Accounting Ratio to Manipulate Accounting

Accounting Ratio to Manipulate Accounting Companies use accounting ratios to manipulate their accounts Table of Contents (Jump to) Abstract Chapter 1 Introduction 1.1 Introduction 1.1 Aims and objectives Hypothesis 1 1.2. Overview Chapter 2 Critical Literature Review 2.1 Introduction 2.2. International Financial Reporting Standards 2.2.1 Coverage and aims of the standards 2.2.2 Areas of concern 2.3. The art and purpose of Creative Accounting or financial statement Manipulation 2.5 The impact of Creative accounting on Financial Ratios 2.5.1 Definition and purpose of financial ratios 2.5.2 Manipulation of financial ratios Chapter 3 Research Methodology 3.1 Introduction 3.2 Issues considered 3.2 Options of research methods 3.2.1 Quantitative and qualitative 3.2.2 Deductive and inductive methods 3.3 Choice of research method 3.4 Performance of the research Chapter 4. Findings and evaluations 4.1. Introduction 4.2. Findings Abstract Financial ratios have become part of the process by which investors, financial observers and other stakeholders within the market make their decisions and about the activities, profitability and liquidity of a particular corporation. As such, it is therefore important that these reflect the same level of accuracy and compliance to the financial reporting standards as the financial statements. However, it has become increasingly apparent over recent years that the practice of manipulation has been extended in its use to influence these ratios. This dissertation set out with the aim of confirming whether this is the case. It was also intended to identify the particular areas of concern that this practice is generating. It is found that there is evidence of manipulation of financial ratios and that this is particularly relevant in relation to the manipulation of fair valuation and the treatment of off balance sheet items. Although the study has been limited in terms of sample size, the findings are that the practice is particularly apparent in the financial markets sector and this has contributed to the current financial and economic crises. There is a need for a clearer framework for the calculation of fair valuation and a more robust method of regulating the activities of corporate management in an effort to reduce the longer term detrimental impact of this practice. Chapter One: Introduction 1.1 Introduction Following collapses of major global corporations such as Enron, as well as increasing pressure from shareholders and other stakeholders for a more open and understandable system of financial reporting, governments worldwide as well as those involved in international corporate controls came together to bring about one of the biggest changes in controls and governance. Using the offices of the IASB[1] (2008), there followed the introduction of international standards to be used for both accounting procedures and the preparation and presentation of financial statements. The intention of these standards is to create a situation where financial statements have a level of â€Å"understandability, relevance, reliability and comparability† (Lindsall 2005, p.2) that meets the needs of those stakeholders who rely upon these statements. The ISAB confirmed this purpose in an early statement of mission which read that their aim was: â€Å"To develop, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards that require high-quality, transparent and comparable information in financial statements and other financial reporting to help participants in the various capital markets of the world and other users to make economic decisions† (Gregoriou and Gaber 2006, p.16). In other words, part of the aims of these standards was to endeavour to eliminate the practice of manipulating financial statements. Nevertheless, despite these good intentions subsequent events have shown that the aims and objectives of these standards are still a long way from being achieved, with concern regarding the understandability, relevance, reliability and comparability of financial statements increasing rather the opposite direction hoped for by the authorities. In fact, many believe that the standards themselves, due to ambiguities, have created a platform for the increase in what has increasingly become known as â€Å"Creative Accounting† (Griffiths 1988). This in reality is another term for the process by which management and/.or their financial advisers and auditors are able to manipulate the figures reported within the financial statements in a manner that can lead to these being misrepresented and, what’s more, it is legal. Opponents of the practice bel ieve it to be damaging to investor and other corporate stakeholders, including shareholders and creditors. Indeed some have even gone as far as suggesting that manipulation of financial statements is the root cause of the current â€Å"credit crunch† (Letters 2008). Since the time of Ian Griffiths (1988) book on the issue of creative accounting and manipulation of financial statements there has been a plethora of academic studies into this phenomenon, as will be shown within the literature review in chapter two of this dissertation, and a growing debate between those who applaud and oppose this situation. Understandably, most of this literature is concentrated upon the physical changes that take place within the financial statements themselves However, one area of manipulation