Earnings Management, Window Earnings Management, Window Dressing, Forensic Accounting and Dressing, Forensic Accounting and

Corporate GovernanceCorporate Governance

Earnings ManagementEarnings Management

EARNINGS MANAGEMENT occurs EARNINGS MANAGEMENT occurs when managers use judgment in financial when managers use judgment in financial reporting and in structuring transactions to reporting and in structuring transactions to alter financial reports to either mislead alter financial reports to either mislead some stakeholders about the underlying some stakeholders about the underlying economic performance of the company, or economic performance of the company, or to influence contractual outcomes that to influence contractual outcomes that depend on reported accounting numbers.depend on reported accounting numbers.

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Earnings ManagementEarnings Management

Important to understand:Important to understand: More often the problem is not the More often the problem is not the flexibility of the reporting rules, but the fact that the watchdogs flexibility of the reporting rules, but the fact that the watchdogs are not doing their job!!!are not doing their job!!!

– Audit failureAudit failure

– Poor corporate governancePoor corporate governance

– Shareholder involvementShareholder involvement

– SEC / SEBI enforcementSEC / SEBI enforcement

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Common Earnings Management PracticesCommon Earnings Management Practices

1.1. Shifting income between periods:Shifting income between periods:

Revenues Expenses

Borrowing earnings from the future

1. Premature recognition of revenues Example: Xerox

2. Capitalization of expensesExample: WorldCom

Postponing earnings to the future

3. Deferring recognition of revenuesExample: Microsoft

4. Exaggerating current expenses/losses to create cookie jar reservesExample: Microsoft

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Actual J.E. Proper recognition J.E.

1. Borrowing revenues from the future

DR CR Cash revenue

DR CR cash def. revenuelater: def. revenue revenue

2. Deferring expenses to the future

DR CR Asset cashlater: Expense asset

DR CR expense cash

3. Deferring revenue to the future

DR CR cash def. revenuelater: def. revenue revenue

DR CR Cash revenue

4. Exaggerating current expenses/losses to create cookie jar

DR CR loss liability/Assetlater: liability cash

DR CR No journal entrylater: loss cash

Common Earnings Management Practices (cont’d): J.E.

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Common Earnings Management Practices (cont’d)Common Earnings Management Practices (cont’d)

2.2. Classification of gains and losses:Classification of gains and losses:– Classifying one-time gains as earnings from continuing operationsClassifying one-time gains as earnings from continuing operations

– Classifying losses from continuing operations as one-time itemsClassifying losses from continuing operations as one-time items

3.3. Hiding Debt in unconsolidated subsidiariesHiding Debt in unconsolidated subsidiaries– Example: EnronExample: Enron

Legitimate Earnings Management (Within GAAP)

Violation of GAAP or SEC rules

Manipulation of accruals to: I. smooth earnings - Income smoothingII. Turn permanent expenses into temporary losses

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Example of Scope of Manipulations and Example of Scope of Manipulations and Incentives: Xerox CaseIncentives: Xerox Case

Xerox sells/leases copy machines, and related service to be Xerox sells/leases copy machines, and related service to be provided for several years after sale.provided for several years after sale.

Recorded service revenue at the time of sale. Recorded service revenue at the time of sale. According to the SEC investigation, “accounting tricks” According to the SEC investigation, “accounting tricks”

boosted pretax profit by 1.5 billion from 1997 through boosted pretax profit by 1.5 billion from 1997 through 2000.2000.

In November 1999, CFO told management: In November 1999, CFO told management: ""When accounting actions were stripped away, Xerox had When accounting actions were stripped away, Xerox had essentially no growth through the late 1990sessentially no growth through the late 1990s.”.”

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Without the accounting scheme the company would have Without the accounting scheme the company would have missed Wall Street's consensus per-share earnings targets missed Wall Street's consensus per-share earnings targets in 11 of 12 quarters from 1997 to 1999.in 11 of 12 quarters from 1997 to 1999.

