Accounting Ratios for Account Manipulation

Published Date: 13 Sep 2016 Last Modified: 15 Jan 2018

How companies manipulate their accounts using accounting ratios?

Abstract

The emergence of accounting scandals in the US has shaken the world over. Professionals, stakeholders, shareholders and regulatory authorities blame a multitude of factors for the proliferation of cases like Enron, Tyco, WorldCom and Xerox etc. The researcher is of the view that the rising number of bankruptcies and fraud cases in the corporate sector has been the result of weakness within the financial system and regulatory standards. In the US especially the flexibility of the financial standards has given firms the opportunities to manipulate accounts with the help of financial and accounting professionals for the benefit of top management. These individuals have knowledge of GAAP (generally accepted accounting principle) and its loopholes. They capitalize on these loopholes to the extent of crippling the economy and professional standards. The following research investigates the rationale for firms that resort to accounts manipulation through financial ratios and how it could be curbed. It identifies the measures for counteracting unethical professional behaviour by outlining the core weaknesses within the accounting standards and systems. It also compares the US standards with those of the UK to conclude that the UK is less liable to fraudulent behaviour because its authority has taken measures to strictly regulate accounting professionals, auditors and top executives to avoid engage in accounting manipulation and fraud.

Table of Contents

Chapter 1 Introduction

Background

Rationale

Objectives

Scope

Work Map

Chapter 2 Literature review

Introduction

Enron

WorldCom

Ratios

Differing Accounting Standards in the UK and US

Chapter 3 Research Methodology

Inductive and Deductive Reasoning

Qualitative and Quantitative Research

Secondary and Primary Resources

Research Rationale

Chapter 4 Data collection and analysis

Chapter 5 Conclusion and Recommendations

Bibliography

Appendices

Background

The growing number of accounting scandals with the likes of Enron, Tyco, WorldCom and Xerox etc. has raised cause for concern for stakeholders, shareholders, professional bodies and trade authorities alike. They are of the view that corporate finance has undergone transformation for the worse in the last ten years. Williams’ research (2002) indicates that accuracy of revenues and earnings help in operational decision support and formulation of corporate strategy for almost 60 percent of the firms. Others, approximately 58 percent, feel financial reporting transparency and compliance (93 percent) with external reporting requirements imperative for effective corporate and industry performance. However, the growing number of scandals related to fraudulent earnings, inflated asset values 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 financial information system of public companies and regulatory authority that oversees them. When Enron filed for Chapter 11 bankruptcy on December 2, 2001 and WorldCom did the same later, investors blamed their business failures on accounting manipulations. This practice is not new. In fact according to Mishra and Drtina (2004) some 200 companies in the past five years have restated their earnings as a result of accounting manipulations. CFO Magazine survey indicates chief financial officers (CFOs) are forced to misrepresent earnings or are pressured to violate generally accepted accounting principles (GAAP) to satisfy shareholders and top executive management. Accounting manipulation not only offers the chance for companies like Enron and WorldCom to increase the asset valuation but also to understate liabilities that would appreciate stock prices, hide losses and increase company valuation. The practice is not limited to the US only.

In the UK accounting manipulation is also known as creative accounting. According to Amat, Blake and Dowds (1999) creative accounting refers to "a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business." Since the accounting process itself is flawed in the sense that it provides flexibility, and opportunities for manipulation and misstatement, financial professionals find it easy to engage in creative accounting. The practice helps in presenting increased profits, genuine economic growth and management efficiency whereas the opposite may also be true.

According to Kamal Nasser (1993 qt. Amat, Blake and Dowds 1999) "Creative accounting is the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing 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 damage resulting from accounting manipulation affects the accounting principles that the stakeholders, public and investors depend on and use to estimate, judge and predict corporate performance. The usefulness of accounting principles has regulated industries, balanced 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 value of the investment. Artificial transactions can be used to manipulate balance sheet amount; profits can be moved from period to period; and assets can be re-arranged to depict a positive financial standing.

