Fraud in Financial Statements 2014031077, 9780415742702, 9781315814391

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Fraud in Financial Statements

As the monetary cost of fraud escalates globally, and the ensuing confidence in financial markets deteriorates, the international demand for quality in financial statements intensifies. But what constitutes quality in financial statements? This book examines financial statement fraud, a topical and increasingly challenging area for financial accounting, business, and the law. Evidence shows that accounting anomalies in an organization’s financial statements diminish the quality and serviceability of financial information. However, an anomaly does not necessarily signal fraud. Financial statement fraud is intended to mislead shareholders and other stakeholders. In this book, elements that underpin diversity of accounting anomalies likely found in fraudulent financial accounting statements are revealed. Multiple research methods are used in the analysis of selected international fraud cases, each illustrating examples of financial statement fraud, including: revenue recognition, overstatement and/or misappropriation of assets, understatement of expenses and liabilities, disclosure fraud, bribery and corruption. Additionally, the phoenix phenomenon with regard to fraud in financial accounting is investigated. Drawing on documented observations of commercial and legal cases globally this study highlights the necessity for continued development of financial audit practices and other audit services. Julie E. Margret is Senior Lecturer in the Department of Accounting at La Trobe University, Australia. She is author of Solvency in Financial Accounting (Routledge, 2012). Geoffrey Peck is Principal in Deloitte’s Forensic group, based in Melbourne, Australia. Prior to joining Deloitte in 2009, Geoffrey was a Director with PricewaterhouseCoopers and also served for more than 21 years with the Victoria Police, including seven years as a Detective Sergeant with the Major Fraud Group. He is one of Deloitte’s most experienced risk management specialists and has undertaken risk management work extensively throughout the Asia Pacific region and the Middle East.

Routledge Studies in Accounting

1 A Journey into Accounting Thought Louis Goldberg Edited by Stewart A. Leech 2 Accounting, Accountants and Accountability Post-structuralist positions Norman Belding Macintosh 3 Accounting and Emancipation Some Critical Interventions Sonja Gallhofer and Jim Haslam 4 Intellectual Capital Accounting Practices in a Developing Country Indra Abeysekera 5 Accounting in Politics Devolution and Democratic Accountability Edited by Mahmoud Ezzamel, Noel Hyndman, Åge Johnsen and Irvine Lapsley 6 Accounting for Goodwill Andrea Beretta Zanoni

9 Law, Corporate Governance, and Accounting European Perspectives Edited by Victoria Krivogorsky 10 Management Accounting Research in Practice Lessons Learned from an Interventionist Approach Petri Suomala and Jouni Lyly-Yrjänäinen 11 Solvency in Financial Accounting Julie E. Margret 12 Accounting and Order Mahmoud Ezzamel 13 Accounting and Business Economics Insights from National Traditions Edited by Yuri Biondi and Stefano Zambon 14 The Nature of Accounting Regulation Ian Dennis

7 Accounting in Networks Edited by Håkan Håkansson, Kalle Kraus, and Johnny Lind

15 International Classification of Financial Reporting, Third Edition Christopher Nobes

8 Accounting and Distributive Justice John Flower

16 Fraud in Financial Statements Julie E. Margret and Geoffrey Peck

Fraud in Financial Statements Julie E. Margret and Geoffrey Peck

First published 2015 by Routledge 711 Third Avenue, New York, NY 10017 and by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Routledge is an imprint of the Taylor & Francis Group, an informa business © 2015 Taylor & Francis The right of Julie E. Margret and Geoffrey Peck to be identified as authors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging-in-Publication Data Margret, Julie E., 1950– Fraud in financial statements / by Julie E. Margret and Geoffrey Peck. pages cm. — (Routledge studies in accounting ; 16) Includes bibliographical references and index. 1. Misleading financial statements. 2. Accounting fraud. 3. Fraud. I. Title. HF5681.B2M287 2015 364.16'3—dc23 2014031077 ISBN: 978-0-415-74270-2 (hbk) ISBN: 978-1-315-81439-1 (ebk) Typeset in Sabon by Apex CoVantage, LLC

This book is dedicated to my family and my friends without whom life would be so empty. I thank you sincerely for your continued support, friendship, and love. Julie Margret This book is dedicated to Daniel, Jarrod, and Aaron, my three sons who still take the time to look after their ‘old man.’ To Jarrod in particular who helped me navigate the occasional computer dilemma during the writing of this book. Geoff Peck

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Contents

Preface Acknowledgments

ix xi

1

Management and Fraud

1

2

Stakeholders, Governance, and Corporate Culture

21

3

Quality in Financial Statements

40

4

Fundamental Elements: Assets, Revenue, and Expenses

59

5

Financial Obligations: Liabilities

84

6

Phoenix Activity: Companies in Crisis

108

7

Fraud and the Phoenix Rising

132

Glossary Index

141 143

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Preface

This book explores the question of why fraudulent endeavours can be so well hidden in financial statements. This is important as financial statement fraud (FSF) continues to be an increasingly challenging area for global business, financial accounting, and the law. Principally, this work reconsiders the constructs of financial accounting with particular regard to the problem of fraud in financial statements. Hence this study examines FSF that is sometimes referred to as management fraud. This is notable. Firstly, it emphasises that management are responsible for the financial statements and their content. Secondly, that management generally are in a position to alter, enhance, or impair the accounts if they so choose, or deem it appropriate. Those in positions of authority and power have incentives to portray the business they direct or manage in a sound financial state. Sometimes this is done whether the financials are exact or not. Such motivation is heightened when the business is financially unsteady. Fraud committed in financial statements is intentional, it distorts the reported financial position of a business entity and its financial worth. The deceit has the capacity to cause great harm to communities in both a social and economic context. So drawing on an array of national and international cases that have bewildered and confused many, we further explore this phenomenon. The underlying framework has regard for Cressey’s theory of the fraud triangle that is used in conjunction with elements of stakeholder theory. This convergence provides the story with a practical and comprehensible foundation. The aim is to examine fundamentals of accounting and financial accounting constructs that recur in circumstances of FSF and to explore the context in which those elements might enable FSF. The objective in that analysis is to reveal accounting dilemmas for directors and managers. A particular instance is with regard to business reconstructions in the face of financial distress. Hence, linkage between management concerns, financial accounting choices, and fraudulent behaviour are examined. The likely connections warrant scrutiny as the resulting actions can lead to error, mismanagement, or fraud.

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Acknowledgments

This book is the result of the patience and forbearance of many. To my family and friends for their tireless support and encouragement in my continued pursuits—thank you. To my colleagues in the Department of Accounting at La Trobe University, I extend my sincere appreciation for the friendship and cooperation that so many of us have shared across the years. To the publishers Routledge and their amazingly supportive staff, thank you for the opportunity, for your advice along the way, and for your belief in the substance of this research. To those scholars upon whose work this study hopes to build, thank you for your clarity of thought and your tireless pursuit of knowledge. We also thank Transparency International for their permission to reproduce the Corruption Perceptions Index Map within this book. We thank Jou-juo Chu of the National Chung Cheng University of Taiwan for permission to reproduce his table of ‘Port Reform Strategies and Union Reactions in New Zealand, Australia, and Taiwan’ from his conference paper (2007) presented in Auckland, New Zealand. That diagram is included in our chapter six as Table 6.1. Sincerely we thank you all. Julie Margret I add my sincere thanks to the publishers Routledge and their staff for believing in this project. To Transparency International, thank you for your efforts in producing the Corruption Perceptions Index, which you kindly permitted us to reproduce and for your pursuit of transparency, accountability, and integrity. I particularly thank Dr. Julie Margret, who conceived the idea of this book and carried such a heavy load to make it a reality. Geoff Peck

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1

Management and Fraud

At the entity or micro level, the executives who run the business have a good deal of freedom to choose among alternative ways of presenting its operating results and its financial position. (Solomons, 1989, p. 1)

INTRODUCTION This book examines financial statement fraud (FSF) sometimes called management fraud.1 Fraud committed in financial statements fundamentally distorts the monetary position of a business entity and its financial worth. The deception has the capacity to cause great harm in both a social and economic context. There are numerous ways in which to commit fraud in financial statements of account. Drawing on an array of national and international cases, we explore this phenomenon. To elaborate necessitates a framework that herein we base on Cressey’s theory of the fraud triangle.2 It also requires a clear description of the fraud investigated. Hence we define FSF as: Fraud in financial statements is an act of deliberate deceit that results in a misleading representation, material misstatement or intended exclusion in a business entity’s financial accounts. The deception is committed with the intent to mislead shareholders and other stakeholders about the financial state of the business entity. The fraud may misleadingly relate financial circumstances, or an otherwise non-financial material fact. Previously the Treadway Commission (1987, p. 2) advised they ‘defined fraudulent financial reporting as intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements.’3 ASIC (2005, p. 3) stated: ‘Definitions differ, but the common thread is that financial statement fraud involves deliberately misleading or omitting amounts or disclosures in financial statements in an attempt to deceive financial statement users, particularly investors or creditors.’4

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Management and Fraud

That FSF may be called management fraud is notable. First, it emphasises that management are responsible for the financial statements and their content. Second, they are in a position to alter, enhance, or impair the accounts. Arguably those in positions of authority with a degree of power have an incentive to portray the business in a healthy, sound financial state—whether accurate or not. Such motivation is heightened when the business is financially unsteady. Hence those in senior positions are more likely to rationalise fraud in financial reports, and in all probability they have the opportunity to do so. The underlying pressure that motivates the fraud may or may not be evident. Importantly it is not always senior management who solely commit FSF.5 Others in positions of some authority (such as middle managers, department heads, or supervisors, who have the incentive and see the opportunity) are possible contributors. Bonus schemes based on increasing revenues, decreasing or stabilising costs, across the organization or by department, are likely motivators. Essentially anyone with the opportunity to commit fraud, especially if under some perception of pressure to do so, may well rationalise the act. The fact that pressure is perceived is significant. The perception of pressure will affect people in different ways. Some people will react adversely and subsequently their choices may not be well considered. Others may not be swayed or coerced.6 So not all people suffering pressure under similar or dissimilar situations will participate in or become perpetrators of fraud. In 2013 KPMG reported results of their international survey that revealed characteristics of a typical fraudster who would likely, among other things, be 36–45 years, acting mostly in fraud against their organization and employed in a middle management to senior/executive position.7 Given the difficulty of amassing details of all fraudulent activity many argue there is no particular profile of a fraudster.8 We believe the latter is a more realistic and impartial an approach. If organizations focus on a particular profile of a fraudster, actual occurrences of fraud may go unchecked. Hence Cressey’s theory of the fraud triangle is based on three fundamental factors: perceived pressure, opportunity, and rationalisation. The fraud triangle, though, has two parts, the factors or motivators to commit fraud and the elements of fraud. Fundamentally the elements of fraud are theft, concealment, and conversion.9 This theoretical concept is expanded diagrammatically and discussed further with regard to stakeholder theory in chapter two. In sum, for FSF to occur the perpetrator/s will suffer under some form of perceived pressure, and where the opportunity to relieve that pressure is evident, the perpetrator/s will rationalise the fraud. In that vein, the fraudster proceeds to steal from the company, conceal the theft, and convert what has been stolen into some other form. Hence, the framework to underpin the problem is established.

Management and Fraud

3

Incentives / Pressures

Theft

Concealment

Conversion

Attitudes / Rationalisation

Diagram 1.1

Opportunity

The Fraud Triangle: Factors and Elements

Source: The diagram has been devised by the authors based on Cressey’s (1919–1987) theory of the fraud triangle.

THE PROBLEM FSF continues to be a topical and an increasingly challenging area for business, financial accounting, and the law. The problem of fraud is a global problem, particularly from a practical and public policy perspective, as the monetary cost of fraud escalates and the ensuing confidence in financial markets deteriorates.10 In this environment, stakeholder demand for quality in financial statements intensifies. Debate about what constitutes quality in financial statements continues. This is not least because many business organizations throughout the world continue to collapse unexpectedly.11 At times this occurs after the business has published financial statements that portray the entity as financially sound.12 This is perplexing and the circumstances of each case warrant scrutiny. Arguably shareholders and other stakeholders may expect an entity’s published financial statements to be precise and informative, and that the financial details within the statements are serviceable to their needs. It is evident, however, as reportedly profitable and financially sound business organizations do collapse unexpectedly that seemingly uninformative, imprecise financial details are sometimes published. If the intent in those publications is to mislead the readers of those financial reports, then almost certainly FSF prevails. This is likely to occur where the entity’s attention to governance

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Management and Fraud

and its internal control environment are lacking. In that context the culture generated throughout the organization is of concern. An organization’s culture grows from a combination of factors throughout the entity. Mostly it is a philosophy that emanates from the top and it is essentially that which drives the organization’s culture, work ethic, and spirit. So the outcomes of decisions, actions, and behaviour of the directors, executive officers, and managers spread throughout the business. Consequently, that tone will affect the attitude and behaviour of all employees. If dishonesty is endemic, then the probability of fraud committed for the organization, as well as against the organization, will in all likelihood occur. An act committed for the organization usually is intended to portray the financial state of the business in a much stronger position than it actually enjoys. There are many reasons why this may be done and many ways in which it may be achieved. On the one hand, assets and their financial equivalents might be intentionally misreported, expenses may be understated, liabilities might be undisclosed, and details in the notes to accounts could be uncommonly vague.13 Alternatively relevant details about the organization’s business activities and the outcome of some might not be disclosed or may be ill-defined. In which case the financial statements and accompanying notes published to inform shareholders and other stakeholders will be imprecise or false. As such the market is misinformed. Sometimes fallacious accounts and erroneous stories radiate widely throughout business and are not ever discovered. Thankfully many are and the likelihood of discovery into the future increases, as awareness of FSF and unacceptance of its outcomes across communities increase. Progressively investors, regulators, and others realise the adverse social and economic outcomes of fraud and FSF to local, national, and international communities. Those interested seek further data, information, and explanation to enable their education and vigilance. To identify how best to combat the problem necessitates a heightened attentiveness to detail, awareness, and continued investigation. Evidence shows that experienced, well-educated, knowledgeable professionals and regulators and business participants generally can be deceived, and sometimes for a long time.14 Instinctively a business organization in an apparent healthy financial condition is unlikely to be questioned. It is most likely to enjoy a stable reputation, continuing business operations, and, if a listed company, a healthy market capitalization position. On the other hand, a business that is seen to be floundering financially is likely to be pursued by its creditors, experience diminishing support from its financiers, and observed with increasing caution by other investors. In which case, the management team or part thereof might be tempted to do something to augment the organization’s published financial story. Given the incentive some managers may easily rationalise a necessity to fiddle the figures to help the financially challenged business to look good—even if it is for a short while.

Management and Fraud

5

The motivation to commit such fraud may stem for example from personal greed, coercion from others, or a misguided attempt to maintain the business’ status.15 In a bizarre form of perceived altruism, the focus may be to retain the reputation of the company, to sustain employment opportunities for staff, and to maintain or grow financial returns to and for shareholders. On the other hand, the latter may also constitute an element of personal greed whereby the perpetrators, through shareholdings, options, or the like, secure a financial reward and also retain their employment, reputation, and status. Many cases of unexpected corporate collapse and fraudulent endeavour16 indicate the necessity for further research into the constructs that underpin FSF. The reasons why perpetrators embark on the journey are at times exposed.17 In other cases the actual reasons may not ever be known. Perceptions of why perpetrators commit FSF warrant further research but that is beyond the scope of this book. Herein we explore and analyse critically, elements of financial accounting that may contribute to FSF. In this vein we investigate how best to mitigate opportunities for FSF to persist into the future.18 In that context we examine a particular construct sometimes utilized by business that facilitates asset transfers and off-balance sheet liabilities. This activity is known as the phoenix phenomenon. Otherwise it is deciphered as a complex area of re-structuring companies under the guise of a phoenix. Interestingly it is a type of business reconstruction that can be legal or illegal. It is an area that is, in part, explained but it is not well defined in accounting or the law. It is also an area that is rife for fraud. Hence a major contribution of this work to the deliberations of FSF has regard for phoenix activity. This particular spectacle of business is explained and analysed with supporting case examples in chapter six. ELEMENTS OF FRAUD IN FINANCIAL STATEMENTS In financial reports there are many components to consider. Each part contains fundamental elements that may seem innocuous, but provide opportunities for fraud. Revenue (sales and revenue recognition), asset misappropriation (valuation, theft), expenses (periodicity, matching, capitalization), liabilities (obligations disclosed or non-disclosed), and inventory (valuation, COGS, units of work in progress, units obsolete) are the common subjects of fraud. They may also be the subject of error. So, to recognize anomalies that may exist in and between such accounts is imperative. A business and its attention to its internal control environment, its governance (culture), and its fraud risk management are crucial in helping to identify, mitigate, and prevent FSF. Consider the circumstance where inventories of a business’ physical assets say, its computers, were inaccurate. It is likely that the recorded

6

Management and Fraud

details of its computers (stock on hand) would be wrong. Subsequently, details of the number of computers held and the total financials of all its assets as recorded would be incorrect. In which case, the internal controls and the accounting systems might well be considered lacking. In addition there may be inadequate supervision of staff or a scarcity of fraud-related training programs for employees. Furthermore there may not be an effective code of conduct documented, communicated, emphasized, and expected throughout the organization. In effect the employees responsible for accurate record-keeping might be inept. Alternatively they may be incompetent or lazy, or both; or there might be an absolute intent to mislead that indicates fraud. To differentiate is essential. Irregularities in the accounts are anomalies.19 Accounting anomalies can arise when, for instance, details on invoices, claims forms, despatch dockets, and such are incorrectly recorded. If so, the anomaly results in incorrect entries in journals, ledgers, and ultimately incorrect details in the financial reports. This can be of detriment to the business. The accounting anomaly, however, may be fraudulent; or it might be a mistake. The organization, for instance, might have a computer malfunction in terms of incorrect reporting due to incorrect data input and/or an accounting software problem. Within the system there may be missing documents or payments made on duplicate invoices. The latter again may indicate fraud, or incompetence, as well as a lack of internal control. Anomalies in an organization’s financial statements diminish the quality of the financial details and as such they do misinform. To the extent that the misinformation is considered material may decide the extent to which the event is investigated. As fraud necessitates intent to deceive, if there is no such intent, there is no fraud. Analytical anomalies refer basically to unusual relationships between accounts, or strangeness in events. For instance, if the relationship (connection) between relevant accounts (e.g. sales, revenue, inventory, cost of goods sold) does not make sense, given a certain set of transactions, this indicates that something is likely wrong. Any situation that appears out of the usual—too odd, too abnormal, unbelievable (an extreme departure from common sense)—is questionable. Examples of questionable anomalies include a somewhat inexplicable number of items missing from inventory, apparent excess purchases when sales are declining, and seemingly excessive expenses in an accounting period.20

A Critical View of Financials FSF is intended to misinform. Accounting and analytical anomalies, although odd, may signal the possibility of fraud but may not be indicative of actual fraud. In that context, specific elements of financial statements are significant, and the manner in which financial statements are compiled matters. The way essentials within the financial statements are treated in the recording process is of concern. Partly because the suite of published financial

Management and Fraud

7

statements of an entity’s financial condition contains a conglomeration of pecuniary interests across time.21 Gul et al. (1991, p. 532) further explained: [T]he financial statements . . . [are a] mixture of recorded facts such as cash at bank; accounting conventions such as use of the lower of cost or net realisable value rule for inventory valuation; postulates such as the going concern postulate . . . and personal judgements applied to estimate the provision for doubtful debts or select the method used in calculating depreciation of fixed assets. Choices available in interpreting accounting standards also challenge management. In the case of the HIH group: ‘misinterpretation of the [accounting] standards . . . [in part] allowed HIH to publish financial statements that did not truly or fairly represent the financial position or performance of the HIH group’ (Justice Owen, HIH Final Report, 2003, p. 4, s. 7). In that context, conventional financial statements of account are in all probability questionable. To illustrate further, consider the capitalization of expenses. Where, for instance, a sizeable expense incurred in a current period may arguably add value to the business by generating revenue across future accounting periods, and so the expense is capitalized. It is then called an asset, and the cost is spread across a designated number of future accounting periods. The number of accounting periods may well be wisely chosen based on past experience but, it is still problematic. This is not least because the future is unknown and so the reported revenue that may be generated from, or matched to, this “asset” is at best an estimate. The result sometimes is an inaccurate guesstimate or, with intent to de-fraud, an absolute nonsense. On the other hand, in the case of the Burns Philp Group, who arguably rightly capitalized restructuring and rationalization costs and slotting fee expenses, soon found that decision to be destructive to their business. The procedures revealed ‘reduced reported costs at a time when the Group’s business expenses were actually rising’ (Margret, 2012, p. 136).22 Other wrongly applied instances arose in the circumstances of ‘WorldCom’s capitalisation of [its] operating expenditures, [and] Waste Management’s lengthening of its truck fleet’s assets’ lives to decrease amortisation charges, [plus] Enron’s and Xerox’s front-end loading of revenues . . .’ (Clarke et al., 2003, p. 329). Recognition and measurement concepts that underpin financial statement content evidently require considered thought in application; and even then can be wrong. Generally accepted accounting practices can, and arguably do, exacerbate doubtful decisions and habitual behaviour of management in financial reporting. ‘Traditionally financial reporting has not reported explicitly the risks and uncertainties associated with an entity’s activities and financial position’ (Loftus and Miller, 2000, p. 41). Yet, arguably, management are in a position to do better. They are in a position of trust, accountability, and responsibility and have a duty to exercise good

8

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business judgement. On that basis management ‘must exercise their judgement responsibly; and this includes being able to provide an account not only of what they have decided, but why. This can be incorporated into reporting systems and systems of accountability’ (Cohen and Grace, 2001, p. 118, emphasis in original). Qualitative characteristics within accounting recognition and measurement concepts demand such attention. Importantly, the characteristics of relevance and reliability are given equal billing. Yet relevance is thwarted frequently in financial accounting; disregarded in favour of reliability. Kranacher et al. (2011, p. 413) explained: ‘Relevance implies that certain information will make a difference in arriving at a decision [arguably important]. Reliability . . . means that the user can depend on the factual accuracy of the information.’ Yet the factual accuracy as recorded on an invoice for instance may be incorrectly recorded, or made up—hence, completely wrong. In financial accounting we disregard (at times) that which may be relevant in favour of that which is considered reliable. Mainly because the former is likely subjective and the latter is verifiable by document. In the challenge to mitigate and prevent FSF both relevant and reliable characteristics of all data, financial and otherwise are vital. In forensic solutions to FSF this must be acknowledged. To commit FSF seemingly requires knowledge, influence, and/or a position of power. Thus, individuals who hold positions of authority at senior levels of an organization are reasonably the most likely to commit or to be involved in the fraud. Possibly because they have the clout, the opportunity, the reason, and debatably they have the expertise to do so. MISMANAGEMENT AS OPPOSED TO FRAUD In numerous cases of unexpected corporate collapse, management and their mismanagement of a business organization’s resources have been blamed for business failure.23 Recall, business failure does not denote fraudulent behaviour necessarily; however, it does not wipe out the possibility. In the case of HIH (2001) a Royal Commission (HIHRC) into the company’s collapse found mismanagement to be of particular concern. It is noteworthy that senior executives of HIH were charged, convicted, and sentenced to jail with regard to certain management decisions and subsequent actions taken. It was then stated: ‘The charges relate to a series of transactions where the true financial position of HIH was hidden from HIH shareholders and the regulators for many years.’24 The use of the word hidden implies intent to deceive. The latter may signal fraud but it does not prove fraud was evident. Circumstances of this case are examined later in this book. Mismanagement and fraudulent behaviour are different, but there are dilemmas within the context of the two that may cross boundaries. Management and business stakeholders ought to be aware. Management are

Management and Fraud

9

given many choices within international financial accounting standards in which to portray the financial state of the business they manage and its operational outcomes. Areas within the conceptual framework for financial reporting provide additional licence with regard, for instance, decisions on materiality, accounting procedures for industry-specific practice, and matters of conservatism. Management rightly needs flexibility in operating business and reporting on financial outcomes of those business activities. Therein, however, lay the opportunity for fraud. Consider Clarke et al. (2003, p. 327): ‘evidence before [the HIHRC] and the ASIC investigation into One.Tel has revealed the flimsy foundation of many accounting practices . . . the ease with which the myriad Standards and rules of accounting practice are circumvented.’ When addressing mismanagement as opposed to fraud many emotive issues are likely to arise for stakeholders. One example in the case of a claims’ corporate detailed that apparent: ‘ “Management failings” were responsible for “facilitating” $57 million in fraud perpetrated against the Conference of Material Claims Against Germany over 16 years.’25 The relevant ombudsman considered cultural problems with organizational behaviour were amongst the reported failings of management and the directors. Of course not all agreed. Lack of diligence in pursuing investigation and lack of appropriate controls appeared to be of much concern. Various officials including directors were targeted as lacking in attentiveness. A key point here is that mismanagement might be considered fraud. The circumstances of each case again are evidently and directly relevant in deciding the outcome. Further, they must be considered in the context of the prevailing conditions surrounding the case. THE AIM OF THE STUDY The aim of this study is to examine fundamentals of accounting and financial accounting constructs that recur in circumstances of FSF. Further, to explore the context in which elements of financial accounting and its procedures enable FSF. In analysis, accounting dilemmas for directors and managers are revealed. One such dilemma has regard for business reconstructions in the face of financial distress; in particular with regard to phoenix activity. Hence, linkage between management concerns, financial accounting choices, and fraudulent behaviour are examined. The likelihood of such connections warrant scrutiny as the resulting actions may lead to error, mismanagement, or fraud. The objective is to bring attention to and develop practical solutions to continue to mitigate opportunities for FSF occurring into the future. This is important as the ever-increasing occurrences of FSF globally result in escalating financial loss, and heightened criticism of management, senior executives, and directors.

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Principally, this work aims to reconsider financial accounting and forensic accounting solutions to the problem of fraud in financial statements. It demonstrates through case analyses that conventional and publicly available financial accounting statements are easily flawed. Without clarity, continued debate, and informed change it is unlikely that instances of FSF will diminish.

To Elucidate In financial accounting, generally accepted procedures are sometimes of concern due to ambiguities perceived to be inherent in the financial accounting standards, which are backed by the law. West (2003, p. 2) explained: ‘financial statements can only provide representations of the phenomena . . . The serviceability of these statements will be dependent on the extent to which they depict accurately the phenomena they purport to represent’ (emphasis in original). With regard to business failures and unexpected corporate collapses, Clarke and Dean (2007, p. 211) argued: ‘Whereas most of those failures over many decades have entailed some devious behaviour, for the most part their accounting complied generally with the Standards . . . At the margin there is likely to be deviation. This is especially so as foozles [bungles] become frauds.’ This notion that there are problems inherent in conventional financial statements is not new. Previous studies have explored defects in traditional financial statements with regard to accounting fundamentals and quality (serviceability) of the content.26 The following is a brief account through the literature.

An Historical View Some thirty years ago Martin (1984, p. 392) asserted ‘the balance sheet is not additive because it contains amounts representing different properties of the assets’; he further explained ‘to add a current market value to a written down historic cost, a market value prevailing two years ago and a current market value . . . must be misleading for analytical purposes.’ Vickrey (1970, p. 738) stated ‘the logic and usefulness of measurements depend on the additivity of extensive properties . . . [and] all accounting calculations depend ultimately on addition’. The inference was that the business entity’s financial condition as depicted in the financial statements may be in error. Currently, historical cost accounting methods are still used and, with regard to the rules of arithmetic, unlike items in the financial reports are still added. Hence in analysis of a business and its financial state the content of published financial statements warrant careful and continued scrutiny. It seems reasonable to assert that directors, executives, managers, and all business stakeholders would want current details and clarity in reported

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financials. This might be, at least, to enable sound economic decision making, to observe the law, to enable good business judgement, and to help society prosper. As Clarke et al. (2003, p. 266) remarked ‘[a]ccounting data are reasonably expected to reflect financial reality in its legal, social and economic contexts’. Yet this is unlikely if published financial statements remain a mix of monetary details, historical and current, that together are more likely to confuse if not misinform interested parties. A current view of financials, for instance, would most likely better assist managers to ascertain with some accuracy the business entity’s capacity to service its accumulated debt. On debt, senior executives and directors generally must know if the entity is solvent (that is, able to pay its debts when due and payable). This information is necessary to comply with the law in some jurisdictions and to ensure the entity does not trade when insolvent.27 Current financial details are then arguably of constant interest to the entity’s senior executives and its directors. If the entity’s financial viability diminishes and is ignored or hidden by management, and relevant details are unexplored by directors, insolvent trading and/or FSF may follow. In the case of Water Wheel, civil proceedings against three directors, executive and non-executive, ensued for contravening corporation’s legislation on insolvent trading.28 More recently the case of Kleenmaid, a whitegoods distributing company, developed into charges of fraud and insolvent trading. This arose some three years after the business failed.29 Reportedly, the business was insolvent in 2008 but the directors continued to trade. Subsequently three directors ‘will stand trial on 20 criminal charges, including a $13 million fraud against Westpac and 18 charges of insolvent trading’ (Redrup, 2014).30 On insolvent trading, Ramsay (2000) provided extensive discourse in Company Directors’ Liability for Insolvent Trading. Linkage between insolvent trading and FSF is evident with reference to the fundamental factors of the fraud triangle. This link is discussed in-depth in chapter two and underpins argument throughout later chapters. Directors’ duty of care to shareholders and other stakeholders arguably converges with their duty to ensure the business is financial and viable.31 The extent of their duty has been and still is considered controversial (Ramsay, 2000, p. 1). Yet, directors’ accountability for decisions and actions taken in conjunction with their responsibility to shareholders and other stakeholders is somewhat apparent. Basically, directors are responsible for business continuity of the business they direct. Their duties entail a surety that creditors are paid and employee entitlements remain intact. The link between insolvent trading and fraud is entrenched in law.32 Drawing on Ramsay (2000), the following elucidate. In Australia for instance, the notion of corporate officers being liable for debts of the company developed from ‘the English fraudulent trading provisions contained in s275 of the companies act 1929 (Eng) . . . The shift to provisions dealing with the specific case of insolvent trading can be traced to the offence introduced by s 303(3) of the Uniform Companies Act 1961 . . . based on the British Bankruptcy legislation’ (Coburn, 2000, pp. 73, 74).33

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Directors’ liability with regard to New Zealand (NZ) legislation is explored by Goddard (2000, pp. 169–189). He explained the NZ ‘Companies Act 1993 drew heavily on North American models, in particular the Canada Business Corporations Act’ (p. 169). But additional factors of liability were imposed ‘on directors for insolvent trading, and unreasonably risking insolvency’. Payne and Prentice (2000, pp. 190–209) elaborated civil obligations of directors, under English law, on the subject of corporate debts. On directors’ liability to creditors, or the possibility thereof, they examined issues of lifting the corporate veil, taking account of creditor interests, and directors’ duty due to creditors. At times, insolvent trading and FSF converge. In this context we explore relevant aspects of governance and risk management. This is done using stakeholder theory in conjunction with theoretical perspectives of the fraud triangle. The following section explains. Further we investigate practical aspects of governance with regard to directors’ duties in financial reporting to stakeholders. METHOD AND METHODOLOGY To achieve the aim of this work we employ multiple methods of analysis based on a case study approach to research. Drawing on an array of international FSF cases including: Waste Management (USA), Parmalat (Italy), Satyam (India), Securency (Australia) Lehman Brothers (USA), WorldCom (USA), and Adelphia (USA), we critically examine specific and problematic financial accounting elements. Additional cases of fraud, insolvent trading, and unexpected corporate collapse, and otherwise related areas of national as well as international significance, are also included in chapters four, five, and six, where they connect to the area of concern, such as capitalizing expenses, recognition of revenues, off-balance sheet items, curious cash records, specious financial ledger accounts, and asset overstatements. Hence, with regard to fraud, each case examined herein is selected because of the type of FSF revealed. Previous works assert major forms of FSF and how they have developed from misappropriation, mistreatment, misreporting and miscalculation of assets, revenues, expenses, and liabilities.34 Each element is fundamental of financial accounting and its procedures. Notably these attributes of financial accounting are inherent in most cases of FSF.35 Ultimately then, the problem addressed in this study centres on five specific types of FSF here referred to as: asset fraud, revenue fraud, expenses fraud, liability fraud, and disclosure fraud. Underpinning analysis of each major case are circumstances of other FSF cases explored in various sections and sub-sections of the chapters. In particular, analyses of data are organized and relevant to the financial accounting challenge explored in each chapter. This method of enquiry, based on systematic observations and critical analysis, supports a practical approach

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to investigation. The cases herein sustain study of awkward instances of financial accounting that persist in FSF. Drawing on details of recorded and so observable financial accounting data the study is empirical. It is acknowledged that the capacity for generalisation may be limited in line with the number and circumstances of the cases herein. Markedly, however, each FSF case, whether past, present, or into the future, is and will continue to be specific to its own conditions. On that basis the documented instances across companies and industries explored are significant and arguably helpful in further understanding instances of FSF. Chambers (1973) described such instances as ‘observation—a method of enquiry,’ and case study research embraces this form. Of note is that others can assess the publicly available detail of cases and so documented data can be verified or argued. In analyses continued financial accounting dilemmas for management are revealed. Linkage between management predicaments and an array of financial accounting choices are examined. Such connection warrants scrutiny as it may result in fraudulent behaviour that ends in insolvent trading and/or FSF. Figure 1.1 provides an outline of the content of this book. The following elaborates the underlying framework for this story.

Theory and Framework As explained earlier fundamental factors and elements of the fraud triangle in conjunction with relevant aspects of stakeholder theory provide the framework. On BusinessDictionary.com, ‘stakeholder theory’ is defined in terms of concepts that underpin ethics and management behaviour in business.36 In that context it outlines connection to moral values juxtaposed with economic and other business concerns of organizations and notes that ‘stakeholder theory was first proposed in the book Strategic Management: A Stakeholder Approach by R. Edward Freeman [1984]’.37 Drawing on Freeman’s work, particularly Freeman et al. (2004), we develop further the notion of a stakeholder approach to business. Briefly, we differentiate between a shareholder approach and more generally a stakeholder approach to doing business. We acknowledge that shareholders are stakeholders, but recognise that so too are creditors, employees, financiers, potential investors, regulators, and others. As shareholders are sometimes referred to as primary stakeholders this may invoke the idea of a preferential position. If so, the shareholder approach may be seen to be narrow in its focus because it likely undermines the position of other stakeholders. For some this may seem reasonable because the shareholder owns the business. Their investment in the entity is after all directly related to receiving a return on their moneys invested. Other stakeholders may be seen to be more indirectly involved and as such are of a secondary nature.38 In isolation such reasoning may appear justified. Shareholders, however, are diverse. Individuals, groups, and institutional shareholders differ in their

Chapter One Management and Fraud • Problem • Aim • Method • Structure

Chapter Two Stakeholders, Governance, and Corporate Culture • Fraud and the dynamics of business • Theoretical foundations • Cases to consider

Chapter Seven Fraud and the Phoenix Rising • The ignominy of fraud • A critical view of business financials • Hypothetical: A Phoenix Rising • Questionable tactics • Case scrutiny • Phoenix activity • In sum: Three main areas of concern

Communication: • The notion of stakeholders—primary and secondary • Contrasting views on stakeholder theory • Theory of the fraud triangle • “Tone at the top” • Ethical concerns

Chapter Three Quality in Financial Statements • Serviceability of content of conventional financial statements • The role of management • Case analysis: Bribery and corruption • Governance and due diligence • Misrepresented financials

Chapter Four Fundamental Elements: Assets, Revenue, and Expenses • Fundamental elements in financial statements explored • Problematic situations, for example, in capitalizing expenses—revealed • Relevant case analyses • Note: Opportunities for fraud

Chapter Five Chapter Six Phoenix Activity: Companies in crisis • The phoenix, company constructs, and the conduct of business • Definitions of the phoenix • An international perspective • Goodwill and the phoenix company • Cases: Analyze and consider • Into the future . . .

Figure 1.1

Financial Obligations: Liabilities • Liabilities in context • Debts, obligations, and provisions • The significance of contingent debt • Debt, reserves, and the relevance of cash • Disclosure and the essence of disclosure • Debt and survival • Includes relevant case analyses

Outline of this Book

Source: Figure 1.1 has been devised and constructed by the authors of this book.

