Fraudulent Accounting Practices

Polly Peck, WorldCom, Parmalat, Enron, Olympus, Lehman Brothers and most recently, Autonomy – all are cases of accounting fraud which have shocked the world. 
 
This article looks to explore some of the accounting methods by which companies can manipulate the presentation of their financial results to achieve desired outcomes, sometimes for fraudulent purposes. 
 
Accounting, in itself, is a flexible tool – this is by necessity as it is the substance of a transaction which should be reflected in a company’s accounts, rather than its form.  In its purest form, accounting rules will assist the reader of a company’s financial statements to understand the important elements of its performance.  However, accounting can be used as a tool to manipulate the reader to come away with a false impression of the company’s performance.  Simplistically, if we assume profit maximisation as the main motive of a company’s existence, creative accounting can be used to demonstrate an increase in revenues and assets and a decrease in spend and liabilities, over and above actual income and expenditure.
 
In the case of Autonomy, it is alleged that the company overstated its revenue levels and margins through a simple re-categorisation of sales from ‘software sales’ to ‘hardware sales’.  This would have had the effect of recognising 100% of the revenues arising on those sales at the initial point of sale, rather than being deferred over the life of the licenses granted (as is common practice), thus inflating reported revenues and margins in the period.  If this were true (and the case is still ongoing at the time of writing), it would certainly contribute to Autonomy’s attractiveness to HP.
 
A more aggressive method of abusing accounting principles on revenue would be to book a false sale just prior to the end of a financial year, and reversing that sale in the subsequent financial year, as perpetrated by Kanebo in the early 2000s.
 
Famously, Enron managed to present years of escalating revenues, increasing profits and a strong balance sheet, brimful of assets, to its investors before filing for bankruptcy at the end of 2001.  One of its mechanisms for ensuring a strong balance sheet position was its use of offshore subsidiaries into which it siphoned off its debt obligations.  These obligations were never consolidated into publicly available accounts, as Enron made use of existing accounting conventions to exclude them. 
 
The accruals concept in accounting is easily abused – in its benign form, companies should provide for known debt obligations as well as revenue won so to present a fair view of their performance to the outsider.  In reality, many companies will insert provisions with little or no backing.  There are many reasons for doing so, many of which are not necessarily fraudulent – ranging from profit smoothing objectives to public relations management.  The stock market rewards companies that produce steady profits, and tends to penalise those with erratic profits – therefore, it behoves management to present smooth results.  As many management teams are rewarded with share options, there is a strong personal motivation for ensuring that market price stability is maintained.
 
Another accounting convention which has been much abused in recent times is that of matching income with the associated costs.  Where the income arising from a spend occurs over a number of years, it is standard practice to capitalise that spend, releasing it to the income-expenditure account over the period in which the associated income arises.  One of the elements of the fraud perpetrated by WorldCom built on this concept.  The company reported spend on leasing other telecommunications companies’ phone lines as additions to plant, property and equipment, then depreciated this spend over extended periods.  This, and other creative accounting measures, resulted in the overstated profits and assets reported by WorldCom.
 
It is notable that there is a fine line between creative accounting practices that are legally acceptable, and creative accounting practices that are not.  In most cases, large-scale fraud involves an element of collusion amongst top management.  Very often, where the CEO is involved, the fraud arises as a result of a strong personality overriding key internal controls, mainly for personal benefit.
 
So, what steps can a company take to reduce the risk of fraudulent accounting?  An important one would be the implementation of an effective system of internal checks and controls on senior management.  In the UK, the overall regulatory framework to ensure good corporate governance is set out in the FRC’s published UK Corporate Governance Code, of which the key aspects are:
 
(i) A single board collectively responsible for the sustainable success of the company
(ii) Checks and balances including
a. Separate Chairman and Chief Executive
b. A balance of executive and independent non-executive Directors
c. Strong, independent audit and remuneration committees
d. Annual board performance evaluation
(iii) Transparency on appointments and remuneration
(iv) Effective rights for shareholders (and the UK Stewardship Code) 
 
If operated effectively, these measures are a big step towards providing protection against fraudulent accounting activity.
 

Bee Lean Chew is a Chartered Accountant and Partner at Wilder Coe LLP. Her main areas of expertise include forensic accounting, audit, financial reporting and taxation.
 
Bee has a degree in Law from Kent University and a Masters Degree in Finance from Strathclyde University and is an ICAEW-accredited Forensic Accountant.  She is a Director of the Network of Independent Forensic Accountants, a provider of CPD training to solicitors and fellow business professionals, an associate member of the Society of Share and Business Valuers and a member of the ICAEW's Audit and Assurance Faculty's Practitioner Services Committee.
 
Bee Lean Chew can be contacted by phone on 020 7616 8868 or alternatively via email at bee.chew@wildercoe.co.uk.