Amat, Blake and Dowds (1999) are also of the view that companies employ creative accounting to smooth 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 often 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 company’s management can boost share price by reducing the levels of borrowing, lower risks and generate capital through new shares. Using the accounting rules companies often arrange financial accounts so that they would not reflect in the balance sheet, income statement or cash 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 others. In the US for example the FASB (Financial Accounting Standard Board) rules that income from extended warranties may be recognized at the time of sale. Banks may not recognize this when they calculate the debt to equity ratios to allow the company to borrow through inventory. 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, smoothing income to create artificial opportunities for investments and manipulating accounting principles to control market 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 mandate for detailed accounting rather than broad principles, which makes it even harder to detect fraud.

The trend 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 company. Ratios such as return on assets and return on equity are not adequate to gauge the firm's ability to meet debt obligations or to measure the financial distress it is in. Similarly, ratios that accounting models use to tract shifting revenues and expenses through cash flow statement information merely asses the firm's cash level based on operations, 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, company’s stock performance is based on the performance of the stock prices but these values are risk dependent and the prices are set with the assumption that market value of the firm is efficient and the stock prices reflect information 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).

Rationale

When firms are constrained by fraud risks such as: opportunities, pressure and rationalization of unethical management, company information itself forms the basis for high 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 commit fraud, is due 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 understand fraud in the accounting environment write 59 percent of a KPMG 1998 Fraud Survey respondents believe fraud will become more prominent in the future. The reasons they cite include economic pressures, inadequate punishment for conviction, weakening social values, insufficient emphasis on prevention 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 collar 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 certain target and tailor the financial results of the firm to match it. The basic premise is that management can manipulate soft numbers resulting from accrual accounting.

As mentioned earlier firms engage in accounts manipulation due to several reasons some are unethical while others are due to the environment in which they operate. The approach to manipulate accounting principles to benefit from persistent high quality earnings and influence process decisions motivate firms to smooth income, inflate revenues, restate earnings and deflate liabilities. They try to meet the analyst's expectations and company performance predictions (Abdelghany 2005). Other reasons include debt covenant avoidance, costs of investment, sustainable long-term 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. Abuse 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.

Objectives

The objectives of this study are as follows:

1. To investigate how firms like Enron and WorldCom engage in accounts manipulation using financial ratios.

2. To investigate the ethical and professional implications of financial ratios manipulation through accounting misstatements, earnings management and restatements.

3. To study the role of the regulatory authority in contributing or deterring accounts manipulation by comparing the accounting standards in the US and UK.

Scope

The researcher aims to evaluate pertinent industry practice by evaluating case studies of Enron and WorldCom. The researcher shall also delve into issues of accounting principles weaknesses and the role of the authority in contributing to the current 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 might find the use of theoretical frameworks to study a current accounting dilemma 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 Map

The study shall be divided into the following sections:

Chapter 1 introduces the topic 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 topic for discussion in the following chapters.

Chapter 2 is a Literature Review, which shall trace 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 adopted by the UK and US to compare which one is more prone to accounts manipulation.

Chapter 3 shall outline the various methods considered and chosen for the development of the current study.

Chapter 4 is an analysis of the data collected and evaluated from the researcher's point of view based on the expertise of the scholars discussed in the Literature Review.

Chapter 5 shall conclude the findings, and offers some recommendations to resolve the issues outlined in the objectives.

Overview

An 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. Disclosure therefore 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 ethics is relegated through understanding among accountants, auditors, management and executives on the premise that the market is entitled to receive full accounts and reports of companies’ performance as per regulatory authority. The form and content 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 due to limited liability, losses and performance pressure. Any compromise 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 demand of the market, companies have to reshuffle their internal systems to comply with them. The preparation of accounts in accordance to applicable accounting standards often conflict with the company's 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 company's financial standing, analysts use ratios to estimate and evaluate its performance by comparing it with the current status or against the industry's standards. Financial managers of companies are aware of the use of this tool to evaluate company's 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 firm's objectives for the short or long term. For example some companies might inflate earnings per share to depict higher dividend to increase the company's investment attractiveness. Others might deflate liabilities 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 extent constitutes unethical or illegal practice will be investigated in the following sections.