Management and Fraud

15

opinion and position in life. Some shareholders will seek a steady monetary return on their investment by way of dividend payments. Other shareholders may prefer profit taking by way of capital gain—or a combination of both. Shareholders converge however in their interest in the business organization’s reported earnings and its reported trend in profits, over time. The focus is economic. That is understandable but it may work to the disadvantage of other stakeholders. As Freeman (2004, p. 368) explained, it ‘ascribes one objective function to all corporations’. Given the increasing global focus on sustainable business activities, environmental concerns, and the diversity of corporations throughout the world this is unlikely. An alternative view considers more broadly the purpose of business and its outcomes. As such the collective interests of those who have a stake in the business are considered. Hence, maximizing shareholders’ returns are an objective but not the only, or sometimes not the main, objective. Underpinning many business decisions are ethical and moral considerations.39 Increasingly businesses are challenged with environmental and social concerns that are tantamount to business continuity. In this context, financial stability and economic growth are still essential for business to continue as a going-concern. However, ‘[m]any proponents of a shareholder, single objective view of the firm distinguish the economic from the ethical consequences and values’ (Freeman, 2004, p. 364). It is more likely that all stakeholders are essential to the on-going achievements of the business and so add value to the organization. The necessity for business to make money and report profits in an economic environment is accepted. The obligation for business activities into the future to acknowledge and act upon environmental and social concerns is inevitable. In turn there are increased pressures on directors, senior executives, and managers to enable economic growth and report on financial stability in their business. Concurrently they are expected to ensure their business entities comply with changing rules and regulations and consumer demands. In this scenario the link, sometimes tenuous, to the possibility of fraud and fraudulent behaviour may be ignored. We show that a broad stakeholder approach to business, rather than specifically a shareholder approach, is likely to diminish unwarranted pressures on management. In that context this non-separatist view is also likely to mitigate the rationale for FSF. On this basis there are three themes in this book as explained in the following section. THE STRUCTURE OF THIS STUDY This book consists of seven chapters. Chapter two examines theoretical perspectives that link business, its culture, and governance concerns. Attention is given to directors and other corporate officers, their duties and responsibilities. Stakeholder theory provides the basis for discussion on directors

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and senior officers’ accountability to shareholders and other stakeholders. The theory and practical elements of the fraud triangle are analysed. Chapter three revisits the notion of quality in financial statements based on case study analysis. The set of published financial statements that focus on an entity’s reported financial condition and elements of those reports are discussed. The role of directors, senior executives, and managers are considered foremost with regard to fraud and the potential for fraud to occur. Chapter four and chapter five concentrate on specific elements of financial accounting that contribute commonly to reported instances of FSF. Chapter four covers assets, revenues, and expenses with regard to definition, recognition, and their potential for blatant misrepresentation. Chapter five reviews financial liabilities and disclosure fraud. The obligation for the entity to pay its debts when due and payable is explored. Directors’ duty to ensure that the business they direct has the financial capacity to meet its financial obligations is examined. Such attention to debts and debt management is fundamental to good business practice and essential for business continuity. These factors are critically appraised with consideration of the law and financial accounting issues, and the circumstances of selected cases. Chapter six adds something unique. It investigates the phenomenon of phoenix activity. The analysis identifies the problem of differentiating between that which may be considered legal or illegal. With reference to case observations, the chapter shows how complex is the area of phoenixing. Basically there are three types of phoenix actions: innocent activity, occupational hazard, and careerist offenders. The careerist offender is the most likely to be fraudulent. The case examples include corporate and legal instances. Linkage between illicit phoenix activity and the misuse of financial accounting with regard to FSF is argued. In conclusion, chapter seven synthesizes earlier material. It highlights fundamental elements of financial accounting that recur in circumstances of FSF. Drawing on case examples, it reveals the context in which such rudiments of financial accounting and its procedures persist. In analysis, accounting dilemmas for management are revealed. Practical solutions to mitigate opportunities for FSF occurring into the future are shown to be possible. Nonetheless continued scrutiny, debate, and action on FSF to diminish the precarious situation for business internationally are warranted.

NOTES 1. See Albrecht et al. (2012, pp. 10, 11). Also at www.jsrsys.com/fema/ch04.htm, accessed October 2013. Also refer to Wells (2011), for instance, the Preface, pp. xi–xiv and note reference therein to the “executive suite” (p. xii) and “those in ultimate charge” (p. xiv). 2. Cressey, Donald, R. (1919–1987); see www.acfe.com/fraud-triangle.aspx, accessed May 27, 2014. Details in Cressey, D. R. (1973) Other People’s

Management and Fraud

3. 4.

5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

17

Money: A study in the social psychology of embezzlement, Patterson Smith Publishing, Montclair, New Jersey. See the National Commission on Fraudulent Financial Reporting (1987, p. 2) for further explanation of this definition. The presenter elaborated: ‘When we talk about “fraud” in this context, we are probably using the term more widely to include wrongdoing that would not traditionally be seen as fraudulent in the strict legal sense. However, to be a fraud, the wrongdoing must be deliberate and intentional’ (ASIC, 2005, p. 3). In Zack (2012) refer to Foreword by Wells (pp. xiii–xv). See Kranacher et al. (2011, p. 13). Also Cressey (1973) for in-depth discussion and analysis. For more details see KPMG’s publication: “Global profiles of the fraudster” available at www.kpmg.com/au/en/issuesandinsights/articlespublications/ pages/fraudster-global-profiles.aspx, accessed January 21, 2014. Refer, for instance, to Albrecht et al. (2012). Also note explanations in Albrecht et al. (2012, p. 81) and Kranacher et al. (2011, p. 25). See, for instance, Albrecht and Searcy (2001); Williams (2011). For further details, see Clarke et al. (1997/2003); Clarke and Dean (2007); Dean et al. (2008); Margret (2012). Ibid. Such ideas are expanded in later chapters especially chapters four through six; the story is supported with relevant case studies. As in the cases of Lehman Brothers, Enron, WorldCom, Waste Management, Adelphia (USA), Clive Peeters, HIH, Water Wheel, One.Tel (Australia), Satyam (India), Parmalat (Italy), Olympus (Japan), Gyrus Group (UK), and many others. Otherwise, fraudulent behaviour more generally may stem from credit card debt, unexpected illness and increasing medical bills, education expenses, gambling, divorce proceedings, drug abuse, etc. Some analysed in later chapters of this book. Also refer to Margret (2012); Zack (2012); Clarke and Dean (2007); Clarke et al. (1997/2003) and references therein. For instance, as revealed in the case of Satyam (India). We also acknowledge that continued education, widespread discussion, and increased social unacceptance of FSF throughout world communities are arguably foremost in mitigating its existence. Albrecht et al. (2012, p. 137) explained: ‘Accounting anomalies result from unusual processes or procedures in the accounting system.’ Kranacher et al. (2011, pp. 186–189); Albrecht et al. (2012, pp. 139–142); and Zack (2012), for instance, provide further technical details on accounting and analytical anomalies. Many studies discuss this dilemma. Somewhat recently see, for instance, Clarke et al. (1997/2003); Loftus and Miller (2000); Clarke and Dean (2007); Margret (2012) and references therein. Also see Margret (2005) in ‘Surviving Financial Distress: The Case of Too Many Herbs and Spices’, Journal of Applied Management Accounting Research (JAMAR), Vol. 3, No. 2, pp. 51–67. The published work of Clarke et al. (1997/2003); Clarke and Dean (2007) raise and explain in-depth many issues with regard to unexpected corporate collapse. See www.asic.gov.au/asic/asic.nsf/byheadline/05–94+Ray+Williams+senten ced+to+four-and-a-half+years%E2%80%99+jail?openDocument. Refer to: Australian Securities and Investment Commission (ASIC) Media Release 05–94.

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25. Further details available at www.jpost.com/LandedPages/PrintArticle.aspx?id= 319190#, accessed November 4, 2013. 26. Including Canning (1929); MacNeal (1939); Chambers (1966); Sterling (1970); Wolnizer (1987); Clarke et al. 1997/2003); Clarke and Dean (2007); Margret (2012). 27. For instance, in Australia under the ACA (2001) s.295(4) and s.295A. 28. In ASIC v Plymin, Elliott & Harrison [2003] VCS 123. 29. Preliminary details on Kleenmaid insolvent trading and fraud case: Stafford (2012) ‘Kleenmaid directors face insolvent trading and fraud charges three years after collapse’ available at www.smartcompany.com.au/finance/ cashflow/24424-kleenmaid-directors-face-insolvent-trading-and-fraudcharges-three-years-after-collapse.html, accessed November 2013. 30. Further details in the Redrup article (2014) ‘The Kleenmaid saga continues as former directors face trial for insolvent trading and $13 million fraud’, Wednesday, 2 April, at Smart Company, Australian Business, available at www.smartcompany.com.au/legal/41363-the-kleenmaid-saga-continues-asformer-directors-face-trial-for-insolvent-trading-and-13-million-fraud.html#, accessed July 2014. 31. In Australia directors’ duty to prevent insolvent trading under ACA, 2001, s.588G. 32. Refer Ramsay, I. (Ed) (2000) Company Directors’ Liability for Insolvent Trading, CCH Australia & Centre for Corporate Law and Securities Regulation, Faculty of Law, University of Melbourne. Suggested citation posted August 15, 2006. Ramsay, Ian, Company Directors’ Liability for Insolvent Trading. Available at SSRN: http://ssrn.com/abstract=924314, accessed November 2013. 33. Coburn (2000, Part III, Chapter 4, pp. 73–128). Coburn examines legal principles of insolvent trading in Australia. 34. Jones (2011, pp. 460–467) elaborated in terms of increasing income, decreasing expenses, increasing assets, and decreasing liabilities. 35. Ibid. Also see Albrecht et al. (2012, p. 364) and Kranacher et al. (2011, pp. 421–438). 36. Available at www.businessdictionary.com/definition/stakeholder-theory.html, accessed November 11, 2013. Freeman (1984) was again later published in 2010. 37. R. Edward Freeman 1951 (1984/2010) Strategic Management: A Stakeholder Approach, 2010, xii, 276. First published in 1984 as a part of the Pitman series in Business and Public Policy. 38. Chapter two expands and discusses the relevance of both concepts with regard to ethical considerations as well as economic success and monetary gains. 39. For explication, see Freeman (2004, p. 364).

BIBLIOGRAPHY Albrecht, W. S. and Searcy, D. J. (2001) ‘Top 10 reasons why fraud is increasing in the U.S.’, Strategic Finance, May, pp. 58–61. Albrecht, S. W., Albrecht, C. O., Albrecht, C. C., and Zimbelman, M. F. (2012) Fraud Examination, 4th edition, South-Western Cengage Learning, Mason, Ohio. Australian Corporations Act (2001) Butterworths, Sydney. Australian Securities Investment Commission (ASIC) (2005) Financial Statement Fraud: Corporate crime of the 21st century, KPMG Centre, Directors briefing, presentation by Jeremy Cooper—Australian Institute of Company Directors (AICD) NSW Division, Wednesday 8. Canning, J. B. (1929) The Economics of Accountancy: A critical analysis of accounting theory, Ronald Press Company, New York.

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Chambers, R.J. (1966) Accounting, Evaluation, and Economic Behavior, Prentice-Hall, Englewood Cliffs, N.J. Reprinted Scholars Book Company, Houston, TX, 1974. Chambers, R. J. (1973) ‘Accounting Principles and the Law’, Australian Business Law Review, June, pp. 112–129. Clarke, F. L., Dean, G., and Oliver, K. G. (2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, Cambridge, England. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne and New York. Coburn, N. F. (2000) ‘Insolvent Trading in Australia: The legal principles’, Chapter 4, pp. 73–128, in Company Directors’ Liability for Insolvent Trading (2000) Ian M. Ramsay (ed), CCH Australia Limited, Melbourne. Cohen, S. and Grace, D. J. (2001) ‘Ethics and the Sustainability of Business’, in Collapse Incorporated, CCH Australia, North Ryde, pp. 100–128. Cressey, D. R. (1973) Other People’s Money: A study in the social psychology of embezzlement, Patterson Smith Publishing, Montclair, New Jersey. Dean, G., Clarke, F., and Margret, J. (2008) ‘Solvency Solecisms: Corporate officers; problematic perceptions’, Australian Accounting Review, Vol. 18, No. 1, March, pp. 1–10. Freeman, R. Edward, 1951 (1984/2010) Strategic Management: A Stakeholder Approach, part of the Pitman Series in Business and Public Policy; 2010, xii, 276. Freeman, R. E., Wicks, A. C., and Parmar, B. (2004) ‘Stakeholder Theory and “The Corporate Objective Revisited”’, Organization Science, Vol. 15, No. 3, May–June, pp. 364–369. Goddard, D. (2000) ‘Directors’ Liability for Trading While Insolvent: A critical review of the New Zealand regime’, Chapter 7, pp. 169–209, in Company Directors’ Liability for Insolvent Trading (2000) Ian M. Ramsay (ed), CCH Australia Limited, Melbourne. Gul, F.A., Teoh, B.H., and Andrew, B.H. (1991) Theory and Practice of Australian Auditing, 2nd ed., Thomas Nelson, Melbourne. Jones, M. (2011) ‘Identifying Some Themes’, in Creative Accounting, Fraud and International Accounting Scandals, John Wiley & Sons, Chichester, England. Kranacher, M. J., Riley, R. A., and Wells, J. T. (2011) Forensic Accounting and Fraud Examination, John Wiley & Sons, Chichester, England. Loftus, J. A. and Miller, M. C. (2000) Reporting on Solvency and Cash Condition, Accounting Theory Monograph, Australian Accounting Research Foundation (AARF). MacNeal, K. (1939) Truth in Accounting, University of Pennsylvania Press, Philadelphia. Margret, J. E. (2005) ‘Surviving Financial Distress: The Case of Too Many Herbs and Spices’, Journal of Applied Management Accounting Research (JAMAR), Vol. 3, No. 2, pp. 51–67. Margret, J. E. (2012) Solvency in financial accounting, Routledge/Taylor Francis Group, New York. Martin, C. (1984) An introduction to accounting, McGraw-Hill, Sydney. Owen, Justice Neville (2003) The Failure of HIH Insurance, HIH Royal Commissioner’s Final Report, HIH Royal Commission, Commonwealth of Australia. Payne, J. and Prentice, D. (2000) ‘Civil Liability of Directors for Company Debts under English Law’, Chapter 8, pp. 190–209, in Company Directors’ Liability for Insolvent Trading (2000) Ian M. Ramsay (ed), CCH Australia Limited, Melbourne. Ramsay, I. M. (ed) (2000) Company Directors’ Liability for Insolvent Trading, CCH Australia Limited and Centre for Corporate Law and Securities Regulation, Faculty of Law, University of Melbourne. Redrup, Y. (2014) ‘The Kleenmaid saga continues as former directors face trial for insolvent trading and $13 million fraud’, Wednesday, 02 April, Smart Company,

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Australian Business, available at www.smartcompany.com.au/legal/41363-thekleenmaid-saga-continues-as-former-directors-face-trial-for-insolvent-tradingand-13-million-fraud.html#, accessed July 2014. Solomons, D. (1989) Guidelines for Financial Reporting Standards, Institute of Chartered Accountants in England and Wales (ICAEW). Stafford, P. (2012) ‘Kleenmaid directors face insolvent trading and fraud charges three years after collapse’, available at www.smartcompany.com.au/finance/ cashflow/24424-kleenmaid-directors-face-insolvent-trading-and-fraud-chargesthree-years-after-collapse.html, accessed November 2013. Sterling, R.R. (1970) Theory of the Measurement of Enterprise Income, University Press of Kansas, Lawrence. Reprinted Scholars Book Company, Houston, TX, 1979. Treadway Commission (1987) Report of the National Commission on Fraudulent Financial Reporting, National Commission on Fraudulent Financial Reporting, October. Vickrey, D. W. (1970) ‘Is Accounting a Measurement Discipline?’, Accounting Review, Vol. XIV, No. 4, October, pp. 731–742. Wells, J. T. (2011) (Editor) Financial Statement Fraud Casebook: Baking the ledgers and cooking the books, Association of Certified Fraud Examiners (ACFE), Wiley, Hoboken. West, B. P. (2003) Professionalism and Accounting Rules, Routledge/Taylor and Francis Group, New York. Williams, C. (2011) ‘Financial Statement Fraud—Chinese Style’, Association of Certified Fraud Examiners, 2011 ACFE Asia-Pacific Fraud Conference, pp. 1–13. Available at www.acfe.com/uploadedFiles/ACFE_Website/Content/asiapac/pre sentations/catherine-williams-cpp.pdf, accessed February/July 2014. Wolnizer, P.W. (1987) Auditing as Independent Authentication, Sydney University Press, Sydney, Australia. Zack, G. M. (2012) Financial Statement Fraud: Strategies for detection and investigation, Wiley, Hoboken.

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Stakeholder theory is managerial . . . [S]takeholder theory asks, what responsibility does management have to stakeholders? . . . Many proponents of a shareholder, single-objective view of the firm distinguish the economic from the ethical consequences and values. (Freeman, 2004, p. 364)

STAKEHOLDERS In the conduct of business, with investment and consumer interests, the concept of a stakeholder may include shareholders, creditors, employees, financiers, customers, regulators, financial analysts, and local, national, or international communities. Stakeholders may comprise anyone who has a direct or indirect interest in a business and its activities. Traditionally shareholders are considered primary stakeholders as they have a direct interest in the business.1 The notion of a primary stakeholder, however, suggests that other stakeholders are secondary and that implies they are of less importance. The demarcation denotes a preferential sequence where the interests of one group take priority over the other. In this book, with its emphasis on fraud business, stakeholders are viewed as a collective, one group. Adverse economic and social consequences of financial statement fraud (FSF) are widely dispersed as evidenced by international case examples.2 Albeit that the degree of suffering experienced by individuals or stakeholder groups will differ, both entities arguably are of equal import and ought not to be differentiated. For management, delineating stakeholders as either primary or secondary may be somewhat tricky as they try to balance the wants of both. Advocates of the “separatist” stakeholder concept suggest: ‘One of the challenges of managing an organization is to balance the needs of both primary and secondary stakeholders.’3 Yet this is problematic. To identify both primary and secondary stakeholders and to establish their actual needs is impracticable. Arguably it is not possible to identify all stakeholders in any particular business, at any particular time.

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Stakeholders, Governance, and Corporate Culture

On the other hand, the concept of direct and indirect stakeholders in business is reasonable. Evidently some stakeholders hold a direct stake in the business (e.g. owners, employees, creditors) whilst others still with interest are more external to the business and its operations (e.g. regulators, potential investors, financial analysts). It is the tenor of primary and secondary stakeholders that is of concern. If the wants of one stakeholder group are given precedence over another, the result is likely to end in dispute. Such conflict, in turn, increases pressure on directors and managers to achieve business outcomes that satisfy a seemingly disconnected bunch. Therein corporate officers may be more inclined to take opportunities to appease the more vocal or powerful group. Mounting pressure to achieve a particular periodic financial outcome where opportunities to diminish that pressure prevail can result in fraudulent behaviour. Hence, it seems advantageous for directors and managers to work in concert to achieve the organization’s goals with focus on one stakeholder group. The purpose of the business may be multifaceted. Its objectives and goals should be focused to maximize financial returns for shareholders and sustain business continuity, but not to the detriment of others (communities or the environment). In this context, the conduct of business would take account of economic, social, and ethical issues. The business and its activities then would more likely be sustainable in both financial and non-financial concerns. The contrasting views on stakeholder theory and the shareholder versus stakeholder approach to business and its purpose are of concern. Confusing to some is that maximizing shareholder wealth is arguably an ethical consideration.4 In many situations it embodies good management. On the other hand it likely encourages a short-term focus on maintaining or increasing profits—regardless of whom or what may be disadvantaged. This in turn can intensify the pressure on managers to be able to report financial results and non-financial outcomes that some expect, but that may not be reasonable (acceptable or ethical) in a particular environment. When pressure and opportunity to mitigate the pressure converge, the circumstances for fraud are set. It does not mean that fraud will occur but it signals a warning. The potential fraudster needs to rationalize the act. Under varying situations of intense pressure, given the opportunity, many otherwise honest people will rationalize a fraudulent act. Debatably there is no generally agreed profile of a fraudster. It may be anyone who under a different set of circumstances would not consider or participate in fraud.5 See Diagram 2.1. Kranacher et al. (2011, p. 12) explained ‘whether fraud perpetrators are male or female, they look like average people . . . fraudsters typically do not have a criminal background . . . [and] it is not uncommon for a fraud perpetrator to be a well-respected member of the community’. On the other hand some advocate there are certain characteristics that may be attributed to the most likely fraudster.6 On that point the debate continues.

Stakeholders, Governance, and Corporate Culture

Diagram 2.1

23

The Fraud Triangle Factors and Elements

Source: The diagram has been devised and constructed by the authors.

Stakeholder Outcomes: Short-Term vs. Longer View To effectively sustain business practice obliges managers and directors to attend to both financial and non-financial outcomes of business activities. Such attention should not be short term. If a short-term view is taken and rising pressure from shareholders and other stakeholders to perform well and report on short-term achievements is evident; the risk of management fraud escalates. Issues of corporate social responsibility (CSR) are increasingly of concern to business and to sustainable business practices. Assuredly most managers want to maximize shareholder wealth and sustain business activities, and debatably the two need not be in conflict. Unfortunately, sometimes they are. Moser and Martin (2012, p. 797) explained that ‘accounting researchers (e.g., Friedman, 1970; Shank et al., 2005; Dhaliwal et al., 2011), as well as some writers in the financial press (Karnani, 2010), have typically taken the perspective that companies will, or should, only engage in socially responsible activities when doing so maximizes shareholder value’ [emphasis added]. Others disagree and remind us that actively pursuing socially responsible operations is more likely to increase business profitability, hence the wealth of all.7 Importantly, the costs associated with socially responsible

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business operations and reporting need not be at the expense of shareholder returns (Moser and Martin, 2012). Kim et al. (2012) suggested that socially responsible activities engaged by business that diminished shareholder returns were unethical as earnings management is deemed unethical. Others, with focus on the shareholder approach, advocate maximizing shareholder returns is socially responsible.8 Some consider it manifestly so.9 Yet a singular and short-term attention to rates of return on investments augments corporate pressure and as such increases the likelihood of management fraud. Investors, like financial analysts, might expect to take some responsibility for being aware of circumstances that are apt to result in fraudulent behaviour. The seemingly endless pursuit of “who is to blame?” in an unexpected corporate collapse, or unexpected fraud, warrants continued attention. It may be that it is not necessarily who is to blame for the circumstance10 but what provides the opportunity11 for the circumstances that prevail. Directors and managers need to know the financial state of their business and its capacity to continue to trade. That is in many jurisdictions a financial and a non-financial necessity to enable business continuity and to avoid insolvent trading.12 Albeit that is, that most non-financial circumstances in business eventually trade into a financial result. Perceptibly then shareholders, employees, customers, creditors, financiers, and many others are interested in the business continuing its operations. Additionally they are interested in the outcome of those operations (financial and non-financial), as those business activities will potentially benefit or adversely affect many. In that vein stakeholders generally are liable to want a considered and well-reasoned approach to the management of business. Hence a longer-term approach to profitable outcomes of maximizing financial returns with business continuity and sustainable operations is probable.

Stakeholders and the Concept of Maximizing Returns Recall that shareholders as primary stakeholders signal a single-minded approach to the conduct of business. That focus enables the underlying theory of corporations to emphasize maximizing financial returns for the owners. So the idea facilitates action to glean a “best” rate of return on the amount of money shareholders invest in the business.13 Globally, case examples illustrate this is not always in the best interests of other stakeholders, for instance employees.14 Interestingly, some suggest employees along with customers are also primary stakeholders.15 In addition, local communities are of prime importance for business especially when determining business interests and possible outcomes of their actions.16 When businesses engage in activities that maximize economic returns for shareholders the results may, but not always, connect with socially responsible outcomes for others.17 In this context the concept of primary stakeholders versus secondary stakeholders again is tricky. Archival excerpts on the Ok Tedi mine in PNG,18 for instance, reveal that BHP’s connection to

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25

operating the massive gold and copper mine was problematic to the extent that the conglomerate moved to extricate itself from operations largely due to the scale of the resulting ecological spoil.19 The apparent increased pressure to extricate economic satisfaction for shareholders and others adversely affected governance and socially responsible choices. Environmental and social damage in the case of Ok Tedi was huge. Partly it resulted from economic influences that were, at that time, subject to public and private decisions. Those decisions seemingly were in conflict with the safety and well-being of the people.20 In this case public officials and corporate officers could be seen to be primary stakeholders in that particular “reform” process. The episode illustrates how the notion of primary and secondary stakeholders, in all processes, can become tricky. That a business exists solely to maximize financial returns for its shareholders is a narrow concept. Freeman et al. (2004, p. 364) explained: Many proponents of a shareholder, single-objective view of the firm distinguish the economic from the ethical consequences and values. The resulting theory is a narrow view that cannot possibly do justice to the panoply [full array] of human activity that is value creation and trade, i.e., business. (emphasis added) Some advocates of the shareholder approach separate actions necessary to achieve economic goals from the principles of conducting business in an ethical manner (fair, decent, and just). The broader stakeholder approach and that includes shareholders, with its communal focus does not separate the two. Theoretically then under the broader approach it is more likely that financial, social and environmental awareness will converge for the betterment of communities and thus enable a dynamic and more just business community. In that environment, pressure that may be attributed to a probable increase in FSF may actually dissipate. In turn it is more likely that business continuity will sustain. As on-going business activities require both an economic certainty (sound financial position) and a culture that does not violate the rights of any (social responsibility), the fundamental theory of a firm in the conduct of its business could well be revisited.

Business Outcomes: Economic and Ethical Previous studies have determined that business managers comprehend the necessity to consider and embrace a broad approach to the purpose of business.21 In so doing their business activities have achieved improved outcomes both in terms of profitability and business relationships. In this context, a crucial driver of business continuity is to focus on both the economic and ethical (moral) suppositions of conducting business. On the other hand, a business organization might secure continuity of its operations, attend to its economic needs, and do so to the detriment of others. Evidently this is unethical. Recall that after the invasion of Kuwait

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(1990), the UN placed heavy sanctions on Iraq. In its disadvantaged state Iraq was unable to provide enough food for its people. In response, by 1995 the UN Oil-for-Food programme was established. Subsequently by 1996 Iraq was able to sell its oil to purchase food and other humanitarian goods for its people—all under UN contracts, supervision, and agreements. One of its purchases was for wheat and the major supplier was the Australian Wheat Board (AWB).22 The case of the AWB and its involvement in the UN’s oil-for-food programme is an exemplar of economic versus ethical dilemma. The AWB chose the economic route, and by 1999 around 10 per cent of the Australian wheat exports per annum went to Iraq. It wasn’t the sale of wheat per se that was the problem, but the varying shades of the process that caused grave concern. Ultimately the AWB—at that time—was found lacking in moral and corporate responsibilities in the conduct of its business. The organization’s unethical behaviour ended in a Royal Commission that scathingly rebuked the AWB, its executives, and others. Since that time the AWB has implemented many changes to reconstruct its organization and to promote itself as an ethical and socially responsible business; different from the one that operated during the Oil-for-Food programme, 1999–2004.23 The following example reminds of the unethical and fraudulent undertones that pervaded circumstances of and for many business constructs during the time of the UN humanitarian programme.

The AWB and the Royal Commission Inquiry into the Oil-for-Food Programme The question of corporate ethics and culture was extensively examined during the Royal Commission into ‘certain Australian companies in relation to the UN Oil-for-Food Programme.’24 The Honourable Terrence Cole (2006) AO RFD QC questioned the activities of Australian companies, specifically with regard to allegations of bribery of foreign officials connected to the Iraqi government.25 The Royal Commission examined in detail the activities of the AWB and its payment schemes. One of which was a ‘discharge and land transport fee of US$12.00 per metric tonne to an Iraqi entity, the Land Transport Co.’26 In fact this fee was, and arguably the AWB then knew it was, a means of making US dollar payments to the Iraq government in contravention of UN Sanctions. The Royal Commission found that the somewhat inappropriate ‘conduct of the AWB and its officers was due to a failure in [the organization’s] corporate culture.’ It was found that the AWB operated, at that time, in an ethos of self focus in order to achieve its economic goals. That is, it spent time and money with intent to find ways in which to arrange its business activities in Iraq to avoid breaching the law; rather than working diligently in conjunction with the UN’s oil-for-food programme.27 The latter is important

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because the programme was intended to help sustain the innocent people of the land by providing them with much needed food, medical supplies, and other essentials. Globally, the AWB was not the only organization so involved. With regard to the AWB however the cost was high. The Royal Commission reported, that among other things the ‘AWB lost its reputation,’ ‘shareholders lost half the value of their investment,’ ‘trade with Iraq worth more than A$500 million per annum was forfeited,’ and ‘many senior executives resigned’. Further there were threats of litigation both nationally and internationally as well as ‘potential further restrictions on AWB’s trade overseas’.28 Of course that was then and for the AWB the tide may well have turned and the organization reborn as a productive entity.29 One of the primary warnings from such activities however, that continue to evolve is the affect of related outcomes on all stakeholders. Thus we return to earlier consideration of different stakeholder groups. In essence it may be said that elevating the rights of one stakeholder group is ostensibly detrimental to other stakeholder groups. Freeman et al. (2004, p. 365) suggested: ‘Shareholder rights are far from absolute, regardless of how much economists talk about the corporation as being the private property of the shareholders. The rights of shareholders are prima facie at best, and cannot be used to justify limiting the freedom [choices] of others without their consent.’ Seemingly it is evident, given case circumstances of business operations and outcomes of same that stakeholders will either benefit or suffer from the economic and social outcomes attributed to those activities. In this context a stakeholder approach to business is twofold. It pays attention to both the purpose of the organization in achieving its business goals (economic) and the necessity to attend to the relationships that foster good business (social awareness and ethics). The stakeholder approach considers principles broadly, in that ethics and economics are not separated in the conduct of business. We acknowledge many may argue the shareholder approach to conducting business does not discount ethics in business deliberations. We suggest, however, this argument is tenuous without including in its purpose, awareness of, and actions that support, social responsibility. The latter is of particular importance herein as we deliberate circumstances of fraud in published statements of financial account. Although maximizing shareholder returns is a legitimate aim in progressing business economically, it is also in some circumstances likely to be a constricted view in sustaining business environmentally. The broader stakeholder approach advances the shareholder approach to achieve improved results generally. In this way it enables sustainable business activities that result in more positive outcomes for business organizations; and that betters the situation for all. Moreover this approach is likely to help management on a practical level, as ‘[s]takeholder theory . . . reflects [on] and directs how managers operate rather than primarily addressing management theorists and economists [focus on “financial” rates of return]’ (Freeman et al., 2004, p. 364).

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Diagram 2.2 Stakeholder Theory (Shareholder vs. Stakeholder Approach: Primary and Secondary Stakeholders) Source: The diagram has been devised and constructed by the authors.

Understandably, different business organizations nurture different business goals. In that context the purpose of specific businesses and the outcomes of their activities need to be articulated clearly to stakeholders. This is of particular import in matters of governance. GOVERNANCE Recently the focus on corporate governance, internationally, has become entrenched with regard to securities markets and that concept tends to emphasize the importance of following a set of rules or principles. Corporate entities might be seen to satisfy governance mandates by instigating a ‘tick the box’ approach to compliance and accountability. Being seen to conform to expectations of regulators and securities markets arguably does little to address actual governance concerns. In other words a business organization may be seen to be doing what is required by the authorities, rather than identifying and instigating action for the betterment of the

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organization, its business initiatives and outcomes, and for its stakeholders. That is the form of corporate governance. Emphasis on governance is different to giving weight to corporate governance and necessitates action to focus on substance over form.30 Some may argue that corporate entities do continually enhance and change their governance practices to achieve the best outcomes possible and do so in ever-changing and challenging economic environments. In particular, regulators and other authoritative organizations support proactive corporate behaviour. In the USA, for instance, “Business Roundtable” as an authority on corporate governance is of this view.31 It also strongly suggests that ‘best practices by public companies [are achieved] within a framework of laws and regulations that establish minimum requirements while affording companies the ability to develop individualized practices that are appropriate for them’ (Business Roundtable, 2012, p. 1).32 This is debatably a widely held and important view, certainly as business organizations are commonly accepted to be different one from the other, and so require the flexibility to act in the organizations’ and its stakeholders’ interests. In recent years the USA corporate entities have increasingly been encouraged to: Adopt best practices within the framework of strengthened securities market listing standards and legal requirements that developed beginning with the passage of the Sarbanes-Oxley Act of 2002 and have continued with the financial crisis and the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act.33 Such action and expectations to so act have been initiated by many countries globally.34 This has particularly occurred since the earlier years of this millennium and following the Global Financial Crisis (GFC).35 Although businesses, companies, multi-national corporations may be seen to initiate good governance practices, the concept of “good governance” in itself is problematic. Clarke and Dean (2007, p. 33) with regard to two relatively recent unexpected corporate collapses in the USA and Australia explained: Responses to the Enron and HIH collapses provide a sorry tale. Overdosing on governance rules, and the public’s seduction by flimsy evidence in support of them, characterised those responses. Common sense has been outplayed by the false appeal of swift regulatory action. Appearances of good governance have outvalued the reality of achieving it. (emphasis added)36 Economic circumstances are at times difficult and whilst we engage in a money economy this will in all likelihood continue. Importantly, what is considered arduous in the context of trade by one business may not be so

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for another. The individual business challenges for each organization will define, to some extent, the willingness of its managers (and stakeholders) to participate in what they deem to be good governance practices. Moreover, what authorities may deem to be “best practices” may not apply across all organizations. Hence, individual business entities given flexibility will likely seek to practice good governance in the spirit in which it was intended; because those actions will be good for business outcomes and business continuity.

Governance Broadly Governance in its broader context suggests directors, executives, and managers centre their attention on leading and managing the organization and its resources, with focus on its people and organizational goals. They do this to achieve the best results for the business and its outcomes with due attention to what securities markets may require. In this mode it is probable that stakeholders will be privy to voluntary publications of governance matters. Such publications are apt to supplement reported details that comply with the wants of securities markets. So good governance will incorporate both, that which may be considered a mandate and further details given voluntarily to better inform stakeholders. Notably the concept of governance per se is not a recent development.37 Yet many seem to think, or act as though, it is. Steinberg (2011, p. 2) explained that governance to him means ‘the allocation of power among the board, management and shareholders’, although ‘the term is used also to encompass an array of actions taken by management in running a company, from senior levels down throughout the management ranks’, (emphasis in the original). The notion of including shareholders in the sphere of governance of a business and its activities is interesting. It empowers shareholders as activists in the decision-making realm of the organization. But how this could work in a serviceable manner for all stakeholders is problematic. The concept is awkward. Depending on the extent of shareholder activist involvement, it could be disruptive and counter-productive. Shareholders as the owners are directly involved in the business. On the other hand, they are external to the organization and its business operations. They are not inherently part of its daily operating procedures. Thus, the concept of shareholder activists, individual or groups, involved in daily business decisions seems odd. Furthermore there are likely to be disadvantages surfacing within the shareholder group itself. For instance, in determining the extent to which minority shareholders and or preference shareholders may form an activist group, or be discounted. At worst: If the shareholder power pendulum swings too far, we may be faced with frequent turnover of directors, large numbers of dissident directors, and boards unable to come to consensus. A result may be an adversarial

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board-CEO relationship, distracted senior management, and disrupted corporate performance. Directors spending time campaigning or otherwise politicking and CEOs dealing with dysfunctional boards serve no purpose, and will be both distracting and destructive. (Steinberg, 2011, p. 285) With such a scenario the pressure and possibly the opportunity to invoke fraudulent behaviour increases. Shareholders by and large do have decision-making power, for example, by way of discussion, argument, input at annual general meetings, special meetings, investment choices, and the like. There is also the power of the media that shareholders and other stakeholders can call upon. Albeit that the responsibility and accountability for decision outcomes on business operations rests ultimately with management and directors, stakeholders in business can create waves and sometimes be disruptive.38 This is hardly in the best interests of business continuity. A continuing and financially secure corporate business operation requires a well selected group of skilled, experienced, educated, knowledgeable directors with the fortitude to work in harmony.39 An effective board of directors will have the tenacity to ask hard questions when necessary and demand answers that satisfy. This is increasingly a requisite for an effective board.40 It is of concern on a global front as the stipulations for directors’ increase and the punitive outcomes for misleading disclosures made by, or allowed to be published by, directors and/or the board escalate.41 Hence the culture that emanates from the top of the organization throughout the entire body of the business is of concern. Commonly this culture is referred to as the ‘tone at the top.’ We advocate that many, incorrectly, view the responsibility for this tenor in the business, to be solely the responsibility of the directors, the CEO, and other executive officers. In reality the tone of the culture that permeates throughout an organization is dependent on the attitude and actions of all the organizations’ employees. We agree, however, that the beginning of the culture (the organizational cult) rests with the executives. If employees throughout the organization witness that slack behaviour, loose business morals, and unethical transactions are rife in their business—employees at all levels are likely to follow suit. CORPORATE CULTURE The ‘tone at the top’ is a concept that centres on an organization’s culture. It goes beyond attention to the traditional theory of a business firm—to maximise profits and maximise shareholder returns.42 In this context culture invokes attention to broader aspects inherent to an organization and its activities. It includes social awareness and ethical behaviour in the conduct of business. It alerts stakeholders to the organization’s business systems, its internal control environment, the dynamics of its leadership, and the

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business’ willingness to be proactive as well as adapt to changing business circumstances. In this mode, business and its leaders are challenged to inform and educate stakeholders and embed controls that diminish the opportunity for fraud to occur within business’ internal control environment. Attention to sustainable business practices is ever-increasing.43 In line with this is awareness of business’ corporate social responsibility.44 Moreover persistent critical thought and debate on what constitutes basically the theory of business continues. Importantly in the case of long-running, profitable, and otherwise ‘successful’ businesses it is evident that the underlying theory of business (its mission, its vision for the future) is not static.45 Drucker (1994) provided many examples of such business achievements; for instance, in the case of the University of Berlin (1809), radical theories defined the organization. That is, until the reign of Hitler, the Deutsche Bank (1870) and Georg Siemens’ (its first CEO) view of the theory of business focussed on entrepreneurial involvement and finance. Mitsubishi (1870s) developed radical thought on business theory that within 20 years cemented its place in multi-national business, and as a leader in Japan. Later in the USA General Motors (GM) and IBM demonstrated such dynamics throughout the twentieth century and arguably highlighted that malaise in business theory underpins expected and unexpected business collapse. In the case of General Motors and other car manufacturers in Australia from around 2010 this appears to be evident. As this book is written, a major concern for many is that by 2016 General Motors (GM) will not be manufacturing cars in Australia. Ford Australia is already on the way out and Toyota is suspected to follow. It may be argued that this apparent collapse of car manufacturing in Australia is somewhat due to inattention to changing markets and international challenges. That the changing focus internationally in what denotes sustainable business practice in car manufacturing and associated industries has been unattended in Australia—and for some time. Reiterating the theory of a business firm is not embedded necessarily in economic concepts or historic operational achievements. Business is dynamic. A vibrant business organization is constantly aware of its environment (economic and social) and will initiate change in its business activities in tune with its surroundings. Such change may be proactive, reactive, or both. The alternative—a static view—is not viable, and it is arguably more likely to result in business failure.46 The process of conducting business globally is vigorous, and demands continual development. So too are the theories that underpin the activities of business enterprise. Those theories are also linked to what may constitute ethics in business practice. Seemingly ethical behaviour in business is likely to lessen fraudulent behaviour.

