Study Pack 29 Profit Manipulation

In the light of recent corporate scandals, accounting today as an objective way of presenting economic reality is suffering from a real crisis of confidence. Central to the Anglo-Saxon system of corporate governance, it has been pushed into the public spotlight, where its impartiality and objectivity is being questioned. Even though most of the scandals have taken place in the United States, the crisis of confidence has had an impact far beyond U.S. borders, as the Anglo-Saxon system of governance is spreading throughout continental Europe. In order to contain the crisis, all countries are committed to institutional and legal reform. Moreover, those identified as having perpetrated such manipulation, essentially auditors and financial directors, have been legally sanctioned. We should nonetheless question whether these legal and legislative measures will be sufficient to restore long-term confidence in the system. Isnt it necessary first to understand the reasons behind profit manipulation and how it functions before changing legislation? Tenants of Positive Accounting Theory have represented the mainstream of accounting research since the early 80s. They see profit manipulation, which they euphemistically call earnings management, from an exclusively economic standpoint. How and why do management take part in profit manipulation? That shareholder pressure leads management to manipulate their firms profits. Going beyond individual responsibility, the organization imposed on a company by its shareholders with the aim of respecting criteria of Anglo-Saxon corporate governance is itself the cause of accounting manipulation at all levels. The contracts between the firm and its stakeholders create incentives for earnings management. There are three hypotheses:

The bonus plan hypotheses (directors who benefit from bonuses tied to profits are more prone to using accounting techniques that transfer future profits into the present) The debt/equity hypotheses (the more a company is in debt, the more it is in its interest to focus on present earnings because debt covenants, common in the United States, require certain levels of profitability) The political cost hypotheses (the larger a company, the more it is in its interest to postpone its profits until a future accounting period to face any risk of burdensome legislation being implemented)

Profit manipulation can take two forms: earnings management and falsification. Earnings management involves smoothing the period affected by an operation. This is done by changing the measurement methods. For example, speeding up a sale or delaying a purchase. Falsification involves disclosing wrongful data which is normally considered criminal. However, the fine line between these two types of manipulation remains blurred. Several profit manipulation strategies can be applied. Smoothing, or levelling out, reduces the variance of earnings and therefore reduces perceived risk. This is used to move profits around between different accounting periods so as to give the perception of stability. The pressure to reach net earnings or budgeted expenses encourages managers to move earnings from year to year by manipulating the accounts. Big bath accounting wipes the slate clean for a new appointed director; or quite simply opportunistic management. Here, write-offs or accelerated profits are created as a one off transaction. These techniques are the privilege of headquarters level, i.e. boardrooms deciding to manipulate corporate results so that consolidated accounts provide the expected figures.

That profit manipulation depends in large part on the forecasting process. Often the response to failure in reaching forecasts is creative book-keeping. Creating defensive positions and to make the information and reporting systems opaque. How much profit manipulation takes place does not only depend on how accounting is used to evaluate the performance of managers and their pay but also how forecasts are made that will be used as a baseline for such performance appraisal. As a consequence, it is the legitimacy and corporate governance of accounts that lies at the heart of the debate. In general, accounts can be seen as perfectly legitimate by management, when they are only seen as signals enabling them to see clearly the direct and indirect consequences of their actions. It is expected that accounts would encourage stakeholders in their actions to take into account what a narrow-minded or short-term vision of their responsibilities would lead them to neglect. False Accounting False accounting fraud happens when company assets are overstated or liabilities are understated in order to make a business appear financially stronger than it really is. It involves an employee or an organisation altering, destroying or defacing any account; or presenting accounts from an individual or an organisation so they dont reflect their true value or the financial activities of that company. False accounting can take place for a number of reasons: to obtain additional financing from a bank to report unrealistic profits to inflate the share price to hide losses to attract customers by appearing to be more successful than you are to achieve a performance-related bonus to cover up theft.