Enron

Among the recent cases of accounts manipulation is Enron. Enron products and services relate to gas and energy 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 company's plan had been to expand into energy trading 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 however 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 despite the fact that the company had been considered one of the fastest growing companies in the industry. While the book value of the assets tripled from $23.5 billion 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 artificial 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 organization's value. In theory the use of earnings management helps firms to manipulate price earning ratios to, firstly show firm's 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 the 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 firm's equity or account for the allocation of resources.

Wamy’s (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 special partnerships to hide debt, inflate profits and to engage in allied unethical and heinous business practices." The company's 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 company's 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 required 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 2002). Further, the company has also abused the fair value framework by using hedging 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 fictitious 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).

WorldCom

WorldCom (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 equal to $11 billion. According to Scharff (2005) the company's 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 mitigate fraud that had become an integral part of WorldCom's operations. WorldCom's 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 WorldCom's 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 engaged 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 department had been encouraged by top management to engage in fraudulent behaviours (See Appendix 2) to cover for the invulnerable position the organization had been in.

However, the most important 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 the 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 compensate for the lack of cash, WorldCom also manipulated the GAAP rules of allowing cash raised through securities sales recorded in the “cash from operations” section, even though the activity is not related to cash flow. (Tergesen 2002).

The motivation according to Zekany, Braun and Warder (2004) stemmed 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 company's performance deteriorated along with the industry yet it had to prove that it performs above the others (Zekany, Braun and Warder 2004). The accounting department 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 difficult 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 save 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).

Ratios

Fraudulent 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 firm's value. Performance 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 write:

"Earnings reported on firms' financial statements differ from cash flows by accounting adjustments known as accruals. These are designed in principle to reflect better economic circumstances...high accruals predict 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 defined in the context of normal return employed in future years. In reality, earnings prediction depends on the value of the index as well as the incremental book/market returns. Frank and Lee (1999) in their research indicate that internationally such a model, when applied to cross-country firms such as Enron or WorldCom tend to produce abnormal returns, resulting in inadequate strategy for comparing stock prices or its performance prediction. In such a condition misevaluations can occur and so does manipulation. This is known as timing. Timing is used to mislead stock events to influence “when and whether” buying actions (Legoria, Cagwin and Sellers 2000). Legoria, Cagwin and Sellers (2000) note that when firms engage in timing of discretionary accruals they are motivated by opportunities for new debts, creditor confidence, and favourable reversals during the period of debt issuance, especially in firms where earnings are volatile they are viewed as risky. Reporting volatile earnings reduce stock attractiveness for investors. For this reason accounting principles allow managers to smooth earnings conducive to positive investment decisions.

Another author Mcmenamin (1999) points out that weaknesses in asset-based valuation methods on the other hand ignores earnings or cash flow generating potential of the firm. Instead investors adopt the price/earnings (P/E) method to predict future earnings to overcome the weakness mentioned above. P/E ratio is a popular method for share valuation amongst investment analysts, managers and shareholders. It gauges the earnings potential of the company's earnings per share (EPS) and compares it with the share's market price. P/E is determined by dividing the market price of the company's ordinary share by EPS. P/E ratios reflect individual circumstances of the company based on the company's returns, risks and future prospects. It is sensitive to the investors' need to asses the company's potential and future performance to wield high returns (Mcmenamin 1999).

However, Chan, Jegadeesh and Sougiannis (2004) are of the view that although ratios have been adequate methods for earnings evaluation, nevertheless earnings manipulation is common practice for US corporations. They find that there are a growing number of literatures that account for the use of accruals to counteract cross-section stock returns such as size, book-to market and past returns. The earnings management approach to report earnings not only relegate manipulation behaviour among managers, but also induce over-optimism over earnings. Earnings management allows accountants and financial managers to adjust cash flows, so as to revert accruals into earnings to meet analysts’ expectations on the firms' future performance. This inadvertently causes low future returns and high current accruals so that the negative effect on future accruals is minimized but there is a great impact on the current earnings. According to the authors, firms with relatively high stock prices, which result in high P/E and high market-to-book (M/B), are motivated to manipulate these stock figures for their own benefit. In the long run however, accruals manipulation often reverts in regressive future earnings. (Campbell and Ammer 1993).