Ethics and Ethical Behaviour The notion of ethics and ethical behaviour in ordinary daily life is arguably the same as that applied in the conduct of business. On this topic individuals

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may differ in their opinion. Some may choose to behave in a completely different way in a business trading circumstance to that of their daily life.47 Debatably there is or should be no difference between the concept of business ethics and personal ethics. Given the apparently increasing amount of fraud and fraudulent behaviour in business the idea warrants discussion and continued debate. Numerous case examples show that a lack of ethical behaviour in business can, and often does, lead to fraud. In the case of professional ethics as opposed to business ethics, individuals may disagree (personally) with a course of action but still be required within their professional discipline to abide by a certain code or legal requirement. This can lead to conflict and trauma for some. Two online examples from New Zealand elaborate:48 • A police officer [for instance] may personally believe that a law that they are required to enforce is wrong. However, under the Code of Conduct for the New Zealand Police, they are required to obey all lawful and reasonable instructions unless there is good and sufficient cause to do otherwise. • A doctor may not personally believe that the course of medical treatment chosen by a patient is the right choice. However, under the Code of Ethics for the New Zealand Medical Profession, they must respect the rights, autonomy and freedom of choice of the patient. Circumstances of this type are similar in many countries. The culture that emanates from a professional body is expressed to some extent by the behaviour of its individual members. That behaviour may be attributed to the professions’ code of conduct. Of which the substance of the code would take precedence over its form. Notably there are different attributes between a business undertaking and that of a profession. Tawney (1920, p. 94) for instance explained: ‘The essence of . . . [industry] is that its only criterion is the financial return which it offers to its shareholders. The essence of the . . . [profession] is that, though men [and women] enter it for the sake of their livelihood, the measure of their success is the service which they perform, not the gains which they amass.’ The primary difference is altruism as it is attributed to professional rite. Even so the substance of a set of instructions (code) may be misinterpreted by individuals in the profession because of the form in which they are written. Accounting standards that underpin generally accepted financial accounting practice are an example. The content of many such standards are arguably convoluted and confusing. Some advocate that accounting standards are problematic in assisting business stakeholders in economic decisions. Clarke and Dean (2007, p. 211) asserted, ‘financial disclosure in accord with conventional accounting [practice] generally fails to disclose the wealth and progress of companies, and the recently promoted IFRSs [International Financial Reporting Standards] will do little to remedy that.’

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Foremost and relevant to note is that the apparent current fixation on ethics and ethical behaviour is not new. Debated for at least 2500 years, and commonly understood to be the product of personal choice, ethics can be equated to the depths of the ocean. While there are some things that we know (e.g., the ocean floor contains water and ethics are the ground rules by which we live our lives), other elements are mysteries (what organisms live on the ocean floor and what does it mean to be ethical). Generally, people are continuously exploring the depths of both. Because ethics are defined individually, there are presumably six billion [or more] viewpoints about ethics on this planet.49 Central to considerations of fraud and fraudulent behaviour in an organization are the norms established by the entity with regard to its people and expectations of their behaviour. This translates into a required standard of organizational behaviour that may be written into a code of conduct or similarly, a code of ethics. As such, the organization’s outlook considers the effect of its actions (type of business operations and outcomes of same) on the broader community as well as its stakeholders. This may sound ideological to some, but people can desensitize themselves to harmful behaviour and its outcomes. So, if that thought is applied to business ethics, then an organization without ethical standards may find its employees submit to opportunities that result in outcomes that would otherwise be considered harmful and unethical.50 With regard to FSF there is a direct link between the tenor of the organization and opportunities within the organization for fraud to occur. As business circumstances, people, and the natural world are ever-changing, a constant review of a business organization’s internal control environment and its linkage to mitigate opportunities for fraud is warranted. BUSINESS DYNAMIC AND FRAUD FSF has regard to the quality of the content of statements made (verbal or written) about the financial state of the organization. As such those involved in constructing or delivering those statements are accountable for the content of the statements. So once again we are confronted with determining what denotes quality in a statement about an organization’s financials. Although much has been written and debated on this point across time, it remains of concern. Herein we take the view that quality of published financials with regard to business transactions and the outcomes of same are depicted by the serviceability of the financial numbers reported, hence the information content therein. Notably this is a difficult area and one of contention for many.

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Consider for instance: How is it that we may best determine the substance of the information? On the one hand, for financial details to be serviceable they need to be of use. In a financial context that means surely that the content needs to be both suitable and relevant to the task at hand. Thus the content of published financial statements would directly relate to the subject of the report—that is, depicted by the title of the financial report. Chapter three explores this notion of quality with regard to the content of a suite of conventional financial statements. It elaborates management’s role in providing financial information to stakeholders within and external to the organization. The link to fraud and fraudulent behaviour is made with specific regard to bribery and corruption because this is an area of growing concern internationally. Drawing on case examples, the role of directors and other corporate officers are examined with due regard for corporate legislation. Underpinning this story is attention to the necessity for effective communication throughout an organization as well as with external parties. Thus the duties and accountability of directors and other corporate officers are shown to be entwined with the details of published financial and non-financial disclosures.

NOTES 1. Consider this: ‘While shareholders are stakeholders in the organization, not all stakeholders are shareholders. Additionally, shareholders are primary stakeholders, but they are not the only primary stakeholders in the organization. Other primary stakeholders include, but are not limited to, customers and employees.’ Available at www.ehow.com/info_7998291_primary-stakeholder. html#ixzz2l2wWxW7u, accessed November 2013. 2. Consider, for example, the stories behind the fraud and failures of Satyam (India); Enron, Adelphia, Tyco (USA); HIH (Australia); Parmalat (Italy); and many others. 3. See www.ehow.com/info_7998291_primary-stakeholder.html#ixzz2l2wWxW7u, accessed November 2013. 4. Refer to, for instance, ‘Maximising shareholder value: An ethical responsibility?’ Available at http://knowledge.insead.edu.csr/ethics/maximising-shareholdervalue-an-ethical-responsibility, accessed November 2013. 5. Nonetheless there are certain characteristics that may be attributed to the most likely fraudster. See, for instance, Greenlee et al. (2007); Kranacher et al. (2011, p. 12); and Albrecht et al. (2012, p. 33). 6. See, for instance, Greenlee et al. (2007); Kranacher et al. (2011, p. 12); and Albrecht et al. (2012, p. 33). 7. See, for instance, http://news.vanderbilt.edu/2013/09/surprising-link-disclosureprofits/, accessed November 2013. 8. See, for instance, ‘Social responsibility has a dollar value’ at www.theage.com. au/news/business/social-responsibility-has-a-dollar-value/2006/07/26/115 3816252246.html, accessed November 2013. The article asserts a valid point on linkage between CSR and shareholder returns. 9. Ibid.

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10. ‘There is a widespread phobia that commercial order is threatened by the incapacity of directors and auditors to form honest judgments, independent of undue influences’ (Clarke and Dean, 2007, p. 211). 11. In non-fraud cases, for instance, ‘[d]isclosure relating to corporate groups’ financial status and performance is [arguably] at best equivocal, generally misleading and, sometimes, completely meaningless. Protection offered by the corporate veil to shareholders in respect of claims on their capital, and to creditors by quarantining a company’s assets to satisfy their claims, has frequently been misappropriated to their collective detriment but to the betterment of others’ (Clarke and Dean, 2007, p. 128). 12. In Australia under the ACA, s95A defines solvency/insolvency and s588G stipulates the directors’ duty to prevent insolvent trading. Under s295(4)(c) a directors’ declaration is required on whether the business entity is able to pay its debts when due and payable. Similar requirements are evident in the legislation of other countries for instance the UK, Canada, USA and New Zealand. Refer, for example, to Margret (2012, pp. 41–68). 13. See Sundaram and Inkpen (2004); also Freeman et al. (2004) for a response in ‘Stakeholder Theory and “The Corporate Objective Revisited”’. 14. Pressure on management to portray a failing business as profitable with a sound financial position might result in a massive cost cutting exercise. Given wages and salaries are major costs to most businesses, the likely outcome is that employees en masse lose their jobs. In many cases of unexpected corporate collapse, employees have suffered along with creditors, customers, communities, shareholders, and others; see, for instance, Clarke et al. (2003) and (Clarke and Dean (2007). 15. See note 1 and reference therein. 16. Consider the OK Tedi mining dilemma for BHP in Papua New Guinea (from 1975 to, arguably, current times) where the company’s mining interests conflicted with reportedly their own environmental concerns. 17. In addition their activities caused untold damage to the local river systems and social, economic, and political environment. Details available at www. theaustralian.com.au/business/mining-energy/png-ups-the-ante-in-withbhp-over-ok-tedi-mine-row/story-e6frg9df-1226567072656# and www.act nowpng.org/project/Ok%20Tedi%20mine, accessed November 2013. 18. Archival excerpt from Four Corners, available at www.abc.net.au/news/2013–01– 07/an-radio-doco3a-ok-tedi/4455092, accessed November 2013. 19. From excerpt available at www.abc.net.au/pm/content/2012/s3656207.htm, accessed November 2013. 20. By way of example: ‘During construction Ok Tedi’s tailings dam failed. The company made the fateful decision to put all its waste directly into the creeks that run into the Ok Tedi and Fly Rivers. By the 1990s hundreds of millions of tonnes of waste clogged those waterways, destroying thousands of hectares of forest and inundating villages and vegetable patches.’ Available at www.abc. net.au/pm/content/2012/s3656207.htm, accessed November 2013. 21. See Collins (2001) and Collins and Porras (1994). They are also mentioned in Freeman et al. (2004). 22. Refer to the Report of the Inquiry into Certain Australian companies in relation to the UN Oil-for-Food Programme, Volume 1, Summary, Recommendations and Background, under Prologue and Summary, available at www. oilforfoodinquiry.gov.au/, accessed June 2014. 23. Further details at ‘AWB response to Oil-for-Food Inquiry Report’ (2006), available at www.awb.com.au/investors/companyannouncements/mediareleases/2006 mediareleases/AWBresponsetoilforfoodinquiryreport.htm, accessed June 2014.

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24. Report of the Inquiry into certain Australian companies in relation to the UN Oil-for-Food Programme, Vol. 4, Findings, available at www.oilforfood inquiry.gov.au/agd/WWW/rwpattach.nsf/VAP/(22D92C3251275720C801B 3 3 1 4 F 7 A 9 B A 2 ) _ Vo l u m e % 2 B I V % 2 B ( 2 1 N o v 0 6 ) - C D . p d f / $ f i l e / Volume%2BIV%2B(21Nov06)-CD.pdf, accessed June 2014. 25. Refer to the Report of the Inquiry into Certain Australian companies in relation to the UN Oil-for-Food Programme, Volume 1, Summary, recommendations, and background, available at www.oilforfoodinquiry.gov.au/, accessed June 2014. 26. Ibid., p. xiv. 27. Ibid., under summary. 28. Ibid., p. xi. 29. Recall the details of the AWB’s reform agenda in the ‘AWB response to Oil-forFood Inquiry Report’ (2006). 30. The Royal Commission into the HIH case provides examples. A summary of relevant points are available in the article by Mills and Marjoribanks ‘The HIH legacy: Corporate governance and shareholder value,’ available at www.findlaw.com.au/articles/1431/the-hih-legacy-corporate-governance-andshareholde.aspx, accessed December 2013. 31. See Business Roundtable (2012, p. 1). 32. ‘Business Roundtable is an association of chief executive officers of leading U.S. companies with more than $6 trillion in annual revenues and more than 12 million employees. Member companies comprise nearly a third of the total value of the U.S. stock markets and represent nearly a third of all corporate income taxes paid to the federal government’ (Business Roundtable, 2012, p. 1). 33. Ibid. 34. Countries’ corporate governance principles are available at www.ecgi.org/ codes/documents/brt_cgov_principles_27mar2012_en.pdf, accessed November 2013. 35. Margret (2012, p. 68) provides an historical chronology of governance issues. 36. The HIH saga in Australia was of international significance. Details of the Royal Commission are published in the report of Justice Neville Owen (2003). 37. ‘Curiously, despite the hullabaloo surrounding the governance movement, nothing in the regimes introduces principles by way of controlling devices that have not been in the corporate legislation for over 160 years’ (Clarke and Dean, 2007, p. 51). 38. See, for instance, Steinberg (2011, p. 261). 39. Steinberg (2011, p. 286) explained: ‘Boards should be allowed to operate in an environment where institutional and other shareholders are permitted to appropriately exercise reasonable rights, but where boards are positioned to retain continuity, ensure the right mix of knowledge and skills in the boardroom, and operate so that the tough issues are debated in a collegial manner.’ 40. Steinberg (2011, pp. 286–287). 41. Refer to, for example, Margret (2012, pp. 41–68) on solvency and directors’ duties; Clarke and Dean (2007, pp. 128–159) on corporate legal entities, moral and legal issues. 42. Briefly: ‘A microeconomic concept founded in neoclassical economics that states that firms (corporations) exist and make decisions in order to maximize profits,’ available, with further explanation, at www.investopedia.com/ terms/t/theory-firm.asp. 43. Refer, for instance, to Gray et al. (2014); Adams (2011); Adams and McNicholas (2007).

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44. See Adams (2008) with regard to CSR, risk, and risk management. 45. A key article with regard to changing theories of business is: Drucker (1994) ‘The Theory of the Business’, Harvard Business Review, September. The date of the article does not detract from the relevance of its content to current times and business situations. 46. Ibid. 47. Adams and Frost (2006) provided a meaningful discourse in: ‘Accounting for ethical, social, environmental and economical issues: Towards an integrated approach.’ 48. Available at www.iaa.govt.nz/policy-manual/part-c/difference-personal-pro fessional.asp, accessed December 2013. 49. Further details available at www.ivysea.com/pages/ldrex_0601_01.html, accessed December 2013. 50. Ibid.

BIBLIOGRAPHY Adams, C. A. (2008) ‘A commentary on: Corporate social responsibility reporting and reputation risk management’, Accounting, Auditing and Accountability Journal, Vol. 21, Issue 3, pp. 365–370. Adams, C. A. (2011) ‘Sustainability reporting key to long-term viability’, Keeping Good Companies, September, pp. 569–570. Adams, C. A. and Frost, G. (2006) ‘Accounting for ethical, social, environmental and economic issues: Towards an integrated approach’, CIMA Research Executive Summaries, Vol. 2, No. 12, pp. 1–8. Adams, C. A. and McNicholas, P. (2007) ‘Making a difference: Sustainability, reporting, accountability and organisational change’, Accounting, Auditing and Accountability Journal, Vol. 20, Issue 3, pp. 382–402. Albrecht, S. W., Albrecht, C. O., Albrecht, C. C., and Zimbelman, M. F. (2012) Fraud Examination, 4th edition, South-Western Cengage Learning, Mason, Ohio. Business Roundtable (2012) Principles of Corporate Governance, available at www. alcoa.com/global/en/about_alcoa/corp_gov/PDFs/BRT_2012_Principles_of_ Corp_Governance.pdf, accessed 15 September 2014. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, New York. Clarke, F. L., Dean, G., and Oliver, K. G. (2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, Cambridge, England. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Cole, Honourable Terance (2006) Report of the Inquiry into Certain Australian Companies in Relation to the UN Oil-for-Food Programme, Vol. 1, Vol. 4, Commonwealth of Australia. Available at www.oilforfoodinquiry.gov.au/, accessed June, July 2014. Collins, J. C. (2001) Good to Great, HarperCollins, New York. Collins, J. C. and Porras, J. L. (1994) Built to Last, HarperCollins, New York. Dhaliwal, D. S., Li, O. Z., Tsang, A., and Yang, Y.G. (2011) ‘Voluntary nonfinancial disclosure and the cost of equity capital: The initiation of corporate social responsibility reporting, Accounting Review, Vol. 86, No. 1, pp. 59–100. Drucker, P. (1994) “The Theory of the Business”, Harvard Business Review, Vol. 72, No. 5, September–October, pp. 95–104. Freeman, R. E., Wicks, A. C., and Parmar, B. (2004) ‘Stakeholder Theory and “The Corporate Objective Revisited” ’, Organization Science, Vol. 15, No. 3, May–June, pp. 364–369.

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Friedman, M. (1970) ‘The social responsibility of business is to increase its profits’, New York Times Magazine, September 13, pp. 32–33,122–124. Gray, R., Adams, C. A., and Owen, D. (2014) Accountability, Social Responsibility and Sustainability: Accounting for Society and the Environment, Pearson, Boston. Greenlee, J., Fischer, M., Gordon, T., and Keating, E. (2007) ‘An investigation of fraud in non-profit organizations: Occurrences and deterrents’, Nonprofit and Voluntary Sector Quarterly, Vol. 36, Issue 4, December, pp. 676–694. Karnani, A. (2010) ‘The case against corporate social responsibility’, Wall Street Journal, August 23, available at http://online.wsj.com/news/articles/SB10001424 052748703338004575230112664504890, accessed 10 September 2014. Kim, Y., Park, M. S., and Wier, B. (2012), ‘Is earnings quality associated with corporate social responsibility?’, Accounting Review, Vol. 87, No. 3, pp. 761–796. Kranacher, M. J., Riley, R. A., and Wells, J. T. (2011) Forensic Accounting and Fraud Examination, John Wiley & Sons, Chichester, England. Margret, J. E. (2012) Solvency in Financial Accounting, Routledge/Taylor and Francis Group, New York. Moser, D. V. and Martin, P. R. (2012) ‘A broader perspective on corporate social responsibility research in accounting’, Accounting Review, May, Vol. 87, No. 3, pp. 797–806. Owen, Justice Neville (2003) The Failure of HIH Insurance, HIH Royal Commissioner’s Final Report, HIH Royal Commission, Commonwealth of Australia. Shank, T., Manullang, D., and Hill, R. (2005) ‘“Doing well while doing good” revisited: A study of socially responsible firms’ short term versus long-term performance’, Managerial Finance, Vol. 31, No. 8, pp. 33–46. Steinberg, R. M. (2011) Governance, Risk Management and Compliance, John Wiley & Sons, Hoboken. Sundaram, A. and Inkpen, A. (2004) ‘The corporate objective revisited’, Organization Science, Vol. 15, No. 3, pp. 350–363. Tawney, R.H. (1920) The Acquisitive Society, Harcourt, Brace and Company, New York.

3

Quality in Financial Statements

Perhaps the common sense by which quality is determined outside of accounting is expected to be applied in respect of it also—that the data in a company’s financials are true and fair ‘if and only if’ they are serviceable for determining its financial performance and financial position, and for deriving the financial indicators invariably calculated with them. (Clarke and Dean, 2007, p. 104)

FINANCIAL ACCOUNTING STATEMENTS Fundamentally, the suite of published and generally accepted accounting reports include the entity’s statement of its financial position (balance sheet), its financial performance (profit and loss statement), and a cash flow statement. Herein we concentrate on the balance sheet and the profit and loss statements because they are directly involved in change analysis in determining the likelihood of fraud in financial statements. The cash flow statement is already a change statement and so analysis of that statement, with regard to fraud, is planned for another work. In addition to these fundamental financial statements, businesses may choose to provide voluntarily other informative reports on business activities and outcomes. Such reports may be included in the entity’s annual reports or published separately online. Primarily the mission of the fundamental financial statements is to provide the entity’s stakeholders with a considered and truthful view of the financial outcome of that entity’s trading, its business activities for a particular period. Over time, much has been written about the meaning of truth in financial accounting reports and what may determine a true and fair view of an entity’s periodic financials.1 More recently emphasis on what presents fairly an entity’s financial state has gained momentum. This is especially so with regard to the requisites of generally accepted accounting practice (GAAP) and that includes consideration of both national and international

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accounting standards, past and present. In some jurisdictions the focus on truth in financial reporting correlates with what is considered fair.2 This in turn, however, requires a definitive guide as to the meaning of truth and fairness. Margret (2012, p. 47) provided a brief comparison of the use of varied words and terms such as ‘true’ and ‘fair’ in statutes across the United States, United Kingdom, Canada, and Australia. Chambers and Wolnizer (1991) provided an in-depth and historical discourse on alternating views around such terms as ‘true and fair,’ ‘true and correct,’ and the like.3 In this book we consider truth in financial statements to mean that the title of the statement should directly relate to, and so indicate, the content of the statement. Thus, the content of a business’ financial statement should reflect its title. On that basis, a balance sheet would detail the ledger balances of accounts of a particular business entity and show that the debit and credit accounts as recorded in the company’s books’ balance. Hence, all the periodic accounting entries posted into ledger accounts via journal entries would most likely be accurate. In that context the accuracy of the balance sheet would depict an element of truth in relating the numbers as recorded in the ledger accounts. It would not depict necessarily the ‘truthfulness’ of the story that underpins the numbers.4 For instance, all periodic trading and accounting entries might be recorded precisely and so be accurate. The entries may be in accord with supporting documents and to that extent only, might be considered reliable. Conversely the details on the documents to support account entries might be false. Or, there may be no relevant supporting documentation for the entries made in the business entity’s accounting system. In that sense the content of the balance sheet is problematic. The situation deteriorates when the balance sheet is referred to as a statement of financial position. That is because, to some, the two accounting reports are different. On the content of such accounting reports later discussion related to case studies, for instance Satyam in India, elaborate. On the difference between the balance sheet and the concept of a statement of financial position, Chambers and Wolnizer (1990, p. 354) explained: The balance sheet has long, and widely, been described as a statement of financial position. It has also been described as a list of account balances . . . [and] On the face of it . . . ‘account balances’ relates to the firm’s records and ‘financial position’ has reference to the relationships of the firm itself with other parties. The two terms are logically different; their connotations are different. The term ‘financial position’ for many individuals, groups, regulators, and others signifies a particular and a financial state of affairs. As the statement of financial position is also made as at a certain point in time the date of the financial report is of significance. Hence a business entity’s dated financial

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position might be expected to equate with its actual financial state at that time. Arguably this is not the same as a debit equals credit statement of ledger balances. Accuracy and reliability alone, with regard to financial account entries, is not enough. The recorded financials debatably must also be relevant to be ‘useful’ to stakeholders or any interested party. To be relevant requires the content be of use, hence to be serviceable for interested parties. Clarke and Dean (2007) provided case details that show for reported financials to be serviceable require financial ‘data that are fit for the uses ordinarily made of them’ (p. 214). Hence the financial statements would be of quality.

Quality in Financial Statements Defined Herein, quality with regard to financial statement content means that the numbers in the financial statements are serviceable for the users of those statements. Further that those reported financials relate directly to the title of the statement. In that context, quality has the trait of excellence—serviceability— that which surpasses merit.5 Clearly this requires that a published financial statement of an entity’s financial position per se will provide stakeholders with details of the financial state of that business at a particular point in time. To elaborate, a business entity’s financial state has regard for its purchasing power, its debt paying ability, and its financial capacity to continue operating into the future. Focusing on fraud and the potential for FSF; the flexibility available and arguably necessary for good business practice within GAAP, for management to report on a business entity’s financial state, also provides opportunities for deceitful manipulation of the accounting numbers.6 Most likely the instigators will be managers—those in positions of power and trust. Hence FSF is usually a management fraud. In situations of intense competition, for example, and decreasing profitability, managers’ perception of pressure is likely to increase. If the pressure is considered extreme and the opportunity arises some managers may commit or be party to a FSF. Further, if managers’ performance metrics are also based on earnings growth and reported profits, the likelihood of fraud and FSF in particular increases. In this environment the role of management gets tougher. It is not just a matter of doing a good job. The concept of doing a good job may well mean different things to different people, under different circumstances. So the notion must be clearly defined, in and by each organization, and with relevance to the organization’s accepted ‘code of conduct.’ With an eye on fraud and fraudulent behaviour, all too frequently “doing a good job” has regard to the business entity’s reported financial position and its financial performance. Managers may well translate this into pressure to inflate or otherwise manoeuvre reported profits and the entity’s financial position. In so doing the focus is short term and that leaves the entity and its capacity for continuing business into the future, vulnerable.

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THE ROLE OF MANAGEMENT Generally, managers are responsible for the outcomes of their decisions. As such managers are accountable to the business and its stakeholders, and possibly to senior colleagues. The level of their accountability is probably in line with their position in the entity’s organizational structure as well as with regard to the outcomes of their decisions. Managers’ perception of stakeholders influence on their performance indicators—used to determine how well they do their job—might be a trigger for volatility in perceived pressure. In this regard the degree of individual manager’s acuity will determine, to some extent, the manager’s behaviour in achieving his and/or her expected level of performance. Rodrigue et al. (2013) developed such from an internal environmental perspective. It was based on interchange between an organization’s performance measurements and the role of, or influence of, stakeholders on that system. Drawing on Simons (1995) the authors explained the perception of stakeholder influence on the organization’s environmental performance indicators (EPI) ‘through: (1) environmental strategy (mediated influence); (2) direct pressure on EPI selection; (3) a joint effort, in which stakeholders and the firm interact to achieve a common environmental goal; and (4) environmental performance benchmarking.’7 Simons’ (1995) beliefs system connects an organization’s employees with its core values (ethics, code of conduct) in line with commitment to achieve the entity’s goals. In constructing a financial picture of the state of the business, management’s role is to ensure the recorded financial details represent the entity’s business undertakings and the financial outcome of its activities. In this way periodic published financial reports enable stakeholders to be informed about the entity’s financial situation. At times stakeholders make economic decisions based on the information content conveyed in those published financial statements. Hence corporations’ legislation of many countries, in addition to governance requisites, obliges senior executives and directors to be cognizant of the entity’s financial state.8 Nonetheless, collectively, the entity’s accountants, managers, and senior executives are all directly involved in the construct of the accounts, albeit at varying levels. Moreover all employees who feed data into the accounting system are involved, directly or indirectly, in forming the entity’s financials. Management, however, is responsible for the published financial statements of the organization. Its commitment to the core values of the organization is reflected in the financial information content of those reports. Directors’ oversight of the organization’s published financials also link to their beliefs with regard to the organization’s core values. In this context, Simons’ (1995) beliefs system is valid here. It provides a strengthened control base on which to frame the organization’s internal control environment. In so doing it is likely to mitigate management fraud. As the COSO report (2010, p. 3) advised: ‘Better understanding of

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the psyche of individuals who have engaged in fraud may provide insights as to factors that cause an individual to set aside his or her set of beliefs to engage in fraud.’ Further a carefully and constantly monitored system of controls lessens the opportunity for managers to override such constraints. Hence documented, well-communicated, and implemented restrictions on behaviour that are believed by employees to be reasonable and in line with their belief system, and the organization’s code of conduct, are well-placed to achieve positive results. Further it is likely to diminish opportunities for fraud and fraudulent behaviour to flourish. The restrictions, if widely accepted, make it more difficult for those in positions of authority to, for instance, use their ‘power’ to orchestrate inappropriate changes to the organization’s accounts. Recall again the case of Waste Management in the late 1990s and their altered depreciation rates on assets such as their fleet of trucks. The subsequent change in that entity’s accounts enabled for some time, the reporting of sound financials, when in fact the entity was in financial distress. In 1997 it was revealed that changes to the organization’s accounting procedures resulted in a $1.2 billion loss and reduced retained earnings by $1 billion.9 Other discrepancies apparently included misstated taxes and deferred costs, overstated earnings and concealed expenses during a lengthy period from 1992 to 1996.10 Increased or increasing pressure for managers to perform and to achieve sometimes unreasonable but expected outcomes, will adversely affect the belief system of some individuals. The result can be a disassociation from the core values of the organization. If this disconnection converges with the opportunity to lessen the pressure by a wrong but doable act; some will rationalise a perceived need to commit the offence. Simons’ (1995) beliefs system extends the theoretical underpinnings of this study. It builds on the interconnectedness of stakeholder theory and the fraud triangle as shown in chapter two. Management perceptions of pressure are thus likely to alter their perception of wrongdoing.

Management: Issues of Deceit Managers are concerned about the outcome of business activities and the pressure to reveal positive financials. In this vein they may decide to suppress their business entity’s actual financial results. This may be done to, among other reasons, shield themselves from accusations of mismanagement, to protect their level of remuneration, to retain investment hype, or to promote a sound market status for “their” organization, along with a constant and healthy market capitalization position. Alternatively, they may relate their wrongdoings to global or national economic downturns, the effects of which are or may be used to rationalize actions. Whatever the reasons or perceived necessities of the perpetrator/s to action FSF, the company’s accounts will be, in some way, fabricated.

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When pressure and wrongdoing converge and affect the reported financials of a business, the end result is probably anything but truthful or fair. Arguably the mass of financial accounting standards provide a platform to exacerbate the problem. Clarke and Dean (2007, p. 217) explained: ‘As long as the true and fair criterion is deemed subservient to compliance with the Accounting Standards, and deemed to be satisfied by that compliance, the general run of companies’ financial statements will be misleading, and the data therein will not be serviceable in the assessments and evaluations ordinarily made with them.’ Across legally required conventional financial statements, certain common categories of FSF are likely to excel. These tend to include inappropriate revenue recognition, improper asset valuation, fictitious cash deposits, irregular capitalization of expenses, and concealed liabilities. These are in addition to obscure expenses, timing differences, and irregular disclosures or non-disclosure of material facts. The scope across which stakeholders might be misinformed is enormous. And not least because of the inordinate demands on business to produce short-term profit results. Across this scenario the compulsion for managers to get on with business and produce the expected results intensifies. Of growing concern internationally are the increasing numbers of identified cases of bribery and corruption. Many are the colourful subject of media reports; however, the actual number of cases involving some form of bribery and corruption is unknown. This adds to the rising level of concern. Many cases are hidden, not reported, or perhaps simply not pursued by law enforcement agencies. As business activities expand further into multi-national offshore operations, more companies are faced with the perception of ‘having to’ participate in unwanted deals to effect business continuity. Although the associated costs to communities globally are possibly in the billions of dollars, due largely to unidentified as well as unreported cases the actual costs remain unknown. Traditionally the concept of bribery involved governments, government agencies, and government officials. It meant something of value was given or offered and/or received in order to shape the outcome of an official act. Later commercial bribery took hold. That is also about the power of influence but is more directly focused on changing or manipulating business decisions rather than those of governments. All such crimes are corrupt and serve to distort actual circumstances of business or official acts of governments. In addition to bribery, corruption includes other schemes such as undisclosed conflicts of interest, monetary extortion, and illicit gratuities. With regard to financial statements, fraudulent acts of bribery and corruption might be improperly disclosed within the reports or more likely not disclosed at all. In both cases the reported financial state of the business organization is distorted. Hence, similar to asset misappropriation the illegal act of corruption is a crime against the organization.

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Seemingly some executives and others have not grappled well with this concept. Hypothetically, arguments proclaim: ‘this is the way business is done in this country,’ ‘we have to clear the incoming shipment to keep the business operating,’ ‘if the money isn’t paid, the company loses the contract, thousands of jobs will be lost.’ In such situations the bribe paid may be considered an act for the organization; after all, the perpetrators are working to keep the business in operation. The act, however, is still a crime. The rationalization is a play on words. The reasoning undermines moral principles and possibly is not in accord with the entity’s code of conduct. Acts of bribery and corruption and their acceptance demonstrate how the theory of the fraud triangle connects to the fraud act. Under an unmanageable pressure (or a perception of intense pressure) and given the opportunity, some will rationalize the necessity to commit a particular crime. In such an instance the crime of bribery and corruption may easily translate into FSF. THE CASE OF SECURENCY INTERNATIONAL PTY. LTD. (SECURENCY) Securency provides polypropylene film globally. Although the company’s origin is in Australia, the resounding effects of alleged bribery and corruption crossed multiple borders. To begin, it was reportedly in 2007 when the Reserve Bank of Australia (RBA) advised that Securency earned over 90 per cent of its revenue from exports, in addition to supplying its product for Australian banknotes.11 This was a company moving into the future, deemed to be a financial triumph. The case also involved the RBA’s subsidiary Note Printing Australia Limited (NPA), whose initial core activity was to print the Australian bank notes.12 Securency’s polymer substrate product (known as Guardian) could be used for banknotes and high-security documents like land titles, security cards, passports, birth certificates, and the like.13 NPA sourced its substrate from Securency. Thus, Securency manufactured the substrate and NPA printed the banknotes. The product was innovative and had somewhat remarkable export potential evidenced by it being quickly adopted across 27 countries (approximately) worldwide.14 Securency’s problems began with the growing intensity of its export business. Agents were employed in foreign locations to secure lucrative contracts for its product. This in itself was not a problem but seemingly it became one. The use of foreign agents can quickly become problematic if an organization’s governance policies, code of conduct, and related procedures are not implemented and carefully monitored. Not that this was the case necessarily for Securency or NPA, as discussed in following sections. NPA’s problems followed its transition into the new millennium. It planned to improve its commercial viability and to do so felt the need to diversify its note printing services into an internationally accepted export

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business. This strategy, however, was at loggerheads with the more conservative governance charter of the RBA. The significance of this is that the RBA, Australia’s central bank, was established under the Reserve Bank Act (1959) by an act of Parliament. This means that it is accountable to that specific Act and not as such to the usual Australian Corporations Act (2001).

The Organizations Prior to 2013 the RBA had a major ownership interest in both Securency and NPA.15 At that time, Securency was a 50–50 joint venture between the RBA and Innovia Films BVBA16 and NPA was a wholly owned subsidiary. Previously, in 1996 Securency began as a joint venture between the RBA and a Belgian multinational known as UCB.17 The latter also manufactured a thermoplastic substance (polymer film) at that time. The polymer substrate product was innovative with a technological advanced export potential. It was dynamic in its capabilities for future development. Innovia Films became involved when UCB later sold its joint venture interest (in 2005) to a UK-based enterprise that became Innovia.18 The development of the seemingly lucrative export market, however, over a relatively short period of time, soured. In 2013 the RBA sold its 50 per cent ownership interest in Securency to Innovia for an amount reportedly around A$65 million,19 but NPA was retained and remains still a wholly owned subsidiary of the RBA. The investments, directorships, and subsidiaries of the RBA are of interest not least because it is Australia’s central bank. Established in 1959, the RBA has operated as such since January 1960 and its reputation has been impeccable. Undoubtedly the Securency case tarnished that reputation, for some.20 It has since recovered. Its reputation and status is of considered worth because as the central bank the RBA imposes significant effect on the Australian financial sector and it is looked to for national financial stability. The sale of Securency, organizational changes to NPA, and the RBA’s strategies have done much to mitigate the reputational blemish. Reportedly doubts about the governance standards at the RBA and its subsidiaries were raised and recorded by the RBA itself.21 Consequently the RBA commissioned an independent review of its oversight of Securency and NPA. Generally in the context of FSF it is crucial to determine linkage between effective governance and the innate culture of an organization. This helps to recognize and then diminish opportunities for fraud within the entity’s internal control environment. Drawing on the Cameron Ralph ‘Independent Governance Review’22 and relevant publicly available media releases and articles, the following explains.

The Business Securency was exporting its product to numerous countries across Asia,23 as well as Mexico, New Zealand, Brunei, Papua New Guinea (PNG), Nigeria,

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Romania, and supplying Australia.24 Capital improvements to its manufacturing plant in Victoria, Australia, doubled its manufacturing capacity. Reportedly it was dedicated to investment and development in technology to diminish risk of counterfeit and progress in its management strategies.25 In manufacturing and marketing a highly technologically driven product and developing its export strategies Securency was progressive. To further capitalize on its overseas success, Securency entered a joint-venture arrangement with Banco de Mexico to establish a manufacturing plant there to produce polymer security substrate. This would extend relationships between the countries and provide many employment opportunities for the local population in Mexico. The plant was to be located North of Mexico City, in Queretaro and would operate from 2009. At that time Securency’s board of directors was seemingly well structured. It comprised three directors appointed by the RBA and three by Innovia, as well as the managing director in a non-voting position. Geographically, Securency, NPA, and the Innovia plants were located on the same site at Craigieburn in Victoria, Australia.26 It was an interconnected, functioning, well-positioned business to advance the product internationally and into the future; however, as previously indicated, securing a sustained and productive business offshore can be a challenge and somewhat tricky.

Trouble Ahead The degree of the challenge increased with the geographic location of its business. Throughout certain areas of the globe the predilection toward fraud is rife. Arguably it exists in all countries internationally but to a lesser degree in some than others. Diagram 3.1 depicts Transparency International’s Corruption Perceptions Index, which shows the perceived level of public sector corruption in countries and territories around the world. For Securency, a major problem arose with the commissioning of foreign agents to secure business contracts. It seems some of the prevailing individuals in positions of authority made dubious choices. The focus was to increase Securency’s presence and competitiveness in and throughout Asia.27 But in the process of developing its business, multi-million dollar payments were made to officials across ‘Malaysia, Indonesia, Nigeria, South Africa, India, Nepal, and Uruguay.’28 Under circumstances of intent to secure a business advantage, such payments are tantamount to bribes. Commonly it can be expected that organization’s transacting business across international and national borders will ensure they are cognizant of differing legislative requirements. The organization’s code of conduct for itself and its employees should exist, be available to, and its’ content well-known, by all employees throughout the entity. Further, any agents or external parties employed by the organization ought to be well-versed in that code.

Transparency International—Corruptions Perception Index 2013

Source: Transparency International. All Rights Reserved. For more information, visit www.transparency.org.

