Accounting Ratios for Account Manipulation

business relationship Ratios for Account ManipulationHow companies manipulate their tarradiddles using account proportions?AbstractThe emergence of chronicle s digestdals in the US has agitate the beingness over. Professionals, stakeholders, shargonholders and regulatory authorities blame a multitude of factors for the proliferation of cases like Enron, Tyco, WorldCom and chase away etc. The investigator is of the visual sense that the rising number of bankruptcies and dodge cases in the corporate sector has been the moment of pur sufferlessness within the fiscal form and regulatory standards. In the US e particular(prenominal)ly the flexibleness of the pecuniary standards has effrontery satisfyings the opportunities to manipulate accounts with the help of fiscal and history professionals for the benefit of top focus. These individuals expect familiarity of generally accepted accounting principles (generally accepted account principle) and its loopholes. They lar ge(p)ize on these loopholes to the fulfilment of crippling the economy and professional standards. The pastime research investigates the rationale for firms that mend to accounts consumption by means of fiscal ratios and how it could be curbed. It identifies the dance steps for counteracting unethical professional doings by discloselining the core weaknesses within the accountancy standards and systems. It withal compargons the US standards with those of the UK to reason out that the UK is less liable to lampoonulent conduct beca treatment its authority has taken measures to rigorously regulate write up professionals, auditors and top executives to avoid engage in accountancy mathematical function and fraud.Table of ContentsChapter 1 cornerst aceBackgroundrationaleObjectivesScope work at MapChapter 2 Literature re cycloramaIntroductionEnronWorldComRatiosDiffering Accounting Standards in the UK and USChapter 3 Research Methodology inductive and Deductive ReasoningQu alitative and Quantitative ResearchSecondary and capital ResourcesResearch ruleChapter 4 Data collection and abbreviationChapter 5 Conclusion and RecommendationsBibliographyAppendicesBackgroundThe growing number of accounting s candals with the likes of Enron, Tyco, WorldCom and Xerox etc. has raised ca make do of for concern for stakeholders, sh argonholders, professional bodies and trade authorities as well. They atomic number 18 of the view that corporate finance has undergone transformation for the worse in the run low ten classs. Williams research (2002) indicates that accuracy of tax revenues and gelt help in useable decisiveness support and formulation of corporate strategy for almost 60 donation of the firms. Others, approximately 58 percent, feel fiscal report transpargonnce and compliance (93 percent) with external reporting adoptments imperative for effective corporate and effort surgical procedure. However, the growing number of scandals related to doub le-tongued earnings, inflated addition rank and understated liabilities have undermined this system of corporate governance (Lev 2003). Investor confidence has been shaken as each scandal reveals the weak foundation of pecuniary reading system of macrocosm companies and regulatory authority that oversees them. When Enron filed for Chapter 11 loser on December 2, 2001 and WorldCom did the same later, investors blamed their business failures on accounting manipulations. This coiffe is non unsanded. In fact according to Mishra and Drtina (2004) few 200 companies in the past five years have replicated their earnings as a conduce of accounting manipulations. CFO Magazine survey indicates chief financial officers (CFOs) atomic number 18 forced to misrepresent earnings or argon closetd to revile generally accepted accounting principles (GAAP) to satisfy make doholders and top executive forethought. Accounting manipulation not except offers the chance for companies like Enr on and WorldCom to amplify the asset valuation tho in any case to understate liabilities that would appreciate trite sets, traverse losses and increase family valuation. The practice session is not moderate to the US only.In the UK accounting manipulation is excessively known as fictive accounting. According to Amat, Blake and Dowds (1999) creative accounting refers to a work on whereby accountants use their fellowship of accounting rules to manipulate the figures reported in the accounts of a business. Since the accounting ferment itself is f law of natureed in the sense that it provides flexibility, and opportunities for manipulation and mis narration, financial professionals take place it blue-blooded to engage in creative accounting. The practice helps in presenting increase lucre, veridical scotch growth and forethought efficiency whereas the opposite may withal be true.According to Kamal Nasser (1993 qt. Amat, Blake and Dowds 1999) Creative accounting is t he transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the actual rules and/or ignoring some or all of them. The views of these authors indicate that accounting rules in Western countries are weak and offer plenty of room for manipulation. The footing resulting from accounting