Despite the downside of this practice it is expected that firms engage in earnings manipulation to reflect on negative transaction impact. The magnitude of its effect depends on the itinerary that the firm has used to manipulate earnings such as receivables, inventory, net working capital or total accruals. Such material overstatement or misstatement may, according to Rosner (2003), violate GAAP, depending on the techniques and degree used for deliberate manipulation. Detection is possible through a wide range of existing financial analytical procedures. Kaminski, Wetzel and Guan (2004) are of the view that unintentional and intentional misstatements are possible through analytical procedures such as quantitative and ratio analysis. They point out the use of stepwise-logistic models such as financial leverage, capital turnover, asset composition and firm size, as significant factors for detecting fraudulent financial reporting. Since analytical procedures are endorsed by policy makers, it is also the official method for detecting accounts manipulation in firms to detect bankruptcy earlier. Moreover, such methods ensure that investigation cover limitations and opportunities provided by the accounting principles, adopted by the industry (Kaminski, Wetzel and Guan 2004).

Harrington (2005) writes that financial misstatements can be detected by using ratios to counter check company's earnings and performance information in the financial statement. The author is of the view that income statements and balance sheets produce results that are vague leading to accounts manipulation such as increasing receivables, decreasing gross profit margins, decreasing asset quality, high sales growth and increasing accruals. The problem is mediated by using the following ratios to detect potential fraud:

a. Sales growth index helps in detecting fraud pertaining to companies that manipulate earnings to meet expectations of management and analysts.

b. Gross margin index is another ratio, which allows one to detect the reason why gross margins deteriorate by evaluating cost of goods sold and sales figures.

c. Asset quality index detects total assets congruent to the realization of risks and how proportionate it is to the deferred costs and performance of the firm.

d. Days' sales in receivables index help in the measurement of receivables change that may or may not inflate revenue.

e. Sales, general and administrative index, measure and rationalize the inclusion of expenses that relate to revenue (Harrington 2005).

In each of the above the author points out that the ratios can detect fraud to the extent it has been used to manipulate accounts, that makes the activity criminal, or within the paradigms of the GAAP.

Overall however, Neely (2002) writes "There is thus no definitive set of financial ratios that can be said to measure the performance of a business." Instead, financial ratios merely enable professionals to gauge different aspects of the firm's financial performance to benefit their own cause (See Appendix 3). Financial reports in essential are derived from the use and manipulation of accounting principles. Thus it is not uncommon for firms to "window dress" reported financial statements within the paradigms of GAAP. The occasional use of creative accounting however, must be curbed and that responsibility is entrusted to the external independent auditors.

Differing Accounting Standards in the UK and US

Accounting disclosures and determinants analysis is two of the most important aspects of monitoring businesses in the context of their operations and activities. The majority of the disclosure information for evaluation and analysis have been based on scores of dependent variables that investors, shareholders and the public use to relate to its performance. However, such disclosures are limited by the dominant practice in the market and the firms' culture of published information. Companies like Enron, WorldCom, Xerox and AOL etc. have been subjected to great scrutiny, as they are perceived to have violated provisions for disclosure by the US accounting standards (Chavent M. et al 2004). The general premise had been that the rules used for disclosure, offer rooms for manipulation so that companies can decide to base their accounts reportage based on company operations (Aharony, Falk and Yehuda 2003). The ability of firms to misstate or omit accounts to project positive financial statement disclosures has purported financial fraud, which raised concerns from all spheres. The argument is that GAAP leaves room for fraudulent reporting and accounts manipulation. There are no control systems that counteract great losses from apparent bankruptcies.