Diagram 3.1

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Quality in Financial Statements

Governance: Due Diligence and the RBA Apparently, and to their credit, the RBA gave due diligence to its governance and oversight responsibilities with regard to both Securency and NPA. This was done in accord with the then general practice.29 To this end accredited people were appointed to positions of trust and authority and they were expected to act with the requisite care and skill demanded of their position. Important was the composition of the relative boards of directors at both Securency and NPA. Generally a link between the involved companies would be established and maintained through their respective boards, via the appointment of a chairman. This would enable firm oversight of the subsidiaries by its parent and customer, in this case the RBA. Hence the oversight would link to RBA’s culture and internal control environment. Following, commercial expertise would be introduced and nurtured via the appointment of a CEO with the necessary experience in dynamic enterprise.30 A major contributor to effective governance and oversight are the reports generated by the organization for its senior decision-makers. In the case of Securency the organization’s reports both formal and informal (financial and non-financial) were apparently received by management. At six monthly intervals the RBA Board received a report on both Securency and NPA delivered by the Chairman, seemingly of each organization.31 The reports nonetheless were somewhat brief—as explained in the Cameron Ralph independent review (2012)—and somewhat basic in content.32 This is not necessarily of concern because at the time in question both Securency and NPA were considered to be immaterial in significance to the overall business of the RBA. In that sense the concept of materiality is likely of issue. On the one hand, it is not troublesome necessarily that the reports (either qualitative or quantitative) were brief in content. On the other hand, it is worrying if the content of the reports were insufficient in depth of detail. That is, if the reported details were not relevant, reliable, and serviceable to the needs of the decision-makers. In that instance, it is more than likely the reports would not be informative and as such would be lacking in quality. In this case, it is understood that the governance procedures and reporting arrangements were consistent with general practice at the time. This was especially with regard to joint ventures and subsidiaries that were small in size in respect of the parent. Herein it is deemed that the relativity of size (subsidiaries to parent) refers to the concept of materiality in a financial sense. In fact Cameron Ralph (2012, s.8.1, p. 37) asserted the same with specific regard to the financial statements of the RBA, its balance sheet, and profit and loss reports. The RBA have subsequently and publicly concurred that always, with the benefit of hindsight, more could have been done. Nonetheless at the time of unfolding circumstances the RBA’s governance was seen to be appropriate.33

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With the RBA’s governance and oversight accountability seemingly intact, its subsidiaries Securency and NPA, however, were heading for stormy waters. The ever increasing likelihood of fraud and the entanglements of fraudulent behaviour in the areas of bribery and corruption were somewhat apparent.

Bribery and Corruption In this case, the potential for misplaced decisions arose with the employment of foreign agents. That is not to imply that the use of foreign agents in all circumstances is fraught with the danger of fraud. It is a situation, however, that requires all parties involved in the set-up and implementation of such international business to be privy to the exactness of the relevant organization’s code of conduct and its punitive measures if the code is not adhered to. This would entail that the organization apply, as well as document, its policies for stringent governance, internal control, and monitoring. In particular, from the organization’s point of view, it is critical that when engaging with agents it applies strict processes to ensure that agents are who they claim to be, are of good repute, and can be monitored when undertaking activities on behalf of the organization. In addition the legislative and other regulatory mandates of the countries involved in transacting business must be known and adhered to. Further, there must be transparency in reporting financial and non-financial outcomes of cross-border business transactions to the organization’s stakeholders.

Unfolding Details at Securency In 2009 the RBA advised via media release (09–11) that Securency International Pty Ltd was alleged to be involved in fraudulent activities. The Age newspaper in Australia had suggested payments made to foreign agents by Securency to secure business may have been used to pay kickbacks to foreign officials. The issue was promptly referred to the Federal police in Australia by the Securency board of directors.34 Subsequently years of investigation across national and international borders led to charges against the companies allegedly involved, as well as against certain individuals who either worked or formerly worked for those organizations. The bribery and corruption charges against both Securency and NPA as well as six individuals (previously senior executives therein) was massive in its possible harm to reputations, including that of Australia. The bribery was alleged to involve kickbacks and alleged payments to foreign officials in order to secure banknote contracts. The circumstances marked a catastrophe for Australia—and reverberated around the world. This was the largest bribery and corruption scandal on record in Australia. Moreover it necessitated accessing international laws on bribery in the investigation process to

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supplement Australian law. This was mainly because for an extended period (1999–2005) senior staff from Securency and NPA allegedly used international sales agents in the process of bribing officials overseas to secure contracts.35 The offshoot was a deeply concerned Australian government. The degree of alarm heightened due to the potential damage to international relationships and diminishing public confidence in Australia’s central bank. The RBA is, after all, the mainstay of Australia’s financial system.36 This is a financial system known to have weathered rough times and is acknowledged as being of sound and dependable substance. In comparing Australia to other countries internationally the International Monetary Fund (IMF) asserted that after Chile, Australia attained the lowest gross debt level in comparison to other member states of the Organisation for Economic Cooperation and Development (OECD).37 With regard to fraudulent activity, Diagram 3.2 elaborates by country the Transparency Corruptions Index presented earlier. With regard to due diligence and economic survival Australia endured the global financial crisis (GFC). To boost the economy it diligently applied quantitative easing when deemed essential, although otherwise controversial.38 Confidence to some extent was retained. This may be attributed to a combination of luck, good management, or a concerted diligence in terms of the financial regulatory system, good governance of its banks and other financial institutions. For Securency and NPA, however, the story was not over.

Misrepresentation in the Financial Records Entities that make corrupt payments face the challenge of accounting for those payments. Very few, if any, business entities have accounts within their financial statements called ‘Bribery’ or even ‘Facilitation Payments.’ Therefore we see these transactions disguised and so financial statements and information therein misrepresented. An example of the concealment of payments made to agents by Securency is discussed in the sentencing remarks of Hollingworth, J. in the case of R v Ellery [2012] VSC 349.39 Mr Ellery had pleaded guilty in the Supreme Court of Victoria to a count of false accounting contrary to Section 83(1)(a) of the Crimes Act 1958 (Vic). Ultimately he received a six-month sentence that was wholly suspended for two years.40 Briefly, Mr Ellery was the Chief Financial Officer of Securency in June and July 2006 when he was asked to make a payment of $79,502 to an agent as a commission for work performed in securing a contract between Bank Negara Malaysia and NPA for the supply of polymer banknotes. It was alleged by the Director of Public Prosecutions in separate proceedings that bribes paid to officials in the Malaysian bank were to be paid from the commission paid to the agent. Although Securency was not a party to the contract, it was

Transparency Global Map with Countries Specified

Source: Transparency International. All Rights Reserved. For more information, visit www.transparency.org.

Diagram 3.2

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allegedly determined by the organization that a commission should be paid to the agent and that it should be recorded as a reimbursement of expenses. Apparently this was to be payment in relation to the agent’s on-going development of polymer in Malaysia, rather than a commission. The agent’s company subsequently presented a debit note for the sum of $79,502 to Securency, which Mr Ellery arranged to be paid. The effect of the payment was to record an expense in the Securency financial records—that meant the payment was recorded in the financial records as an expense reimbursement rather than a commission payment to an agent. The case continues. CONCLUDING REMARKS The degree of perceived quality in financial statements is arguably commensurate with the degree of confidence in the financial system overall. Financial statements are used by some to assess the past performance of an entity and to estimate its future prospects. If there was generally a considered reduction in the quality of these financial statements the confidence in, and the performance of, the financial system would be questionable. In essence then business stakeholders, including lawmakers and regulators, should be vigilant in determining what constitutes quality in published financial statements of account. Evidence shows that opportunities for improper behaviour are rife in the conduct of business.41 Whenever incentives for management to manipulate financial statements exist, there will be rationale for fraudulent behaviour to persist, and improper financial reports published in order to conceal the illegal behaviour. Particularly in the case of bribery of foreign officials, we see illegal payments being disguised as legitimate expenses or commission payments, and transacted in an opaque way by the use of foreign bank accounts or special purpose entities. Also, the amount of effort and creativity required to hide illegal transactions tends to give lie to such proclamations as ‘this is the way business is done in this country,’ ‘we have to clear the incoming shipment to keep the business operating,’ ‘if the money isn’t paid, the company loses the contract, thousands of jobs will be lost.’ If any of these claims were true, there should be no need to commit fraud to keep such transactions secret. Yet fraud persists and examples of bribery and corrupt practice continue in particular to secure continuity of business. In the case of Alcoa World Alumina, the company acknowledged it was involved in improper offshore banking and shell companies. The transactions therein were utilized to channel bribes and otherwise corrupt payments to government officials.42 In the more recent case of GlaxoSmithKline and its subsidiaries (GSK) the case surrounds a complex scheme of bribery and related payments that includes hospitals as well as medical practitioners. This is a massive scandal for a

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foreign company and its corrupt practices in China, and one that follows closely on the heels of the Rio Tinto case (2009).43 In 2010 Daimler AG agreed to settle a US Department of Justice investigation into allegations of bribery of foreign public officials in contravention of the Foreign Corrupt Practices Act with the payment of $185 million for combined criminal and civil penalties. In this case, the Department of Justice alleged that Daimler and certain subsidiaries of Daimler engaged in the payment of bribes to foreign government officials. Those payments were supposedly transacted via third-party accounts, corporate cash desks, offshore bank accounts, deceptive pricing arrangements, and third-party intermediaries.44 Court documents further claimed that Daimler and its subsidiaries made improper payments amounting to tens of millions of dollars to foreign officials in up to 22 countries. The payments were to secure contracts with government customers for the purchase of Daimler vehicles. Within Daimler and its subsidiaries, bribe payments were reportedly identified and recorded as commissions, special discounts, and/or “nützliche Aufwendungen” or “N.A.” payments (translation: a useful payment or a necessary payment). The Department of Justice alleged that in all cases, Daimler improperly recorded these corrupt payments in its corporate books and records.45 All such misrepresentations and instances of false accounting feed ultimately into the quality of the financial statements. Hence the construct of each element contained within the financial statements and the financial equivalent given to each is of concern. Chapter four explores fundamental elements of those financial accounts such as assets, revenue, and expenses. Chapter five continues by examining facets of liabilities as financial obligations.

NOTES 1. For instance, Wolnizer (1987) provided an enlightened view from an auditing perspective. In later works Chambers and Wolnizer (1990 and 1991) focussed on truth from what may be determined as a true as well as a fair view of an entity’s financial position. 2. In, for instance, the Australian Corporations Act (2001) s.297 mandates both ‘a true and fair view.’ 3. See ‘A true and fair view of position and results: the historical background,’ pp. 197–213. Full reference details in the bibliography. 4. Cases and discussion in Margret (2002); Clarke et al. (1997 and 2003); Clarke and Dean (2007); Margret (2012) and references therein elaborate. 5. See Margret (2012, p. 3) and readings therein for further explanation. 6. Consider the circumstances of Waste Management (USA) and the manipulation of depreciation to inflate its assets and overall its financial wherewithal. 7. Rodrigue et al. (2013, p. 302) further explained their study extended ‘Simons’ lever of control perspective into a new realm, showing that EPI can be used as either diagnostic or interactive controls, in light of stakeholder influence.’

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8. As explained previously in Australia, the ACA s.297 mandates a “true and fair view” of the entity’s financial position and financial performance. Additionally ACA, s.295A(1) & (2) requires the CEO and CFO support the directors’ declaration of solvency by themselves declaring proper maintenance of the financial records. 9. Refer to Rezaee and Riley (2010, p. 287). Also Jones (editor) (2011) with regard to amortisation (pp. 415, 464) and inflated fixed assets (p. 80). 10. Rezaee and Riley (2010); Jones (2011). 11. The Cameron Ralph Pty Ltd. (2012) independent report on the RBA’s oversight of its subsidiaries Securency and NPA dated March 2012, its findings released February 2013, available at www.rba.gov.au/media-releases/2013/ mr-13–02-inde-review.html, accessed February 2014. 12. Refer to RBA, Document 1 (June 2010): No 78726 @ rba.gov.au 13. Further information available at www.rba.gov.au/banknotes/production/ securency.html, for instance: ‘Joint venture with Securency,’ first accessed December 2011. 14. Ibid. 15. Our Correspondent (2012) ‘Australia’s continuing RBA bribery scandal,’ November, 5, available at www.asiasentinel.com/society/australias-continuingrba-bribery-scandal/ 16. Beforehand: UCB Films PLC. 17. See Cameron Ralph (2012, p. 5). 18. Refer to RBA Document 1: 78726, dated 2 June 2010. 19. Arle Capital Partners, a British group, owns Innovia. See ‘Securency gone, but risk not forgotten’, at www.smh.com.au/action/printArticle?id=4026758 for further details. Accessed March 2014. 20. In addition, see Creighton (2013). 21. See ‘Papers refute RBA chief’, Sydney Morning Herald (SMH) 11 September 2012 available at www.smh.com.au/national/papers-refute-rba-chief20120911–25q6x.html, accessed January 2013. See McKenzie, N. and Baker, R. (2012) ‘Papers refute RBA chief’, Sydney Morning Herald (SMH) Sept. 11, available at www.smh.com.au/national/papers-refute-rba-chief20120911-25q6x.html, accessed January 2013. Also: Joye, C. (2013) ‘Questions remain on RBA’s involvement in scandal’, Australian Financial Review (AFR), October 2, available at www.afr.com/p/national/ques tions_remain_on_rba_involvement_3c6rUWm9E8byi26IxbOOxI, accessed January 2014. 22. The Cameron Ralph Pty Ltd. (2012) independent report on the RBA’s oversight of its subsidiaries Securency and NPA dated March 2012, its findings released February 2013, available at www.rba.gov.au/media-releases/2013/ mr-13–02-inde-review.html, accessed February 2014. 23. The RBA Annual Report (2007) mentioned Hong Kong, Singapore, Taiwan, Vietnam, Malaysia. 24. Ibid. 25. Ibid. 26. Refer to www.rba.gov.au/publications/annual-reports/rba/2007/html/securency. html, accessed February 2014. 27. See article available at www.asiasentinel.com/society/australias-continuingrba-bribery-scandal/, accessed January 2014. 28. Ibid. 29. For further details, refer to the Cameron Ralph (2012) independent report on details of the RBA’s governance. 30. Cameron Ralph (2012, s.ii, pp. 38, 39) under Board Composition.

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31. Ibid. (2012, s.iv, p. 39) under Reporting. 32. Ibid. 33. See, for example, www.rba.gov.au/media-releases/2013/pdf/mr-13–01-igr-secur ency-npa.pdf, accessed February 2014. Also the Cameron Ralph (2012). 34. As reported in the RBA media release 09–11, available at www.rba.gov.au/ media-releases/2009/mr-09–11.html, accessed December 2011. 35. Specific details are readily sourced through the media and online search engines, for example, the article by McKenzie and Baker (2011) ‘Former Securency bosses arrested’, at www.smh.com.au/action/printArticle?id=2464676, full details in the bibliography. 36. Ibid. Also available at www.smh.com.au/business/former-securency-bossesarrested-20110701–1gtr8.html, accessed February 2014. 37. ‘Organisation of Economic Development and Co-operation (OECD). In terms of net debt, only Chile, Denmark, New Zealand, Norway and Sweden have [had] lower levels,’ at www.abs.gov.au/AUSSTATS/[email protected]/Lookup/1301.0 Chapter27092009%E2%80%9310#, accessed March 2014. 38. See, for instance, www.abs.gov.au/AUSSTATS/[email protected]/Lookup/1301.0Chap ter27092009%E2%80%9310#, accessed March 2014. 39. Details may also be found at www.fcpaprofessor.com/category/securencyinternational, accessed June 2014. 40. In R v Ellery [2012] VSC 349, available at www.austlii.edu.au. Further details are also available at www.fcpaprofessor.com/category/securency-international 41. In addition to other cases mentioned herein, see also the circumstances surrounding the cases of Daimler-Chrysler (US), Alcoa World Alumina (US), and GlaxoSmithKline (China). 42. Refer to, for instance, www.theguardian.com/business/2014/jan/09/alcoabahrain-bribery-us-kickbacks, accessed July 2014. 43. Further details are available at http://uk.reuters.com/article/2014/05/27/ uk-gsk-sfo-idUKKBN0E72AX20140527, accessed July 2014. 44. See US Department of Justice, Office of Public Affairs, Press Release, 9 January 2014. Reproduced at www.justice.gov/opa/pr/2010/april/10-crm-360. html, accessed 21 April 2014. 45. Also refer to: Department of Justice, Office of Public Affairs, media release, Thursday, 1 April 2010, ‘Daimler AG and Three Subsidiaries Resolve Foreign Corrupt Practices Act Investigation and Agree to Pay $93.6 Million in Criminal Penalties. Combined Criminal and Civil Penalties of $185 Million to be Paid’. Available at www.justice.gov/opa/pr/2010/April/10-crm-360.html, accessed 10 September 2014.

BIBLIOGRAPHY Australian Corporations Act (2001) Butterworths, Sydney. Cameron Ralph Pty Ltd. (2012) Independent report on the RBA’s oversight of its subsidiaries Securency and NPA, findings released February 2013, available at www.rba.gov.au/media-releases/2013/mr-13–02-inde-review.html, accessed February 2014. Chambers, R. J. and Wolnizer, P. W. (1990) ‘A true and fair view of financial position’, Company and Securities Law Journal, December, pp. 353–368. Chambers, R. J. and Wolnizer, P. W. (1991) ‘A true and fair view of position and results: The historical background’, Accounting, Business and Financial History, Vol. 1, No. 2, pp. 197–213.

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Clarke, F. L., Dean, G., and Oliver, K. G. (2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, Melbourne. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne. COSO (2010) ‘Fraudulent Financial Reporting: 1987–2007’, An analysis of US Public Companies, Commissioned by the Committee of Sponsoring Organizations (COSO), May. Available at www.coso.org/documents/cosofraudstudy2010_001. pdf, accessed February 2014. Creighton, A. (2013) ‘RBA sells scandal-hit subsidiary Securency International’, The Australian, February 13, 2013, available at www.theaustralian.com.au/ business/companies/rba-sells-scandal-hit-subsidiary-securency-international/ story-fn91v9q3–1226576553681, accessed January 2014. Hollingworth, J. In R v Ellery [2012] VSC 349. Joye, C. (2013) ‘Questions remain on RBA’s involvement in scandal’, Australian Financial Review (AFR), October 2, 2013, available at www.afr.com/p/national/ questions_remain_on_rba_involvement_3c6rUWm9E8byi26IxbOOxI, accessed January 2014. Margret, J. E. (2002) ‘Insolvency and tests of insolvency: An analysis of the “balance sheet” and “cash flow” tests’, Australian Accounting Review, Vol. 12, No. 2, pp. 59–72. Margret, J. E. (2012) Solvency in Financial Accounting, Routledge/Taylor and Francis Group, New York. McKenzie, N. and Baker, R. (2011) ‘Former Securency bosses arrested’ Sydney Morning Herald (SMH), July 11, available at www.smh.com.au/business/ former-securency-bosses-arrested-20110701–1gtr8.html#ixzz2sDHe2Zfj, accessed January and March, 2014. McKenzie, N. and Baker, R. (2012) ‘Papers refute RBA chief’, Sydney Morning Herald (SMH), 11 September, available at www.smh.com.au/national/papers-refut e-rba-chief-20120911–25q6x.html, accessed January 2014. Our Correspondent (2012) ‘Australia’s continuing RBA bribery scandal’, Asia Sentinel, 5 November, available at www.asiasentinel.com/society/australias-continuingrba-bribery-scandal/, accessed January 2014. Rezaee, Z. and Riley, R. (2010) Financial Statement Fraud: Prevention and detection, John Wiley and Sons, Hoboken, New Jersey. Rodrigue, M., Magnan, M., and Boulianne, E. (2013) ‘Stakeholders’ influence on environmental strategy and performance indicators: A managerial perspective’, Management Accounting Research, Vol. 24, Issue 4, pp. 301–316. Simons, R. (1995) Levers of Control: How managers use innovative control systems to drive strategic renewal, Harvard Business School Press, Boston, MA. Wolnizer, P.W. (1987) Auditing as Independent Authentication, Sydney University Press, Sydney.

4

Fundamental Elements Assets, Revenue, and Expenses

Business operation means a constant process of shifting in both property and equity. (Paton, 1917, p. 25)

ELEMENTS IN FINANCIAL ACCOUNTS Assets, revenue, and expenses are fundamental elements in the conduct of business. They are also fundamental to recording and reporting on the financial outcomes of a business entity’s commercial transactions. Hence they are inherent in the process of determining a business entity’s financial capacity to transact its business and to continue to do so. The way in which these elements are firstly considered by the entity, and then recorded in numeric form in its books, are crucial in depicting its financial state. In this context, the definition of each element is vital to the process and ultimately to the quality of the content in published financial statements. There has been much debate in financial accounting and related disciplines about how best to define the elements of financial reports and therein state their monetary (or other) equivalents.1 Such argument has resulted in little change, essentially in generally accepted accounting procedures (GAAP) globally. This is evident as the historical cost basis (capitalization of expenses) method otherwise known as historical cost accounting (HCA) that underpins financial accounting statements has endured for well over a hundred years.2 Its longevity is understandable as the convenience of book-keeping with original costs supports the technical application of the conventional double-entry accounting system.3 In itself this is not a problem—necessarily. But it demands that one differentiates between the technical constructs of book-keeping practices and the deliberations and critical analysis inherent in professional accounting applications.4 For example: Paton (1917) differentiated between book-keeping and accounting (p. 7). The difference is especially critical in comprehending the construct of accounts and how they may be used to ascertain a business entity’s dated financial state. Paton remarked on the probability of confused

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entries with regard to difficulties of classification in the double-entry system of HCA. He reiterated however that there was ‘little hope of changing [its] usage [because it was] . . . so well established’ (1917, p. 10). But to some, this view (of habitual behaviour and acceptance) is not acceptable.5 In reporting financial outcomes of business operations, the continued use of the HCA method does not in itself justify certain results.6 This is of particular concern in circumstances of unexpected business failure, insolvencies, insolvent trading, and fraud. In which case, the recorded book amounts are likely to be inflated. Paton (1917), focussing on insolvency, stated ‘the book-value of the equities may be greater than the value of the property [assets]’ (p. 10). He continued that when a business, through loss, disperses its assets but retains the recorded book amounts, there is likely ‘an equality that is not grounded in any logical classification of facts, but is rather artificially maintained by including among the so-called equity items highly dissimilar things’ (p. 11). Arguably it is a trait of mankind to want to retain that which is familiar and to continue to use procedures that are well-known. MacNeal (1939) considered that ‘history records no unwillingness quite so persistent as the unwillingness of mankind to abandon time-honored [sic] principles’ (p. 184). Yet across time, changing circumstances, whether environmental, commercial, or personal, decree sometimes that we alter previously held beliefs or opinions. It is evident that on occasion, rules, laws, regulations, and theoretical notions and the relationships between them are revised, adjusted, or corrected to better reflect facts, conditions, and the tone of the day. ‘We cannot presume that a relationship which existed at a previous point in time still exists. . . . Because [for instance] the financial relationship between an entity and the market environment is dynamic, its solvency, gearing and profitability do not remain constant over time.’ (Wolnizer, 1987, p. 12). With specific regard to the elements of financial reports Paton (1917) suggested that the use of the terms ‘property and equities’ instead of ‘assets and liabilities’ would be better to avoid the ‘danger of misunderstanding and bad accounting practice’ (1917, p. 10). Of course, that was stated in the context of the day. Nonetheless he reasoned that across an era the use of the terms had become entrenched in accounting practice, and although the differences were of practical import, they were not fundamental to accounting.7 This is curious. It is especially so given the sometimes contentious nature of items recorded as assets in commercial or other organizations’ books of account. In that vein, the definition of each element and the financial equivalents of same as recorded in the accounts and reported in the financial statements are of concern.

In Numerics Business stakeholders might well expect that the numeric content of an entity’s accounts are precise and serviceable for analysis and interpretation of the entity’s financial wherewithal. In that context the numbers arguably should reflect the adaptive and changing nature of business and the entity’s

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financial capacity to continue its operations. Nonetheless this apparently essential element is lost sometimes frequently in the construct of accounts, as discussed in chapter three. Thus it remains that certain generally accepted accounting techniques may result in erroneous representations of a business entity’s financial worth. This is evident across many cases of unexpected corporate collapses prior to, during, and beyond the twentieth century.8 In the calculation of depreciation expense, for example, Leake (1912) stated that ‘[i]n its true commercial sense the word depreciation means [a] fall in exchangeable value of wasting assets’ (1912/1976, p. 9). In conventional financial accounting practice, however, depreciation is an allocation of cost across time. It is calculated by formula and as such the depreciation amount is an estimate. It is considered an expense and is applied to diminish the recorded amount of an asset. Hence it is important in the process of accounting for the financial position of a business entity. As depreciation is a calculated number, it can be altered. Essentially, this is not a problem. However, if depreciation expense is changed inexplicably, it may signal a problem. If it is altered with the intent to inappropriately record asset holdings, it may flag a fraudulent act. So it is essential to comprehend that depreciation expense in conventional financial statements is the result of a calculation. On that note, and the fact that the calculation can alter, Most (1977, p. 289) warned that depreciation ‘methods are equally arbitrary, whether based on years of useful life, units of output, hours of production or even estimated net revenues.’ The case of Waste Management Inc. (2002) in the USA is an exemplar. It was alleged (US District Court in Chicago) that the company misrepresented its financial state during a five-year period, 1992–1997.9 Its story shows the capacity for an entity to manipulate its depreciation expense and overstate its assets and financial worth. Nonetheless it is relevant for continued debate to consider that: ‘Waste Management’s problem with estimating asset lives for depreciation purposes is not uncommon. . . . Its simple modus operandi was to lengthen the estimates of the trucks’ useful lives and thereby lessen the yearly depreciation charges, increasing reported profit figures’ (Clarke and Dean, 2007, p. 110).

Waste Management in Brief On the 26 March 2002, the Securities and Exchange Commission filed suit in the US District Court in Chicago against the founder of Waste Management Inc. and five of its former senior executives.10 It was alleged a systematic fraud that lasted over five years led to the misrepresentation of the company’s financial results between 1992 and 1997.11 Further that the fraud was perpetrated in order to meet predetermined earnings targets. Depreciation was not the only element in the accounts to be affected. Others included unrecorded asset write-offs, improperly deferred and capitalized expenses, unrecorded expenses, and under-reserved liabilities, including income tax.

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It is often the case with fraud in financial statements that the crime has its genesis in the pressure management perceives it is under in attempting to meet earnings or profit expectations. Those expectations may be set either by managers themselves or superiors in the company, or by the market or by financial analysts. The case of Waste Management further illustrates outcomes that may be attributed, in part, to improbable targets that are supposedly set to measure employees’ performance. In the case of Waste Management, in order to meet targets that were perhaps perceived as ‘unrealistic,’ management allegedly and improperly eliminated and deferred current period expenses to inflate current earnings—among other improprieties. In their media release (2002–44), the SEC alleged that the fraud pursued by the executives included avoiding depreciation expenses on garbage trucks. This included using unsubstantiated and exaggerated salvage values. In addition, the useful lives of the trucks were increased. Other schemes involved allocating somewhat random salvage amounts to other assets, ignoring expenses related to the diminishing values of landfill and so understating expenses. This understatement was increased by then not recording expenses incurred in writing off associated costs of abandoned projects in landfill expansion. Apparently liabilities in conjunction with environment reserves were also inflated. Seemingly this was done to provide reserves in excess to evade the recognition of some operating expenses. Nonetheless there were not sufficient reserves established to cover expenses such as taxation. There were, however, a number of expenses improperly capitalized and so assets were inflated.12 It was also alleged therein that the company’s auditors were somewhat complicit in the fraud. This was considered so because the auditor’s did not produce qualified audit opinions on what were later deemed to be material circumstances. Earlier there was some dispute on circumstances of conflict of interest due to ‘capped audit fees’ and that the auditor had supposedly calculated the influence of inappropriate accounting procedures on the entity’s reported financial state that was not, allegedly, attended to by management. The details of arrangements such as side agreements to shape the fraud are debatably relevant here; because if the initial act is intentionally to deceive, then, regardless of ‘agreements,’ fraud in the financial statements is most likely. A similar example concerned that of a local government entity (a local Council) in Australia. In this case the Council, in an attempt to increase its traditional revenue base, created a profit making enterprise (a company) that would be wholly owned by, but independent of, the Council.

The Case of a Local Government Council (Australia) The company was to provide services to the Council’s residents typically expected to be undertaken by the Council itself. Those services included road construction and maintenance, parks and gardens maintenance, and waste management. The company was also expected to compete with the

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private sector to provide such services to other councils in varying localities. In addition, the company included a wholly owned subsidiary—a commercial printing company—that was also involved in research and development of software that could be applied to local governments. As such it could further enhance revenues. At the helm was a General Manager who would report regularly to a Board of Management. Management had high expectations that the company would perform well for the benefit of the Council, and ultimately the increased financial returns would benefit the local residents. The expected financial returns, however, did not eventuate. Costs were higher than anticipated and work the company was tendering for were not scoped properly and thus resulted in under-costed jobs. In turn those jobs resulted in little to no profit. The ensuing problems understandably caused grief for the general manager who was not keen on reporting losses to the board of management. Hence the general manager’s perception of work-related pressure escalated. Thereafter it seems considerable thought was given by senior management to how those losses might be turned into profits. This was so discerned because a number of different techniques were somewhat rapidly developed to increase reported profits by altering accounting numbers. Allegedly, one such procedure was to alter the calculation of the company’s depreciation expenses and so increase the reported profit and inflate the company’s asset holding. Subsequently its depreciation expense was under-stated for certain assets like heavy vehicles and garbage trucks, and those assets were overstated in the company’s books of account. As may be expected, the strategy to inflate the financial condition of the company appeared to work for a number of accounting periods, but it was short-lived. Problems again arose when the vehicles in question needed to be replaced. The carrying value of those vehicles as recorded in the company’s financial records was not anywhere near their realisable value in accord with the market, current at that time. This meant the company was positioned to take a significant loss on the sale of those assets. In order to alleviate this problem, an arrangement was entered into with the provider of the replacement vehicles. The plan was to record the sale price of the old vehicles at their book value and to increase the purchase price of the new vehicles by a commensurate amount. The effect of this was to capitalize the amount that would have been the loss on sale of the vehicles. In this way the equivalent dollar amount recorded for the new vehicles (assets) was inflated. As the purchase price of the new assets was inflated, the depreciation charge to be allocated across future accounting periods would also be an improper amount.

On Depreciation Any change in the calculated depreciable amount of an asset will result in a change in the carry-forward amount of the related asset in the financial statements. That in turn will alter the asset’s equivalent monetary amount recorded in the financial accounts for each period. It will also change the

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reported financial state of the entity. In addition to the example of the Council, discussed in detail above, depreciation expense might also be altered by change in the estimated useful life of the asset and its likely salvage value. Accounting standards provide guidance in recognizing depreciable assets13 and in determining the amount to be depreciated14 as well as the depreciation method to be used.15 This not only provides assistance for financial accountants in fulfilling their duties, it also provides opportunity for misinformation to be circulated. To avoid speculation on, or allegations of, intended abuse of the system, management need to fully disclose reasons for any change or proposed change to such calculations. Business entities, for instance, are expected to alter the reported asset monetary values when asset items are impaired.16 An asset is impaired when the recoverable amount on the asset is less than its book-carrying amount. Specific definitions are available in AASB136 (para.6), the international equivalent is IAS36 Impairment of Assets. Other depreciable items are covered, for instance, at AASB102 (IAS2) Inventories; AASB111 (IAS11) Construction Contracts; AASB112 (IAS12) Income Taxes; AASB119 (IAS19) Employee Benefits, AASB139 (IAS39) Financial Instruments: Recognition and measurement, AASB140 (IAS40) Investment Property, AASB141 (IAS41) Agriculture (biological assets). Deferred acquisition costs and intangible assets related to insurer’s contracts are covered at AASB4 (IFRS4)17 Insurance Contracts, AASB1023 (IFRS4) General Insurance Contracts and AASB1038 (IFRS4) Life Insurance Contracts. Other fixed assets are covered at AASB5 (IFRS5) under Non-Current Assets Held for Sale and Discontinued Operations. It is curious that in comparison to depreciation, amortization, and impairment of assets, limited attention is given to the appreciation of business assets. Clarke and Dean (2007, p. 17) alluded to many claims across time ‘that one of the problems in the late 1920s and early 1930s was the abuse of asset revaluations (“appreciation” was the label then) to produce creative accounts.’ They argued, however, that presenting ‘the money’s worth of items was not the cause of the problems in either era’ (p. 17). Their continued discourse with case examples is enlightening. To continue, the following sections focus in turn on assets, revenues, and expenses. As expenses are sometimes capitalized inappropriately and reported as assets they are here included. The emphasis is that the capitalization process can be problematic. In regard to management endeavours and the possibilities of error, mismanagement, or fraud, this is important.

ASSETS

The Concept of an Asset Assets generally denote something of value whether of a monetary, intrinsic, or emotional worth to a particular person, family, group, business,

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corporation, or other entity. As such, an asset may be of a tangible or intangible state. In everyday life, in a money economy, assets are considered somewhat broadly as something that contributes to our accumulated wealth. Assets are usually owned but they may also be controlled, as in a leased item of some consequence; for a business entity that may be a fleet of cars, tractors, warehouses, office space, or the like. Ordinarily, we tend to think of our assets as that which may be converted to an alternative resource hopefully of equal or greater value. So a house, for instance, is an asset that may be sold and converted to money. In that context both the cash money and the house are assets, resources, and symbols of wealth. Likewise an owned piece of artwork, such as a painting or a sculpture may be of substantial financial worth, or it may be of intrinsic worth. The latter explains that the consequence of money in this instance is of a secondary nature; perhaps because the art work was painted or sculptured by a family member and held within that family for some time. If so it probably, as opposed a financial value, has an emotional and/or sentimental value, to the extent that the family are unlikely to give it up. For the individual then, the concept of what signifies an asset is likely to be dependent upon the situation at hand. Assets held may reflect an accumulation of wealth based on what the individual wants and changes in those wants across time. In that case some assets will relate to financial considerations necessary for use as collateral in furthering wealth or used to cover debt obligations. Seemingly this is not that different from a business perspective. Yet across time the focus on what constitutes an asset in a commercial environment has, in financial accounting, changed considerably. Williams (2003) provided an in-depth historical account of what denotes an asset. She explained the historical transition from use of words such as ‘effects’ and ‘property’ with emphasis on ownership and exchangeability, to the use of the word ‘assets,’ with its meaning originally attributed to ‘sufficient’ in terms of meeting claims—against the person or other entity.18 In conventional financial accounting, however, assets are defined in an intangible context, with particular regard to an entity’s expected future economic benefits. The transition signalled a move away from attention on the balance sheet to determine an entity’s financial worth to emphasize the earnings potential of an entity. The latter changed focus to the profit and loss statement. It also reduced attention on the construct of the balance sheet as a statement of financial position; and the monetary equivalents of those assets as recorded therein. The shift to future benefits and service potential as the accepted norm was duly rationalized. The intangible as an asset gained momentum. Williams (2003, p. 150) explained ‘[a]s cost allocations (such as depreciation), based on expectations of future earnings and asset usage came to dominate practice, the accounting profession struggled to provide a theoretically defensible definition of the unallocated costs reported in the balance sheet.’ Thus the opportunity

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to create illusionary assets increased. Arguably the opportunities to commit fraud heightened. In dispute resolutions the necessity to equate assets with their current monetary worth is sometimes vital. This is likely to occur, for instance, in determining an entity’s state of solvency, or if a business is trading while insolvent, or perhaps in some divorce proceedings.

In Resolving Financial Disputes On occasion individuals may be required to produce written statements of their personal financial circumstances. This could occur for many reasons—for example, when a couple are settling finances as a result of a divorce, or when a person is applying to a financial institution for a loan, or when setting up a business partnership, or when in dispute with creditors and such. In each case the elements of the financial statement may differ, or should differ, because the prevailing circumstances are different. Typically in the case of divorce proceedings the financial statements are concerned with assets and liabilities. Assets in this case may more precisely be referred to as property. Liabilities will be obligations but more specifically debt. Hence, in a financial sense, the property owned minus the debt owing will equal the net wealth of the parties involved. In this situation the ‘assets’ otherwise known as the ‘property’ need to be carefully defined and identified to enable a ‘true’ value, in the context of a monetary equivalent, to be discerned. The quote marks are used here to emphasize that the words therein are problematic in accounting, and they must be considered in the context of the situation at hand. Another symbol of asset confusion has to do with heritage assets. Those collections of arguably untold financial value are an incalculable worth that is debatably immeasurable. That is not least because they in fact belong to the people of the relevant nation. Nonetheless, some want and attempt to seemingly de-value them by sticking the collections, those heritage assets, onto a balance sheet. There may be argument for doing so as Ouda (2014) expresses. There is also definitive argument for not doing so (Carnegie and Wolnizer 1999). The debate continues and is warranted in delimiting opportunities for misleading stakeholders (in this case primarily the public) and the possibility of fraud.

The Case of Heritage and National Assets Consider the story of a nation’s museum of arts and historical treasures, of which its authoritative powers wanted to value the museum’s collections as financial assets—in order to construct a financial statement of worth—as though this could ever actually be achieved! The museum and its collections belonged and belong to the people of the nation. To attempt to put a financial amount on such arguably priceless objects, and call it a financial value,

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is to some a malignant action. To others it may be deemed pathetic. It is questionably, perhaps, a worthless exercise except to those who will derive a perceived or a direct benefit from the act. If done with the intent to mislead or deceive, it could also be labelled fraudulent. Carnegie and Wolnizer (1995) asserted that such ‘collections cannot properly be described as financial assets’ (p. 31). Further that they ‘sympathise[d] with Adams’ (1937, p. 2) view that to represent the collections in financial terms for inclusion in a balance sheet would be an “intellectual vulgarism”, and suggest that any such financial quantification would also be an accounting fiction’ (pp. 31–32). How far we may go in fictionalizing accounting numbers ‘legally’; or inventing financial stories with intent to deceive might be considered debatable. It is unquestionably of concern.