Accounting scheme helped keep Xerox's stock price Accounting scheme helped keep Xerox's stock price artificially high in the late 1990s so executives could cash artificially high in the late 1990s so executives could cash in in $5 million in performance-based compensation$5 million in performance-based compensation and and more than more than $30 million from stock sales$30 million from stock sales..

Xerox Case: what were the incentives?

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Satyam – Rs.7000 crore scamSatyam – Rs.7000 crore scam

The 2008 balance sheet comprised faked The 2008 balance sheet comprised faked and inflated figures of revenue, profit, and inflated figures of revenue, profit, interest and debt. The list includes Rs 5,040 interest and debt. The list includes Rs 5,040 crore of non-existent cash and bank crore of non-existent cash and bank balances, non-existent accrued interest, balances, non-existent accrued interest, understated liability of Rs 1,230 crore on understated liability of Rs 1,230 crore on account of funds raised by Mr Raju and account of funds raised by Mr Raju and overstated debtors position of Rs 490 crore overstated debtors position of Rs 490 crore (as against Rs 2,651 crore).(as against Rs 2,651 crore).

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Window DressingWindow Dressing

Ways of Window DressingWays of Window Dressing

Premature recognition of IncomePremature recognition of Income Non-operational IncomeNon-operational Income Non-provision of diminution in LT Non-provision of diminution in LT

investmentsinvestments Capitalisation or deferment of revenue Capitalisation or deferment of revenue

expensesexpenses Revaluation of fixed assetsRevaluation of fixed assets Extension of accounting year Extension of accounting year Reducing from Reserves & SurplusReducing from Reserves & Surplus

Ways to Window dressWays to Window dress

Advancing bills of customers to inflate the Advancing bills of customers to inflate the bottom line or top linebottom line or top line

Inadequate or no provision for doubtful Inadequate or no provision for doubtful debtsdebts

Increase estimated useful life to charge Increase estimated useful life to charge lower depreciationlower depreciation

No separate disclosure for prior-period No separate disclosure for prior-period adjustments / extra-ordinary itemsadjustments / extra-ordinary items

Forensic AccountingForensic Accounting

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Forensic Accounting DefinedForensic Accounting Defined

Forensic accounting is the action of Forensic accounting is the action of identifying, recording, settling, extracting, identifying, recording, settling, extracting, sorting, reporting, and verifying past financial sorting, reporting, and verifying past financial data or other accounting activities for settling data or other accounting activities for settling current or prospective legal disputes or using current or prospective legal disputes or using such past financial data for projecting future such past financial data for projecting future financial data to settle legal disputes.financial data to settle legal disputes.

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Forensic Accounting vs. Fraud AuditingForensic Accounting vs. Fraud Auditing

Fraud Auditor:Fraud Auditor: An accountant especially An accountant especially skilled in auditing who is generally engaged skilled in auditing who is generally engaged in auditing with a view toward fraud in auditing with a view toward fraud discovery, documentation, and prevention.discovery, documentation, and prevention.

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Forensic Accounting vs. Fraud AuditingForensic Accounting vs. Fraud Auditing

Forensic Accountant:Forensic Accountant: A forensic accountant A forensic accountant may take on fraud auditing engagements and may take on fraud auditing engagements and may be a fraud auditor, but he or she will also may be a fraud auditor, but he or she will also use other accounting, consulting, and legal use other accounting, consulting, and legal skills in broader engagements. In addition to skills in broader engagements. In addition to accounting skills, he or she will need a accounting skills, he or she will need a working knowledge of the legal system and working knowledge of the legal system and excellent communication skills to carry out excellent communication skills to carry out expert testimony in the courtroom and to aid expert testimony in the courtroom and to aid in other litigation support engagements.in other litigation support engagements.

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Defining FraudDefining Fraud

A A representationrepresentation About a About a materialmaterial point, point, Which is Which is falsefalse,, And And intentionallyintentionally or or recklesslyrecklessly so, so, Which is Which is believedbelieved And And acted uponacted upon by the victim by the victim To the victim’s To the victim’s damagedamage

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What Drives FraudWhat Drives Fraud

Key driversKey drivers– Confidence earnedConfidence earned– PressuresPressures– GreedGreed

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Accountant’s Role in Fraud DetectionAccountant’s Role in Fraud Detection

In the early 1980s, companies began to use In the early 1980s, companies began to use computers to perform their record keepingcomputers to perform their record keeping

Intense competition caused auditing fees to fall Intense competition caused auditing fees to fall as much as 50% from the mid-1980s to the mid-as much as 50% from the mid-1980s to the mid-1990s. 1990s.