Whatever the reasons for false accounting, they are all motivated by the need to falsify records, alter figures, or possibly keep two sets of financial accounts. It can be hard to discover acts of falsifying accounts, particularly if you are managing an organisation. Some examples of false accounting fraud include: An employee making inflated expenses claims. A customer or an employee falsifying accounts in order to steal money. An employee using false accounting to cover up losses built up through trading or fraudulent activity. Unless you are alerted to the problem, you wont know about any losses, or the criminal activity. At the extreme end of the scale, the fraud may mean that a company has incurred serious financial losses and/or is trading while insolvent. Creative Accounting

Creative Accounting is a dirty word in accounting. It is done for one of two reasons. Either to, increase profits, so as to make the company appear more profitable. Or, to depress profits so as to make the company less profitable and thus pay less tax. Some of the common methods include:

Setting up provisions for possible future expenditure. Recognising profits on long term contracts before they are completed provides opportunities for profit smoothing. Extraordinary items are large unusal items from items from events or transactions that fall outside the scope of ordinary activities of the business and not expected to recur.

Profit smoothing is the practice of adjusting the timing of income and expenses recognition for the purpose of avoiding large changes in reported profits from period to period. Generally Accepted Accounting Principals require the matching of expenses to the revenue generated by them to ensure accurate recognition of income. Profit smoothing may or may not adhere to this principle depending on the timing of large income or expense items. Creative accounting, also called aggressive accounting, is the manipulation of financial numbers, usually within the letter of the law and accounting standards, but very much against their spirit and certainly not providing the true and fair view of a company that accounts are supposed to. A typical aim of creative accounting will be to inflate profit figures. Some companies may also reduce reported profits in good years to smooth results. Assets and liabilities may also be manipulated, either to remain within limits such as debt covenants, or to hide problems. Typical creative accounting tricks include off balance sheet financing, over-optimistic revenue recognition and the use of exaggerated non-recurring items. Window Dressing The term window dressing has similar meaning when applied to accounts, but is a broader term that can be applied to other areas. Creative accounting is a description of accounting practices that are not considered illegal, but may be somewhat out of the ordinary. Sometimes referred to as Hollywood accounting, earnings management, or cooking the books, the idea behind creative accounting practices is often to emphasize the positive aspects of the companys financial situation, while downplaying any negative factors. To an extent accounting irregularities of this type can be misleading to potential investors, and thus are often considered to be unethical, even though the strategy may remain within the letter of the law. As with most types of misrepresentation, the most effective examples of creative accounting are the ones that tell a portion of the truth, but downplay any elements that could alter the perception that the company wishes to convey to others. For example, a company may play up the fact that it recently experienced significantly increased sales during the last quarter. At the same time, little is said about the fact that expenses increased in proportion to that jump in sales, effectively offsetting that extra sales volume. If those who hear about the increase in sales do not probe a little deeper, the perception is likely to be that the company is now financially stronger, when in fact the business has achieved little to no growth at all. There are many reasons why a business would make use of creative accounting. One of the more common is to increase the desire for the stock issued by the business. In some countries, this can be accomplished by releasing reports that indicate the officers are receiving bonuses due to increased sales volume, even though that volume did not result in any real increase in profits. At the same time, the business releases additional shares of stock. This sends the message to investors that the company is on the move, and will entice some to

execute orders to purchase shares before they are snapped up by other investors. The end result is that the demand for the stock drives up the value of the shares, and benefits the business financially. In recent years, a number of nations have taken steps to minimize the incidence of creative accounting by implementing regulations that make it more difficult for businesses to cook the books and present a financial position that is does not tell the entire story. The hope is that by doing so, investors will be able to obtain all the data required to make an informed decision about their investment options, and prevent the economy from being adversely affected by misleading financial accounting practices at major corporations. Since there are a number of ways to engage in creative accounting, chances are it will take a number of years to craft regulations that will make those unorthodox accounting processes explicitly illegal. Example In the first quarter, Company X has an unusually large sales volume which would cause Q1 profits to be substantially larger than Q2 projected profits. Company X smooths the profit variance by post dating the invoices on some of the Q1 sales to appear as if they were made in Q2. This decreases Q1 profits and increases Q2 profits closing the gap between the two periods reported profits, thus "smoothing profits".