In the Case of a Bank Loan The overstatement of the value of assets has historically been a significant problem when individuals are seeking a bank loan. In order to qualify, not only do banks want to know that the loan can be serviced by sufficient income, but they want to know that in the event of default the sum advanced can be recovered by sale of the asset being financed or by the sale of some other asset. Therefore we often see the value of the asset (say, a house) being financed, and the value of other assets of the would-be borrower, being deliberately over-valued. It is often the case when banks closely examine bad-loan files. There it is likely discovered that the borrowers should never have been advanced funds in the first place. One reason is because they have misstated the value of the assets that were used to secure the borrowings. In the past, this type of fraud has been a significant problem globally.19 In Australia, this problem surfaced particularly when, shall we say, rogue loan brokers20 were involved in securing finance for their clients. In some cases brokers were so keen to earn financial commissions and other rewards for securing loans for their clients, that they misstated assets and liabilities on financial statements prepared for loan applications. And they did so without their client’s knowledge. The fact that loan applications do require a statement of financial position from the applicant is notable because it is important how that statement is constructed—hence how the elements within are defined.

Financial Accounting Assets The balance sheet, over time, has been referred to as a statement of financial position.21 This is confusing because, arguably, a balance sheet and a statement of financial position are not the same. Basically, the balance sheet delineates an entity’s assets, liabilities, and equity; whereas, an entity’s statement of financial position could be expected to (and should) clarify the entity’s financial state; with regard to the results of its business activities at

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a particular point in time. The balance sheet depicts the ledger balances of the entity, correctly tabled so that an entity’s debits equal its credits. This has regard for the double entry bookkeeping processes of accounting. That is, if the balance sheet is balanced (debits = credits), the books of account within a business entity accurately detail the entity’s recording of its business transactions in numerics for a particular period. This is done with due regard for GAAP and the law. As such the balance sheet shows a technically correct bookkeeping application of rules and accepted accounting principles. In that context, it does not resemble a financial statement that is helpful to stakeholders in determining the dated financial worth of an entity’s assets. Moreover, it is not helpful in ascertaining an entity’s net financial worth or its state of solvency.22 In some circumstances, like the possibility of insolvent trading and/ or fraudulent activity, this concern intensifies. In the following case, of JBI Inc. (USA), the SEC alleged that the company misrepresented and overstated the actual financial value of certain assets. So on that basis its statement of financial position would warrant investigation. At the same time, the company’s balance sheet may have ‘accurately’ tabled the entity’s ledger balances and in that context correctly depicted that its debits equalled its credits. The latter is not a statement of financial value, however, it is a statement of numbers.

THE CASE OF JBI INC. (JBI)

Background JBI Inc. began its life as John Bordynuik, Inc., and that company was initially incorporated in 2005 in Canada. At that time its business was data recovery and restoration, later with further research and development the company moved into liquid hydrocarbons (oil). In 2009 the company acquired 310 Holdings, Inc., reportedly a development company. Then by ‘July 15, 2009 in a purportedly arms length transaction, 310 Holdings purchased the assets of John Bordynuik, Inc’.23 The story of the acquisition resembled somewhat the pre- and post-takeover (and reverse takeover) tale in the 1988 Duke affair in Australia and that story is elaborated in Margret (2012, pp. 126–129). Returning to 310 Holdings, Inc., by October 2009 it had become JBI Inc.24 The following concentrate on specific financials that could be considered manoeuvres and relevant to the tale herein.

Details of JBI in Brief By 2012 the SEC alleged that during two reporting periods in 2009, and in contravention of GAAP, JBI produced materially false and inaccurate financial information in its financial statements. Further that the company

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misrepresented and overstated the actual value of certain assets, known as ‘media credits.’ These credits were correlated apparently with prepaid print and radio advertisements. The overstatement reportedly by almost 1,000 per cent was to bolster the company’s balance sheet. The company valued these assets (the largest in the company) at $9,997,134 when in fact they had been purchased for $1,000,000 and, according to the SEC, should have been completely written off by 30 September 2009.25 It seems that JBI used the overvalued financial statements in two private capital raising efforts; Private Investment in Public Equity (PIPES) raised over $8.4 million from investors who would have relied on the accuracy of the financial statements. A short time after obtaining the $8.4 million, the company issued a public statement indicating its financial statements could no longer be relied upon. This was partly due to the erroneous valuation of the media credits and other ‘assets’ on the balance sheet. The following is in accord with the complaint.26 Despite being aware of the issues regarding the valuation of the media credits, and of the significance of the value of the media credits for JBI’s balance sheets and other financials the valuations were disputed. Certain senior employees allegedly failed to conduct any reasonable due diligence on the appropriate accounting for those media credits. It was questionable, however, as to how one was to define media credits. Again the definition of assets under particular circumstances comes to the fore, and does so repeatedly it seems. Foremost when the assets are differentiated between those that are tangible, and those that are intangible.

Tangible and Intangible Assets If an item is tangible, it can be seen, it has substance, and it retains a physical and corporeal state. On the other hand, an intangible item is somewhat indefinable. It may be elusive, vague, and even ethereal. In financial accounting assets may be either tangible or intangible. The financial accounting definition of an asset highlights the intangible aspects of what may be deemed to be an asset. So, in a financial sense the substance of the item with regard to its deemed financial worth is of interest. And this is particularly so in terms of insolvent trading and other aspects of error, misrepresentation, and/or fraud. Intangible assets may add a considerable amount to an entity’s book value and its reported financial state. But that amount may have no absolute monetary value in current terms and as such is not necessarily of financial substance for the business. Goodwill, for instance, is fundamentally calculated as the difference between the purchase price of a business and its net asset worth. That amount in financial accounting practice is then usually recorded in the business entity’s books as an asset. The rationale is that goodwill contributes to the business entity’s future earning potential. On the other hand, goodwill has the characteristics of an expense that to some, ought not to be capitalized as an asset.27

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Goodwill in itself is not able to be separated from the business and exchanged for money. As such it has no purchasing power and is not able to be used to pay debts. Pixley (1881/1976, p. 139) referred to assets broadly in two forms, those that were ‘actual and fictitious’; and goodwill was considered a fictitious asset as it more rightly, to him and some others, represented an expense in the acquisition of a business. As previously explained, assets initially were aligned with an entity’s property that was owned and so available to cover the entity’s accumulated debts. So assets were tangible, severable, and exchangeable with emphasis at that time on the ability to determine the solvent state of the entity. In that context, it may be said that ‘money actually expended for any purpose whatever except in the purchase of property is a nominal or fictitious asset . . . incapable of paying anything’ (Cayley, 1894, p. 15). Such ideas were in line with a balance sheet approach to determining the financial position of a business or other entity; including its state of solvency.28 As mentioned above, with the move to an earnings approach to determining a business’ financial state, the focus on solvency decreased. Yet solvency was, and arguably still is, an inherent part of the financial position of a business or other entity. The fix on earnings and the profit and loss account moved conventional accounting thought toward the intangible concept of assets. It also arguably increased opportunities for misleading statements to stakeholders. And that likely resulted in an upsurge of fabricated asset holdings and possibly deceptive statements on earnings. The following case illustrates. THE CASE OF CAPITAL ONE FINANCIAL CORPORATION Capital One Financial Corporation (Capital One),29 a provider of consumer and commercial lending, was found by the SEC to have materially understated its provision for loan and lease losses for the second and third quarters of 2007.30 The SEC issued proceedings against Capital One in 2013 alleging that it understated the provision for loan losses for its automotive finance business, known as Capital One Auto Finance (COAF). As a result of the understatement, Capital One materially understated the provision for loan losses by as much as US$72 million for its second quarterly filing and as much as US$51 million in its third quarterly filing. It was found that from at least October 2006 and continuing through the third quarter of 2007, COAF experienced significantly higher delinquencies for its loans than it had forecasted. It relied heavily on “subprime” consumers and as such experienced higher loss variances across all types of loans, than might otherwise be expected. Toward the end of 2007 its credit markets began to decline. COAF assessed from its internal loss forecasting tool that its escalating loss variances were attributable to an increase in a forecasting factor

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it called the “exogenous.” This factor measured the impact [effect] on credit losses from conditions external to the business, including macroeconomic conditions. A change in the exogenous factor generally had a significant impact on COAF’s loan loss expense.31 ‘Instead of incorporating the full exogenous levels generated by its loss forecasting tool into COAF’s loss forecast, Capital One failed to include any of COAF’s exogenous-driven losses for the second quarter provision for loan losses.’32 Moreover it only included one-third of these incurred losses in its third quarter provision for loan losses. As a result, Capital One’s second and third quarter loan loss expense for COAF did not appropriately estimate probable incurred losses in accordance with accounting requirements. Therefore ‘[a]s a result of Capital One’s understatement, its consolidated provision for loan and lease loss was understated by approximately 18% in the second quarter and 9% in the third quarter of 2007. [Furthermore] COAF’s loan loss expense was understated by approximately 40% and 21%, respectively, for the second and third quarters of 2007.’33 As conventional accounting thought became focussed on assets as items that were to be considered of an economic benefit to the entity, and more precisely a future economic benefit invention became a reality. Aeons ago Page (1916, p. 251) warned that ‘[f]ictitious assets are merely bookkeeping devices to preserve a balance of the books, and to permit the increment of profits for the year to be displayed without influence from the business, transacted in previous years.’ Later, Carter reiterated ‘[f]ictitious assets are those that represent intangible expenditure; such as preliminary expenses . . . which cannot be realized’ (1923, p. 3). The ideas of ‘truth’ and ‘reality’ became more and more a fiction themselves.

OPPORTUNITY AND FRAUD

An Overview The opportunities for fraud and fraudulent behaviour are evident. In 1929 Canning exclaimed ‘to include in . . . the balance sheet mere expectancies would be to introduce items to the value of which is highly speculative among items of value of which can be measured with greater reliability (1929, p. 20). That idea in itself seems quite tentative. The point, however, is the expectation of a financial recompense is a guesstimate, but the expected financial result is sometimes thought of as a fact. Therein is a trap for business stakeholders. Regrettably there is also the heightened potential for fraud. Consider again the concept of goodwill as an asset. In 1939 MacNeal asserted, ‘Goodwill is an estimate of the future . . . It can be created by propaganda and destroyed by a rumor’ (1939, p. 236). The implication across time was that goodwill is, to a purchaser, more in tune with an expense than an asset and should thus be recognized. To a

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seller, goodwill arguably is related to a degree of financial worth built during the period of the conduct of business. In either case goodwill is an intangible. To a seller it may indeed represent an inflow of cash, hence it is an asset. To a purchaser it more precisely represents an outflow of moneys and as such it is an expense. In order to better determine an entity’s financial state Napper (1964) explained, ‘goodwill or intangible assets appearing in the balance sheet will normally be eliminated’ (1964, p. 3). More to the point in 1981 Westwick remarked ‘goodwill . . . cannot be sold except in a sale of the whole business, . . . [and so] goodwill should be written off in acquisition’ (1981, p. 43). Herein we have concentrated mostly on the intangible goodwill to highlight the potential for abuse in the financial accounting domain. There are numerous intangible assets some of which may be exchangeable in a general market environment. For instance, intellectual property might be packaged cleverly and sold as if inventory or some such asset. Mostly, however, intangible assets are not severable from the business entity and as such are not a viable choice in covering debt obligations. In sum both intangible and tangible assets are able to be distorted in terms of their reported financial equivalents in the books of a business and in its published financial statements.34 Mostly this is due to the anomalies within the financial accounting system when using the HCA method that encapsulates the capitalization of expenses. Recall the case of the local council in Australia that manipulated the depreciation rates that were applied to its heavy vehicles. In that case, the general manager also created an intellectual property (called an asset) from his salary expense. He purported to use a percentage of his time in the office developing future income-generating offerings (in particular computer terminals) that could be used by customers to explore the tourism opportunities in the area. On this basis, the general manager capitalized a percentage of his salary. In this vein he achieved not only a reduction in expenses incurred by the organization, but simultaneously created an asset on the balance sheet.

GOODWILL AND THE OPPORTUNITY FOR FRAUD

In the Case of Caterpillar Inc. (Caterpillar) On a much larger scale, in January 2013 Caterpillar announced that an internal investigation had uncovered deliberate, multi-year, coordinated accounting misconduct at Siwei (Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd.).35 This entity was a wholly owned subsidiary of ERA which Caterpillar had acquired in June 2012 for $886 million. The fraud as discovered led to a non-cash goodwill impairment charge. Caterpillar’s investigation determined that certain Siwei senior managers, one of

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whom was an ERA director, had engaged in this misconduct and, as a result, Caterpillar removed all those responsible. Caterpillar consequently announced that it would be taking a $580 million write-down in the fourth quarter. This was subsequent to identifying the accounting fraud. Furthermore, in its press release of 18 January 2013, Caterpillar announced that an internal investigation had revealed discrepancies between the recorded inventory amounts and those attributed to the physical count. The difference was reportedly due to an improper cost allocation that in turn resulted in an overstated profit figure. Following, and as might be expected, the investigation seemingly identified improper revenue practices that included early and at times unsupported revenue recognition.36 REVENUE Revenue can be viewed as money paid or owed to the business for the provision of goods and/or services, interest on investments, royalties, or dividends.37 In accord with international accounting standards revenue is a flow of “economic benefits” to the entity related to its business activities for a certain time period.38 This concept differentiates business revenue from a contribution of moneys to the entity from its owners. The former is potentially an increase in earnings whereas the latter indicates an inflow of capital and a direct increase in owners’ equity. It is important for a business to delineate carefully its earnings from its operations, against other monetary contributions or cash inflows. For instance, dependent on the type of business and its normal activities, the sale of fixed assets is not revenue—necessarily. Fixed assets usually are not a part of general business operations. Hence, if treated as such, this is likely to be a flag signalling a problem even a possible fraudulent act. The timing of revenue recognition in the books of account is potentially another area of concern. It requires focus on the probability of the entity receiving its moneys due and that the amount determined to be revenue can be measured reliably.39 Across industries there are different circumstances that may denote the recognition of revenue. In the agricultural industry alone there are many choices available for the legitimate recognition of revenue. Such flexibility is warranted in the mode of good business practice and the requisite need for businesses at times to raise funds for the continuity of their operations. On the other hand, it is also an avenue rife for the possibility to misrepresent a business entity’s most likely financial situation with the intent to deceive. In 1999 the Committee of Sponsoring Organisations of the Treadway Commission (COSO) commissioned an analysis of public companies in the USA that had regard for fraud in financial reports for a ten-year period between 1987 to 1997.40 The COSO study (1999) identified in excess of half of the frauds in financial statements concerned an overstatement of revenues. Mostly this

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involved recording the revenues prematurely or fictitiously, and the timing of when those transactions were recorded was also an issue.41 Additionally there was on average a misstatement of revenues, pre-tax income, and net income that seemingly moved from a $9.2 million amount to $16.5 million; and this occurred with the median range moving from $2.3 million to $5.4 million.42 Improper methods of recognition of revenue according to the study concerned 26 per cent of fictitious revenues and 24 per cent that involved recording revenues prematurely.43 Later in 2010, COSO again commissioned such an analysis of U.S. Public Companies from 1998 to 2007. Although at this time more than four years old, many of the findings and observations are as relevant now as they were then.44 This COSO study identified that the two most common techniques used to overstate financial statements were improper revenue recognition (61%) and overstatement of assets (51%), ‘primarily by overvaluing existing assets or capitalizing expenses.’45 It found that the total misstatement including misappropriation crossing 300 fraud cases was almost $120 billion. The mean of which was around $400 million per case in comparison to $25 million in the 1999 study. More to the point the median fraud (2010 study) was $12.05 million and that tripled the median fraud (1999 study) of $4.1 million.46 Furthermore, the most cited motivators for FSF included: • the perceived pressure to meet earnings expectations (internal or external); • attempting to hide the company’s declining financial state; • a perceived need to increase the company’s stock (securities) price; • boosting financial results in anticipation of debt or equity funding; • the pursuit of increased management reimbursements, relevant to financial performance and outcomes.47 In financial accounting, revenue for a particular accounting period is meant to be matched to the relevant expenses in earning that revenue. In this matching process only revenue related to the specific accounting period should be, in accord with conventional accounting practice, reported in that time frame. Hence the timing of revenue recognition within a business entity’s books of account is crucial in determining the entity’s periodic earnings. If recorded incorrectly then the calculation of earnings can be inflated or, alternatively, the entity’s reported periodic profit may be too low. Both are conducive to situations that can likely create opportunities for fraud.

A Balance Sheet Focus Revenue may be either cash received or the expectation to receive payment for the provision of goods and or services in trade. Hence the financial worth

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of recorded revenue, in money, to any business is ultimately the amount actually received by the business. In that sense revenue is an important part of calculated income and is reported in the profit and loss statement (or statement of financial performance). In the balance sheet, revenue—yet to be received—is reported as accounts receivable (or debtors). In this context the amount owing to the business is recognized as an asset and if tampered with, it can considerably alter the reported financial state of the entity. Thus accounts receivable form a significant part of the statement of a business entity’s financial worth. Further, the dated worth of the entity’s accounts receivable ought to be correlated most carefully with the likelihood of actually receiving the money. Hence the need to account for the possibility of bad debts, and the amount that will most likely be written off is vital. Moreover to mitigate opportunities for disclosure fraud this process, and its outcomes ought to be relayed precisely by the business to its stakeholders. In the case of a not-for-profit organization the concept of revenue differs. Whereas earnings from business operations in the for-profit organization result in an inflow of money; in the not-for-profit organization its yield represents an outflow of money. Carnegie and Wolnizer (1995, p. 38) explained ‘[c]ommercial or profit-seeking enterprises aim to obtain a net transfer of funds from others; not-for-profit organisations (sic) make a net transfer of funds to others.

In the Case of Not-for-Profit (NFP) It may seem unusual for FSF to appear within the not-for-profit sector, but the perception of pressure is real and of similar intensity to other sectors. As the not-for-profit sector becomes increasingly competitive and entrepreneurial this basic factor of the fraud triangle (pressure) increases.48 At times for example, in order to receive government funding an organisation must provide evidence of its financial viability by producing detailed financial statements. This is in itself can be problematic. Most particularly because the not-for-profit organization is, and has been historically, regarded as one not involved in commercial trade. In the case of dealing with heritage assets reporting on same in the context of conventional financial statements is something of an anomaly. That is, the organization is concerned with “being”, “caring for”, and “holding” onto their heritage items (collections) for the benefit of the public. Arguably heritage assets of any nation belong to that nation and its people. Thus a conventional financial statement to depict the assets and the entity’s financial worth may be considered bizarre. For further discourse on these and related matters see Carnegie and Wolnizer (1995); Stanton and Stanton (1997) and references therein. On the other hand after decades of debate there is apparently no ultimate definition of, or for, heritage assets. Nor is there universally a generally

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accepted accounting method to record and report on those assets or their financial state. Importantly Ouda (2014, p. 31) asserted, ‘there is an urgent need to develop a new Accounting Approach . . . for heritage assets . . . to avoid the exaggeration of net worth and the distortion of performance statement.’ He advocated a ‘Practical Approach’ (pp. 31, 32). And in the face of escalating circumstances of fraud world-wide, the debate continues.

One Not-for-Profit Case Example A not-for-profit organization seeking grant funding from a government authority created separate companies that were wholly owned by the parent. In order to give the impression of a healthy financial outlook, the parent company created receivables from its subsidiaries. In effect the company was trading with itself by providing “shared service” administration facilities to the subsidiaries which created receivables from those services. To some the viability of the parent organization appeared robust. The collectability of the receivables, however, was questionable. Moreover the extent to which any services were actually provided to the subsidiaries was in doubt. For the government a major problem was that the grant funding agreements did not provide for the ability to examine the financial statements of the subsidiary companies. Therefore the legitimacy of the inter-company services could not fully be examined and so verified. As this book goes to print, this case is still under investigation.

Dubious Receivables: ZZZZ Best Carpet Cleaning Company (ZZZZ) Barry Minkow, once feted as a wonder boy of Wall Street, when interviewed in prison in 1992 by the Association of Certified Fraud Examiners reportedly stated: [W]ell accounts receivable are a wonderful thing, they are a tool that is used by a fraudster like me to ask to borrow money, mainly, and to show earnings. So I can borrow money, hey I need the money look at these receivables, and I can show earnings because once you book the receivables you are already accounting for the income and [thus] showing earnings . . .49 Minkow perpetrated a significant fraud in the 1980s with his company ZZZZ. The company at one time was valued at more than $350 million but was ultimately liquidated for less than $60,000. The fraud involved false invoices and fictitious receivables for insurance-based building restoration work. The work was never carried out. The fraud continued for a number of years because Minkow created several shell companies through

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which he funnelled cash from investors. This gave the appearance that the false invoices were being paid and the fictitious receivables were a source of revenue. The expedience of using receivables to boost the reported financial condition of a business seems clear. That the boost to the entity’s accounts receivables and so its earnings and its booked assets also enable its financial state to be augmented is apparent. As such, if an entity is under financial pressure or otherwise suffering financial distress, in which case the managers may intend for the financials to be misreported, is also probable. The extent of which depends upon prevailing circumstances.

In the Case of the Local Council Returning to our local council example above, where so many different methods of FSF were utilized. In terms of revenue, the general manager misused and so misrepresented its printing business. This seemed to be an easy approach to elicit unwarranted financial gains. The business tendered for work, generated receivables, and created “work in process” that provided opportunities for manipulation. In this case, management recognized and recorded revenue for work that had not yet been commenced. In some instances the work related to projects that had not even been contracted. Subsequently, in each accounting period the level of misrepresentation increased to cover what had been misreported in the previous period. Whilst the scam continued, the accumulated losses were ignored and profit was inappropriately generated for each current period. Loss for any organized entity can be attributed to a range of factors but for business basically it is a deficit and as such it is a form of expense. It is understandable that business entities want the financial outcome from their operations to be positive. For the commercial venture that most likely means profitable. So managers arguably have a fundamental incentive to reduce expenses in order to achieve greater profits. This can be done within the auspices of good management and related skills or it can be created deceptively. EXPENSES At first glance, the term ‘expenses’ seems easy to define. An expense generally is an outgoing of money. The concept of an expense tells of a debt, an obligation to pay for the provision of goods and, or services provided. In business it is, then, a reduction in revenue, perhaps a sunk cost, and as such diminishes to some extent the asset holding of the entity. Usually debts are contracted financial amounts that are owed by one party to another. Basically, the circumstances of the debt contract are likely to be well detailed

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and as such any probable dispute on the amount owed is reduced. Nonetheless, there is the possibility of argument arising under some, here unspecified, situations. An expense can be capitalized and recorded as an asset therefore opportunities will arise within financial accounting practice to reduce recorded and reported debt. This may be done with intent to accurately depict the periodic financial circumstance of the business. As such it may be to abide the requirements of professional accounting standards and other regulatory authorities. Alternatively recording an expense as an asset might be to purposely inflate the business entity’s asset holdings and so misreport its financial state. In financial accounting the rationale for classifying an expense as an asset can be found in the financial accounting definition of an asset as explained above. Nonetheless, expenses must qualify to be considered for capitalization. To assist, IAS23 (AASB12) defines items that may be deemed rightly to qualify for, and to be recognized as, an item ‘eligible for capitalisation.’50 Accounting standards also include guidance on when to cease the capitalizing of expenses as assets and determinants of disclosure.51 In this context there ought to be little, if any, concern about ‘doing the right thing’ in accounting for an entity’s business operations and recording its assets and debt obligations. Or, so it would seem. The following brief case examples illustrate certain difficulties that may arise in misclassifying expenses in the capitalization process.

Case Examples: WorldCom, Rolls Royce, Satyam In one of the more recent and celebrated cases, WorldCom created assets from expenses during the period from 2001 to 2002. At that time WorldCom reported $3.8 billion of expenses as capital when many of its alleged capital purchases were in fact relatively usual day-to-day expenses. These included, for instance, ‘line costs,’ which is what a company pays to another telecommunications company for the right to access its networks. Reportedly, WorldCom falsely declared its income by around $11 billion and that meant its balance sheet was overstated by some $75 billion. The loss to shareholders was estimated at around $200 billion.52 Moreover, the loss to other stakeholders, hence the total loss to and throughout communities, is unlikely ever to be known. The SEC alleged that the fraud was committed in two particular ways. WorldCom decreased its operating expenses by, firstly, ‘improperly releasing certain reserves held against operating expenses’;53 and, secondly, by inappropriately capitalizing ‘certain expenses as capital assets’.54 Thus WorldCom’s expenses were reduced and its income improperly increased so any published financial statement thereof was in that context false, for instance, from 1999 to 2002. Furthermore, the accounting practice and methods used in the fabrication did not comply with GAAP; and the procedures were

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not disclosed to its stakeholders notwithstanding that they differed from the company’s earlier accounting practices, and thus the non-disclosure was also an act of deceit.55 WorldCom failed to institute and follow appropriate standards of operation and reporting. Moreover it did not initiate, mandate, and direct proper internal controls within a well-instructed internal control environment. Since that time, Clarke and Dean (2007, p. 10) noted that ‘[l]ittle has been recalled in the context of WorldCom’s woes of the UK’s Rolls-Royce’s 1970s fall following its capitalisation of . . . costs.’ It was 1971 and allegedly the British Rolls-Royce company had inappropriately capitalized costs associated with their newly devised jet engine. Hence the company’s capital was inflated and its financial condition was misreported.56 In February of that year the company was out of money, unable to cover its debts, and Rolls Royce was bankrupt. Reportedly that ‘collapse put at risk thousands of jobs and remains one of Britain’s largest ever corporate failures’ (Ruddick and Wilson, 2011).57 At the time of the Rolls Royce dilemma, action from Heath’s conservative UK government swiftly nationalized Rolls Royce Company to effect a rescue plan. By 1973 the company was re-structured with its automotive arm gone and ‘[i]n 1987, the company returned to the private sector with a flotation.’58 The case of Rolls-Royce (1971) indicated error in reporting, inadequate cash, access to cash, and ultimate bankruptcy. Seemingly the company had deluded or convinced ‘itself that costs related to the development of a new jet engine were . . . capital expenditure.’59 The hazy edges of misusing accounting procedures to promote a genuine belief in the financial construct of a business, as opposed misuse of those procedures with intent to deceive—can be very close. More recently the Indian company Satyam (2009) near collapsed under the weight of fraud and misreporting; however, there too the government quickly stepped in to prevent the collapse and what was perceived a total disaster. The Company Law Board in India started the process and appointed a new board of directors. Ultimately after tender and due process the company Tech Mahindra acquired Satyam and the newly formed company became Mahindra-Satyam. The tale of Satyam involved misreported revenues, fictitious cash, hence inflated asset holdings which were apparently not identified or explored.60 The fact that Satyam survived under the auspices of Mahindra Satyam is significant and adds to the different, albeit failed circumstances of the Rolls Royce (1971) story. It is evident that governments and others do, at times, support or otherwise bolster failing organizations to prevent their ultimate downfall—in a variety of circumstances. Many of which do relate to financial accounting practice and its procedures implemented to report on a business entity’s financial state.

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IN SUM Whether the case is one of management error, or fraud, the way in which a business entity’s financial condition is stated, reported on, and disclosed to stakeholders warrants examination and continued debate. Chapter five extends our discussion on elements of financial statements, and the accounting for, and reporting of same. It focuses on the concepts of debt, liabilities, and financial obligations. NOTES 1. See Chambers (1995) An Accounting Thesaurus: 500 years of accounting, for myriad examples and related references. 2. See, for instance, Tabart-Gay and Wolnizer (1997). 3. Refer to Paton’s (1917) ‘Theory of the Double-Entry System’. 4. Or that should be included in generally accepted accounting practice (GAAP) due to, at least, the professional status awarded to the discipline of accounting. See West (2003). 5. For insightful critique, discussion and case analyses, refer, for example, to MacNeal (1939), Chambers (1966), Wolnizer (1987), Clarke et al. (1997/2003), Clarke and Dean (2007), Margret (2012) and other references therein. 6. Ibid. 7. In context, however, Paton (1917) explored the double-entry system and the origin of debit entries equalling credit entries in books of account rather than accounting per se. Nonetheless, he also emphasized the processes of change and the cyclical nature of property in that the life of property held ends and it is replaced. In regard to business continuity, the latter is important and of significance today in, for example, determining the financial capacity of a business to adapt to changing situations and be able to continue to operate as a going-concern. 8. In particular, refer to the work of Clarke et al. (1997/2003) and Clarke and Dean (2007). 9. In Media Release on ‘Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud’, 2002–44 available at www.sec.gov/news/ headlines/wastemgmt6.htm, accessed July 2014. 10. Source: SEC Media Release 2002–44 on 26/3/2002. Available at www.sec. gov/news/headlines/wastemgt6.htm, accessed June/July 2014. 11. Ibid. For accounting standard details, see, for instance, Australian Accounting Handbook (2013). 12. Source: SEC Media Release 2002–44 on 26/3/2002. Available at www.sec. gov/news/headlines/wastemgt6.htm, accessed June/July 2014. 13. In Australia AASB116 (para.7 (a) (b)); equivalent to the international accounting standard IAS16. 14. Ibid. Paras 50 and 51. 15. Ibid. Paras 60 and 61. 16. See international accounting standard IAS 36, the equivalent in Australia AASB136. 17. International Financial Reporting Standard (IFRS). 18. See Williams (2003), p. 135. 19. As evidenced by some outcomes to do with this millennium’s global financial crisis (GFC).

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20. The term may be found online through a general search engine—such as Google. 21. See, for instance, Webster (1919), Kester (1946), Clarke et al. (2003). 22. Refer to Margret (2012) for in-depth discussion on the subject. 23. As explained in the case report SEC v JBI, Inc., John W. Bordynuik and Ronald Baldwin, Jr., available at www.sec.gov/litigation/complaints/2012/ comp22220.pdf, accessed 15 June 2014 (p. 5). 24. Ibid., pp. 1–28. 25. Ibid. pp. 1, 2, 7, 16. 26. Ibid., pp. 1–28. 27. This point of concern is discussed many times throughout the chapters of this book. 28. Also see Margret (2002) for debate on the balance sheet as a test of [in]solvency. 29. Source: SEC Accounting and Auditing Enforcement Release No. 3456/ April 24, 2013. Administrative Proceeding File Number 3–15299 in the matter of Capital One Financial Corporation, Peter A. Schnall and David A. Lagassa. 30. Ibid. 31. Ibid., under Summary, para. 2, p. 2. Available at www.sec.gov/litigation/ admin/2013/34–69442.pdf, accessed July 2014. 32. Ibid., at para 3. 33. Ibid., at para 4. 34. Refer again to Clarke et al. (1997/2003); Clarke and Dean (2007); Margret (2012). See Wilson (1974), for example, for discussion on accounting fact as opposed economic conjecture. 35. For instance, in Caterpillar Corporate Release, 16 May 2013, available at www. caterpillar.com/en/news/corporate-press-releases/h/caterpillar-and-miningmachinery-limited-announce-settlement-agreement-related-to-siwei-acqui sition.html, accessed June 2014. Refer again to Clarke et al. (1997/2003); Clarke and Dean (2007); Margret (2012). 36. As tabled in the Caterpillar Press Release of 18 January 2013, available at www.sec.gov/Archives/edgar/data/18230/000001823013000041/pressre lease_ex9911.htm, accessed June 2014. 37. See IAS18. Its equivalent in Australia AASB118, para 1. 38. Ibid. at para 7. 39. Ibid. at for instance: paras 14, 29, and 30. 40. See COSO (1999) ‘Fraudulent Financial Reporting: 1987–1997’, An analysis of US Public Companies, Commissioned by COSO, Vol. 22, No. 3, Summer—Executive summary. The complete report available at www.coso. org/publications/ffr_1987_1997.pdf, accessed May and July 2014. 41. Ibid., and at p. 6. 42. Ibid., at p. 29. 43. Ibid., at p. 32. 44. See: COSO (2010) ‘Fraudulent Financial Reporting: 1987–2007’, An analysis of US Public Companies, Commissioned by COSO, May. Available at www. coso.org/documents/cosofraudstudy2010_001.pdf, accessed October 2013 and July 2014. 45. Ibid., p. 4. 46. Ibid., p. 3. 47. Ibid., also at p. 3. 48. Refer to chapter two of this book for details on the fraud triangle. 49. Refer to the Association of Fraud Examiners (1992) report at www.youtube. com/watch?v=7fZVyyWvWE8&list=PL1B8D6F60F0CAFFCA, accessed June 2014.

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50. See, for instance, AASB123 (paras 5, 8, 12, and 17). 51. Ibid. at para 22 and para 26. 52. At United States District Court Southern District of New York. SEC v WorldCom, Inc. 02 Civ 4963 (JSR) Opinion and Order, p. 02/15. Available at www.sec.gov/litigation/complaints/courtorder070703.pdf, accessed June, July 2014. 53. In the First Amended Complaint (Securities Fraud) Civ No. 02-CV-4963 (JSR) of SEC v WorldCom at United States District Court Southern District of New York (para 2). Available at www.sec.gov/litigation/complaints/comp17829. htm, accessed June, July 2014. 54. Ibid. 55. Ibid. 56. See, for instance, Clarke and Dean (2007, p. 10); and also ‘Another cowboy bites the dust’, Economist, 27 June 2002, available at www.economist.com/ node/1203814/print, accessed June 2014. 57. ‘Rolls-Royce results will be a historic day for Sir John Rose and the company’, Telegraph, UK, 10 February 2011, available at www.telegraph.co.uk/finance/ newsbysector/transport/8314440/Rolls-Royce-results-will-be-a-historic-dayfor-Sir-John-Rose-and-the-company.html, accessed June 2014. 58. Ibid. 59. ‘Another cowboy bites the dust’, Economist, 27 June 2002, available at www. economist.com/node/1203814/print, accessed June 2014. 60. For discussion and critique of the Satyam (2009) case, see Margret and Hoque (2014).

BIBLIOGRAPHY Adams, T. R. (1937) ‘The Civic Value of Museums’, American Association for Adult Education, New York. Australian Accounting Handbook (2013) Incorporating Australian Accounting Standards and the International Accounting Standards and International Financial Reporting Standard equivalents, CPA Australia, Pearson Australia. Canning, J. B. (1929) The Economics of Accounting: A critical analysis of accounting theory, Ronald Press Company, New York. Carnegie, G. D. and Wolnizer, P. W. (1995) ‘The Financial Value of Cultural, Heritage and Scientific Collections: An Accounting Fiction’, Australian Accounting Review, Vol. 5, No. 9, pp. 31–47. Carnegie, G. and Wolnizer, P. W. (1999) ‘Unravelling the rhetoric about the financial reporting of public collections as assets’, Australian Accounting Review, Vol. 9, No. 1, pp. 16–21. Carter, R. N. (1923/1956) Advanced Accounts, Pitman, London. Cayley, A. (1894) The principles of bookkeeping by double entry, Cambridge University Press, Cambridge. Listed at para. 445 in Chambers (1995). Chambers, R. J. (1966) Accounting Evaluation and Economic Behavior, Prentice-Hall, Englewood-Cliffs, NJ, reprinted Scholars Book Company, Houston, Texas, 1974. Chambers, R.J. (1995) An Accounting Thesaurus: 500 years of accounting, Pergamon, Elsevier Science Ltd., Oxford, UK. Clarke, F. L., Dean, G., and Oliver, K. G. (1997/2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, Melbourne. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne.

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Committee of Sponsoring Organisations of the Treadway Commission (COSO) (1999) ‘Fraudulent Financial Reporting: 1987–1997’, An analysis of US Public Companies, Commissioned by COSO, Vol. 22, No. 3, Summer—Executive summary. The complete report is available at www.coso.org/publications/ ffr_1987_1997.pdf, accessed May and July 2014. Kester, R. B. (1946) ‘Advanced accounting’, in Chambers (1995). Leake, P. D. (1912/1976) Depreciation and Wasting Assets, Good, London, reprinted by Arno Press, New York. MacNeal, K. (1939) Truth in Accounting, University of Pennsylvania Press, Philadelphia. Margret, J. E. (2003) ‘Insolvency and tests of insolvency: An analysis of the “balance sheet” and “cash flow” tests’, Australian Accounting Review, Vol. 12, No. 2, pp. 59–72. Margret, J. E. (2012) Solvency in Financial Accounting, Routledge/Taylor and Francis Group, New York. Margret, J. E. and Hoque, Z. (2014) ‘Business Continuity: In the face of fraud and organizational change’, forthcoming in Australian Accounting Review. Most, K.S. (1977) ‘The rise and fall of the matching principle’, Accounting and Business Research, Vol. 7, Issue 28, pp. 286–290. Napper, D. (1964) ‘Accountancy’, Journal of Accountancy, October and November; also in Chambers (1995). Ouda, Hassan A. G. (2014) ‘Towards a practical accounting approach for heritage assets: An alternative reporting model for the NPM practices’, Journal of Finance and Accounting, Vol. 2, No. 2, pp. 19–33. Page, E. D. (1916) Journal of Accountancy, April; also in Chambers (1995). Paton, W.A. (1917) ‘Theory of the double-entry system’, Journal of Accountancy, Vol. 23, pp. 7–26. Pixley, F. W. (1881/1976) Auditors: Their duties and responsibilities, Effingham, London. Ruddick, G. and Wilson, A. (2011) ‘Rolls-Royce results will be a historic day for Sir John Rose and the company’, Telegraph, UK, 10 February 2011, available at www.telegraph.co.uk/finance/newsbysector/transport/8314440/Rolls-Royceresults-will-be-a-historic-day-for-Sir-John-Rose-and-the-company.html, accessed June 2014. Schnall, P. A. and Lagassa, D. A. (2013) ‘In the matter of Capital One Financial Corporation’, SEC Accounting and Auditing Enforcement, Release No. 3456/April 24, 2013. Administrative Proceeding File Number 3–15299. Stanton, P. J. and Stanton, P. A. (1997) ‘Governmental accounting for heritage assets: economic, social implications’, International Journal of Social Economics, Vol. 24, No. 7/8/9, pp. 988–1006. Tabart-Gay, J. M. and Wolnizer, P. W. (1997) ‘Business firms as Adaptive Entities: The case of the major Australian Banks 1983–1994’, Abacus, Vol. 33, No. 2, pp. 186–207. Webster, G. R. (1919) Journal of Accountancy (AIA, AICPA), October; also in Chambers (1995). West, B. P. (2003) Professionalism and Accounting Rules, Routledge/Taylor and Francis Group, New York. Westwick, C. A. (1981) The Accountant’s Magazine (ICAS); also in Chambers (1995). Williams, S. J. (2003) ‘Assets in accounting: Reality lost’, Accounting Historians Journal, Vol. 30, No. 2, pp. 133–174. Wilson, R. G. (1974) Journal of Accountancy, August 8; also in Chambers (1995). Wolnizer, P. W. (1987) Auditing as Independent Authentication, Sydney University Press, Sydney, Australia.

