What? The active manipulation of accounting results for the purpose of creating an altered impression of performance. Managers choosing accounting policies so as to maximize their own utility and/or the market value of the firm.
Accounting Tricks - Examples Waste Management Inc. – Understated depreciation and capitalized interest improperly, failed to write down impaired assets. Total restatement $2 billion.
Waste Management Overstated Income
Accounting Tricks - Examples WorldCom – Recorded expenses as capital expenditures, double- booked revenues, booked revenues as cost reductions. Total restatement $4.6 billion
WorldCom – Reported vs. Restated EBITDA
How would you detect this type of fraud? A decrease in the asset turnover ratio. A fictitious asset cannot produce revenue PPE increases while revenue decreases When an expense that is fixed remains constant as a percentage of sales, despite decreases in revenue Possible from disclosures on significant accounting policies Writing off previously capitalized cost
Accounting Tricks - Examples Xerox – Recorded revenue on long-term leases of copiers prematurely. Total restatement $3 billion (but part of this increased later revenues).
Xerox – Reported and Restated Revenue
How would you detect? Examine Days in receivables – if this increases because revenue is being recognized significantly earlier than it is collected. The relationship between CFFO and revenue significantly decreases
Accounting Tricks - Examples Adelphia – Hid billions in debt off-balance sheet in unconsolidated subsidiaries, diverted undetermined millions to the family stockholders, inflated subscriber numbers in press reports, overstated earnings.
Accounting Tricks - Examples Sunbeam – Inflated revenues by channel stuffing and bill &hold. Reduced expenses by capitalizing advertising costs, reducing allowance for bad debts.
Sunbeam – Revenues and Net Income
Signals of this type of fraud Days in Receivables increases An increase in Gross Margin percentage CFFO falls Change to a more aggressive revenue recognition policy Offers large discounts or other inducements to get orders Revenue is recorded despite a right of return
Accounting Tricks - Examples Rite-Aid – Inflated revenues by recording vendor rebates that pertained to future purchases. Reduced expenses by capitalizing expenses, not recording certain expenses, failing to write off inventory shrinkage, understating depreciation.
Rite-Aid – Net Income Restatement
Detecting overstated inventory Not recording “shrinkage” of inventory Recognizing rebates from vendors before Rite Aid actually sold the goods
Accounting Tricks - Examples Enron - Hiding debt and losses in unconsolidated entities
Enron – Reported and Restated Net Income
Why? -- Share price effects -- Borrowing cost effects -- Bonus plan effects -- Political cost effects
What is principle-based accounting? –What are its advantages and disadvantages? How? 3. Rule-based versus principle-based accounting What is rule-based accounting? –What are its advantages and disadvantages? Sickening example – SPE’s