Creative accounting has many aspects, both qualitative and quantitative. The February 1997 (2/97) issue of McKinsey Quarterlymakes reference to certain rel- atively simple ideas which can lead to major if temporary financial advantages.5 A good example to keep in mind is the effect of manipulating financial results by means of off-balance sheet (read: derivatives) deals: ‘The deployment of off-balance-sheet funds using institutional investment money …’
● ‘Fostered (Enron’s) securitization skills …’, and
● ‘Granted it access to capital at below the hurdle rates of (other) major oil companies.’
A second reference from the same source helps to explain how some types of nego- tiating and manipulating skills lead to new opportunities, altering the way work is traditionally done: ‘Enron was not distinctive at building and operating power sta- tions, but it didn’t matter; the skills could be contracted out. Rather, it was good at negotiating contracts, financing, and (obtaining) government guarantees – precisely the skills that distinguished successful players (in a virtual economy).’
The tie-in comes from the fact a virtual economy provides plenty of opportuni- ties for creative accounting which, in turn, strengthens ‘negotiating skills’ of an unscrupulous management. Credit (or rather debit) for some of Enron’s moves goes to a team that developed an electric power and natural gas hedge fund, and contributed to the engineering of:
● The huge California power price spike, and
● The unforgettable (as well as unforgivable) California power blackout.
Other big companies, too, don’t shy from creative accounting practices and the ephemeral benefits they provide. Mid-January 2005, Nortel Networks released restated results from 2003, which reducedprior reported profits by some $300 mil- lion. As a justification, the well-known telecom equipment manufacturer blamed several former executives for using ‘inappropriate’ accounting methods to:
● Inflate profits, and
● Beef-up their own bonuses.
Where were Nortel’s internal control procedures, which should have reported the scam? Where was the vigilance of the board’s Audit Committee? Apart from the fact that this creative accounting scandal, like so many others, is indecent, a
dozen senior executives who said ‘they had not been directly involved’ will nev- ertheless return $8.6 million in bonuses over the next three years. Five Nortel board directors stepped down.6
One of the best case studies on the many colours of creative accounting is AIG’s 2004 proforma reporting. Proforma earningshas been the brainchild of EBITDA.
Proforma is a 1990s manipulation of operating earnings, with the resulting unre- liable financial reports popularized by dot.coms. The way proforma is being used tends to exclude basic costs like marketing and interest, among others, thereby giving a fake picture of profitability.
Over time, like the spider crab, which has been renamed the Alaskan king crab and become an instant success, proforma was rebaptized as adjusted earnings.
When the reader hears about adjusted earnings, he or she will do well to remem- ber this is merely a new term for proforma, invented after the latter has:
● Highly disappointed investors, and
● Led to lots of money being lost.
Proformas are creative accounting gimmicks; they are financial statements which do not have to conform to the US GAAP. They are not approved by regulators, they do not conform to accepted accounting principles, and they are unreliable, but curiously enough accepted by a market thirsty for ‘good news’.
There is nothing better than a real life case study to demonstrate what companies can do when they are free to choose the metrics and methods through which they report their financial results. American International Group (AIG) is one of the biggest and best-known companies in the insurance business.
● It is the largest American insurer, and
● It seems to be cherry-picking in its financial reporting.
On 11 February 2004 AIG announced a 68% increase of net income. This boosted the company’s stock, which had anyway been rising for a whole quarter. Struck by the huge gains in profits, David Schiff, of Schiff’s Insurance Observer, took a closer look at the impressive profits being announced and found that:
● IfAIG had used the same methodology as it had in the past,
● Then it would have been up a far less impressive 15% in profitability terms, instead of 68%.
The way The Economisthad it, this most interesting discovery prompted Schiff to take a deeper look at AIG’s record.7What he found is that when, in the fourth
quarter of 2002, AIG began its net income announcement, it provided investors with an adjusted number that:
● Excluded realized losses on its securities portfolio, and
● Featured a large charge-off for miscalculating previous losses.
The pivot point of this resetting of financial facts and figures was that a 3%
increase in net income could be viewed as a 12% increase. By contrast, iffinan- cial and accounting gimmicks were put to test, and as David Schiff says the var- ious superfluous adjustments were left out, then in reality AIG’s earnings declined by 4% in that year.
With this significant finding regarding AIG’s 2002 financial accounts, David Schiff went back over four more years of AIG accounting to find that the insur- ance company has been able to improve the appearance of its profits growth in 19 out of the 20 preceding quarterly financial statements. The miracle was achieved by shifting the emphasis in its presentation of results between four different meas- ures of profits (the cherry-picking). While stating net income, the company:
● Sometimes offered an adjusted figure highlighting realized investment returns
● In other times, it highlighted various losses, and
● In still other cases it did neither, so that quarter-to-quarter financial results were no longer comparable.
The net effect of this cherry-picking has been the creation of a far more positive impression of the company’s growth which, as expected, misguided investors.
The miracle was achieved by manipulating the freedom provided by proforma statements, that commonly appear at the beginning of company reports and pub- lic announcement.
The price is legal risk. In early 2005 American International Group filed its annual report, after three previous delays, and restated net profit for the past five years, reducing it by $3.9 billion – which is a large sum. In the sequel, the State of New York brought a civil lawsuit against the insurance giant and its former chief executive officer, accusing them of manipulating financial statements.
In conclusion, as AIG’s case and a myriad of others demonstrate, proformas have been invented and used to paint a company’s financial performance in an overly flattering way. In 2003, as part of the new Sarbanes–Oxley legislation (see section 3), the SEC passed rules to crack down on proforma abuses.
Companies who had lost no opportunity to mislead investors made reference to the new regulatory requirements noting that:
● Their proforma statements were not in accordance with GAAP, and
● A reconciliation or restatement would be made at some later date.
The management of these companies could never use the excuse that ‘senior executives did not know …’. As David Schiff pointed out, in AIG’s case, the NYSE’s manual for listed companies writes clearly in black and white that
‘changes in accounting methods to mask’ unfavourable news ‘endangers man- agement’s reputation for integrity’. But who cares?