According to Spathis and Zopounidis (2002) accounts manipulation is not only costly for the stakeholders and investors but also for the economy. The US with several accumulated declaration of bankruptcies and financial fraud had to acknowledge the fact that there is great need for a regulatory body to counteract them. The Statement on Auditing Standards (SAS) No. 82 considers that, assessment of risks and encouragement of internal control system would mitigate financial fraud. However, even though this standard had been implemented in 1997 it has not been able to deflect fraud risks. Some of the reasons for the inefficacy of SAS No. 82 had been management characteristics, industry conditions, and financial stability (Spathis and Zopounidis 2002).

Rezaee, Olibe and Mimmier (2003) writes that the number of earnings restatements by public companies in the US have sharpened the Securities and Exchange Commission as well as the Stock Exchange(s) to regulate financial reporting process and internal control structure as well as audit functions of firms. The Sarbanes-Oxley Act of 2002 is perhaps the most important legislation that expanded the responsibilities of the accounting authority in the US. It specifies the role of the external auditors and mandatory guidelines for reportage. According to the authors Public Oversight Board (POB) of the SEC Practice Section of the American Institute of Certified Public Accountants (AICPA) (1993) has played an important role in revising corporate governance role in organizational management and accounting management. There are six major requirements that the Sarbanes-Oxley Act of 2002, which affect the role of auditors and the future of financial statements, audit:

"1 the audit committee should be composed entirely of independent members of the board of directors;

2 the audit committee should be directly responsible for the appointment, compensation, and oversight of the work of external auditors;

3 the audit committee should have authority to engage advisors;

4 the audit committee should be properly funded to effectively carry out its duties;

5 auditors must report to the audit committee all "critical accounting policies and practices" used by the client; and

6 the SEC should issue rules to require public companies disclose whether at least one member of their audit committee is a "financial expert." (Rezaee, Olibe and Mimmier 2003).

Despite these mandates however, generally accepted auditing standards (GAAS) and a host of other regulations seem to be under progress and require professional associations’ acceptance for effective implementation. Moreover, there is great need for the SEC to be vigilant of corporate activities of public companies especially on the top management including the chief executive officers and chief financial officers by subjecting them to stiff penalties for fraudulent behaviours. Nevertheless, Caro and Maoz (2003) are of the view that GAAP compliance and SEC mandates through the Sarbanes-Oxley Act is inadequate as these do not have internal controls for disclosure of all financial information necessary for gauging firms' performance or for gauging misleading and manipulating activities (Caro and Maoz 2003).

Lawrence (2002) is of the view that accounting irregularities in the US have critical roles in implicating "the future development of the accountancy profession" at the global level. It also affects global policy makers such as those in the UK to set standards and regulate fraud. In the UK, the author notes the Statements of Standard Accounting Practice (SSAP) and the Financial Reporting Standards (FRS) and the International Accounting Standards (IAS) are responsible for regulating one set standards of reportage. This convergence model according to Lawrence has been critical in aligning change in the UK GAAP with the IAS. The IAS has become a regular national standard for practice. However, the UK SSAPs and FRSs differ from the Accounting Standards Board (ASB). This is because the UK operates on the basis of local standards but sometimes have to meet the regulatory requirements as set by the European Union. The differences within these standards and its adoption expose companies, investors and shareholders to discrepancies and opportunities for fraud. Like the US GAAP, the FRS 18 Accounting Policies and the IAS 8, record net profit or loss, fundamental errors and changes in accounting policies with room for individual interpretation. Although the accounting policy has set a benchmark for adjustment of accounts, nevertheless it still exposes earnings and adjustments of retained earnings in the balance sheet, to fraud.

Alternatively, Bruce (2005) writes that post-Enron measures have undermined the confidence of firms and professionals alike. In the UK, the formation of the Financial Reporting Review Panel, under the directive of the Financial Reporting Council, has outlined regulations to govern reporting as well as measures for reporting anomalies. The UK is challenged by the events in the US. To counteract potential financial manipulation the authority has selected measures that would help detect fraudulent behaviours, as well as firm's tendency to breach legislation.

