ATPB 313 ACCOUNTING THEORY AND PRACTICE SEM I 2013/2014

(updated October 2013)

TOPIC 8
Earnings management/creative accounting

Learning Outcomes
At 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 Accounting

Using 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 recognition of provisions and reserves Overstate asset write-offs

Within GAAP

Aggressive Accounting

Understate provision for bad debts Drawing down provisions/reserves in an overly aggressive manner

Fraudulent Accounting

Recording fictitious sales Backdating sales invoices Overstating inventory

Violates GAAP

Five Factors that Influence Fraud

Source: Accountants Today June 2010

Incentives to Creative Accounting

Main 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 Accounting

CG weaknesses

Performance expectation

Questionable ethical values

etc

Political costs

Borrowing costs
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The loopholes
lack of effective internal controls

the lack of due diligence on third party vendors

the absence of appropriate inventory management systems

existing supply chain processes were so complex

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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

Bad Side
Mislead investors through untruthful financial reporting The credibility of accounting profession might be tarnished
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Maintain debt finance and the financial support of creditors

Malaysian Creative Accounting Cases

PwCs 2011 Global Economic Crime Survey: Economic crime in Malaysia continues to increase

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Malaysian Creative Accounting Cases

KPMG 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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Malaysian Creative Accounting Cases

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.
Source: The Star, June 19, 2010
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Malaysian Creative Accounting Cases

Megan Media Holdings Bhd
substantial irregularities in the Memory Techs 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.
Source: The Star, June 19, 2010
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Malaysian Creative Accounting Cases

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 companys underlying performance.
Source: The Star, June 19, 2010
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Malaysian Creative Accounting Cases

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 Birds eight unaudited quarterly financial accounts for the financial years ended Oct 31, 2010, and 2011
Source: The Star, September 11, 2013
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Malaysian Creative Accounting Cases

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.
Source: The Star, September 11, 2013
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KPMG Forensics 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-compliance Diversion or theft of funds or goods Financial 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 flags

Changes in the lifestyle of an employee

evidenced by unusual purchases of assets significant personal debt or credit problems drug or alcohol abuse high 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 flags

Reluctance to provide information to auditors or

engagement in frequent disputes with them Weak internal controls The display by managers of significant disrespect for regulations and regulatory bodies The existence of an excessive number of bank accounts The continuous rollover of loans Significant downsizing in a healthy market
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Prevention Ideas

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Ethics & Creative Accounting

Is 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 Accounting

Teleological 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
Overview
Teleologicalism Deontologicalism Ethical Realism

Ethics

Incentives

Creative Accounting Malaysian Cases

Extraordinary items Income smoothing Techniques Smoothing expenses Fixed assets Big bath Cookie jar reserves
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Tutorial
1. Discuss 2. 3. 4.

5.

TWO (2) differences between earnings management and fraudulent accounting. Identify and explain some of the techniques of creative accounting. What are the possible implications of creative accounting? Discuss whether, as an accountant, you should take a higher ethical position than that often found in society and business. Discuss as many as possible Malaysian cases that involve creative accounting.

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