5

Financial Obligations Liabilities

The liabilities of a business include all debt owed by it, and such other obligations as it is [or may be] legally liable for. (Bentley, 1911, p. 22)

LIABILITIES IN CONTEXT Liabilities are considered herein with regard to the fundamentals of debt. This provides the foundation to explore opportunities where liabilities, debt, or other obligations might be drivers of fraud in financial statements. Hence we include case studies, both anecdotal and evidence based, to illustrate possible links. Basically the concept of a liability, as an obligation, is straightforward. On the other hand, a liability may be conditional and so take many forms. It is sometimes when the apparently uncomplicated becomes somewhat complicated that irregularities likely occur. Essentially in a commercial situation a liability is a debt owed by one party to another. It incorporates a duty to meet an agreed responsibility. Thus a liability may be in the form of a legal debt or, a casual agreement or, it might be provisional on a change in circumstance. The financial amount of the debt may be absolute, in accord with a contract between agreed parties. Alternatively the amount owed may be contingent upon a future and currently unknown happening. Martin (1984) explained liabilities, debt, and obligations as a factor of legal standing; that ‘[s]ince liabilities are not necessarily legal debts, they are [also] defined as obligations’ (p. 358). An obligation may be multifaceted. Clearly, it may be a duty to pay money to another party for goods and/or services rendered. More broadly however, an obligation is a commitment to do, or to provide, ‘something’ for another. It involves a sense of duty to act. Part of the responsibilities of a business entity is to inform its stakeholders about the outcomes, financial and non-financial, of its business activities. In that context the entity is obliged, morally and/or legally, to disclose certain facts about its business deals. The latter could be directly of a monetary nature or more indirectly of an environmental nature.

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Liabilities, Obligations, and Indebtedness The idea of being indebted to another party considers both financial and non-financial situations. In business, indebtedness might be attributed to a financial obligation related to another party’s past action to provide some manner of assistance. Alternatively, it may be an emotional response of feeling in debt, or obligated, to another because of a prior act of good intention. On the other hand, actions associated with a feeling or expectation of someone being indebted to another is an area that could warn of intended misconduct. Customarily the thought of being indebted to someone is based on having received something of worth from that other party. A benefit that was otherwise perhaps unattainable. Hence, the knowledge of indebtedness likely generates a feeling of gratitude and/or obligation. The origin of which may have been, for instance, the saving of a life. In that context, one would assuredly feel an innate if not overwhelming sense of thanks—that their life, the life of a loved one, or friend had been saved. In turn that leads to feeling indebted to the other party in an emotional and physical sense apart from any monetary influence. In contrast such an act of consideration might be financially based. If, for instance, one party (entity) saves another from the likelihood of bankruptcy. As such indebtedness is a bond that ties one party to another by a sense of obligation; and that may be legal or moral in nature. A debt that is not currently legal is likely to be contingent upon some future event arising. Hence it is an obligation that is conditional on some future event. And that event is likely to be based on a current and agreed obligation.

Contingencies: Debts, Obligations, and Provisions In Australia, AASB1371 covers: Provisions, Contingent Liabilities and Contingent Assets. Assets and related considerations thereof are dealt with in the previous chapter four. In the context of a contingent debt, an obligation or provision to pay is of concern because it has the characteristic of uncertainty. That uncertainty may well be attributed to the timing of the occurrence, and the amount of the probable debt. For instance, the ‘uncertain future event’ (para.10) may or may not occur. In line with the ‘possible obligation’ (para.10(a)), that may or may not eventuate. To enable recognition of the contingent liability it must be able to be ‘measured with sufficient reliability’ (para.10(b)). To recognise a provision, ‘a reliable estimate’ (para.14) and/or ‘the best estimate of the expenditure’ (para.36) is imperative. The somewhat imprecise nature of the accounting standard is due in part to the vagaries of the nature of a contingent debt. Arguably this apparent inexactness provides opportunity for misreporting. It does not, however, give reason for non-disclosure of contingent debts and their possible, or probable, effect on the entity’s financial condition.

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To substantiate the financial condition of a business all debts, accumulated and contingent, must be accounted for in some way. The latter refers to appropriate disclosures to be found in either the financial statements or notes thereto. All debts are obligations of the entity and as such draw (sometimes heavily) on its financial position. Hence, a probable debt arguably like any debt must not be ignored. This is especially of concern in determining the overall economic state, or, in other words, the financial wherewithal of the entity. Dependent on generally accepted accounting practice (GAAP), national preferences, and mandates of corporations’ legislation globally, contingent debts may be required to be disclosed in the notes to accounts, as estimates in the financial statements, or perhaps both.2 Certainly for completeness and for published financial reports to be precise and informative for stakeholders, they are to be disclosed. Evidence shows that debts that are not currently payable, but that may be payable in the future can drain an entity’s resources. This is resolute even though the future circumstance is currently indeterminate. The probability of the contingent debt becoming a legal debt in substance will depend on the specific circumstances of each case.

The Case of Classification The way in which a company classifies its transactions is important and of concern to business generally. This is because the items as classified will have an effect, possibly significant, on the reported financial state of the company. With regard to a contingent debt and its classification, however, the situation can be baffling. Sometimes the business may not expect to ever be called upon to meet the contingency and so make a payment. In which case, the business may not classify the situation as a contingent debt, or debt obligation per se. Moreover it might ignore the possibility of debt because of a perception that any future liability for payment is unlikely. Overall this is unhelpful and in a published report to stakeholders could be misleading. As Hatfield (1927/1971, pp. 234, 235) explained, a contingent liability might comprise ‘such items as endorsements, guarantees, unfulfilled contracts, etc. . . . [that may] constitute a definite liability to the holder of the endorsed note, but one which the endorser does not expect to be called upon to pay . . . [Nonetheless] even if he does not expect to have to provide funds [to pay the debt] his obligation should be shown.’ More broadly, items such as repurchase agreements, otherwise called ‘repos’ that are widely used in finance, are of concern. Basically repurchase agreements are short-term loans between a borrower (seller) and a lender (perhaps a commercial bank). To raise finance (money) the borrower sells a security (as collateral) to the lender agreeing to repurchase the security at an agreed future date, and at a specified amount. The amount includes the

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agreed rate of interest which is paid out when the borrower ‘repossesses’ the security. The determinants of success in such agreements depend on a number of factors including the integrity of the participants and the suitability of the securities used in the trade. Prior to and then during the global financial crisis (GFC) many securities so used became known as toxic. As Hanson et al. (2011, p. 12) remarked, ‘a refusal of repo and commercial paper creditors to roll over their loans—played a key role in the demise of Northern Rock, Bear Stearns, and Lehman Brothers, among other high-profile failures.’ On that subject they also advised reference to Shin (2009), Gorton and Metrick (2010), and Duffifie (2010). Lehman Brothers had a number of problems to deal with, and they included the repo market and a somewhat broad perception that the company’s debt, hence its leverage was way too high. That initiated a scramble to reduce the level of debt. If that could not be done in fact then it could perhaps be done with ingenuity and creative thought. The following is a brief extract of the Lehman story with attention given to a concern in classification.

Lehman Brothers—A Case in Classification During 2008 Lehman Brothers (Lehman) collapsed, filing for bankruptcy in September of that year.3 At that time it had around ‘$639 billion in assets and $619 billion in debt’4 and had been operating with a colossal leverage the ratio in 2007 being around 31.5 Much of Lehman’s problem could be attributed to the sub-prime mortgage market, the effect of which ultimately resounded across the world with the Global Financial Crisis (GFC). For Lehman another concern allegedly was attributed to the terms of certain repurchase agreements. They were to reduce the level of Lehman’s reported debt and that in turn would reduce its reported leverage ratio, and so pacify its stakeholders. So Lehman’s repurchase agreements known as Repo 105 and Repo 108 were enabled. The transfer of its collateral (securities) was classified as a sale with the obligation to repurchase. Arguably the transfer should have been classified as collateral for a loan. In the case of Repo 105 the collateral was 5 per cent above the borrowed amount, and in Repo 108 it was 8 per cent above the borrowed amount. Usually a borrower will provide assets as collateral that are approximately 2 per cent above the borrowed amount and do so at the time of the loan.6 In the case of Lehman this is important because the agreements were typically used toward the end of the reporting period. Thus there was a timing issue. Due to the agreements and the timing of their use Lehman was able to reduce the reported level of debt (liability) on its balance sheet and so improve its leverage ratio.7 This highlights that misinformation may be linked to financial ratios and as such that is a warning for the unwary.

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IN THE CASE OF DEBT AND CONDITIONAL OBLIGATION Clearly when a determinable monetary amount cannot be directly attributed to a debt it is likely to be on a condition. Disclosure of such an obligation and its related circumstances is still warranted—perhaps in the notes to account. Hatfield (1927/1971, p. 236) asserted ‘where the amount of the liability cannot be obtained . . . with a fair degree of accuracy . . . the contingent liability is not to be shown in the balance sheet but should be explained in a footnote or appendix thereto.’ With an eye on the intangible, any future and presently unknown occurrence is of concern in accounting for the current financial state of an entity. This is primarily because the vagueness of the concept is in itself somewhat unfathomable. Montgomery et al. (1949, p. 363) explained the indefinable contingency as ‘a possible liability of presently determinable or indeterminable amount which arises from past circumstances or actions and may or may not become a legal obligation in the future.’ Although the incomprehensible may continue, there are somewhat straightforward examples of what may constitute a presently unknown but a possible future debt. Such obligations include the liability attached to warranty payments for instance, where the entity guarantees the quality of a product it sells for a specified period of time. If the product fails to comply with the seller’s assurances, then either a replacement of, or repair of, the product will ensue. Similarly in a personal situation, a relative might choose to be a guarantor for a young member of the family who wants to buy a car or perhaps an apartment without the requisite financial resources. Here the relative, as guarantor, has a contingent liability.

A Hypothetical If the young family member makes all required payments and satisfies the loan, the liability disappears. If the payments are not made as and when due and payable the relative (as guarantor) is obligated to provide the moneys due. Hence the guarantor ought sensibly to ensure the probable requisite amount is readily available to them—until the debt is satisfied by the initiator, in this case the young relative. That means that the amount of the debt would be invested in such a way as to be easily attainable to the guarantor. It is no different in business. If business firms, or companies, have a contingent debt, they also have the responsibility to ensure funds are held in requisite amounts in available reserve to cover a possible eventuality. Reasons for payment may be precise or may include circumstances related to a pending law suit. The latter may be personal like the deemed inappropriate dismissal of an employee; or environmental argument, for instance, degradation of lands or pollution of waterways. Whatever the basis for the legal proceedings, the degree of guilt determined by the courts relevant to the case circumstances will decide whether the business is actually liable and if so, to

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what extent a monetary recompense is warranted. The entity sensibly must be prepared. A contingent liability is about equitable behaviour, degrees of which may focus on stakeholder wants, beliefs, or expectations. It may also have regard for and to ethical conduct. Good business sense might attribute to precise disclosure of the entity’s activities so that stakeholders are well-informed of all its accumulated debt and the circumstances under which the debt is, or might be, recognized. In that context all debt would be well-managed and acknowledged. To some extent this requires that the entity provide reserves adequate enough to cover its debts when due and payable, including the probability of contingent debts arising. A reserve account of this kind, however, does not denote a farce. It is about providing funds that coincide with a timely access to cash. The case of dividend payments due and payable to shareholders could be an example. Dividends are paid out of profits, or retained profits. Although such profits represent a calculated number, they do not necessarily represent money in the bank. Hence there must be cash available (or access to cash) in order to effect the actual payments to shareholders and to do so in a timely fashion; for ‘the declared dividend is an obligation’ (Hatfield, 1927/1971, p. 237). To continue, the following case extract of Microsoft Corporation (Microsoft) emphasizes the significance of reserves held with regard to cash and reported revenues. The focus in this instance was apparently to manage, thus smooth the entity’s reported income across future accounting periods.

Microsoft Corporation: Debt, Reserves, and the Relevance of Cash In some cases, like Microsoft,8 and other publically listed companies, there is pressure brought to bear on management to avoid surprising the market with bad news. In particular this is likely with regard to the entity’s reported financial position and its financial performance results. Financial performance metrics are usually linked to earnings figures (otherwise called income or revenues). Hence, increased pressure on managers to smooth the picture of earnings over multiple and future periods might well result. One way to do this is to manipulate reserves. Microsoft apparently, to some extent, went down this path. In June 2002 the Securities and Exchange Commission (SEC) reportedly ordered Microsoft to stop committing accounting violations with respect to seven reserve accounts. One of which was a ‘cyclical accrual for marketing expenses’ that along with the other accounts did not comply with GAAP or the then US ‘federal securities laws.’9 In sum, the SEC alleged that Microsoft misstated its income by material amounts between 1 July 1994 and 30 June 1998. In addition to the inappropriate entries in the various reserve accounts Microsoft’s internal controls were deemed inadequate and were also under scrutiny.10

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Across its reserves Microsoft had questionable entries in some accounts that did not have properly substantiated bases, as required by GAAP. These reserves included accounts such as; sales to original equipment manufacturers, accelerated depreciation, inventory obsolescence, fixed (long-term) and financial assets, interest income, and impairment of manufacturing facilities. Furthermore and during the 1995–1998 period in question, the total balance of these accounts ranged from approximately $200 million to $900 million.11 Moreover the SEC was concerned that the entity’s quarterly and annual filings with them contained undisclosed and unsupported adjustments to reserve accounts that, to a material extent, did not comply with GAAP. By including these adjustments in its financial statements, Microsoft failed to accurately report its financial results, causing overstatements of income in some quarters and understatements of income during other quarters (therefore smoothing revenue over multiple periods).12 Microsoft also failed to maintain sufficient documentation to support the basis for the reserve accounts. It did not apply its own accounting policies relating to the reconciliation of entries into its accounts within its own accounting system. There were supposed large discrepancies between the entries (and estimates given) for the operating units against those at the corporate level. Microsoft exempted the reserve accounts from its company-wide requirement that every account be reconciled at least once each quarter. That was important because the reconciliation was, partly, to ascertain if there was adequate supporting documentation with due regard to the activity in the reserve account. As a result, Microsoft was lacking in implementing important safeguards to ensure that adjustments to the reserve accounts and the balances of those accounts were not only appropriate but also were reported in conformity with GAAP.13 In essence Microsoft’s reporting of its reserves were unsubstantiated, based on limited or inadequate documents and so improper. Finally, however, under legal analysis of all violations, Microsoft consented to the SEC’s Order without admitting or denying the findings. Whatever method a business entity resorts to, in order to report its earnings, or report on its capacity for growth in periodic revenues; both at some point must correlate with cash and the cash money that the entity has, or has access to. SIGNIFICANCE OF CASH AND ACCESS TO CASH Cash and the access to cash is the lifeblood of any business. Good management of the business entity’s cash inflow and outflow will contribute to the likelihood of its continuity of operations. The accessibility of debt to alleviate short-term cash insufficiencies is usual and arguably essential to continuing business operations. Always, however, is the necessity to be able to

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service the debt accumulated, to meet the entity’s payment obligations, and to do so in a timely fashion. To pay debt when it is due and payable is a legal responsibility.14 Solvency is akin to liquidity but importantly it is with a view to long-term debt. Thus it signifies a higher degree of the entity’s financial substance. Those financials that depict the entity’s solvent state will (or should) enable the entity to continue to trade, to alter its business operations when deemed necessary, and to continue its business activities (in whatever form) into the future.15 So, the underlying concept of liquidity and solvency differ. Liquidity is a short-term view of an entity’s financial capacity to cover its debt when currently due and payable, we might say, indicative of a twelve-month period of time in the accounting calendar. As such liquidity incorporates the management of cash and access to cash to ensure the business entity is in a financial position to trade, and to pay its bills now. In that context liquidity leads to attributes of solvency. Solvency is a longer-term view of an entity’s ability to pay its debts when due and payable. The latter is significant because as circumstances of business and its outcomes change so can creditors demands on the return of moneys invested alter. Margret (2012) provides in-depth discussion on attributes of solvency in business and on the financial reporting of same. The following cases illustrate the necessity of keeping one’s eye on cash and the flow of cash into and out of a business. As Nicholls (1975, p. 121) asserted: ‘It is the present and near future money flows which should be the continuing concern of businessmen’ (emphasis added). Hence if focus is on the appropriateness of a business entity’s cash management in order to keep it current then the management of same is dynamic. That means that the management of a business entity’s access to cash currently, and into the future, will enable that business to trade in a solvent state. In turn that will delimit the probability of it trading whilst insolvent. The following case example illustrates how cash and a business entity’s access to cash money can be misrepresented and its stakeholders thwarted, in the supposed accurate reporting of a business entity’s financial circumstance.

In the Case of Parmalat Finanziaria S.p.A (Parmalat) Parmalat is the story of a flourishing multinational food and dairy corporation that went sour. It was, at the time of its demise, an Italian company that from its early inception became a global leader in the production of ultra high temperature (UHT) milk. The following brief extract is about the historic company, Parmalat, which collapsed in 2003 with reportedly around a €14 billion deficit. Today the current Parmalat has operations throughout Europe, North America and Latin America, China, South Africa, as well as Australia. It has been a subsidiary of the French group Lactalis since around 2011.16 Returning to the troubled era into 2004; it was apparently the default by Parmalat on a $185 million bond payment that triggered its collapse

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and the subsequent investigation into its financial affairs.17 It was a massive fraud and between 1997 and 2002 cost US institutional investors alone in excess of USD ‘$1 billion in debt securities.’18 The SEC alleged that Parmalat pronounced non-existent ‘excess cash balances . . . to repurchase corporate debt securities worth €2.9 billion when in fact . . . they remained outstanding.’19 One of its larger assets was said to be cash of USD$4.9 billion that were held in a Bank of America account by a Parmalat subsidiary in the Cayman Islands.20 This could easily be attributed to a red flag—a warning that something was very likely amiss. The Bank of America duly reported that the account, as mentioned, did not exist.21 The Securities and Exchange Commission alleged that ‘Parmalat falsely claimed that excess cash holdings had been used to repurchase corporate debt securities valued at $3.6 billion, when in fact it had not repurchased the debt.’ Internal Parmalat investigations subsequently found that the actual debt was at least $16.6 billion.22 Reportedly the then-Parmalat auditors did not identify the fictitious nature of the account. In 2002 as part of their work, the auditors queried the account in the Cayman Islands and ultimately received a letter from the Bank of America on its stationary (letterhead) in March 2003, confirming the existence of the account and its balance. The auditors seemingly did not independently verify the account with the bank. Subsequently it was found that the confirmation letter was shown to be a forgery.23 In addition the SEC pursued Parmalat, alleging securities fraud against institutional investors. This story evolved when Parmalat apparently sold more than USD$1 billion in debt securities between 1997 and 2002. The SEC outlined a series of allegations that included an overstatement of its cash and marketable securities. Consider, for instance, that: • at year end 2002 apparently the cash and marketable securities holdings of Parmalat were overstated by at least USD$4.9 billion; and • as at September 2003 reported debt of €6.4 billion had been understated by €7.9 billion. Allegedly this had been achieved by eliminating debt held by a nominee entity, and recording debt as equity through fictitious loan agreements. Furthermore, it was by removing liabilities such as falsely describing the sale of ‘receive bales’ as ‘non-recourse,’ and mis-recording bank debt as inter-company debt, and eliminating payables by claiming they had been paid when in fact they had not. Moreover somewhat uncollectible and impaired receivables were transferred to nominee entities.24 Cash and such related disclosure deceit also fared in the case of Satyam (India), as explained below.

In the Case of Satyam Computer Services Ltd. (Satyam) In 1987 Satyam was incorporated in India as an information technology services company. It grew rapidly and soon traded globally under the eye of

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its founder, Ramalinga Raju, who was well-educated in both India and the United States of America (USA). Satyam developed into a highly acclaimed international company. By 2008 Satyam rated ‘as India’s fourth-largest information technology services group by revenues . . . [and it traded with] . . . companies such as Nestlé, General Electric and General Motors.’25 Moreover, Satyam was celebrated with an international governance award and frequently was acclaimed ‘as a center of excellence on risk management’ (Basilico et al., 2012, p. 144). Around this time Raju, who was Chairman of the Board of Satyam, admitted to orchestrating a massive FSF.26 The fraudulent activity included distorting reported cash figures, inventing accrued income hence misrepresenting revenues, understating liabilities, overstating accounts receivables (debtors). ‘One particularly troubling item concerned the [US]$1.04 billion that Satyam claimed to have on its balance sheet in “non-interest-bearing” deposits’ (Bhasin, 2012, p. 34). This was surely a massive amount to leave on hold in the company instead of investing for the benefit of the business and its stakeholders. Initially, the total US$ dollar amount investigated was expected to be in excess of US$1.4 billion.27 Ultimately the figure was around US$3.01 billion; the equivalent of around Rs 14,000 crore or 140 billion rupees, ‘instead of the initial estimate of Rs 7,800 crore (Rs 78 billion).’28 Apparently, ‘Raju: (a) inflated figures for cash and bank balances of US$1.04 billion vs. US$1.1 billion reflected in the books; (b) . . . accrued interest of US$77.46 million which was non-existent; (c) . . . understated liability of US$253.38 million . . . and (d) . . . overstated debtor’s position of US$100.94 million vs. US$546.11 million in the books’ (Bhasin, 2012, p. 32). Raju attempted to solve the problem by initiating an acquisition of a financially sound business. The idea was to reinstate actual cash assets into Satyam to replace the fictitious, wholly invented cash story. Unfortunately for Raju the proposed acquisition involved two companies in which the Raju family had a 37 per cent and 35 per cent interest respectively. Although apparently the Satyam Board including its independent directors approved the acquisition plan, the company’s shareholders did not. They were seemingly not impressed.29 The acquisition proceedings were duly dropped, and this left Raju in a heightened predicament. It was the catalyst for Raju’s confession. The Satyam fraud also exemplifies circumstances of disclosure (nondisclosure) fraud. Drawing on a number of case studies, the following sections expand on the concept of disclosure. In this regard the sometimesinadequate disclosure related to business transactions and operating outcomes is evident. Discussion is in the context of the duty of a business to disclose details of its commercial activities and the related outcomes of those activities to its stakeholders. In so doing the necessity for disclosure of all the obligations of a business is argued. Cases illustrate how the lack of disclosure and instances of non-disclosure can result in the publication of misleading reports, and potentially lead to disclosure fraud.

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THE ESSENCE OF DISCLOSURE Disclosure is an exposé of events. In business reporting, disclosure is about informing the business entity’s stakeholders about the business, its operations, and the outcomes of its financial and non-financial activities. Business firms, and organizations of varying size, will have their preferred as well as legally required methods of reporting. To well-inform shareholders and other stakeholders, a publicly listed corporation’s published reports (financial and non-financial) relevant to the outcomes of business operations need to be timely, adequate in content, rational, even-handed, and preferably unbiased. The concept of fair disclosure prevents a business from revealing outcomes of its business activities to selected parties prior to publicly reporting same.30 Hence, all stakeholders are to be treated even-handedly in receiving informative details on the conduct of a business, its activities and related outcomes that—specifically with regard to money—includes any detail that might shape stakeholders’ economic decisions. Evidence shows that disclosure, broadly applied, in business reporting is an area rife for misrepresentation.31 If the distortion of reported events and their outcomes is done with intent to falsify the position of the business, in any sense, it is most likely to be fraudulent. Disclosure fraud may be achieved in many ways. Basically, however, it may be considered to cover three particular circumstances: The distortion of facts about the nature of the company, its products, and/or its services; misreporting details of management discussions with financial analysts, journalists, or other interested parties on financial or non-financial matters of concern; deceptive notes to the financial accounts or omissions in, or to, the footnotes of financial statements. Such actions might be considered tactics to avoid confrontations with shareholders and other stakeholders. Such disclosures could, however, be made through media releases, other news reports, via interviews, or included in the business or company’s annual reports, and other publicly available reports. With regard to liabilities and disclosure fraud, non-disclosure of off-balance sheet items, related party transactions, directors’ loan facilities, special purpose entities, some reinsurance finance agreements and the like, are of concern. In terms of fraud in financial statements, particular areas of interest include the concealment of expenses and other liabilities, creating fictitious revenues and hiding the likelihood of collecting receivables, improperly classifying assets and inaccurately recording their monetary equivalent (valuations), timing differences in matching revenues and expenses, and any other details improperly reported. The field is broad. Irregular disclosures with regard to FSF are usually connected to the like of omissions of liabilities (hiding obligations), incorrectly and/or inaccurately reporting on subsequent events, fabricating or changing details of related-party transactions, and altering accounting policies to intentionally

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misstate the reported financial position of a business. Commonly, methods to conceal irregularities in a business entity’s obligations to pay, comprise omitting the liability/expense from its reports, inappropriately capitalizing expenses as assets, and simply failing to disclose its accumulated or contingent responsibilities. The case of Navistar, described in detail in the following section, highlights a number of these and other issues that may be related to improper accounting practices. The focus is on the amount of reported income.

Navistar International Corporation (Navistar) Navistar was a Fortune 200 company engaged in the manufacture of commercial vehicles such as trucks, buses, and diesel engines. In 2007 the company was delisted from the stock exchange as a result of findings of financial statement fraud. It was alleged that during the period 2001 to 2005 inclusive, Navistar had engaged in fraudulent and improper accounting practices. The result was an overstatement of ‘pre-tax income’ in the vicinity of $137 million.32 The SEC (US) considered the findings did not advocate that management’s conduct was intended for individual gain necessarily.33 Rather the apparent wrongdoings reflected ‘a deficient system of internal controls, evidenced in part by insufficient numbers of employees with accounting training, a lack of written accounting policies and procedures, and flaws in the Company’s organizational structure’ (SEC, 2007, p. 2).34 The SEC’s order further explained: ‘Fraud . . . at a Wisconsin foundry and in connection with certain vendor rebates and vendor tooling transactions accounted for $58 million [of the US$137million and] . . . $79 million resulted from improper accounting for certain warranty reserves and deferred expenses.’35 In brief, among other improprieties, the company apparently had:36 • Inappropriately accounted for certain tooling buyback agreements. This was done by recapturing and booking as income the previously paid amortization on those agreements and then improperly deferring the related depreciation costs. The company continued to utilize this irregular accounting treatment in 2004. The idea was to record 60 days of amortization from the buyback agreements as income. This was done despite employees’ warnings that doing so would be inconsistent with the external auditor’s advice; • Wrongly included various items below-the-line. That is, they were not included in the profit and loss account in the company’s warranty reserve calculation. This caused the warranty reserve expense to be understated. In the case of Navistar, the understatement was around US$17 million in the fiscal year 2002. Further, in the fiscal year 2003 the understatement was by US$18.5 million. Interestingly that total

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Financial Obligations represented 5.9 per cent of the restated loss before income tax for that year; • Deferred certain start-up costs from the fourth quarter of 2001 through the fourth quarter of 2002, and the deferrals were not in compliance with GAAP. Specifically, the company deferred US$4.3 million in the fourth quarter of fiscal year 2001. Then US$12.8 million in the first quarter of fiscal year 2002, and US$13.3 million in each of the second and third quarters of that same year; • Failed to report its Parts Group as a segment in its publicly filed financial statements and notes to accounts. Instead the company allocated the Parts Group’s results between its Truck and Engine divisions. This resulted in loss of information for investors. It also indicated an intention to hide a segment’s results. This could have been done in order to misinform or under-inform stakeholders.

Thus Navistar’s internal control environment was thwarted by an apparently defective accounting and control system. When an organization’s internal control environment is inadequate or let down by the actions of the entity’s senior executives—fraud, particularly in financial statements, is probable. In turn, the circumstances as they develop tend toward an improper disclosure of events or non-disclosure of material circumstances. Alert stakeholders, however, might take precautions to help them identify warning signals as they become apparent. RED FLAGS ASSOCIATED WITH IMPROPER DISCLOSURES Examples of such warning signals, otherwise called red flags, might include a dominant CEO, ineffective BOD, and/or an inappropriately formed and ineffectual audit committee. In addition to which an apparent lack of communication throughout the business, in conjunction with a lack of, or inappropriate policies, with regard to the business’ code of conduct would signal potential for disaster. This is particularly so if such a code and/or a code of ethics were documented but were not implemented effectively throughout the organization. Other likely factors may have regard to the current economic circumstances and that could involve a rapid but inexplicable growth of the business. Alternatively the entity might report unusually high profits as compared with similar business organizations in the same industry. In Australia the Royal Commission into HIH Limited (RCHIH)37 made a number of findings specific to errors in management, unreliable financial and other information, a complicated corporate structure, and the organization’s rapid growth. The allegations and findings were aligned with apparent corporate governance failures, and these were deemed to contribute largely to the company’s ultimate collapse.

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Examples from HIH Limited The Royal Commission found, among other things, that HIH was plagued by a variety of deficiencies in its information systems. As a result, it was deprived of timely and reliable information as a basis for management decisions. Questions concerning the reliability of information provided to management and the group’s ability to keep track of the financial impact of its operations arose time and again throughout the Commission’s inquiries.38 The problems identified were exacerbated by a complex corporate structure and the group’s ever-expanding operations. These information deficiencies impacted upon its electronic financial systems, the reconciliation of ledger and bank accounts, and budgeting.39 It was found that the board failed in its stewardship of the company in a number of ways. This includes decisions on major transactions and acquisitions without due diligence and analysis on matters of concern.40 The audit committee arguably operated at no more than an extension of the board of directors. Subsequently audit committee meetings seemingly did not give separate, or close, consideration to audit issues.41 The apparent failure was to not appreciate the importance of the group’s single biggest liability, and that was its provision for outstanding claims.42 HIH’s under-provisioning for claims and the questionable structure of its reinsurance arrangements along with other dubious disclosures were seemingly missed, or ignored. For instance, ‘reinsurance arrangements recognized as assets that more appropriately were liabilities, related-party transactions that allegedly inflated HIH’s share price . . . and the subsequent effect of . . . capitalizing [certain] expenses and deferring acquisition costs, including FITB’s and goodwill . . . [resulted in] inflated profit figures and a distorted view of the entity’s dated financial position’ (Margret, 2012, pp. 101, 102). The underpinning problem of HIH and its transgressions may not relate directly to fraud as stated by the HIH Royal Commissioner, Justice Neville Owen. He noted that ‘HIH is not a case where wholesale fraud or embezzlement abounded’ (Vol. 1, p. xvi). Rather he thought it was one of mismanagement, but notably certain senior executives of HIH were charged, convicted, and sentenced to jail with regard to various management decisions and actions taken. ‘The charges relate to a series of transactions where the true financial position of HIH was hidden from HIH shareholders and the regulators for many years.’43 In management, the line between that which may be an intentional act of deceit and that which is done mistakenly can be hazy. It certainly alludes to a lack of governance and for HIH Justice Neville declared, ‘I am satisfied by the evidence before the Commission that there were deficiencies in the governance of HIH which I have no doubt contributed to its failure’ (HIH Royal Commission Report, Vol. III, 23.2, p. 260). A major priority in the governance of a business is to ensure quality and integrity in financial reports and information therein published for the benefit of stakeholders.44

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FINANCIAL STATEMENT DISCLOSURE In financial statements, disclosure is fundamentally twofold. It is about both the numbers within the financial reports and explanatory details disclosed in the notes to accounts. Both these quantitative and qualitative aspects of disclosure are significant in informing stakeholders about the outcomes of business activities. The essence of disclosure is in the trustworthiness of the reports. Sometimes, for instance, it may well be far more informative to include an explanatory note to accounts rather than attempt to put a numeric estimate in the body of the financial statement, as discussed above under contingent liabilities. Evidence shows that financial reports have at times failed to represent precisely the financial condition of the business on which they report.45 Arguably this can be done quite innocently and with no intent to deceive based on interpretations of the content of accounting standards and that, to some, includes the IFRS.46 Alternatively, irregularity in reporting could indicate mismanagement, incompetence, or an intended misrepresentation of the entity’s financial circumstances. As such those with the power to override internal controls, or who hold some other influential position in the business, as well as those responsible for compiling financial reports are likely in the firing line. This was evidenced in the above case details of Navistar. Indecisive or blatantly misrepresented financial details could well result in a lack of confidence that permeates throughout capital markets. Intuitively, if investors in the financial markets lack confidence the result can be devastating, as witnessed in the recent global financial crisis (GFC). Certainly it can adversely affect the market capitalization of many companies, and do so globally. That in turn can lead to financial crises for some medium to smaller businesses and individuals alike. A sudden and prolonged market down-turn as witnessed with the GFC adversely affects the economic substance of nations. It stifles growth in business generally and diminishes the standard of living of many across the globe. The necessity to report clearly on the financial wherewithal of business entities is evident. Quality in reporting extends to all facets of financial and non-financial disclosures. Recall that in chapter three we discussed the concept of quality of content in terms of financial statements. Similarly quality of disclosed details in all published reports with regard to the conduct of business, and its related outcomes, signifies the serviceability of those reports. With regard to fraud or the possibility of fraud in financial statements all disclosures are significant whether in the numeric reports or in the text of the notes to accounts. Ultimately the information about the business, its operating activities and their outcomes—or likely outcomes—will to some extent affect the financials of the business. When the outcomes are adverse and unexpected, and particularly when related to fraud, the results may well clamour beyond disbelief as they are likely to be devastating to many.