Inductive and Deductive Reasoning

Research in any field is carried out with the view to acquire knowledge or to critique learned phenomenon. Acquisition of knowledge requires rationale by thinkers to validate the information acquired to the present day. Contemporary research in this context is based on two stages of research rationale, namely: inductive and deductive reasoning.

Inductive reasoning is defined as follows:

“A process whereby from sensible singulars perceived by the senses, one arrives at universal concepts and principles held by the intellect." Johnson-Laird and Byrne 1991). Thus inductive reasoning could be described as the movement of knowledge from the specific to the general. Inductive research and rationale is based on the recognition of facts and fundamental reality to connect with broader accepted frameworks. Judgment as to the acceptance of the occurrence of the case, event or rationale could then be passed to establish new or endorse existing facts.

Deductive reasoning on the other hand is defined by Spangler (1986) as follows:

"The human process of going from one thing to another... In other words the rational person by means of what he already knows is able to go beyond his immediate perception and solve very obscure problems" (Spangler 1986). Deductive research comprises of expanded knowledge derived from general theoretical frameworks adopted by theorists and studied by peers. Knowledge can be derived from the generalized theories to study the subsequent specific data, hypothesis or research rationale.

Depending on the nature of the study, researchers may adopt the deductive or inductive reasoning for rationalizing research outcomes.

Qualitative and Quantitative Research

Research is also organized according to the qualitative or quantitative research, depending on the outcomes that the researcher desires to achieve. According to Myers (1997) application of research methods depends on the disciplines and fields of use. Qualitative research is usually adopted by social science researchers who study social and cultural phenomenon. Qualitative methods, such as action research, case studies, and ethnography for example, rely on data sources from observation and participation to document the researcher's observations (Myers 1997).

Alternatively quantitative research is developed and used in the investigation of natural sciences. Survey methods, lab experiments, numerical calculations and mathematical modeling are some examples of quantitative research methods, which are used to deduce accurate numerical results. One of the disadvantages of quantitative results is that it is limited to the numerical values that are acquired through formulas or mathematical instruments. Any interpretation is wholly dependent on the values set by the pragmatic relevance of the numbers.

On the other hand qualitative research often seeks exploratory study, observation and objective interpretation of theoretical frameworks before any kind of deduction is made. Qualitative study is more preferred by the social sciences because it offers plenty of room for rationalizing different perspectives leading to several alternatives for resolutions.

Secondary and Primary Resources

Research studies are often based on established frameworks and peer publications. This can be acquired from the review of secondary or primary research. Secondary resources refer to documents such as newspapers, magazines, Internet and works citing others. On the other hand primary resources refer to first hand account whether published in the form of books, journals, observations or interviews. Usually research studies combine primary and secondary resources to ensure no perspective is left unturned. However, there are some studies that solely rely on secondary or primary resources.

Research Rationale

For the purpose of achieving the objectives of this research the researcher has chosen to adopt the combination of deductive and inductive research. The premise is that the issue of accounts manipulation is not an isolated incident pertaining to Enron or WorldCom alone but is shared by a host of US and UK companies. It is therefore ideal to adopt both approaches to develop a theoretical framework to study the rationale behind the rapid development of corporate scandals, resulting from accounts manipulation and how it can be detected through ratios.

As far as the choice of qualitative and quantitative research is concerned, the researcher has chosen to adopt a qualitative approach. This is because the topic of accounts manipulation and ratios pertain objective discussions only. It investigates and traces the development of accounts manipulation through financial ratios, and how firms can be checked to curb such practices in the future. There is no need for hypothesis testing or derivatives due to the limitation of space and time.

Secondary and primary resources have been used to form a major part of the study outlining the theoretical frameworks, as well as in understanding the rationale of firms' motivation to engage in malpractice. The inclusion of both secondary and primary resources is also due to desire for study of diverse expert views and opinions.