in financial reporting that does not appear to have received nearly as much attention. This area is financial ratios! This assumption and discovery is supported by Stolowy and Breton (2000) (see appendix 2). Whilst it is accepted that, in a technical sense financial ratios are not considered a part of the financial statements that come within the context or control of the international standards, as they are using equated by those financial external to the company, they are nonetheless considered an important measurement of corporate performance (Bragg 2007). For example, expert financial observers often quote ratios when advising upon the investment value of a particular corporation and many busy investors will take notice and make financial decision based upon what these ratios reveal. Therefore, manipulation by corporations and their advisors might be considered equally as misleading as the practice being used in any other aspect of financial reporting. It is this perceived gap in literature relating to this issue, together with the desire to access how prolific manipulation of financial ratios might be that has generated the author’s interest in researching the subject. 1.1 Aims and objectives With the concentration of the majority of literature relating to creative accounting and manipulation focusing upon the actual results contained within the financial statement, it is the author’s intention to address its deeper impact. Financial ratios are used by many stakeholders as a quick guide to the appropriateness of a corporation as an investment vehicle. Manipulation of these ratios can therefore have an immediate impact upon decision making by stakeholders. To address this issue, the following hypothesis has been set for this dissertation: â€Å"That company management and their advisors are aware that manipulation of financial ratios can have as much, if not more of an impact upon investment decisions as manipulations in the financial statements.† Further, to test the accuracy of the comment made regarding manipulation and the credit crunch, a second hypothesis will be included: Hypothesis 2 â€Å"That manipulation of financial ratios within the banking sector contributed to the current global financial market crisis.† In order to ensure that the aims of this research, and resolution of the research hypothesis, is achieved in a robust manner and provide a valuable conclusion, a framework of objectives has been devised, based on the following: Financial reporting framework and standards The intention is to analyse and assess the component elements of the current regulatory standards, evaluate their stated intentions and the robustness with which these can be transitioned into the practical reporting environment and identify their current limitations. Creative accounting Based upon current literature the dissertation will provide an understanding of the term creative accounting, identify the areas of its potential use within financial reporting and identify the main purposes and beneficiaries of such actions. Financial ratios The objective with regard to financial ratios is to provide an understanding of their purpose and intentions, which includes identifying their strengths and weaknesses. In addition, using primary data, the dissertation will explain how these ratios can be manipulated as well as identifying the reasons for this conduct. Future improvements Resulting from the previous objectives, it is the author’s intention to provide recommendations that will be designed to reduce the current impact of the manipulation of financial ratios and/or methods by which these manipulations can be identified and revised to reflect actual movements. 1.2 Overview To provide the reader with a clear understanding of this research, it aims and the manner in which it has been performed, this dissertation has been presented in the following order. This introductory chapter has set the scene and provided the background to the issues that for the core focus of the research. Immediately following, in chapter two, there is a critical review of current and appropriate literature relative to these issues. This includes an evaluation of the published frameworks of financial reporting standards, the concept of creative accounting, importance and significance of financial ratios and the effects of manipulation. Chapter three outlines the research methodology choices that were available to the author, identifying the method chosen together with the reasons for this choice. The findings of the secondary and primary research are then presented, compared and discussed in further depth in chapter four before recommendations are outlined in chapter five. Finally , the dissertation is concluded in chapter six. Added to the main body of the dissertation had been attached a complete list of all the references used within the body of the text. Furthermore, to add clarity and further understanding for the reader, additional information in the form of appendices has also been attached. Chapter Two: Critical Literature Review 2.1 Introduction The critical review conducted within this chapter has been designed to concentrate upon the literature relating to the issues being studied within this dissertation that has been published in the main within the past two decades as these represent the standards and practices that are currently in use within financial statements. For ease