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With the advent of the new millennium and the fact that unexpected corporate collapses continue, stakeholder concerns are vigilant. This continues to follow the somewhat spectacular failures in the IT (internet and technology) industry of late 1990s and early 2000s. For the speculators and the otherwise longer-term investors the financial loss of days gone by has been enormous. So, for the current stakeholders and investors in business, confidence (broadly) needs to be nurtured to enable sustainable business to develop and grow. An ever-increasing part of this proposed advance is to delimit if not eliminate the pressure and opportunities that support the continuity of fraud and fraudulent behaviour in commercial undertakings. The list of failed business and unexpected corporate collapses and fraudulent endeavours across so many past decades are too many to reiterate; and, it is not necessary, as there are many publications that discuss such failed business endeavours and unexpected corporate collapse.47 As Clarke and Dean (2007, p. 65) exclaimed: ‘Financial difficulties were . . . the lot of several large, old and new economy companies including HIH, Harris Scarfe, One.Tel, Pasminco, and Centaur in Australia, and Enron, WorldCom, Waste Management, Qwest, Freddie Mac, Fannie Mae, Ahold and Adelphia Communications in the US.’ Herein, as previously explained, we explore a number of those creative or otherwise tricky situations in accounting where the creativity translated, or might have translated, into fraud. The following circumstances of cases such as Adelphia and Rite Aid elaborate with particular examples of fraud and fraudulent behaviour. Nonetheless they also indicate that the link between a legal creative accounting situation, and that which may be deemed illegal, is sometimes hazy.48 ADELPHIA COMMUNICATIONS CORPORATION (ADELPHIA) In 1952 John Rigas purchased a cable company in Pennsylvania. Twenty years later in 1972 that company became Adelphia, founded with his brother Gus. The company name meant ‘brothers’ and that for the family was symbolic. Adelphia operated as a publically listed cable television company in the USA for many decades. Its continued growth largely by acquisitions meant that by the late 1990s, Adelphia became one of the largest cable companies in the USA.49 By 1998 Adelphia had attained in excess of two million subscribers that rapidly grew by the end of the 1990s to over 5.2 million across 37 states in the USA.50 During this period, there were extensive moves across the industry to combine, merge, or buy cable companies, and from this, Adelphia emerged as the sixth largest operator.51 In 1999 Adelphia acquired both Frontier Vision Partners L.P.52 and Century Communications Corporation prior to its purchase of ‘Harron Communications Corporation’s cable

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systems in New England and Philadelphia.’53 By 2002, however, with subscribers now close to 5.5 million, it was over. Adelphia was burdened with debt but still analysts into January 2002 favoured the company’s position to continue its path of acquisitions. By March of that year Adelphia revealed it had $2.3 billion in ‘previously unrecorded debt’ and due partly to various loan agreements that figure was likely to grow.54 The circumstances were turning Adelphia’s demise into a somewhat massive financial fraud. Those possibly fraudulent and certainly questionable transactions included the waste and misuse of company assets. Such as in the purchase of office furniture at excessive prices from related parties, constructing a private golf course for the Rigas family, improper use of company aircraft, and inappropriate payment of luxury expenses for the Rigas family and others.55 In addition to such inapt manoeuvres to secure unwarranted personal benefits from company funds, by June 2002 it was known that the company’s financial state was in disarray. Its financials inflated, its cash flow overstated, and its accounting of business transactions muddled with the personal created a fanciful view of Adelphia’s overall condition.56 The SEC allegations were against both Adelphia and a number of its directors and employees. Four members of the Rigas family were at centre along with two senior executives of Adelphia at that time. In accord with the SEC Release 2002–110 the following elaborates. In its complaint, the Commission charges that Adelphia, at the direction of the individual defendants: (1) fraudulently excluded billions of dollars in liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet affiliates; (2) falsified operations statistics and inflated earnings to meet Wall Street’s expectations; and (3) concealed rampant self-dealing . . . including the undisclosed use of corporate funds for . . . stock purchases and the acquisition of luxury condominiums in New York and elsewhere.57 In further detail; and prior to the end of 2001 in excess of $2.3 billion in bank debt (as mentioned above) was not included in the company’s financial statements. It was deliberately moved to the books of off-balance sheet unconsolidated affiliates of Adelphia. This created the basis for false transactions to be recorded that were ‘substantiated’ by fictitious documents. The fanciful impression was that Adelphia had repaid due debts when in fact it hadn’t. Moreover deceptive financial statements were made by use of footnotes to the accounts that asserted or implied the liabilities included in the company’s financials contained details of all outstanding bank debts. On top of this, Adelphia’s earnings before interest, tax, depreciation, and amortization (EBITDA) were inflated.58 Many problems arose for Adelphia due partly to a misconceived notion about the company as a separate legal entity. Certain Rigas family members

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apparently considered the company’s assets to be their own and behaved accordingly. In this context the otherwise-inexplicable muddling of corporate assets with perceived individual ‘rights’ (possibly related to the historic inception of the company—family business) becomes clear. The result, in this case, is still fraud. Another case that began from humble beginnings and ended in trauma for many is that of the Rite Aid Corporation. RITE AID CORPORATION (RITE AID) Rite Aid is a listed company that operates a chain of pharmacies in the USA. It commenced, however, from somewhat humble beginnings with a single store in 1962. It is now among the largest pharmacy chains in the USA.59 A major problem for Rite Aid was due to the overstating of its income. It did this particularly over a two-year period from 1997 to 1999. In due course, and in addition to its deceit in not disclosing certain related-party transactions, ‘Rite Aid was forced to restate its pre-tax income by $2.3 billion and net income by $1.6 billion.’60 In 2002 the Securities and Exchange Commission filed accounting fraud charges against several of its former senior executives. The SEC alleged that the former CEO Martin Grass, former CFO Frank Bergonzi, and former Vice Chairman Franklin Brown enabled a broad scheme in accounting fraud.61 When one considers the types of fraud schemes alleged by the SEC, it appears that the executives engaged in the A to Z of financial statement fraud. Those activities inflated expenses and under-recorded expenses, as well as including inappropriate reversals of expense charges. This was in addition to improperly reducing cost of goods sold account and incorrectly recording the amounts of accounts payable. Moreover, vendors were incorrectly charged on product markdowns—hence they were overcharged—and by end of 1999 the former two accounts were reportedly reduced by ‘$42 million, to reflect rebates purportedly due from two vendors.’62 Other concerns covered an improper recognition of a litigation settlement, improper capitalization of expenses related to abandoned plans for construction of new stores, inappropriate write-down of inventory, and a failure to disclose related-party transactions.63 In sum the aforementioned activities included: • Systematically inflating deductions, for damaged and out-dated products, against the related amounts owed to vendors. • Failing to record legitimate accrued expenses for stock appreciation rights previously granted to employees. • Reversing expense amounts that had been correctly incurred and paid. The effect overstated the company’s income during the relevant

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• • • •

•

Financial Obligations period—when the expenses were incurred. This resulted in the pre-tax income of Rite Aid to be overstated by $9 million in the second quarter of 1998. Cost of goods sold and accounts payable were reduced by improper accounting entries from 1997 through 2000. Those entries were not repeated at year end due to the expected audit of financial statements. In this endeavour alone, and in the second quarter of 1999, Rite Aid apparently overstated its pre-tax income by $100 million. The overcharge to vendors for undisclosed markdowns seemingly resulted in a $30 million pre-tax income overstatement in 1999. Accounts payable and cost of goods sold were reduced by $42 million in 1999. Subsequently, however, the books were reopened around two weeks after year end, and an additional $33 million in credits were recorded. Also in 1999 Rite Aid improperly recognized $17 million from a litigation settlement that was not in legally binding form. Inappropriate capitalization of expenses for legal services, title searches, architectural drawings, and other items relating to various building sites for stores that were planned but were determined not to proceed. At end of 1999 these ‘expenses’ totalled $10.6 million. Otherwise physical inventory counts when less than the inventory carried—the inventory was written down to reflect the reduction. In 1999, Rite Aid did not record an $8.8 million shrink in its inventory. Hence its income was inflated and at that time to the tune of $5 million.64

Expenses, liabilities, debt obligations, and the need to achieve business continuity are real issues, and valid concerns, of all business entities at some time in their life. MOVING FORWARD TO A BUSINESS RECONSTRUCTION With due respect and proper regard for the fundamental elements of financial statements and the quality of their content, as examined in chapters four and five, the story continues. Of major concern are the tales (factional or fictional) that may be told with the birth of a new business. Here it is not the beginning of just any business—that is of interest—it is rather the reconstruct of a company that is financially suffering. Such a re-build may be done from within the company by, for instance changing and so updating, or otherwise improving its core business operations. On the other hand it may be much more radical. One of the increasing interests of current times, for instance, is the birth of the phoenix as a company. The following chapter (chapter six) explains the story of the rise of the phoenix (and associated activities with that rise) in the conduct of continuing business. The overriding issue is that a company

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wants to retain its operating status in the business world and so reconstructs itself to avoid pending financial disaster. In other words, if it didn’t do something radical, the directors of the company likely believe that the company would collapse. The interest here is that this can be a creative and legal process, or the process might be devised and carried out with the intent to avoid the payment of debt obligations, in which case the reconstruction of the financially distressed company that hinges on the construct of a new company may be fraud.

NOTES 1. The international accounting standard IAS37 is the equivalent. 2. Globally, countries are likely to establish a preferred accounting treatment for contingent debts—albeit that conventional move is to abide international standards. Herein, we emphasize the mandates of the international accounting standard IAS37. In Australia, AASB137 is its equivalent and covers for instance; recognition (para. 14–30), measurement (para. 36–50), and disclosure (para. 84–88). The paragraphs as provided include the standard requirements plus explanatory paragraphs. 3. A brief outline of the collapse and events as they unfolded is available at www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp, accessed July 2014. 4. Ibid. 5. Ibid. 6. Refer to the United States Bankruptcy Court, Southern District of New York. Re Lehman Brothers Holdings Inc. et al., the Report of Anton R. Valukas, Examiner (2010). 7. Ibid. 8. On US Admin. Proc. Rel. No. 34–46017/June 3, 2002. Re: Microsoft Corporation. Available at www.sec.gov/litigation/admin/34–46017.htm, accessed July 2014. Also see United States of America Before the Securities and Exchange Commission. Release No. 46017 / June 3, 2002. Accounting and Auditing Enforcement Release No. 1563 / June 3, 2002. Administrative Proceeding File No. 3–10789. 9. Ibid., under “Reserves Maintained or Used Without Proper Support or Basis”, pp. 3, 4. Available online at www.sec.gov/litigation/admin/34–46017.htm, accessed July 2014. 10. Ibid., under “Summary”, p. 2. Administrative Proceeding File No. 3–10789. 11. Ibid., pp. 2, 4–6. 12. Ibid., p. 7. 13. Ibid., pp. 2, 7, 8. 14. For instance, with regard to the definition of insolvency as in the Australian Corporation’s Act (ACA, s.95A); and also insolvent trading is illegal in certain jurisdictions [ACA, s.295 (4) (c)]. Refer also to the circumstances in the case of Water Wheel and charges against executive and non-executive directors related to allegations of insolvent trading. 15. Refer to Margret (2012). 16. Details readily available online, for instance, at ‘The Parmalat Scandal’ (2011) www.worldfinance.com/home/special-reports-home/the-parmalat-scandal, accessed July 2014.

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17. Further details: Securities and Exchange Commission v. Parmalat Finanziaria, S.p.A., Case No. 03 CV 10266 (PKC) (S.D.N.Y) also under summary ‘SEC Alleges Additional Violations by Parmalat Finanziaria, S.p.A and simultaneously Settles Civil Action’, available at www.sec.gov/litigation/litreleases/ lr18803.htm, accessed July 2014. 18. Ibid. 19. Refer to SEC Litigation Release No. 18525 / December 30, 2003, Securities and Exchange Commission v Parmalat Finanziara S.p.A., Case No. 03 CV 10266 (PKC) (S.D.N.Y.). 20. See also Norris, F. (2004) ‘Parmalat Sues 2 Auditors, Saying they Failed to Catch Fraud’, New York Times, August 19. 21. Ibid. 22. See Securities and Exchange Commission v Parmalat Finanziara S.p.A., Complaint No. 03 CV 10266 (PKC) (S.D.N.Y.) at para. 1. 23. Further details available at Securities and Exchange Commission v Parmalat Finanziara S.p.A., Complaint No. 03 CV 10266 (PKC) (S.D.N.Y.) at para. 16. 24. See, for instance, US SEC Litigation Release No. 18803/July 28, 2004. 25. Refer to ‘India’s Satyam fraud trial to begin soon’ at http://news.smh.com.au/ action/printArticle?id=929040, accessed May 2014. 26. Refer to Basilico et al. (2012, pp. 142–175) for further discourse on Raju, Satyam, financial and non-financial red-flags; and where the authors ‘apply five financial fraud prediction measures and examine corporate governance elements’ within the case (2012, p. 143). 27. For further details, refer to www.rediff.com/money/satyam.html and http:// business.rediff.com/report/2009/nov/25/satyam-plunges-11-pc-as-cbi-pegsscam-loss-at-rs-14000-cr.htm?, accessed May 2014. 28. Ibid. 29. Refer to Margret and Hoque (2014) for further details and references to other aspects of the Satyam story. 30. See Rezaee and Riley (2010) for details on selective disclosure with regard to SEC requirements in the USA. Also refer to the SEC (USA) report: Selective Disclosure and Insider Trading for details on new rules effective from 23 October 2000 that also refers to fair disclosure and the relevance of materiality and timing. The report is available at www.sec.gov/rules/final/33–7881. htm#P14_1382, accessed April 2014. 31. For case examples, see Clarke et al. (1997/2003), Clarke and Dean (2007), and references therein. 32. See, for instance, ‘SEC settles charges against six former Navistar finance execs’, The Network of Corporate Finance, available at www.cfozone.com, accessed June 2014. 33. Refer to SEC Accounting and Auditing Enforcement Release No. 3165/ August 5, 2010, Administrative Proceeding File No. 3–13994. In the Matter of Navistar International Corporation, Daniel C. Ustian, Robert C. Lannert, Thomas M. Akers, Jr., James W. Mcintosh, James J. Stanaway, Ernest A. Stinsa, Michael J. Schultz, (at p. 2); also available online at www.sec.gov. 34. Ibid. 35. At p. 1 of the article ‘SEC settles charges against six former Navistar finance execs’, The Network of Corporate Finance, available at www.cfozone.com, accessed June 2014. 36. Refer to details in SEC Accounting and Auditing Enforcement Release No. 3165/ August 5, 2010, Administrative Proceeding File No. 3–13994. In the Matter of Navistar International Corporation, Daniel C. Ustian, Robert C. Lannert, Thomas M. Akers, Jr., James W. Mcintosh, James J. Stanaway, Ernest A. Stinsa, Michael J. Schultz, (at p. 2); also available online at www. sec.gov for instance at pp. 6–13.

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37. See in particular the report of Owen (2003) The failure of HIH Insurance: Reasons, circumstances and responsibilities, Vol. III, April. 38. See Owen (2003) The failure of HIH Insurance, particularly Volume III: ‘Reasons, circumstances and responsibilities,’ April. 39. Ibid., particularly at chapter 18, ‘The inadequacy of management information’. 40. Ibid., at chapter 22 and with regard to acquisition of FAI Insurances Limited, Home Security International (HSI) and subsequent interrelated purchases. 41. Ibid., refer to chapter 23 (23.4.2, p. 279); also chapters 20 and 21; and in Vol. 1, chapter 1. 42. Refer to the HIH Royal Commission Report particularly Vol. II, at chapters 12 through 17. 43. Details available at www.asic.gov.au/asic/asic.nsf/byheadline/05–94+Ray+ Williams+sentenced+to+four-and-a-half+years%E2%80%99+jail?open Document. Furthermore on various media releases, for instance, at Australian Securities and Investment Commission (ASIC) Media Release 05–94. 44. Refer, for instance, to Principle 4 of the ASX Corporate Governance Council’s Principles of Good Corporate Governance to “Safeguard integrity in financial reporting”. Also as detailed in Margret (2012, p. 42). 45. Ibid., and also Margret (2012). 46. For further explanation, refer to Chambers (1966), Sterling (1979), Wolnizer (1987), Clarke et al. (1997/2003), Clarke and Dean (2007), Margret (2012) and references therein. 47. Ibid., and also see Jones (2011). 48. Refer again to the case examples and discourse on accounting standards included in Clark and Dean (2007) and references therein. 49. See the International Directory of Company Histories (2003), Pederson, J. (ed.), St. James Press, Vol. 52. Also at ‘Adelphia Communications Corporation History’ available online at www.fundinguniverse.com/company-histories/ adelphia-communications-corporation-history/ accessed July 2014—under ‘Company History’ and ‘Enjoying national prominence in the 1990s’ (last para). 50. Ibid. 51. See ‘Adelphia Communications Corporation History’ available online at www. fundinguniverse.com/company-histories/adelphia-communications-corpora tion-history/, accessed July 2014. 52. Ibid., under ‘Enjoying national prominence in the 1990s’ (last para). Reportedly this acquisition was at a cost of $550 million cash, $431.4 million in stock, $1.1 billion in debt. 53. Ibid. Supposedly the $5.2 billion cost of Century was split between ‘$3.6 billion plus the assumption of $1.6 billion of Century’s debt.’ Whereas Harron was a $1.17 billion cash purchase (last para). 54. Ibid., under ‘Scandal Erupts: 2002’. 55. Ibid. Also see the SEC Litigation Release No. 17627, July 24, 2002, available at www.sec.gov/litigation/litreleases/lr17627.htm, accessed July 2014. 56. See ‘Adelphia Communications Corporation History’ (p. 3) available online at www.fundinguniverse.com/company-histories/adelphia-communicationscorporation-history/, accessed July 2014. 57. At ‘SEC Charges Adelphia and Rigas Family with Massive Financial Fraud’, 2002–110, available online at www.sec.gov/news/press/2002–110.htm, accessed May, June, July 2014. 58. Ibid., along with the SEC Litigation Release No. 17627 July 24, 2002, available at www.sec.gov/litigation/litreleases/lr17627.htm, accessed July 2014. 59. See, for instance, the SEC Media Release 2002–92, 21 June 2002, available at www.sec.gov/news/press/2002–92.htm, accessed July 2014.

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60. In ‘SEC Announces Fraud Charges against former Rite Aid Senior Management’, SEC Release 2002–92, available at www.sec.gov/news/press/2002–92. htm, accessed July 2014. 61. Ibid. 62. Ibid. 63. Ibid., and as all detailed under appropriate headings therein. 64. Ibid.

BIBLIOGRAPHY Australian Accounting Handbook (2011) Incorporating Australian Accounting Standards (AASB) and the International Accounting Standards (IAS) and International Financial Reporting Standard (IFRS) equivalents, CPA Australia, Pearson Australia. Australian Corporations Act (2001) Butterworths, Sydney. Australian Corporations and Securities Legislation (2010/2014) Corporations Act 2001, CCH Australia Limited, Vol. 1. Basilico, E., Grove, H., and Patelli, L. (2012) ‘Asia’s Enron: Satyam (Sanskrit Word for Truth)’, Journal of Forensic & Investigative Accounting, Vol. 4, No. 2, pp. 142–175. Bentley, H.C. (1911) The Science of Accounts, Ronald, New York. Bhasin, M. (2012) ‘Corporate accounting frauds: A case study of Satyam Computers Limited’, International Journal of Contemporary Business Studies, 13, 10 October. Available online at http://file.scirp.org/Html/2-2670015_30220.htm, accessed May/June 2013. Chambers, R. J. (1966/1974) Accounting Evaluation and Economic Behavior, Prentice-Hall, Englewood Cliffs, NJ; reprinted by Scholars Book Co., Houston, Texas. Clarke, F. L., Dean, G., and Oliver, K. G. (1997/2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, Melbourne. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne. Duffifie, D. (2010) How Big Banks Fail and What To Do About It, Princeton University Press, Princeton. Also available from http://press.princeton.edu/titles/9371. html, accessed June and September 2014. Gorton, G. B. and Metrick, A. (2010) ‘Securitized Banking and the Run on Repo’, Yale ICF, working paper November 09–14, http://papers.ssrn.com/sol3/papers. cfm?abstract_id=1440752, accessed May/July 2014. Hanson, S. G., Kashyap, A. K., and Stein, J. C. (2011) ‘A macroprudential approach to financial regulation’, Journal of Economic Perspectives, Vol. 25, Number 1, Winter, pp. 3–28. Hatfield, H. R. (1927/1971) Accounting: Its Principles and Problems, Scholars Book Co., Lawrence, Kansas; reprinted by Scholars Book Co., Houston, Texas. Jones, M. (ed.) (2011) Creative Accounting, Fraud and International Accounting Scandals, John Wiley & Sons, Chichester, England. Margret, J. E. (2012) Solvency in Financial Accounting, Routledge, Taylor and Francis Group, New York. Margret, J. E. and Hoque, Z. (2014) ‘Business continuity: In the face of fraud and organisational change’, forthcoming in Australian Accounting Review. Martin, C. (1984) An Introduction to Accounting, McGraw-Hill, Sydney.

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Montgomery, R.H., Lenhart, N.J., and Jennings, A.R. (1949) Montgomery’s Auditing, Ronald Press, New York. Nicholls, F. A. (1975) The Certified Accountant (UK), February, p. 193. Also listed in Chambers, R. J. (1995), An Accounting Thesaurus: 500 Years of accounting, Elsevier Science Limited (UK). Owen, Justice Neville (2003) The Failure of HIH Insurance, HIH Royal Commissioner’s Final Report, HIH Royal Commission, Commonwealth of Australia. Pederson, J. (ed.) (2003) International Directory of Company Histories, St. James Press, Chicago, Vol. 52. Rezaee, Z. and Riley, R. (2010) Financial Statement Fraud: Prevention and Detection, 2nd edition, John Wiley and Sons, Hoboken. Shin, H. S. (2009) ‘Reflections on Northern Rock: The bank run that heralded the global financial crisis’, Journal of Economic Perspectives, Vol. 23, No. 1, pp. 101–119. Sterling, R.R. (1979) Toward a Science of Accounting, Scholars Book Company, Houston, Texas. Valukas, A. R. (Examiner) (2010) In Re Lehman Brothers Holdings Inc. et al., Debtors: Report of Anton R Valukas, United States Bankruptcy Court, Southern District of New York. Wolnizer, P.W. (1987) Auditing as Independent Authentication, Sydney University Press, Sydney.

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Phoenix Activity Companies in Crisis

Fraudulent phoenix activity must be distinguished from a proper acquisition of [a financially distressed, or] an insolvent company’s assets. (Anderson, 2012, p. 425)

PHOENIX RISING The concept of the phoenix originated in mythology.1 Some attribute the story of the phoenix to the mythologies of many nations including the Egyptians, Greeks, Romans, Persians, and Chinese.2 In that context the phoenix represented a sacred and magnificently coloured ‘fire-bird’ that lived around 500 to 1,000 years before it died consumed by fire, in its own nest. Subsequently, however, the phoenix would arise from those ashes in much the same form as in its previous life.3 In this vein the phoenix performed a creatively destructive act. It was creative because the bird in its newly formed state was purportedly of a higher order than that of the one which died.4 Sadly this is not always the case when a business dies and is re-born. The story of the rising phoenix is a pre-cursor to the concept of phoenix activity in business; where a failed business rapidly reappears in a similar state to the original. The fact that businesses sometimes fail is not of major concern. It is somewhat normal in business and commercial activity. Recall Schumpeter’s thought on ‘creative destruction’ in the context of the business cycle.5 Arguably that inefficient business activities end and failing businesses are replaced by the efficient. Hence, it is the unexpected failure of business that is of concern.6 This is of particular consequence when published financial statements of a business indicate it is financially sound and those statements are accompanied by an unqualified audit report. In which case, stakeholders would likely expect the business to have the financial capacity to continue its operating activities into the future. Yet history shows this is not always correct.7 Moreover, as pressure to perform and report profitable results increases for directors, senior executives, and managers, inaccurate and possibly misleading published financial statements are more likely. When businesses, senior executives, and managers are suffering under adverse conditions, and

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the opportunity to improve such circumstances is evident, it is probable that even the accidental fraudster will rationalize the act and take the chance to relieve the pressure.8 As discussed in previous chapters, there are many ways in which fraud might occur within, for, or against an organization. In this chapter we discuss a further initiative known as phoenix activity. A phoenix company may be a legal ‘creative destruction’ so formed to enable continuity of business. Alternatively it might indicate an illegal and destructive creation formed with the intent to avoid liabilities. So a business that fails suddenly and re-invents itself rapidly in much the same form might signal either good business judgement or fraud. Seemingly this necessitates a well-defined and generally accepted meaning for fraudulent phoenix activity. Although commercial phoenix activity and fraudulent phoenix activity are defined at times in the literature9 and in some corporations’ legislation,10 there is no precise and generally agreed definition globally. This is the situation across both the professional accounting bodies and the law. That the disparity exists is evident; that it warrants a solution is unequivocal.

Definitions of the Phoenix Currently in business phoenix activity may be characterized as: innocent phoenixing, occupational hazard, or a careerist offender.11 Further and in accord with the Phoenix Proposals Paper (2009),12 phoenix situations may be deemed as ‘basic’ or ‘sophisticated.’ The former relates to a seemingly straightforward business entity of whatever size; whereas the latter has regard for the intricacies of corporate groups. This is where management and directors may misuse the concept of the corporate veil. As such, the difficulty in defining phoenix activity becomes more pronounced.13 Generally it is upheld that a phoenix company is one that arises amidst or from the disarray and demise of its predecessor. In the subsequent rebuild, there may be no chaos, the transition orderly, but there may also be deceit and intention to misappropriate money and other assets. Notably as described above, not all phoenix companies are fraudulent. A fraudulent phoenix business is one that has been formed with the intent to deceive. The deception is levelled foremost against employees and creditors. The action involves directors of the antecedent business transferring the assets of that business to the newly formed successor. This leaves the former business heavily burdened with debt and with little to no assets to cover or service that debt. The undue weight of its debt obligations combined with little to no financial assets to offset the burden results in the collapse of the original business. The recently constructed entity then proceeds with assets, little to no liabilities, and continues to operate. The new business re-emerges in like form usually with the same or a similar name. It could emerge with a different name due to concerns of reputation and status, but fundamentally it would still be the same business.14 Some if not all of the original employees may be transferred, or re-employed

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by the new entity; and in that context they have continuity of employment. The downside for the employees in such a shuffle is the likely loss of their employee entitlements such as annual leave and superannuation in addition to some salary and wages. Creditors of the former business also lose financially as the new business is not responsible for its predecessor’s debts. The potential for fraudulent phoenix activity to increasingly become a massive financial burden on individual stakeholders and the commercial world is arguably significant. Investigation and scrutiny into associations between fraudulent phoenix activity and financial statement fraud (FSF) generally, continues and is warranted.

To Elaborate Underpinning the notion of innocent phoenixing, the business under financial stress, due perhaps to poor or incompetent management, tries to reinvent itself legally in order to continue its business. In this context the innocent phoenix may have incurred inappropriate bookkeeping, insufficient and/or inaccurate records, and/or mismanagement of its cash flow. The phoenix as an occupational hazard tends to highlight the inherent risk of continued business operations associated with some industries. Therein the hazard has direct regard for the likelihood of business continuity because of the high probability that some businesses will fail. For instance, in the building and construction industry, the operator’s skill set drives them back into the same industry after a business has collapsed. Debatably due to myriad economic and environmental reasons business entities within that and other such industries (for instance, services and technology) are frequently at high risk of failing. The employees and the employers are effectively locked into their industry due to their skills and the systematic type of work they do. On the other hand, there are the careerist offenders, those that choose to perform and persist in phoenix activities recurrently. This is the most likely area for fraudulent behaviour. Sometimes those that fall within other categories like occupational hazards may become careerist offenders. Similarities might be drawn from the fraudster who initially sets out on the fraudulent path by accident rather than design but develops through intent into a predator.15 As such in the transition of companies the careerist offender is of increasing interest to the business community globally, the accounting and legal fraternity, regulators, shareholders, and other stakeholders. Further this is where tax avoidance is likely to flourish and so it is of much concern for regulators and other tax administrators.

The Case of Gregory Harkin and Emerson Industries Gregory Harkin was a New South Wales building ‘formworker’ who operated through two companies, Adel Formwork Pty Ltd and Adel Formwork (New South Wales) Pty Ltd, later called Emerson Corporation Pty Ltd and then ACN 071 413 191 Pty Ltd.16

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Harkin subsequently established the following three new companies: • a trading company (Emerson Industries Pty Ltd), into which he transferred all contracts; • an assets owning company (Parallax Corporation Pty Ltd), into which he transferred all assets; and • a labour employing company (Emerson Services Pty Ltd), into which he transferred all employees. Debts to federal and state governments and insurance premiums increased and Emerson Services Pty Ltd was liquidated, Harkin replaced this company with another company named ACN 065 040 173 Pty Ltd that it traded under the name of ‘Emerson Services’. Harkin’s wife was the Director of ACN 065 040 173 Pty Ltd. Harkin became bankrupt himself in October 2000. The remaining companies continued under his control but without a director and entered into new contracts including a major subcontract with a construction company working on a New South Wales Government hospital project. In July 2001 the cash flow of Harkin’s companies was such that they were unable to pay employee wages. ACN 065 040 173 Pty Ltd and Emerson Industries Pty Ltd were placed into administration and their contracts cancelled. This left Parallax Corporation Pty Ltd, the assets holding company, of which the Harkin family trust company was a shareholder. The builders for whom Harkins’ companies were performing work agreed to pay Harkins’ companies’ employees their outstanding entitlements. This is an example of companies being set up to separate the assets of a business by transferring them to a company specifically to hold assets and undertake no other activity, in particular activity that may incur debts. In the case of the ‘Emerson Group,’ the contracting company and labour contracting company (which held few if any assets) could collapse without placing at risk the assets of the group, which had been previously transferred to Parallax Corporation Pty Ltd of which the owner’s family trust was a major shareholder. Although this case had been reported to the Australian Securities and Investments Commission (ASIC), ASIC declined to investigate the matter because they had been notified too late to take any meaningful action. The liquidated companies, Emerson Industries Pty Ltd and ACN 065 040 173 Pty Ltd, had accumulated large taxation and insurance debts, which remained unpaid (Final Report of the Royal Commission into the Building and Construction Industry, Reform—National Issues Part 2, page 121). BACKGROUND Globally, limited studies have focussed on phoenix activity but work continues to help identify and differentiate between legal and illegal types of

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phoenix endeavours. It is essential that attention is given to international concerns as diverse business activities progressively transcend state and national borders. In Australia the first major study on the phoenix phenomenon was conducted by the ASC (1996).17 In that study the likely cost of phoenix activity was revealed to be around $1.3 billion to the then-national economy.18 Following, Waters (2012) reported that a study initiated by the Fair Work Ombudsman conducted by PriceWaterhouseCoopers (PWC) estimated the cost to Australia at around $3.19 billion. Such amounts were attributed to a combination of failure in duty to pay employee entitlements like wages and annual leave as well as non-payment of its business debts, including unpaid taxes. Tomasic (1996) emphasized the likely abuse of the corporate form in identifying phoenix companies. This meant that some companies avoided their obligations by ‘hiding behind’ the permitted limited liability allowances within corporations’ legislation. In other words, such companies thwarted the intention of the corporate veil—limited liability.19 Moreover Tomasic (1995) related phoenix company development to rogue directors and elaborated on their likely link to careerist offenders. He proffered that such offenders were aware of the law and that they were a high risk to society. Following the ASC (1996), in late 1998 the Australian Securities and Investment Commission (ASIC) reported a planned target on phoenix activity that included small business operations.20 From 2002 ASIC called on insolvency practitioners to designate any suspected phoenix activity.21 The Cole Royal Commission (2003)22 explored circumstances in the Building and Construction Industry that included scrutiny of what may be deemed to be phoenix companies. McDonald (2005) re-emphasized the importance of defining phoenix activity. The ASIC (2005) implemented an Assetless Administration Fund (AAF) as an initiative to finance mainly liquidator investigations into asset structures of business entities.23 The AAF was to supplement the funds of the suspect company to effect a complete and proper investigation. In which case the liquidator would financially be better able to scrutinize the company’s exact situation; and so determine the extent of any directors’ wrongdoing and breach of corporations’ legislation.24 In 2007 the Australian Tax Office (ATO) initiated an audit of 1,600 business organizations that were considered likely participants in phoenix activity.25 The majority of the businesses were labour intensive and the issues mainly concerned withholding of superannuation and tax obligations.26 McDonald (2010)27 examined the careerist offender in the context of how they likely damage the economy and explained that globally the effect constituted anti-competitiveness. Foremost once again was the concern that no legal recognition of what constituted a phoenix company as opposed an illegal phoenix company was generally accepted or readily available. ASIC (2013) decided to target company directors of failed companies with a close-watch program in an attempt to reduce unlawful phoenix activities. The focus was to be on high-risk industries such as building and

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construction, labour hire, transport, security, and cleaning industries. At that time Walsh (2013) reported the ATO was increasing its attention on phoenix activity with focus on the property development industry. In late 2010 Roach analysed certain international approaches in combating the phoenix phenomenon across the United Kingdom, United States of America, New Zealand, Australia, and Canada. He noted that no clear definition on the phoenix could be attributed to or by the International Association of Insolvency Regulators (IAIR); moreover, he further explored international ideas to combat the phoenix phenomenon and asserted that no clearly defined path could be established.28 Later, Anderson (2012) provided a related international overview with regard to subordination of debt and contribution orders. The latter attributed to companies and their likely insolvent subsidiaries.29 A BRIEF INTERNATIONAL PERSPECTIVE The following explores ideas and initiatives of New Zealand, the UK, Canada, and the USA as well as observations that relate to Australia. Albeit brief, it nonetheless provides a well-referenced summary of similarities between Western nations. The focus is intentional because it highlights the areas emphasized at law between the above-mentioned developed nations that in turn provides a basis for further discussion across borders.

New Zealand (NZ) Ironically given the apparent lack of precise definition in 2006 New Zealand defined phoenix activity and associated provisions under the NZ Companies Act 1993 (NZ Act).30 Basically the NZ definition centred on a failed or liquidated company’s rebirth within a five-year period under the same or a similar name. Noonan and Watson (2008, 4.2, pp. 16, 17) further explained: The Companies Amendment Act 2006 introduced new restrictions in relation to ‘phoenix companies’ modelled on English legislation. New Zealand courts are likely to be influenced by English cases. The main purpose of sections 386 to 386F [for instance] is to impose restrictions and penalties on company directors and company managers who choose to continue the business of a failed company under the cloak of a new company (the phoenix company) while the history of that failure is concealed from the public. Legislation acknowledged the necessity for entrepreneurial operations and as such the reuse of a company’s name or a similar name was not necessarily of concern. Rather it was, and still is, the intent that underpins the action of a company’s or other business’ rebirth that denotes its legal or illegal status.

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To identify and prove that intent is unquestionably problematic. This is not least because an intention, a meaning, or purpose of action, is by its nature intangible. Hence the focus on directors’ duties and directors’ breach of those duties at law is of significant concern to many.31 Noonan and Watson (2008) provide in-depth discourse on directors’ liabilities (NZ) with regard to corporate fault; ‘Section 380(1) makes it an offence for directors to carry on business with an intent to defraud creditors or any other person or for a fraudulent purpose’ (p. 12).32 Under section 320 of the NZ Act creditors might seek redress against directors in circumstances of intent to defraud as in Lion Nathan Ltd. v Lee (1997).33 In this case, however, the creditors’ claim did not succeed. Briefly, the directors of one company in the group (May Campbell Ltd) transferred and/or sold company assets to a related company (Academy Lighting Ltd) allegedly to avoid a major lease liability (MacKenzie, 2008).34 The transaction effectively left the original company unable to pay that debt obligation when due and payable because it was lacking assets and deficient in financial substance. Prior to the transaction, however, the original business was valued independently and the presiding judge found that the price paid for the business was liberal. Seemingly the directors had acted with good intent to recoup as much as possible financially from the business and its assets, to repay the business’ debt—except for the lease liability. Ultimately it was found that in this case the result did not indicate an intention by the directors to defraud.35 In an illegal phoenix situation the transfer/sale of assets from the original company will likely be at a reduced amount—below market value and not at arms’ length. Commonly in such a situation with the sale or transfer of assets, a questionable undervalue is likely attributed to goodwill. Differently, in an acquisition or merger the intention might be to inflate the goodwill hence the net asset worth of the business especially where that business is a target. The inflated net asset worth of the business effectively increases its selling price and so the acquiring company pays more. Whatever the intention, the result is misleading as the business’ reported financials are exaggerated. Consider the case of HIH Insurance Limited (HIH) and its acquisition of FAI Holdings (FAI) prior to the collapse of HIH. Allegedly the takeover of FAI occurred on 1 January 1999. At which time the apparent cost of acquisition was AUD$300.5 million and of that amount the goodwill attributed to the acquisition ‘was recorded in the general ledger [of HIH] at 30 June 1999 at [AUD] $274,997,956’ (Owen, HIH Royal Commission, 2003, p. 124). That left net assets of the business at around AUD$25.5 million and recorded an astonishing amount for the intangible ‘goodwill.’ Eventually it was found that the acquisition was an apparent disaster, not least because ‘HIH paid considerably too much . . . possibly three times FAI’s worth, or [AUD] $200 million too much’ (Brammall, 2001, p. 7).36 Although this was not a phoenix situation, the case

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illustrates the close proximity between inappropriate financial valuations, financial distress, and business failure. In a phoenix situation the recorded amount for goodwill might be underestimated in the transfer of assets with the intent to underrate the likelihood of future income to the business. When goodwill is considered as an indicator of the company’s ability to generate future revenue, it becomes a very important ‘asset.’ It represents an expectation that the substance (expertise, reputation, status, and such) built into a previous business will continue to reap financial benefit for the next. Of course it may not. In which case the amount paid on acquisition for goodwill could reasonably be considered as an expense of purchase; however, with regard to a phoenix situation, goodwill may be a factor to increase the opportunity and the rationale for fraud. Consider the following hypothetical.

A Case of Goodwill and the Phoenix Company Company A is in financial distress. It is not yet insolvent but flagging under the weight of its debt obligations. It has been a well-managed small- to medium-sized business for around 15 years. During this time Company A has established itself with good rapport and reputation within the community. Hence the goodwill attributed to this business is likely to be substantial. Company A directors envisage a way out of the debt dilemma. They will pay their ‘preferred’ creditors duly to retain business connections, reputation, and goodwill built into the business. Payments due, or near due, to other creditors will be delayed and the public will be kept under-informed of the business’ financial state. In due course Company A directors set up a new business called Company AA. The majority of Company A’s assets are transferred or sold, at an agreed but below market price, to Company AA. The business operations in the newly formed company mirror those of the original company. The benefits attributed to the goodwill originating in company A pass to the newly formed Company AA due to the continuity of business operations and perhaps the similarity in the business name. Company A ultimately is left bereft of assets and financial wherewithal to pay its debts when due and payable and so collapses. The likely result of this business re-construction is that some creditors and employees will not be paid their due entitlements. In the above hypothetical the strategy and tactics underpinning the collapse of Company A and the re-birth of the new business Company AA were intentional to avoid the former’s legal liabilities. In which case, the phoenix activity would be illegal. Directors can be held liable for business debts owing and are under the NZ Act s.380(1) not permitted ‘to carry on business with an intent to defraud creditors or any other person or for a fraudulent purpose’ (Noonan and Watson, 2008, p. 12).

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United Kingdom (UK) The UK’s attention to fraud and fraud in financial statements intensifies. Recently it a compliance approach to governance, fraud, and audit considerations were emphasized with due regard to business reconstructions. The latter may move toward the birth of a phoenix company and that may be legal or illegal. Globally phoenix activity is linked to the privilege of the corporate form and the notion of limited liability. Illegal phoenix activity is an abuse of such privilege. The concept of limited liability separates the obligations of the business from its owners. It is arguably good for growth and progress in the commercial world. One reason is that investors know the amount for which they are liable—to the extent of their contribution. Hence the risk of investment likely correlates with the risk profile of the investor. In this sense limited liability, the concept, might be hailed as essential to boost the standard of living for people across nations; as it likely enables more investment money to flow into the capital markets. On that basis it provides opportunities for investors to promote entrepreneurial spirit and encourage growth in employment without draining personal financial wealth. Edwards (1980) provides a history of UK legislation and the transition from the corporate form of the nineteenth century and the joint stock company (the latter essentially a partnership) to the more conventional corporation. Moving from the chartered company to joint stock to the corporation of the modern world has been a journey for limiting liability in transacting business. Although the company per se as a charter granted by the crown dates from the sixteenth century, the ‘developments to the corporate form as we know it today can be traced back to nineteenth century England’ (MacKenzie, 2008, p. 7). Limited liability and separating the business from its owners were, and remain, tangible constructs in the continuity of commercial activities into the future. So, for the health and wealth of nations one might argue that an abuse of the corporate veil is vile. Further that such abuse with intent to deceive is unquestionably a violation of stakeholder rights. Debatably it damages the right of transacting business generally in the commercial world and thwarts the achievement of positive economic and environmental outcomes that are likely to be of benefit to many. It bespeaks a foul misconduct and particularly so in the area of business reconstructions. In which asset transfers are evident and necessary. In the context of structuring a business for sale or merger it is essential to clearly delineate the target company and that business’ element of goodwill. This is a very insecure area. Goodwill is an intangible that is given a financial form and as such it can depict a type of financial benevolence. Across borders, in financial accounting goodwill is considered an asset in the books of the business. Arguably ‘goodwill’ is only an asset to the extent that it can contribute financially to the economic substance of the business, company, or organization. Debatably, then, in the hands of the seller

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it may be an asset (that depicts capital growth) whereas in the hands of the purchaser it is more likely to be an expense (an ‘extra’ amount agreed to be paid) in order to acquire the business. The determined amount of goodwill may depict accurately the business expertise of the previous owner/s and/or the reputation and status of the business. The calculated amount is derived by formula, say, the difference between the net tangible assets of the business and the purchase price. The result is an agreed figure but it is also an intangible amount. It cannot, for instance, be separated from the business, sold and converted into money, and then used to pay debts. It may however be utilized to raise money to pay debts.