At the beginning of the study the researcher has set the following objectives, the results of which are analyzed below:

1. To investigate how firms like Enron and WorldCom engage in accounts manipulation using financial ratios.

The Enron and WorldCom debacles are the result of an inefficient US stock market. The firms had been strived with industry performance pressure and analysts expectations so much, that they have to sustain earnings growth. Enron for example due to the deteriorating oil and gas sector has been forced to adopt creative accounting measures to hide massive debts. The rationale had been to present positive earnings whereas the reality had been otherwise. Firms like Enron adopt accounts manipulation because they are aware of the strategies adopted by investors, analysts and creditors to measure the performance of the firm. By inflating earnings and deflating liabilities Enron stands to gain when these professionals use financial ratios to gauge its performance. Enron had been able to engage in restatements and manipulation of accounts due to the inefficient financial reporting systems and regulatory standards in the US.

This pattern is also seen in other bankrupt and fraudulent companies including WorldCom. The literature review clearly indicates organizations that modulate unethical practices often vie for weakness within the control system for their own benefit or to comply with industry pressures. In the case of WorldCom it had been the industry environment pressure, as well as the corrupt groupthink behaviour of the people working in the company. WorldCom, as Tergesen (2002) notes, had been forced to present a positive operational performance and income to increase its potential, for raising capital, despite the risky stocks it harbours.

Clearly the examples of WorldCom and Enron depict accounting system weakness and unethical behaviours of executives, which have resulted in the manipulation of accounts. They have capitalized on the loopholes within GAAP and the frequent use of financial ratios as strategies used by investors to gauge firm performance.

2. To investigate the ethical and professional implications of financial ratios manipulation through accounting misstatements, earnings management and restatements.

Fraudulent accounting is costly not only to the shareholders but also to investors, stakeholders, public and the economy. Financial manipulation to misstate earnings or to restate earnings impact the wider economy if not prevented in time. According to Kedia and Philippon (2005) Enron and WorldCom's cases illustrate the point that misreporting and manipulation of accounts result in long-term slow productivity. Moreover, when firms are proven guilty of such malpractices top management’s integrity, organizational culture and structure become questionable.

According to Kaminski and Wetzel (2004) for example professionals engaged in the efficient relegation of public traded company information, reporting of credible financial statements, and those who monitor the firms' performance are responsible for maintaining the standards and benchmarks set by the industry, economy and the authority. Earnings misstatement, fraudulent behaviours as well as manipulation of accounts information affect ratios and thereby investor decisions undermine the professional bodies that govern the financial structure and paradigm as well as public accountability standards.

Experts are of the view that firms like Enron and WorldCom, which engage in reporting abnormal returns to inflate stock prices and affect buying decisions, create opportunities to breed unethical behaviours but also give the impression that it is alright to falsify earnings for the benefit of stakeholders. In such cases the executives and stakeholders working in the firm are not the only ones to blame. Accounting regulations through the help of policy makers are being developed hastily without consideration for loopholes offer opportunities for unethical behaviour. When combined with industry pressures and high-risk levels, firms are bound to resort to manipulation and fraudulent behaviour to protect their interests.

3. To study the role of the regulatory authority in contributing or deterring accounts manipulation by comparing the accounting standards in the US and UK.

In such cases the regulatory authority is responsible for developing deterring measures to curb fraudulent behaviours. In the US such measures could be viewed in the form of accounting standards, legislation and new legal mandates such as SAS No. 82 and the Sarbanes-Oxley Act. Nevertheless, these mandates are still at the initial stage of development. As strict regulations are applied and firms are required to measure against benchmarks, new loopholes are expected from the new standards and regulations. This is not to say that the US accounting system is weak and encourages accounts manipulation. In fact, the plethora of accounting scandals and firms engaged in financial frauds are the results of opportunists or firms that are pressured by peer and industry performance.

