounting reports. Journal of Financial Reporting & Accounting, 16(2), 292–310. Retrieved October 23, 2018 from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=129774746&site=ehost-live&scope=site

Albrecht, W. S., Albrecht, C., & Albrecht, C. C. (2008). Current trends in fraud and its detection. Information Security Journal: A Global Perspective, 17(1), 2–12. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=32877303&site=ehost-live

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Gates, S., Prachyl, C. L., & Sullivan, C. (2016). Using report to the nations on occupational fraud and abuse to stimulate discussion of fraud in accounting and business classes. Journal of Business and Behavioral Sciences, 28(1), 106–115. Retrieved October 22, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=117128048&site=ehost-live

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Suggested Reading

Bora, J., & Saha. A. (2016). Investigation on the presence of income smoothing among NSE-listed companies. IUP Journal of Accounting Research and Audit Practices, 15(1), 55–72. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=113440708&site=ehost-live

Clarke, F., Dean, G., & Oliver, K. (2003). Corporate collapse: Accounting, regulatory, and ethical failure. New York, NY: Cambridge University Press.

Cressey, D. (1973). Other people’s money. New York, NY: Patterson Smith.

Desai, M. A. (2006). The degradation of reported corporate profits. Journal of Economic Perspective 19, 171–192. Retrieved October 23, 2016, from EBSCO Online Database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=19214415&site=ehost-live

Elliot, R. K., & Willingham, J. J. (1980). Management fraud: Detection and deterrence. New York, NY: Petrocelli Books.

Riahi-Belhaoui, A. (2003). Accounting—By principle or design? Westport, CT: Praeger.

Schilit, H. M., Perler, J., & Engelhart, Y. (2018). Financial shenanigans : how to detect accounting gimmicks and fraud in financial reports. 4th ed. New York, NY: McGraw-Hill Education.

Stiglitz, J. E. (2003). The roaring nineties: A new history of the world’s most prosperous decade. New York, NY: W. W. Norton.