of reference the chapter has been segmented and analysed into appropriate sections 2.2. International Financial Reporting Standards As Swanson and Miller’s (1989) research shows, the issue of interpreting financial statements had been a subject of debate for many decades prior to the interest in international standards developed. Understanding the different systems of measurement used by management and accountants in financial statements had long proved difficult for investors and other interest parties. It was these areas of concern fuelled the move towards the creation and adoption of an internationally agreed and legally binding framework of accounting and financial reporting standards (Choi et al 2005 and Jones 2006). Amongst these concerns was included the lack of comparability and understanding available to potential investors and other stakeholders when analysing financial statements that were prepared under differing national codes and regulations and the difficulty experienced even when trying to compare accounts of corporations within the same industry (Tarca 2002 and Nobes and Parker 2006). However, as many academic authors had suggested (Nobes 1998, Blake and Lunt 2000, Lee 2006 and Mizra et al 2006 included) another core issue was the growing unease about the practice of â€Å"Creative accounting† and the negative impact this was creating in terms of stakeholder trust and confidence in financial reporting (Lee 2006). Whilst in essence such practices were not illegal, they were becoming a contentious issue in many financial circles, a fact evidenced by the comments of Lord Dearing (1988, p.12) in his committees report on the need for international accounting standards, when he said: â€Å"There is little evidence that companies are engaging in flagrant breaches of accounting standards †¦ However †¦ there is strong pressure on auditors from time to time to accept interpretations of accounting standards which conform to the interests of the preparers rather than with the spirit of the standard.† During the course of the decade following this report government representatives, accounting bodies and other interest financial parties spent a considerable amount of time discussing and agreeing standards that would help to address these anomalies, inconsistencies and concerns, which culminated in the creation of an international accounting and financial framework of standards (IASB[2] 2001 and PWC 2008). These standards were to be designed and operated by the IASB (Feature 2003). However, it still took a number of years to encourage individual national governments to adopt these measures. However the UK government decided that, â€Å"from 2005 UK listed companies must use IFRS for their consolidated statements† (Nobes and Parker, 2006, p.103). Furthermore, the financial reports have to include a statement by directors and auditors, which confirms †applicable accounting standards† were used or giving reasons for this not being the case (Nobes and Parker, 2006, p. 287). 2.2.1 Coverage and aims of the standards As can be seen from the list contained within appendix 1, the scope of the standards was quite extensive. Eight of these standards covered the area of financial statement reporting and presentation (IFRS), which included such issues as business combinations (Group of companies), segmentation and disclosures (Deloitte 2005). A further forty plus standards have been created, which define the accounting methods to be used within the preparation of financial statements (IAS). These laid down the audit principles to be followed Gray and Manson 2004) and covered such issues as the treatment of tangible and intangible assets (Gelb 2002 and FRC 2008). The aim of these standards was, in effect, to create a level playing field for those parties who relied upon corporate financial statements for decision making purposes, be that for investment, lending, extension of credit facilities or simply observance purposes (Chofafas 2004 and Antill and Lee 2005). In other words, the intention is that these statements should comply with four basic principles (IASB 2008), these being: Understandability The objective of this principle was to ensure that the financial statements would be presented in such a manner that they could be relatively easily understood by external stakeholders irrespective of the level of their financial and accounting knowledge, for example the private small investor (Healy et al 1997). Relevance In terms of relevance it was considered important that the information contained within the statements were relevant to the current situation (Saudagaran 2003). In other words it was important that the financial statements reflected current values, prices and other data. Reliability Despite the auditor’s opinion that the financial statements are prepared solely for reporting to the members of the corporation (ICAEW 2008), it has long been accepted that many other stakeholders, including prospective shareholders and creditor rely upon such information. Recognising the importance of this aspect, the IASB extended the principle of reliability to include these other stakeholders (Gregoriou and Gaber 2006). Comparability The need to be able to compare the accounts of individual corporations, even where these are within the same industry sector, whether that is within the national or international marketplace, is a part of the investment decision-making