manipulation affects the accounting principles that the stakeholders, public and investors depend on and use to sum up, judge and count on corporate functioning. The usefulness of accounting principles has regulated industries, equilibrize investment flow and capitalization in the past. However, Enron and the likes have proved that accounting principles (that the masses have depended on in the past) are unreliable. The scandals prove that accounting tools like financial ratio analysis or fundamental analysis for accounts estimation and prediction do not truly reflect the judge of the investment. Artificial transactions can be utili se to manipulate balance sheet amount profits can be moved from closure to period and assets can be re- castd to depict a coercive financial standing.Amat, Blake and Dowds (1999) are withal of the view that companies apply creative accounting to unruffled income and report a steady growth. This is achieved by manipulating accounts to depict improved profits even in weak economic conditions to harmonize the ongoing income. Investors, following accounting principles a good deal utilize accounting ratios to judge and estimate the performance of firms, consider steady income growth as stability and judge a non-volatile stock as a good investment. Similarly Fox (1997) is of the view that accounts manipulation is for the purpose of normalizing income so that the unions management can boost share price by reducing the directs of borrowing, lower finds and engender capital through unfermented shares. Using the accounting rules companies often arrange financial accounts so that t hey would not reflect in the balance sheet, income statement or funds flow statement.The problem arises when the flexibility within the financial principles allows accountants of companies to manipulate accounts to avert investors, banks and financial institutions scrutiny. This kind of flexibility is limited in some countries while it is more pronounced in former(a)s. In the US for example the FASB (Financial Accounting Standard Board) rules that income from excourseed warranties may be accept at the time of change. Banks may not recognize this when they calculate the debt to truth ratios to allow the company to borrow through stemma. In the UK on the other hand there is less provision for using bad debts and inventory as a means to decrease liabilities and inadvertently inflate profitability.Thus, accounting manipulation undermines the moral and ethical standards that are expected of public limited companies. Decreasing apparent volatility in income, inflating debts to avoid taxes, unflurrieding income to take a leak maudlin opportunities for investments and manipulating accounting principles to control securities industry place mechanisms depict the weakness within the economy. It also reflects on the ethical standards and moral of the profession of accounting and auditing. Despite the knowledge and acknowledgement of this fact, professionals in the UK from a survey (Nasser 1993) indicate creative accounting is a problem that can never be resolved (91 percent). In the US creative accounting is more regular because it capitalizes on the order for detailed accounting rather than broad principles, which makes it even harder to notice fraud.The drive in fraud indicates that the foundation of accounting measures and ratios that firms, institutions and public use to estimate financial statements are not reliable. According to Mishra and Drtina (2004) financial statement ratios tend to focus on profitability not quality of the performance of the compa ny. Ratios such(prenominal)(prenominal)(prenominal) as return on assets and return on equity are not adequate to gauge the firms ability to meet debt obligations or to measure the financial distress it is in. Similarly, ratios that accounting flummoxs use to tract shifting revenues and expenses through exchange flow statement training me deposit asses the firms notes in level based on trading physical processs, financing or investing activities. It is limited in calculating the value of the firm based on free cash flows or net income that affect cash flows. As a result, often firms tend to resort to bankruptcy declarations because of the lack of cash inflows. Furthermore, companys stock performance is based on the performance of the stock prices but these values are risk dependent and the prices are set with the hypothesis that trade value of the firm is efficient and the stock prices reflect info in the financial statements. However, when analysts base their decisions on ratios such as price to earnings, dividend yield and price to book ratios they are wholly dependent on information in the financial statements, which may be fraudulent (Mishra and Drtina 2004).RationaleWhen firms are constrained by fraud risks such as opportunities, pressure and rationalization of unethical management, company information itself forms the basis for highschool risk (Hillison, Pacini and Sinason 1999). According to Cressey (1973) non-sharable financial need is responsible for the unethical practice that result in fraud such as accounts manipulation. The urgency, which forces management to pressure accountants and auditors