In the UK likewise regulations are set similar to the US but due to the risks and encouragement from local and EU, regulators have become more vigilant. It is one of the reasons why the UK has witnessed lesser incidents of fraud and misstatements as compared to the US. Furthermore, the UK GAAP is based on a combination of local and international standards dissimilar to the US. As a result firms have to strictly adhere to the mandatory guidelines for reportage as well as ethical conduct. Nevertheless, the UK could be said to comparatively follow a stricter guideline that discourages accounts manipulation with lesser loopholes and opportunities for firms to manipulate financial strategies and ratios to project false performance and earnings. Earnings management have a significantly different meaning when compared between the US and UK.

Overall, the literature review and study on the development of Enron and WorldCom's bankruptcies indicate that there is great potential within the GAAP to proliferate accounts manipulation and financial ratios manipulation. This is because a large body of professionals is engaged in investment decisions based on accounts ratios. It is easy to pin point frequently used ratios by investors, shareholders and the public to make investment decision. Even credit institutions find it relatively easy to depend on financial ratios, to gauge a firm's sound performance and quality materiality despite the fact that they are weak strategies.

Researchers in the past have affirmed the importance of financial statements for the purpose of accountability. It is recognized as the communication standard for the firm as well as the statement of governance. However, when financial statements do no follow the standardized benchmarks and quality required by its audience it translates a different message that may render information useless to its users. Financial misstatements, restatements, manipulation of accounts information to alter financial ratios and fraudulent disclosures result in public doubt and undermine investment confidence. When one reads of Enron and WorldCom and a host of other companies following the same path the pattern depicts a sad and deteriorating corporate discourse, which needs to be re-evaluated and revised. In the context of the above research, the researcher has come to the following conclusions for which some recommendations have been offered:

a. Enron and WorldCom's bankruptcies have proven the fact that the current accounting standards have loopholes that firms can manipulate for their benefits. Accounts manipulation such as earnings, inventory, receivables and liabilities manipulation can result in positive financial performance for the firm to attract or sustain investor interests. In the case of Enron earnings have been "managed" to inflate revenue while liabilities have been shifted to partnership accounts to depict low debt to equity ratio. Similarly, WorldCom has been pressured by the industry to perform to the expectations of analysts. To sustain its position as the second largest telecom company in the US it resorts to financial manipulation to indicate high material assets whereas its resources had been intangible. Such manipulation of accounting principles is regular but the extents to which these firms have utilized them have raised cause for concern for the professional bodies as well as industry stakeholders.

Recommendation: It is recommended that stricter measures through combined efforts of the professionals as well as industry stakeholders to curb such practices.

One measure could be through corporate governance while others may include the setting up of benchmarks and regulatory authority that scrutinize the financial statements and financial systems of firms more closely on a regular basis. Penalties should be levied to ensure there is no repetition of such unethical behaviours among corporate leaders.

b. Experts are of the view that the rising numbers of accounting scandals have been the result of weak accounting standards and control systems. Upon reviewing the various aspects of the accounting standards it has been revealed that the US accounting standards is comparatively weak to the UK in the sense that it is flexible. This flexibility allows users to adapt the principles and standards according to the need of the industry. Yet it is the same fact, which is being used in an unethical manner for the benefit of chosen few - namely the management of firms and high-level executives. They manipulate and violate accounting principles to resolve issues of financial performance, sustaining stock prices as well as investment attractiveness.

Recommendation: To resolve, it is recommended that accounting standards and control systems should be standardized. These should also be based on strict regulations that leave less room for flexibility to allow fraudulent practice. Furthermore, those who implement them such as auditors and accountants should be held accountable for any kind of financial fraud by giving them more power over firm's management.

c. Accounting standards and regulatory bodies in different regions of the world have different legal requirements to meet the requirements of particular region or industry of their own country. However, when firms operate at the international level it is easy for them to refer to international standards to deviate from the report requirements or financial disclosure. For this reason, Enron and WorldCom had been able to capitalize on their multinational status to manipulate financial statements.

Recommendation: For this purpose, it is recommended that there be one harmonized system to help organizations follow similar standards and legal requirements even when they operate abroad.

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