Auditors cut costs by reducing the process of Auditors cut costs by reducing the process of reviewing hundreds of corporate accounts. They reviewing hundreds of corporate accounts. They grew more reliant on internal controls.grew more reliant on internal controls.

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Accountant’s Role in Fraud DetectionAccountant’s Role in Fraud Detection Top executives were able to circumvent internal Top executives were able to circumvent internal

controls and manipulate the records.controls and manipulate the records. This lead to situations such as Enron, This lead to situations such as Enron,

WorldCom, Xerox, Adelphia Communication, WorldCom, Xerox, Adelphia Communication, and the fall of Arthur Andersen in the early and the fall of Arthur Andersen in the early 2000s.2000s.

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Forensic AccountingForensic Accounting

Two parts:Two parts:– Investigative accountingInvestigative accounting– Litigation supportLitigation support

Treats all figures as suspect until proven Treats all figures as suspect until proven otherwiseotherwise

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InvestigationInvestigation

Is the act of determining whether criminal Is the act of determining whether criminal matters such as employee theft, securities matters such as employee theft, securities fraud (including falsification of financial fraud (including falsification of financial statements), and insurance fraud have statements), and insurance fraud have occurred. occurred.

Also includes searching for irregularities Also includes searching for irregularities associated with civil matters, such as a associated with civil matters, such as a search for hidden assets in divorce cases. search for hidden assets in divorce cases.

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Litigation SupportLitigation Support

Is the factual presentation of economic Is the factual presentation of economic issues related to existing or pending issues related to existing or pending litigation.litigation.

The forensic accountant quantifies damages The forensic accountant quantifies damages sustained by parties involved in legal sustained by parties involved in legal disputes and assists in resolving disputes, disputes and assists in resolving disputes, even before they reach the courtroom.even before they reach the courtroom.

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Litigation SupportLitigation Support

Arbitration assistanceArbitration assistance Business valuation for divorce, stockholder disputesBusiness valuation for divorce, stockholder disputes Computation of damages resulting from personal injuries, Computation of damages resulting from personal injuries,

wrongful death, breach of contract, casualty, and fidelity wrongful death, breach of contract, casualty, and fidelity losseslosses

Determination of lost profits due to business interruptionDetermination of lost profits due to business interruption Testifying as an expert witnessTestifying as an expert witness Financial review of contractual obligationsFinancial review of contractual obligations Investigative services related to fraud and other illegal actsInvestigative services related to fraud and other illegal acts

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Red FlagsRed Flags

No Company Policy ManualNo Company Policy Manual Feeling of disorganized Feeling of disorganized

bookkeeping, purchasing, bookkeeping, purchasing, receiving, and/or warehousing receiving, and/or warehousing departmentsdepartments

Missing documentsMissing documents Unrecorded transactionsUnrecorded transactions No bank reconciliationsNo bank reconciliations Subsidiary ledgers out of balanceSubsidiary ledgers out of balance No physical inventory countsNo physical inventory counts Checks written to cashChecks written to cash Large related party loansLarge related party loans Excessive other revenueExcessive other revenue Negative operating cash flowNegative operating cash flow Downward earnings trendDownward earnings trend

Handwritten checksHandwritten checks Extensive fund transfersExtensive fund transfers Unusual transactions (inconsistent)Unusual transactions (inconsistent) Deficient hiring policies and Deficient hiring policies and

proceduresprocedures Employees’ lifestyles inconsistent Employees’ lifestyles inconsistent

with salarieswith salaries Employees who don’t take Employees who don’t take

vacationsvacations SPEsSPEs Excessive insider sales of stockExcessive insider sales of stock Unexplained resignations of upper Unexplained resignations of upper

managementmanagement Excessive debt/equity ratioExcessive debt/equity ratio CPA switchingCPA switching Strange account titlesStrange account titles