to post fraud, is imputable to the need to appropriate assets and resources to curb financial losses. In the process they undermine their professional integrity (See Appendix 1) (Hillison, Pacini and Sinason 1999).Riahi-Belkaoui and Picur (2000) in their attempt to assure fraud in the accounting purlieu write 59 percent of a KPMG 1998 Fraud Surve y respondents believe fraud entrust pay off more prominent in the incoming. The reasons they cite include economic pressures, little punishment for conviction, weakening social values, insufficient emphasis on stripe and detection, and criminal sophistication. Accounts manipulation is the result of favourable situations in which criminals recognize flexibility within the financial reporting system and audit failure to detect manipulation.Furthermore, when institutions gain power, privileges and position to create an environment conducive to white taking into custody crime, members are likely to acquire earnings management knowledge that are within the framework of the accounting policies and alternatives. Abdelghany (2005) notes that earnings management help financial managers select current target and tailor the financial results of the firm to controvert it. The basic premise is that management can manipulate soft verse resulting from assemblage accounting.As mentioned e arlier firms engage in accounts manipulation collect to several reasons some are unethical while others are delinquent to the environment in which they operate. The approach to manipulate accounting principles to benefit from refractory high quality earnings and influence process decisions motivate firms to smooth income, inflate revenues, restate earnings and deflate liabilities. They try to meet the analysts expectations and company performance predictions (Abdelghany 2005). Other reasons include debt covenant avoidance, costs of investment, protractable long-run performance and meeting up with bonus plan requirements etc. among others. The pressures of management performance, leadership, market failure, and future losses tend to motivate top management to conceal internal misappropriations and misstatements. The influence of these pressures on the reported statements is great as analysts depend on the information to make investment decisions, debt covenant, and professional prediction. abhorrence in the form of manipulating accounts affects not only the firm but also the industry and the economy at large.Given the above rationale the researcher is of the view that there is a great need to study accounts manipulation and its affect on industries, the public, accounting and auditing professionals, and the investment environment as a whole.ObjectivesThe objectives of this study are as followsTo investigate how firms like Enron and WorldCom engage in accounts manipulation using financial ratios.To investigate the ethical and professional implications of financial ratios manipulation through accounting misstatements, earnings management and restatements.To study the purpose of the regulatory authority in contributing or deterring accounts manipulation by comparability the accounting standards in the US and UK.ScopeThe researcher aims to appreciate pertinent industry practice by evaluating case studies of Enron and WorldCom. The researcher shall also delv e into issues of accounting principles weaknesses and the role of the authority in contributing to the incumbent trend of accounting fraud and manipulation. Consequently, the study shall benefit professionals who are in the field, trying to find solutions for the current trend and how to curb it. Academicians business leader find the use of theoretical frameworks to study a current accounting predicament interesting and contributory to future works. Moreover, the researcher expects the results of the study enumerating to both students and academicians alike who are interested in the study of accounting fraud and manipulation.However, readers might find the scope of this study limited in the sense that it will be focused on accounts manipulation particularly in the use of financial ratios. There are other methods of accounting manipulations, which will be covered briefly in the research. Overall, readers will find the findings useful and informative.Work MapThe study shall be divi ded into the following sectionsChapter 1 introduces the military issue through a brief overview of the current norms and practices in accounts manipulation. It also points out reasons why there is a need for the study with objectives for directing the root for discussion in the following chapters.Chapter 2 is a Literature Review, which shall soupcon the Enron and WorldCom scandals in the light of accounts manipulation. It also reviews literature on financial ratios fraud and its effects. Lastly, it shall study the accounting standards choose by the UK and US to compare which one is more prone to accounts manipulation.Chapter 3 shall out frontier the various methods considered and chosen for the ontogeny of the current study.Chapter 4 is an analysis of the data collected and evaluated from the researchers point of view based on the expertise of the scholars discussed in the Literature Review.Chapter 