process. Prior to the introduction of the standards this was considered a problem, one which this principle was intended to address (Lindsall 2005, p.2). It should also be noted at this stage that, whilst these standards and principles applied to all corporations, irrespective of their industry sector, certain industry sector have to comply with additional standards. The most noticeable of these is the banking industry, which is further governed by the requirements of the Basel Accords (FSA 2007) and regulated in the UK by the FSA[3]. The focus of these particular industry specific regulations is to ensure that financial institutions retain an appropriate capital adequacy ratio within their balance sheets. However, despite the intentions of all of these standards and regulations, as the plethora of subsequent studies and literature contained within the following section confirm, they have, if anything, added to the areas of concerns that they were meant to address. 2.2.2 Areas of concern As the studies of Tweedie and Wittington (1990), Barth (2006) and Benston (2008) have revealed, a number of serious concerns have been voiced about the international standards, which they and others believe are detracting from the objective of reform and, in some cases, leading to increase volatility being seen in financial statements. In essence, these can be identified within three main areas of financial statement preparation and reporting. Fair Value and choice of valuation measurement Recognition and inclusion of revenue and profits Off balance sheet items Although initially there was no identification of the meaning of the term â€Å"fair value† in the international standards, following representations from accounting bodies, corporate associations and other stakeholders, the IASB introduced a definition, which described it as being: â€Å"the price at which the property could be exchanged between knowledgeable, willing parties in an arm’s length transaction† (IAS 16). However, this description soon came under attack by a number of academics, including Langendijk et al (2003), Bank of England researchers (Staff team 2004), Lindsell 2005)Antill and Lee (2006), Mard and Hitchner (2007) and many others. The criticism of this measurement, rightly identified by these authors, was that it raise questions about the subjectivity and reliability of such valuations. For example, what is considered to be a fair value to one person would not be to another and, furthermore, there might be differing reasons for one party being prepared to pay a greater value for an asset than others consider fair. Evidence of this can be seen in the manner in which companies are valued in times of acquisitions (Antill and Lee 200, King 2006 and Siegal and Borgia 2007). Furthermore, as in most cases the fixed and intangible assets are not intended to be sold at the time of their inclusion within the financial statements, valuation must of necessity be based upon reasonable and expert estimates (Lindsell 2005). The problem to be encountered here is that such expert valuers differ in their opinions of measurement, with some being more optimistic than others (Barth 2006), which can lead to discrepancies. The choice of expert can thus be seen to potentially obscure concrete evidence† of the assets real value (Swanson and Miller 1989, p.1). Furthermore, the standards also allow corporations to make a choice of asset measurement between the historical cost convention and current fair value, which is decided based upon their own judgement (ICAEW 2006 and Mizra et al 2006). Despite many attempts and suggestions aimed at addressing this problem (Benston 2008) to date it has still not been resolved. Recognition of revenue and treatment of profits is another area where differing opinions and purposes of measurement and treatment have been questioned (Bullen and Crook 2005). For example, when engaged upon a project that spans a number of financial years how does the business measure the true value of the revenue and profits to be recorded in each year statements (Mizra et al 2006 and Lee 2006). Some might argue that profit, and thus that element of the revenue, cannot be taken until project completion, whilst others will advocate allocating profit to the completion of project milestones. It is apparent that, given a project of x value spread across say five years, the differences of interpretation outlined above would impact upon the revenues contained within financial statements. The ability for corporations to exclude items from their balance sheets is another issue for many investors and observers (Amat et al 1999). For example, by leasing rather purchasing a piece of equipment this can alter the debt structure of the business, as parts of the leasing contract do not have to be included within the corporate balance sheet. Similarly action can be taken with other assets such as pension schemes (Pitzer 2002). Although there are other issues with the international accounting standards, it is these three areas that appear to raise the most concerns, in particular because they provide the opportunity for firms and their auditors to engage in the practice of manipulation or creative accounting. 