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Motive / Pressure

Rationalization Opportunity

[Source: Michael Kurland, How to Solve A Murder: Macmillan, 1995, pp. 7-8]

The Fraud TriangleThe Fraud Triangle

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Perceived PressurePerceived Pressure

Employees, managers, and owners can feelEmployees, managers, and owners can feelpressure to commit fraud as a result of pressure to commit fraud as a result of

Greed or preoccupation with being successfulGreed or preoccupation with being successful Living beyond meansLiving beyond means High personal debtsHigh personal debts Unexpected financial needsUnexpected financial needs Expensive vicesExpensive vices Family-imposed pressuresFamily-imposed pressuresSource: Carl Pacini, J.D., Ph.D., CPASource: Carl Pacini, J.D., Ph.D., CPA

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Perceived OpportunitiesPerceived Opportunities

Opportunities to commit fraud exist whenOpportunities to commit fraud exist whenlevels of trust in an organization are reachedlevels of trust in an organization are reachedor when controls are weak.or when controls are weak.

Inappropriate segregation of dutiesInappropriate segregation of duties Ineffective supervisionIneffective supervision Transaction authorization not requiredTransaction authorization not required Lack of physical controlsLack of physical controls Lack of adequate audit trailLack of adequate audit trailSource: Carl Pacini, J.D., Ph.D., CPASource: Carl Pacini, J.D., Ph.D., CPA

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RationalizationRationalization

Individuals usually don’t commit fraud unlessIndividuals usually don’t commit fraud unlessthey can justify their actions in relation tothey can justify their actions in relation totheir own code of ethics. their own code of ethics.

Feeling underpaid or overworkedFeeling underpaid or overworked Desire to seek revengeDesire to seek revenge Belief that taking the assets is a loanBelief that taking the assets is a loan Belief they are helping others (family, employees) Belief they are helping others (family, employees)

Source: Carl Pacini, J.D., Ph.D., CPASource: Carl Pacini, J.D., Ph.D., CPA

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Factors affecting occupational FraudFactors affecting occupational Fraud

Financial condition of the Financial condition of the organisationorganisation

Pressure to show profits in Pressure to show profits in the marketplacethe marketplace

Internal accounting Internal accounting controlscontrols

The state of the economyThe state of the economy Integrity level of Integrity level of

corporate leaders and corporate leaders and employeesemployees

Commitment to Commitment to organisation’s value organisation’s value systemsystem

Personal traits and Personal traits and characteristics of characteristics of executives and employeesexecutives and employees

Reward systems for Reward systems for ethical behaviorethical behavior

Organisation culture and Organisation culture and dynamicsdynamics

Peer pressurePeer pressure The perception of The perception of

detectiondetection The swiftness, cnrtainty The swiftness, cnrtainty

and severity of and severity of punishmentpunishment

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How do Forensic AccountantsHow do Forensic AccountantsSearch for Fraud?Search for Fraud?

Proactive fraud detectionProactive fraud detection Reactive fraud detectionReactive fraud detection

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Proactive Fraud DetectionProactive Fraud Detection

Inductive approachesInductive approaches

Use of Data-mining softwareUse of Data-mining software

Digital analysis of company dataDigital analysis of company data

Deductive approachDeductive approach

Determine what kinds of frauds can Determine what kinds of frauds can occur. Search for symptoms of occur. Search for symptoms of these these

frauds.frauds.

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Data-mining Softwares Data-mining Softwares

ExcelExcel ACLACL IDEAIDEA Microsoft AccessMicrosoft Access

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Deductive Approach to Detecting FraudDeductive Approach to Detecting Fraud

Involves a 5-step process:Involves a 5-step process: Understanding the business environmentUnderstanding the business environment Understanding the kinds of fraud that can occur in Understanding the kinds of fraud that can occur in

this environmentthis environment Determining the most likely symptoms Determining the most likely symptoms Using databases and systems to search for the Using databases and systems to search for the

fraud symptomsfraud symptoms Following up on discoveries to determine Following up on discoveries to determine

likelihood fraud existslikelihood fraud existsSource: Albrecht, W. S. 2003. Fraud Examination. Mason, OH: Thomson South-WesternSource: Albrecht, W. S. 2003. Fraud Examination. Mason, OH: Thomson South-Western

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Reactive Fraud DetectionReactive Fraud Detection

Fraud accountants are often engaged after Fraud accountants are often engaged after someone in the entity suspects that fraud someone in the entity suspects that fraud has been committed.has been committed.