5 shall pause the findings, and offers some recommendations to resolve the issu es outlined in the objectives.OverviewAn efficient capital market is one that allows prices to shift rapidly in response to the latest information because public information is conveyed efficiently, interpreted and analyzed to make effective decisions. apocalypse so is an obligation imposed by law to facilitate market performance. Companies are obligated to provide information so that investors and the public can interpret information to participate in the market decisions. Professional moral philosophy is relegated through understanding among accountants, auditors, management and executives on the premise that the market is entitle to receive full accounts and reports of companies performance as per regulatory authority. The form and substance of the individual or consolidated accounts is regulated by the company law and by accounting standards issued to the accounting professionals and auditors. However, sometimes publicly traded company financial position becomes tradeoffs a scribable to limited obligation, losses and performance pressure. Any via media in their performance results in negative market reaction, as they are bound by standards and targets set by the public. This kind of market behaviour force companies to resort to unethical practices (Ferran 1999).Alternatively, when regulations change in response to the imply of the market, companies have to reshuffle their internal systems to comply with them. The preparation of accounts in accord to applicable accounting standards often conflict with the companys standards and values. New accounting information requirements and standards are often viewed with apprehension as they put pressure on the statutory requirements. For example the Listing Rules of the London Stock Exchange require annual reports and accounts of companies to contain additional information. The changing environment therefore creates a problem for companies to align current with past performances (Ferran 1999).To gauge a compa nys financial standing, analysts use ratios to estimate and evaluate its performance by comparing it with the current status or against the industrys standards. Financial managers of companies are aware of the use of this tool to evaluate companys performance. Within the framework of legal accounting standards they employ planning and capital structure decisions to measure the performance of firms. Ratios such as price to earning, for example, are of particular interest to investors interested in gauging the performance of the company they want to invest in (Pike and Neale 1996). When pressured, accountants can manipulate accounts information, such as interests, liabilities, and pre-tax profits etc, to substantially inflate or deflate certain accounts according to the needs of the firms objectives for the short or long term. For example some companies might inflate earnings per share to depict higher dividend to increase the companys investment attractiveness. Others might deflate l iabilities to depict low debt to equity ratio, to create opportunities for borrowing. Whichever the cause, the fact is that firms engage in accounts manipulation within the accounting principles framework. They are within their legal rights to employ such methods, which allow them to create a positive picture to investors, creditors and institutions. How far can firms employ such methods and to what bound constitutes unethical or illegal practice will be investigated in the following sections.EnronAmong the recent cases of accounts manipulation is Enron. Enron products and services relate to gas and aptitude wholesale, as well as retail to a host of customers. The company is considered one of the most innovative with an efficient management team and a leader who is the envy of the industry. According to Mishra and Drtina (2004) Enron filed bankruptcy in 2001 when it had just revealed its strategic plans in the light of asset and non-asset expansions. The companys plan had been to expand into energy profession expertise with a host of new products and services. At the time its share had been traded at $90. From 1999 to 2001 the company underwent great changes in terms of its earnings per share from $1.27 in 1999 to $0.999 in 2000. To deflect speculation, Enron used off-balance sheet partnerships to finance and sustain its investment growth and rating (Mishra and Drtina 2004).This method is not a new practice but is employed by 27 percent of companies. Enron and used it to hide its massive debts by inflating revenue with gain from sale of assets to off-balance sheet partnerships by guaranteeing the partnerships debt with stocks. As a result Enron had to restate its earnings from time to time to reflect the reduction in shareholders equity due to the partnership. The stock price started to decline to less than $1 in November 2001 patronage the fact that the company had been considered one of the fastest growing companies in the industry. bit the book value o f the assets tripled from $23.5 one thousand million in 1997 to $65.5 billion in 2000, in actuality Enron had been deteriorating in its market capitalization (Kedia and