2.3. The art and purpose of Creative Accounting or financial statement Manipulation As indicated within the introduction to this dissertation, creative accounting or the ability to manipulate financial statements was an adopted practice before the international reporting standards became a legal requirement for all corporations. However, the increase in concerns since this event makes a study of this issue even more relevant today. Creative accounting is considered by many to be a euphemism for the practice of manipulating the information that is contained within financial statements. In terms of definition for this practice there have been many over the years. In the title of his book about creative accounting, first published in 1988, Ian Griffiths (2005) defined it as â€Å"how to make your profits what you want them to be,† a view supported by Dean and Clarke (2007). Although other academics would refrain from using such a term, as will be seen within this and following sections and chapters of this dissertation, there is more than a grain of truth in this simple description. However, the more considered definition for the type of manipulation that is that it is† a practice that results in a distortion of the figures contained within financial statements.† However, at the same time this manipulation remains strictly within the boundaries of the legal accounting principles, rules and stand ards (Shah 1998 and Balaciu and Cosmina 2008). A simple example of the meaning of these definitions can be seen in the following diagram (figure 1). In this example manipulation is defined as the greying areas between the intentions of the standards and the areas within which the interpretation of these standards can be manipulated, always stopping short of the ultimate boundaries of the legal framework, beyond which such manipulation would be considered as fraud. As can be seen from this diagram manipulation can have two intentions, this being either to produce a negative or positive impact upon the profits and value of the business (Mulford and Comiskev 2002 and Balaciu and Cosmina 2008). It is generally accepted that manipulation is driven by the needs and demands of management (Pierce-Brown and Steele 1999 and Griffiths 2005). For example, if management believes that the business is likely to have a bad year, which will adversely affect their bonus and benefits they might either exacerbate the losses to increase their benefits in a following year or reduce them to protect these benefits. The same methods would be used if the management wishes to influence the corporation’s level of growth (Pierce-Brown and Steele 2006). This practice is known as the â€Å"Big Bath† method (Investopedia 2008). To achieve the required objective the management might use a combination of the flexibility contained within the concepts of fair value, revenue and profit recognition and off-balance sheet items as discussed in section 2.2.2 of this chapter. For example, an employed expert valuer who takes a pessimistic approach would have the effect of reducing the value of asse ts, thus having an adverse effect upon profits. Delaying recognition of revenue or profits would have the same effect (Mulford and Comiskev 2002). Some academic authors have posed the question as to whether such manipulation is ethical (Amat and Dowds 1999 and Blake and Growthorpe 1998). However, whilst the question of ethics might be of concern to those who rely upon the financial statements presented by corporations (Saudagaran 2003), under the present standards, regulations and their measurements it remains legal (Griffiths 2005). 2.4 The impact of Creative accounting on Financial Ratios As Bragg (2007) indicates within the introduction to his study of business ratios and formulas, these can be applied to virtually every aspect of the business and its operations. However for the purpose of this dissertation, the focus regarding ratios will be restricted to those that relate specifically to the information contained within a corporation’s financial statements. 2.4.1 Definition and purpose of financial ratios The term ratio can broadly be defined as a measurement by which the performance of a corporation, in terms of its operations and activities, can be judged and assessed (Bragg 2007, p.1). In terms of the financial statements produced by corporations this judgement is aimed at measuring a number of performance factors (Stolowy and Breton 2000). As can be seen from the descriptions contained within the following example (figure 2) in this respect the intention of these ratios is to provide an assessment of the profitability of the business and its return on investment (Income statement) and its liquidity position (Balance Sheet) (Bragg 2007). Figure 2 Popular financial ratios Financial Ratios 1) Gross Margin Operating earnings (before exceptional and tax) as a percentage of net sales 2) Operating Margin Operating Income (net profit before tax) as a percentage of net sales 3) Profit Margin Net Income (profit after tax) as a percentage of net sales 4) Return on Equity Net Profit after Taxes as a percentage of equity 5) Return on Investment Net Profit after Taxes as a percentage of total assets 6) Return on Capital Employed Net Profit after Taxes as a percentage of average shareholder equity 7) Current ratio Ratio of current assets to current liabilities 8) Quick ratio Ratio of current assets (less inventory) to current liabilities ( less overdraft and other borrowings) 9) Gearing (debt to equity) ratio Ratio of liabilities to equity 10) Earnings per share (EPS) Net profit divided by number of shares issued 11) P/E ratio