Usually the area in which fraud has been Usually the area in which fraud has been committed is known. Often, the entire area committed is known. Often, the entire area is examined. is examined.

Corporate GovernanceCorporate Governance

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What is Corporate Governance?What is Corporate Governance? A set of procedures and policies by which corporations are A set of procedures and policies by which corporations are

directed and controlled.. Cadbury Report (UK) – 1992directed and controlled.. Cadbury Report (UK) – 1992 “…“…to do with Power and Accountability: who exercises power, on to do with Power and Accountability: who exercises power, on

behalf of whom, how the exercise of power is controlled.”…. behalf of whom, how the exercise of power is controlled.”…. Sir Sir Adrian CadburyAdrian Cadbury

As per OECD, Corporate Governance deals with “… the distribution As per OECD, Corporate Governance deals with “… the distribution of rights and responsibilities among different participants in the of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other corporation, such as, the board, managers, shareholders and other stakeholders, and spells out rules and procedures for making stakeholders, and spells out rules and procedures for making decisions on corporate affairs “decisions on corporate affairs “

Corporate governance deals with the ways in which suppliers of Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their finance to corporations assure themselves of getting a return on their investment….Journal of Finance, Shleifer and Vishnyinvestment….Journal of Finance, Shleifer and Vishny

Corporate governance is about promoting corporate fairness, Corporate governance is about promoting corporate fairness, transparency and accountabilitytransparency and accountability

An Indian DefinitionAn Indian Definition

“…“…fundamental objective of corporate fundamental objective of corporate governance is the ‘enhancement of the governance is the ‘enhancement of the long-term shareholder value while at the long-term shareholder value while at the same time protecting the interests of other same time protecting the interests of other stakeholders.”stakeholders.”

SEBI (Kumar Mangalam Birla) Report on SEBI (Kumar Mangalam Birla) Report on Corporate Governance, January, 2000Corporate Governance, January, 2000

A Gandhian DefinitionA Gandhian Definition

Trusteeship obligations inherent in Trusteeship obligations inherent in company operations, where assets and company operations, where assets and resources are pooled and entrusted to the resources are pooled and entrusted to the managers for optimal utilisation in the managers for optimal utilisation in the stakeholders’ interests.stakeholders’ interests.

What is good Corporate What is good Corporate Governance?Governance?

Systems and procedures adopted and followed that ensure that Systems and procedures adopted and followed that ensure that

all shareholders share equally in the success (or failure) of a all shareholders share equally in the success (or failure) of a

firmfirm

““The Foundation of any structure of Corporate Governance is The Foundation of any structure of Corporate Governance is

disclosure. Openness is the basis of public confidence in the disclosure. Openness is the basis of public confidence in the

corporate system, and funds will flow to the centers of corporate system, and funds will flow to the centers of

economic activity that inspire trust.” Sir Adrian Cadburyeconomic activity that inspire trust.” Sir Adrian Cadbury

AVAILABLE EVALUATION TOOLSBALANCED SCORECARD/TRIPLE BOTTOMLINE/GLOBAL REPORTING INITIATIVE

GUIDING TENETSCAUX / SULLIVAN / GLOBAL COMPACT / MILLENIUM DEVELOPMENT GOALS / INDIAN TRADITIONS

CORPORATE VALUES & REPUTATION

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EXECUTIVE MANAGEMENTINTERNAL CONTROLRISK MANAGEMENTSTRATEGY/PERFORMANCE

COMMUNICATIONSVALUES

STAKEHOLDERSBOARD GOVERNANCE