Philippon 2005). Enron is a typical example of accounts manipulation where misreporting to show increased investment value and simulated income have created contrived resources whereas the company had been running into high level of debts. The real cost of manipulation eventually reflects in the earnings.Earnings management has been used to boost stock prices so that managers can profit from the share trading but in effect undermine the organizations value. In theory the use of earnings management helps firms to manipulate price earning ratios to, firstly show firms potential activities, and secondly to restate the value of the firm. However, as a consequence, the earnings created theoretical growth in investment and employment depicting strong growth (Kedia and Philippon 2005 Healy and Wahlen 1999). According to th e authors, Kedia and Philippon (2005), Enron used an earnings manipulation model, which has resulted real time inefficiencies, as it does not account for the fundamental value of the firms equity or account for the allocation of resources.Wamys (2004) investigation reveals that Enron inflated profits by nearly one billion dollars and top employees raked in millions of dollars (they should not have received) through complex and especial(a) partnerships to hide debt, inflate profits and to engage in allied unethical and heinous business practices. The companys unique business model depicts human capital as the leveraging point for its investments, instead of fixed assets. Since its people are considered physical assets, it could allocate earnings to these individuals to create higher value for the firm that owns them.Theorists blame the companys manipulated accounts as the basis for its bankruptcy in 2001. Others (Barlev and Haddad 2004 Wamy 2004) blame it on the transition within the accounting framework. Barlev and Haddad (2004) attribute the shift of accounting practices due to the inclusion of the new paradigm of fair value accounting has increased the pace of reporting in firms. The authors in their research prove that the new paradigm improved full disclosure, transparency and management efficiency mandates. However, the weak control system that governs accounts information contributed to abuse and manipulations. It has allowed Enron to sell its stakes to special purpose entities thereby minimizing reported activities. Since Enron took the position that as a result of the decrease in its ownership interest, it no longer controlled SPEs and was not needed to consolidate SPEs in its balance sheet. SPEs had been acquired through bank loans and debt issuance, which resulted in high debt to equity ratio, but hidden from the investors. As business transactions at Enron grew, the company is also confronted with its inability to pay for these transactions (Dodd 2 002). Further, the company has also abused the fair value framework by using hedgerow instruments such as changing fair value of assets and liabilities, variable cash flows and foreign currency exposure to emphasize on its valuation (Barlev and Haddad 2004) by recording inaccurate revenue and earnings growth. Enron reported prices and recognized fabricated unrealized gains to account for pretax income worth $1.41 billion for the year 2000, which is attested by its auditors as being true (Makkawi and Schick 2003).WorldComWorldCom (now MCI) is one of the largest distance phone companies in the US to declare bankruptcy in 2004. The reason had been accounting irregularities that fitted to $11 billion. According to Scharff (2005) the companys declaration had been one of the largest accounting frauds in the US history. The author writes of the perpetrator as being the organizational structure, group processes and culture, which excuse fraud that had become an integral part of WorldCom s trading operations. WorldComs rationale for following a corrupt course of action stems from groupthink behaviour and competitive industry environment that pressurize members of the organization to make decisions to pursue fraudulent activities (Whyte 1989).Scharff (2005) traces the development of WorldComs bankruptcy and notes that during the 1990s the company had been under strong pressure to maintain cash flows and earnings before interest. As the telecommunication industry is subjected to strict regulations, WorldCom executives resorted to fraud to allocate costs of capital as prepaid. Similarly, it also active in improper release of accruals so as to reduce current year expenses to increase earnings. Not only this, the company also ensured that minor revenue entries are made to increase operating earnings (Scharff 2005). The finance and accounts subdivision had been encouraged by top management to engage in fraudulent behaviours (See Appendix 2) to cover for the invulnerabl e position the organization had been in.However, the most authoritative issue had been when the company found out about loopholes in the GAAP that would support the entries the executives wanted to include. Through them, the company also managed to inflate cash flows for five quarters with the assumption that the company received cash flows from operations whereas most of its activities had been based on accruals.According to Tergesen (2002) the accounts manipulation engaged at WorldCom had been aimed at inflating consolidated cash flows to present a positive operation picture so that investors are attracted in buying its stocks to increase capitalization. Realizing that investors are risk averse, and avoid company stocks that raise cash through financings, such as debts or investment related activities such as assets, WorldCom managed to pose a positive and attractive picture through accounts manipulation. It managed to secure operations cash flows through securitizing, which is th e selling of account receivables. Selling of receivables is recognized as cash collections, even though they are collected in the future. Although this practice is regular, the timing and the manner of entry makes it culpably the basis for accounts manipulation. Not only this, Tergesen also notes that WorldCom engaged in capitalizing expenses. This practice involves the capitalization of costs of assets in the balance sheet and writing it off as annual instalments. To report for the lack of cash, WorldCom also manipulated the GAAP rules of allowing cash raised through securities gross sales recorded in the cash from operations section, even though the military action is not related to cash flow. (Tergesen 2002).The motivation according to Zekany, Braun and Warder (2004) cauline from the pressure to meet analysts and investors expectations. WorldCom had been closely connected with the stock market and a favourite of investors. To meet analysts forecast expectations, WorldCom used its public relation as guidance for meeting such expectations. These expectations are derived from earnings estimates, securities performance and market position of its stocks. WorldCom, pressured from the intensity of investment demand and analysts expectations, devised financial measures to meet the financial requirements. To increase the stock market value, the top executive had to engage in expansionary acquisitions, to increase revenue growth. At the same time the companys performance deteriorated on with the industry yet it had to prove that it performs above the others (Zekany, Braun and Warder 2004). The accounting discussion section at WorldCom had become an important functional component under the directives of its executives engaged in accounts manipulation activities to boost E/R ratio. The authors explain that WorldCom adopted the line cost accruals system to compensate for the accrual revenue and the liability reported in the balance sheet. However, since the accrual system is highly risky, it is concentrated to make provision for its accurate reportage. The pressure to meet up with the line cost accruals motivated executives to find creative accounting ideas to reduce and go on costs. This approach would have been successful, however since the industry had been strived by deterioration, earnings could not be inflated to achieve the expected levels to portray a positive E/R ratio. E/R is basically a ratio to measure the return on business resources available to the management. It is similar to a measure of shareholder equity and management effectiveness. (Alexander 2001).RatiosFraudulent financial reporting has given new dimensions to corporate fraud. Both external and internal auditors are striving with the legal liability to detect fraudulent financial statements, so as to save damage to their professional reputation and to prevent public dissatisfaction (Kaminski and Wetzel 2004). Previously professionals relied on the efficiency of ratios to detect expectation errors to make decision pertaining to stock prices, risks and value of stocks for future growth. Subsequent decisions are based on the credible reportage. Investors, borrowing institutions and the public, use accounting ratios to predict returns or performance. Ratios rely on earnings and book value to measure a firms value. operation is predicted by a cross-sectional aggregate and indicators from figures in the financial statements. Investors use strategies such as fundamental ratio analysis, accruals analysis and fundamental value analysis, to account for their decisions and treatment of investment portfolios. However, Daniela, Hirshleifer and Teohb (2001) are of the view that these strategies are not effective predictors of future stock returns. They writeEarnings reported on firms financial statements differ from cash flows by accounting adjustments known as accruals. These are designed in principle to reflect better economic circumstanceshigh accruals pr edict negative long-run future returns. (Daniela, Hirshleifer and Teohb 2001)This strategy is affected by the discretionary working capital accrual and new equity. This is so because investors are fixated by earnings numbers. Consequently they tend to underestimate other accrual factors.Similarly, the authors also note that the fundamental value analysis strategy to predict future stock returns, relies on stock prices from an imputed value based on a fundamental value model (Daniela, Hirshleifer and Teohb 2001). Even in this model the discounted value of expected future residual earnings are specify in the context of normal return employed in future years. In re