Australia In a merger or acquisition, the derived goodwill is sometimes significant. Again it might, if substantial, inaccurately support a published account of a financially sound business. That is the goodwill amount as recorded needs careful scrutiny because it can easily be misleading. Recall the circumstances of FAI and HIH in Australia.37 Nonetheless a miscalculation of goodwill does not align necessarily with illegal phoenix activity. An illegal phoenix company is more likely to be constructed prior to the demise of the original company in order to retain, and maintain, the goodwill inherent therein. On the other hand, it is an area of concern with due regard for disclosure of a business entity’s financial state. In the case of HIH—goodwill along with deferred acquisition costs, future income tax benefits, otherwise capitalized expenses served to misrepresent its financial position.38 In the UK, like in other nations, liquidators have explicit responsibilities and especially for instance in reporting illegal director activities.39 One of the most prevalent areas for misconduct is with regard to the transfer of assets between company constructs. In terms of illegal phoenix activity this is of particular note because usually it is the assets of the failing business that are transferred to the newly constructed entity. Previous chapters have explored the likely fraudulent behaviour associated with other elements of financial statements in terms of revenue, expenses, and liabilities and such. To elucidate illegal phoenix activity requires, among other things, careful scrutiny of the spread of an entity’s assets and liabilities more broadly; and the intent that underpins the reported financial construct. Directors in the UK deemed unfit might, with substantial evidence to support the decision, be disqualified for up to fifteen years.40 Reportedly, however, only around a quarter of director disqualifications relate to phoenix activity.41 Like Australia, the UK acknowledges that sometimes there are ‘insufficient residual company funds to enable the liquidator to undertake the necessary legal action’ (Roach, 2010, p. 111). Australia, the UK, and NZ are somewhat similar in legislation, application, and their results—based on the UK law.

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Australia tried to combat a void (apparently somewhat similar between nations) with the AAF, but now that is showing signs of becoming untenable (Anderson, 2012). One of the egregious aspects of asset transfers in mergers, acquisitions, and the like has to do with the ‘financial depiction’ of goodwill, as previously discussed. The UK legislation and its strategies for compliance attempt to prevent the undervaluing of this asset. And that may well help in deterring some illegal phoenix activity. Evidently UK legislation has deterrents and punitive actions for director misconduct. For instance, with regard to the misuse of a name42 and the valuation of assets transferred from a financially distressed entity to a newly constructed business like the phoenix. Other attributes to continued business are also not overlooked: for instance, that the risk to continuity is exacerbated when the risk to growth in revenues is depending on the circumstances heightened, or diminished. This apparent conflict in terms exemplifies that the specifics of the business and decisions taken are paramount to the end result. Consider the circumstance of a failed and subsequently liquidated business that has avoided payment of a substantial debt. That business has gone and any goodwill associated with it has disappeared. If a newly constructed business, operating in the same industry, with a similar name emerges it may well be flagged as a successor to the original company. It may also be considered to have re-emerged as such to avoid payment of the debt of its predecessor. That debt may be directly attributed to a deceitful intent to increase revenues; that is, a business entity’s reported revenue may be actual, calculated in accord with GAAP, reported prematurely, or made-up; as alleged in the case of One.Tel (Australia) from the 1990s through 2001.43 In the case of One.Tel with focus on revenues as a potential asset its ‘[r]eceivables had spiralled from [AUD] $72 million in 1999 to [AUD] $218.4 million the following year, but the provision for doubtful debts figure had not risen in proportion to the receivables due; it had escalated from [AUD] $7.9 million in 1999 to [AUD] $46.4 million in 2000’ (Margret, 2012, p. 95). The point here is that the numbers indicate a problem but the details of that problem need to be thoroughly scrutinized. The numbers that are given to the public, to business stakeholders, can be ambiguous. In their raw state they are part of the story only. Those numbers frequently need to be clarified in the notes to account but recurrently they are not. The ambiguity in financial statements and notes thereto persist. This is part of a disclosure problem and serves to exacerbate disclosure fraud. This sequence can be aligned with governance and risk management considerations. In the UK that recalls the Higgs (2003) review. One that examined the effectiveness of directors’ mainly non-executive directors in the UK and their role and responsibilities associated with the companies they direct. That brings to mind differences (if any) in the role effected by, and between, executive and non-executive company directors. In terms of governance

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and directors’ duties, their role embodies a genuine duty of care and it is not hinged on compliance factors—as some would indicate. Consider the case of Water Wheel (2000), a case involving the decisions and actions of directors including non-executive directors with regard to insolvent trading. Charges were laid and non-executive directors accused.44 ‘Regardless of the adjective, a director is a director; no hair splitting on responsibilities’ (Margret, 2012, p. 99).

Canada In Canada phoenix company activities, like in other Western nations, tends primarily to relate to small businesses and bankruptcy. The significance of this is difficult because there is no apparent, concise, and agreed definition of illegal phoenix behaviour.45 To transfer assets from a failed or insolvent business into a newly formed entity to achieve business continuity can produce an efficient business. The sale of assets to directors of the insolvent or bankrupt company to enable the birth of another may foster better returns for creditors. During the 1990s such asset rollovers in Canada reportedly received a public consensus.46 If thwarted, creditors and other stakeholders might, as in other countries, pursue civil and/or criminal remedies. Investigations and prosecutions are limited, however, due partly to the lack of reliable data and difficulty in establishing fraudulent behaviour. The law provides redress by way of personal liability on directors related to some tax (GST) and other deductions. Directors may rectify the charge or obligation by showing reasonable care was applied.47 Arguably as in other countries it seems corporations’ legislation does not protect creditors and other stakeholders necessarily from recalcitrant conduct and fraudulent behaviour of directors. Similarly there are no reliable and publicly available detailed statistics on such business failures and directors of same. Unlike the UK there is no disqualifying scheme to offer some protection to creditors from obstinate and wrongful acts of directors.48 Canadian law, albeit somewhat close to Australian and New Zealand legislative concerns in the realm of phoenix activity, also aligns with that of the USA.49

United States of America (USA) Although the concept of phoenix activity and the phoenix company is not apparently defined at law, it does proffer a parallel entity. Roach (2010, p. 112) asserted ‘the United States Trustee Manual provides a description of “parallel entities” that closely aligns with phoenixing.’ That being so the domain of illegal phoenix activity does not differ much from other countries. Similarly there are civil and criminal remedies against those who aid the progress of phoenix activity. Recall the circumstances of the Australian case: In ASIC v Sommerville and the details of subsequent action that was

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brought against eight directors and the solicitor who had assisted them by way of providing. Hence the necessity for directors and officers of corporate entities to act in the best interests of their creditors and other stakeholders is widely expected. Moreover in the USA corporate officers are required ‘under oath’ to detail possible phoenix activity.50 Due to the lack of clarity in definition and the complexity in ‘proving’ intent to mislead or deceive, this is again problematic. Bankruptcy provisions, however, under the USA Chapter 11 (insolvency code) and Chapter 7 (business liquidations) are relevant. Recall that phoenix activity thrives under circumstances of financial distress. It is usual for a phoenix company to arise prior to the original company becoming insolvent or otherwise bankrupt. After the global financial crisis (GFC) the USA experienced a massive increase in its business reconstructions and liquidations. This is somewhat understandable under such financially challenged circumstances and might be considered expected. The relevance, if any, to phoenixing is with regard to an illegal reconstruction devised to avoid payment of debt or certain debt. Under bankruptcy, the USA criminal code provides a broad base upon which to deal with illegal circumstance.51 It is increasingly evident that a generally agreed and precise definition of illegal phoenix activity is warranted. This challenge increases because it also necessitates that the difference between an illegal phoenix operation and a legal phoenix activity be clearly demonstrated. This is more than a challenge; it is a thorny problem. It is particularly so given the multitude of economic, environmental, and personal circumstances that may prevail prior to, during, and after a business reconstruction. For continuity of a business its physical reconstruction may involve financial constructs like asset rollovers, asset sales or transfers, liability shedding, off balance-sheet activities, or other such manoeuvring—that may be classified as legal, or not. The following case examples illustrate questionable circumstances of business reconstructions. The cases are important because they involved waterside reforms, the process and results of which reverberated across the globe. Major considerations for such change were to improve efficiencies and reduce costs. Other concerns had regard for privatization of selected ports, instigation of new technologies, and innovative management. Strategies undertaken to achieve reform on the waterfront during the 1990s (Australia) and the 1980s (New Zealand) and the response from workers, unions, management, governments, and the general public are beyond the scope of this book. They are covered in other publications including numerous media releases during the relevant years and into the new millennium. A brief discourse and comparative view on related circumstances that arose in Australia, New Zealand, and Taiwan is given by Jou-juo Chu (2007), as summarized in the following Table 6.1. Due to the availability of limited data, it is the NZ case and the Australian case only that are explored herein. The focus remains on details of

Phoenix Activity Table 6.1

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Strategies of Port Reform: New Zealand, Australia, and Taiwan New Zealand

Port focused

Nelson

Australia

Melbourne, Sydney, Fremantle Period involved 1988–1989 1998–1999 The union involved The Harbour The Maritime Union Workers Union of Australia (HWU) (MUA) Privatization The Nelson Patrick Stevedores initiated Harbour Board Measures taken to tactic callous conduct port reform The mass dismissal Conflict-igniting The 8-hour of MUA Issues day without dockworkers redundancy scheme Action taken by the 22-day strike An international Union blockade Process of Port Gradual, slow and Prompt and radical reform sure Degree of militancy Militant locally Confrontational internationally

Taiwan Kaohsiung 1996–1997 The Kaohsiung Dockworkers Union (KDU) The Kaohsiung Harbour Bureau placatory

Pension plans, retirement and severance pays Continuing negotiations Progressive Least militant, but materialistic

Source: As depicted in Chu, J.-j. (2007) ‘Port reform and dockworkers: The cases of Australia and New Zealand and their Kaohsiung counterpart’, Conference paper, Auckland, N.Z. We thank the author for permission to reproduce his Table 1 herein.

corporate reconstruction and the related financial manoeuvres to achieve the new business structure. The cases show that mixed reasons underpin the physical aspects of a reconstruction process and the intent that fortifies its progress. Hence characteristics of business re-structures are diverse and the likelihood of linkage to phoenix activity, legal and illegal, are complex. It is an area to enter with guarded concern for the exactness of the situation. CASE ANALYSES: RESTRUCTURE OF ASSETS, DEBTS, AND OBLIGATIONS

Patrick Stevedores Pty. Ltd.52 In 1998 Patrick Stevedores Pty. Ltd (Patricks) engaged in a well-publicized battle with the Maritime Workers Union of Australia (MWU). Reportedly it was with the backing of the Australian Government. It was an explosive and (to some) devastating blight on the sequence of industrial relations, in the

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story of business and its operating activities in Australia. At that time many supposed that the stevedoring companies and the waterfront in Australia acting together were inefficient. Allegedly this was due partly to poor work practices, high wages, and a “closed shop” mentality that then reportedly operated on the waterfront.53 Briefly it seemed the then Federal Australian Government (1996) initiated the action to ‘reform working practices in the docks. [Subsequently] New federal legislation was passed, the Workplace Act 1996 which restricted the type of industrial action that . . . could legally be undertaken.’54 The problem was the perceived control of the union workforce with regard to movement of cargo into, out of, and on the docks. The union and the ‘wharfies’ disagreed. To some within the broader community, the waterfront workers were hardly done by and they had a bona fide argument. To others, across the nation, the upheaval and inexplicable detriment to continuity of business perpetrated by the waterfront, had to stop. The situation exploded when those on the waterfront challenged, without apparent consequence to themselves, the authorities. At the time that meant the company (Patricks), the government, and anyone else who opposed the otherwise collective ideas. The story is evocative of bygone eras. It encapsulates the hardship suffered by ‘blue-collar’ workers of times past. It pulls at our heart strings and causes moments of considered abhorrence for those in authority. They were (they are) the individuals and groups who might contrive, seemingly because they have the position, and regulatory power, to act against the people. Yet this particular situation was happening in a free and democratic country. One that works for the people, for freedom of speech, freedom to think, and freedom to act, and encourages care for each other, and care for the nation in which we live. The Patrick saga was embroiled with emotion. In that context it divided the nation. In April 1998 Patrick applied a strategy to change its workforce and increase efficiencies of operations on the docks. The company/group planned to replace its entire workforce in Australia with non-union personnel. Accordingly it moved to restructure the company. However the corporate structure of the Patrick group was already complex and the proposed changes were likely to be complicated.55 Patrick itself was a company within the group. It managed the stevedoring operations across ports in Australia mainly in Sydney and Melbourne. The entire Patrick group was a subsidiary of the then Lang Corporation, which was an extensive public company. The Lang Corporation had a history of acquiring stevedoring companies and this tended to enhance the group’s complex corporate structure.56 The following details from the April 1998 case clarify in brief: • A number of different companies employed the Patrick stevedores. • Four such companies named: Patrick Stevedores No 1 Pty Ltd; Patrick Stevedores No 2 Pty Ltd; Patrick Stevedores No 3 Pty Ltd; and Patrick Stevedores Tasmania Pty Ltd.

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• The employer companies then provided the labour to the overarching Patrick company. • Certain services, and the equipment, as well as the required facilities were supplied by Patrick Stevedores Operations No 2 Pty Ltd. • Therefore Patrick in the main leased (the company was the lessee) of many segments (different areas) in all the major ports around the country (Australia). • Significantly at that time, the stevedores were all members of the Maritime Union Association (MUA).57 The management plan included replacing members of the union workforce with non-union contractors in order to reduce costs and increase efficiencies across the port. To backtrack a little: In the restructure the original company would remain, it would exist but it would be bereft of assets and in that state would be unable to pay its debt obligations when due and payable. On the face of it—the projected strategy (of separating assets and liabilities) resembled a phoenix operation. On the other hand, it might (as it probably was by some) be attributed to good business judgement. After all, the waterfront across nations of the world is the hub of import/export business to and from numerous companies. Nations rely to a large extent on the funds that flow from their exports and imports and the non-disruptive stream of goods that subsequently churn through the waterfront ports. Australia is no different. Arguably all nations, for continuity of good business, would ascribe to efficient and effective operations on their waterfront. How that is achieved is problematic. The Patrick saga was not considered as a phoenix dilemma or in that context a fraud. Proceedings in the Federal Court of Australia seeking temporary orders to keep the employees of Patrick in work, commenced until the main application could be heard. The MWU58 and its members were triumphant in that Patrick had to pay costs and re-employ some MWU workers. ‘On May 4, 1998, the Commission concluded that the sackings were in breach of Australia’s industrial relations laws . . . [and a] peace settlement was reached with Patrick Stevedore on August 5, 1998. By the end of August, 689 permanent workers were re-employed . . . with around 450 casual and guaranteed wages earners.’59 In the case of Patrick, because of its original structure and reconstruction, the actions resembled a phoenix situation. That notion, however, had no part in the court considerations or findings. The emotive social, political, even economic opinions and debate that had consumed the media had no place in the courts. As stated in the 24 April 1998 Federal Court transcript: ‘The business of the Court is legality . . . so it sometimes happens that desirable ends are pursued by unlawful means . . . [and] courts have to rule on the legality of the means, whatever view individual judges may have about the desirability of the end.’60 That in no way was to indicate that the restructure was a phoenix situation or that it was indicative of an illegal phoenix.

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In any business restructure, complex or not, it is the construct of the entities involved and their mix of assets and liabilities that are of interest. The ‘price’ at which assets are sold or transferred from one entity to another will ultimately affect their financial substance. That in turn affects each entity’s financial capacity to pay its debt obligations. Hence it is the form of the asset transfers and ultimately where the debt obligations lay that are of consequence. In New Zealand concerns of phoenixing arose distinctly with the case of New Zealand Stevedoring Limited. The case in itself was not an example of illegal phoenix activity. It did, however, signal how such a phoenix operation might arise.

New Zealand Stevedoring Limited (NZ Stevedoring) In 1998 the collapse of NZ Stevedoring resounded throughout the country. It alerted the NZ public to the potential for abuse of the corporate form and limited liability. It also aroused the public’s attention to phoenix activity, what it meant, and how it might link to fraud in a corporate restructure. In the first instance there are here two points of concern. They are the way in which the corporation is structured, and the concept of limited liability. The latter is with particular regard to the entity’s directors, owners, and the business itself. As previously indicated limited liability restricts the owners’ liability to their invested amount and so limits their risk of financial loss. For directors, and the business as a separate legal entity, the level of accountability and due obligations of each might be different. This is due in part on the circumstances and the results of the businesses operations. For instance, if and when the level of risk associated with a business venture is, or may be determined to be, irrational or otherwise outside the generally accepted or documented risk profile of the business. This might also include situations of environmental damage, pollutants, or human degradation.61 On the one hand, that a company in the normal course of conducting its core business operations suffers financial distress that ends in its insolvency, may not be associated with its corporate form. It may be due to bad management practices, unfortunate economic circumstances that prevail, fraudulent activities, or a combination of those. Further the unexpected corporate collapse is not attributable necessarily to its access to limited liability that some might deem to encourage entrepreneurial flight and careless risk taking. It is known that companies take risks involved in the conduct of business generally. That business risk may result in financial loss is understood or at least, arguably, it should be. Logically, the degree of risk acceptable to creditors, investors, and other stakeholders will vary. Hence creditors and such others would normally decide how best to protect their financial interests in the case of diminished financials or a complete business failure.

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Prior to a business (or company) collapsing its directors might instigate a re-structure to achieve business continuity. In such a business or corporate restructure the situation is questionable when change is done without ‘due diligence’ and the circumstances of those changes are not clearly communicated to stakeholders. This circumstance can be applied in a broad sense to any business, company, or public institution that is re-structuring to reduce costs, without any apparent indication of financial demise. This case albeit, in some ways, similar, is a different area to the concept of phoenix companies and their related transactions dealt with herein. In a financially distressed business (company) heading for insolvency the financial elements of the planned re-structure are particular. Their mix is effected with ‘some’ intent. What that intent may be is arguable—and difficult if not impossible to prove. Of concern in a complex corporate structure is where related companies to the one in financial distress are sold assets of that distressed entity at below market value. In which case, the transaction is likely to be, or to be perceived to be, not at arm’s length. Thus warning signals arise when the sale or transfer of assets from the original entity to the new business is conducted at a low and dubious price. Hence the transaction may be in dispute. Of concern therein is that sufficiency of money is available after the sale of assets to cover the entity’s debt obligations to, for example, its creditors, employees, and financiers. In the case of NZ Stevedoring, allegedly there were insufficient funds to cover its employee’s entitlements and redundancy payments.62 On investigation, however, the NZ Registrar of Companies considered the asset transfer to be of adequate value. Hence there was ultimately no evidence of an illegal phoenix situation. The circumstances of the corporate restructure and the subsequent shift in assets did, however, raise public concern. The focus on phoenixing and the likelihood of a phoenix company rising grew. Change was imminent and occurred at law. It was also determined that with the changes the likelihood of phoenix company abuse would not disappear.63 The corporate structure of NZ Stevedoring at the time of the phoenixing debacle has been difficult (if not impossible) to locate. It is important because reportedly ‘the actions of the New Zealand Stevedoring Company Limited, which in 1998 reorganised its affairs . . . avoided paying $14 million in redundancy payments to 300 staff and wharf employees’.64 Dalziel (2004) asserted that ‘during the insolvency the assets of three companies were sold to a related company as going concerns.’ That would indicate sufficient moneys to pay the accumulated liabilities of the entity in question—but seemingly that was not the case. As this book goes to print, we were unable to locate a reputable sequence that logically structured the arrangement of the NZ Stevedoring corporate form during the 1980s and covered the time of its re-structure.

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CONCLUDING REMARKS We have emphasized throughout the chapters, the necessity for stakeholders to focus on the structure of the business in which they have an interest. In this vein it is essential that stakeholders determine the quality (serviceability) of the entity’s mix of its assets and its liabilities, and do so continually. This means that stakeholders demand that those fundamentally important aspects of business continuity are communicated precisely to all interested parties. In this chapter we centred attention on the concept of phoenix companies and related business arrangements. This is an under-researched area that is of much concern for business, regulators, and governments alike. This is partly because of the probable increase in opportunities for fraudulent behaviour and for fraud in published financial statements to occur into the future. The rationale for this may be attributed to the ever-increasing complexities of conducting business nationally and on a global front. Alternatively, illegal phoenix arrangements may be considered to belong only in the range of small- to medium-sized businesses.65 Attention there has regard for the size of the business in relation to the size of the shareholding, and thus on the mix of business ownership and control. We disagree, in part, because the potential for growth in phoenix company arrangements is limited only by one’s imagination, or lack thereof. Many companies of the larger corporate style (including those publicly listed) have somewhat controlling executives, directors, investors, creditors, and such. It is most likely that the opportunities that enable an illegal phoenix to arise will increase into the future.

NOTES 1. For an in-depth discourse on mythological birds and other creatures, see Joseph Nigg’s The Book of Fabulous Beasts: A Treasury of Writing from Ancient Times to the Present. Also for a brief exposé on the phoenix, refer to Shumaker (2008), available at http://media.swarthmore.edu/ bulletin/?p=117. 2. Further online reference is available at, for instance: www.princeton.edu/~ achaney/tmve/wiki100k/docs/Phoenix_(mythology).html, accessed May 2014. 3. Ibid. 4. Details of varying ideas on the phoenix are readily available online through search engines such as google.com.au and those that delve into ancient history, for instance: http://ancienthistory.about.com/cs/grecoromanmyth1/g/phoenix bird.htm. 5. See his brief chapter on ‘The process of creative destruction’ in, for instance, Schumpeter, J.A. (1947) Capitalism, Socialism and Democracy, Allen and Unwin, London. 6. Refer to detailed case events and argument, for instance, in Clarke et al. (1997/2003); Clarke and Dean (2007); Margret (2012). 7. Ibid.

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8. An accidental fraudster is an otherwise good person who because of circumstances gives in to pressure, grasps the opportunity, and rationalizes the act. Refer also to Kranacher et al. (2011, p. 517). 9. Refer to, for instance, Appleby (2004) in Roach (2010) and Anderson (2012). 10. NZ Companies Act (1993); also see Anderson (2012). 11. As explained, for instance, in the Australian Securities Commission (ASC) 1996, ‘Project One: Phoenix Activities and Insolvent Trading’ paper, May 13. 12. See ‘Action against Fraudulent Phoenix Activity’, Proposals Paper, Treasury, Australian Government, November, 2009. 13. Also see points of discussion in Anderson (2012, p. 412). 14. Refer to Anderson (2012) and the Similar Names Bill; for instance, in Anderson (2012) with reference to enabling the business entity to continue its operations at p. 427. 15. Refer to Kranacher et al.’s (2011) explanation of the accidental fraudster in comparison to the predator. The accidental fraudster may become a predator but the predator cannot be redefined as accidental. 16. From the Final Report of the Royal Commission into the Building and Construction Industry (2003) Reform—National Issues Part 2, page 121, Commissioner: The Honourable Terence Rhoderic Hudson Cole RFD QC. 17. In ‘Project One: Phoenix Activities and Insolvent Trading’ (1996) paper by Barlow, D. 18. Also see Martin (2007) for further details and explanation. 19. For broad discussion on the concept of the corporate veil, see, for instance: Clarke et al. (1997/2003); Clarke and Dean (2007); Anderson (2012). 20. The ASIC was an initiative that developed from the origin of its predecessor, the ASC. 21. ASIC (2002); also in Roach (2010, p. 103). 22. Commonwealth, Royal Commission into the Building and Construction Industry, Final Report (2003) Vol. 8, Chapter 12. 23. The AA fund was set up to finance initial investigations of liquidators into failed and basically assetless companies. It was also to help safeguard liquidators from personal financial loss. Its particular focus was the reduction of fraudulent phoenix activities. 24. Breach of directors’ duties, for instance, under the ACA (2001) s.206B; also see Martin (2007) and Roach (2010) for discussion and further relevant details. 25. Darmanin (2010, p. 3) and Roach (2010, p. 102). 26. ATO (2007). 27. At that time, he was a working barrister. 28. Roach (2010) referenced this to the efforts of the International Association of Insolvency Regulators. 29. In that context, refer to Anderson (2012, pp. 433–435). 30. See, for instance, Taylor (2007, p. 23). 31. Roach (2010) with reference to Keeper (2008) explained how in New Zealand penalties directors might incur for related criminal actions were a deterrent because of a possible five years in prison with a fine of up to $200,000. More broadly, others explicate, for instance, Pavlo in the MCI WorldCom saga, that possible punitive actions do not deter necessarily the fraudster from his/her intent. 32. Article: ‘Liability of Directors for Corporate Fault in New Zealand’, electronic copy available at http://ssrn.com/abstract=2026226, accessed July 2014. 33. Lion Nathan Ltd v Lee (1) 8 NZCLC 261, 360. 34. See MacKenzie (2008, p. 22). 35. Ibid., p. 23. 36. Also see Margret (2012, p. 102).

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37. Refer to a number of studies for related details, for instance, Margret (2012), Monem (2011), Clarke and Dean (2007). 38. Refer to the Royal Commission Report of Owen (2003). 39. See Insolvency Act (UK) 1986, s.218(4); and the Insolvency Act (UK) 2000, s.10. Also in Roach (2010, p. 110). 40. Refer, for instance, to the Company Director Disqualification Act (UK) 1986, s.18. 41. As in Quainton (2008) in Roach (2010, p. 111) 42. Insolvency Act (UK) 1986, ss.216, 217. Also see Roach (2010, p. 111) and footnotes therein. 43. Refer, for instance, to Margret (2012, pp. 92–96) and references therein. 44. Refer, for instance, to Margret (2012, pp. 99, 100). 45. See Roach (2010, p. 105). 46. Ibid. 47. Bomhof (2009, p. 5) as in Roach (2010, p. 105) 48. Refer to Girgis (2009). 49. As explained, for example, in Roach (2010, p. 105). 50. Refer to Roach (2010, p. 112). Also therein reportedly available at www. uscouts.gov/bankform/form7.pdf, herein not accessed. 51. Refer to the USA code at Title 18, Part 1, Chapter 9: Bankruptcy, ss.150–158 as in Roach (2010, p. 112). 52. For an overview, refer to www.takver.com/wharfie/ce980601.htm, accessed May 2014. Also see Maritime Union of Australia & Others v Patrick Stevedores No. 1 Pty Ltd (under administration) (ACN 003 621 645) & Others [1998] FCA 378, 21 April 1998. 53. Refer to Patrick Stevedores Operations Pty. Ltd (plaintiffs) and International Transport Workers Federation (defendants), High Court of Justice 1998 Folio Queens Bench Division 21 April, before Mr Justice Thomas; available at www.austlii.edu.au/au/special/patrick_uk.html, accessed September 2008. 54. Ibid., under ‘THE FACTS AS THEY APPEARED BEFORE ME’ at (a). 55. On 21 April 1998, Justice Thomas in the High Court reiterated that the corporate structure of the Patrick group was complex ‘and that complexity is said in part to be due to the progressive acquisition of stevedoring companies by the Lang Corporation. Patrick is the company within the group which manages the stevedoring operations in those [major Australian] ports’ (p. 2). 56. Ibid., at (c) p. 2. 57. Source: Based on details from the case transcript: In the High Court Justice between Patrick Stevedores Operations Pty. Ltd., and International Transport Workers Federation, April 1998. 58. The MWU are the Maritime Workers Union—in the Patrick debacle in the main the Maritime Union of Australia. 59. With further details in article “MUA vs Patrick Stevedore—1998: Australia’s biggest industrial relations dispute” at www.worksite.actu.asn.au, accessed 16 September 2008. 60. Ibid, at p. 5 under “The case”. 61. Recall, for instance, the BP—Deepwater Horizon Oil Spill into the Gulf of Mexico and further along the coast of the US. Specified details available at https://www.dosomething.org/facts/11-facts-about-bp-oil-spill, accessed July 2014. Other cases might include BHP and its Ok Tedi Mining saga in the 1990s that continued (for some) into the new millennium. See Pascoe (2013) ‘Ok Tedi: Latest act in a saga of tragedy & generosity’ for a recent update on continuing events; available at http://asopa.typepad.com/asopa_ people/2013/03/ok-tedi-latest-act-in-a-saga-of-tragedy-generosity-can-pngpoliticians-be-trusted-to-run-pngsdp-prop.html, accessed July 2014.

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62. See Dalziel (2004), also in MacKenzie (2007, p. 29). See, for instance, Morrison (2002). 63. Consider Keeper (2007) and discussion therein on phoenix companies and related developments. Also Taylor (2007) on insolvency, phoenix activity, and directors’ liabilities. Another reading of interest is Morrison (2012). 64. As stated by Michael Bos: [email protected], available at: www. findlaw.com/12international/countries/nz/articles/1046.html, accessed July 2014. 65. Refer to MacKenzie (2007, p. 20).

BIBLIOGRAPHY Anderson, H. (2012) ‘The proposed deterrence of phoenix activity: An opportunity lost’, Sydney Law Review, Vol. 34, pp. 411–436. Appleby, P. (2004) The Regulation of Phoenix Companies: Collective responses of a survey of members of the International Association of Insolvency Regulators (IAIR) relating to the incidence and control of the phoenix syndrome, IAIR, October. Available at www.docstoc.com/docs/25256488/Final-Draft, accessed June 2014. ASIC v Somerville & Ors (2009) NSWSC 934. Australian Accounting Handbook (2011) Incorporating Australian Accounting Standards and the International Accounting Standards and International Financial Reporting Standard equivalents, CPA Australia, Pearson Australia. Australian Corporations Act (2001) Butterworths, Sydney. Australian Government (2009) ‘Action against Fraudulent Phoenix Activity’, Proposals Paper, Treasury, Commonwealth of Australia, November. Available at http://archive.treasury.gov.au/documents/1647/PDF/Phoenix_Proposal_Paper. pdf, accessed June 2014. Australian Securities Commission (ASC) (1996) ‘Project One: Phoenix Activities and Insolvent Trading’, by Darren Barlow, Principal Analyst, ASIC National Intelligence and Analytical Service, 13 May. Australian Securities and Investment Commission (ASIC) (2002) Submission to the Royal Commission into the Building and Construction Industry, 25 June. Australian Securities and Investment Commission (ASIC) (2005) “Assetless Administration Fund”, https://www.asic.gov.au/aafund. Australian Securities and Investment Commission (ASIC) (2013) Media Release 13-253MR, “ASIC surveillance targets illegal phoenix activity”, 9 September. Available at: http://www.asic.gov.au/asic/asic.nsf/byheadline/13-253MR+ASIC+ surveillance+targets+illegal+phoenix+activity?openDocument Barlow, D. (1996) ‘Project One: Phoenix Activities and Insolvent Trading’, May 13, Australian Securities Commission. Bomhof, S. (2009) ‘Canada: Duties of directors in the insolvency zone’, Mondaq Business Briefing, 21. Available online at www.mondaq.com/canada/x/87815 /Directors+Officers/Duties+Of+Directors+In+The+Insolvency+Zone, accessed June 2014 and September 2014. Brammall, B. (2001) ‘Anatomy of a Disaster’, Herald-Sun, Melbourne, Australia, May 21, p. 7. British Companies Legislation, The Companies Act 1985 and Insolvency Act (UK) 1986, s.218(4); and the Insolvency Act (UK) 2000, s.10. CCH Editions Limited. Chu, Jou-juo (2007) ‘Port Reform and Dockworkers: The cases of Australia and New Zealand and their Kaohsiung counterpart’, Strategy and Human Resource Management Conference Proceedings, Auckland, available at www.mngt.waikato.ac.nz/departments/Strategy%20and%20Human

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%20Resource%20Management/airaanz/proceedings/auckland2007/022.pdf, accessed July 2014. Clarke, F. L., Dean, G., and Oliver, K. G. (2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, New York. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne. Cole, Honourable Terence Rhoderic Hudson Cole RFD QC (2003) Final Report of the Royal Commission into the Building and Construction Industry, Reform—National Issues Part 2 Royal Commissioner, The Honourable Terence Rhoderic Hudson Cole RFD QC February 2003. Dalziel, L. (Hon), Minister of Commerce (2004) ‘Paper for Cabinet Economic Development Committee’, January. Available at www.med.govt.nz Edwards, J. R. (1980) British Company Legislation and Company Accounts, 1844–1976, Arno Press, New York. Girgis, J. (2009) ‘Corporate directors’ disqualification: The new Canadian regime?’, Alberta Law Review, Vol. 46, No. 3, July 2, pp. 1–37. Also available at: http://ssrn. com/abstract=1346589, accessed September 2014. Higgs, D. (2003) The Higgs Report: Review of the Role and Effectiveness of Non-Executive Directors, published in The Effective Board, January. Keeper, T. (2007) ‘Phoenix Companies’, in New Zealand Law Society (NZLS), Business Insolvency, 117 at 118, 127. Keeper, T. (2008) ‘The New Order of the Phoenix’, New Zealand Business Law Quarterly, March, pp. 21–36. Kranacher, M. J., Riley, R. A., and Wells, J. T. (2011) Forensic Accounting and Fraud Examination, John Wiley and Sons, Chichester, England. Lion Nathan Ltd v Lee (1997) 8 NZCLC 261, 360. MacKenzie, D. (2008) Abusing the Corporate Form: Limited Liability, Phoenix Companies, and a Misguided Response, October. ‘A dissertation submitted in partial fulfilment of the degree of Bachelor of Laws (Honours) at the University of Otago’, available online at www.otago.ac.nz/law/research/journals/ otago036279.pdf. Margret, J. E. (2012) Solvency in Financial Accounting, Routledge/Taylor and Francis Group, New York. Maritime Union of Australia & Others v Patrick Stevedores No. 1 Pty Ltd (under administration) (ACN 003 621 645) & Others [1998] FCA 378, 21 April 1998. Martin, A. (2007) ‘Directors’ Duties and Phoenix Companies’ Allens Arthur Robinson, available at www.allens.com.au/pubs/pdf/insol/pap4apr07.pdf, accessed June 2014. McDonald, G. (2005) ‘Phoenix companies; the laws and the myths’, www.hallchad wick.com.au/LiteratureRetrieve.aspx?ID=1431. McDonald, C. (2010) ‘ATO phoenix companies enquiries’, http://archive.treasury. gov.au/documents/1892/PDF/Geoffrey_McDonald.pdf. Monem, R. (2011) ‘The One.Tel collapse: Lessons for corporate governance’, Australian Accounting Review, Vol. 21, No. 59, pp. 340–351. Morrison, D. (2002) ‘The addition of uncommercial transactions to s. 588G and its implications for phoenix activities. (Corporations Act section 588G)’, Insolvency Law Journal (1039–3293), Vol. 10, Issue 4, p. 229. Morrison, D. (2012) ‘Chasing the phoenix’, Insolvency Law Journal, Vol. 20, No. 1, pp. 61–70, available online at http://sites.thomsonreuters.com.au/journals/ files/2012/04/Insolv-LJ-Vol-20-No-1-Contents-Mar-12.pdf, accessed September 2014. New Zealand Companies Act (1993) Companies Amendment Act 2013. Nigg, J. (1999) The Book of Fabulous Beasts: A Treasury of Writing from Ancient Times to the Present, Oxford University Press, New York.

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Noonan, C. and Watson, S. (2008) ‘Liability of Directors for Corporate Fault in New Zealand’, March, pp. 1–31, posted at http://ssrn.com/abstract=2026226. Owen, Justice Neville (2003) The Failure of HIH Insurance, HIH Royal Commissioner’s Final Report, HIH Royal Commission, Commonwealth of Australia. Pascoe, M. (2013) ‘Ok Tedi: Latest act in a saga of tragedy & generosity’, Sydney Morning Herald, March 23. Available online at http://asopa.typepad.com/asopa_ people/2013/03/ok-tedi-latest-act-in-a-saga-of-tragedy-generosity-can-pngpoliticians-be-trusted-to-run-pngsdp-prop.html, accessed July 2014. Patrick Stevedores Operations Pty. Ltd., and International Transport Workers Federation (1998) April, High Court of Justice, Folio No. Queens Bench Division. PriceWaterhouseCoopers (2012) ‘Phoenix activity—sizing the problem and matching solutions’, for the Fair Work Ombudsman, available at www.fairwork. gov.au/Publications/Research/Phoenix-activity-report-sizing-the-problem-andmatching-solutions.pdf. Quainton, D. (2008) ‘Phoenixing: Tempers flare as the phoenix rises’, Event Magazine, Vol. 12, December. Also available online at www.eventmagazine.co.uk/ news/869945/Phoenixing-Tempers-flare-phoenix-rises/?DCMP=ILC-SEARCH. Roach, M. (2010) ‘Combating the Phoenix Phenomenon: An analysis of international approaches”, eJournal of Tax Research, Vol. 8, No. 2, pp. 90–127. Schumpeter, J.A. (1947) Capitalism, Socialism and Democracy, Allen and Unwin, London. Taylor, L. (2007) ‘Director’s Liability on Insolvency’, pp. 1–35, available at http:// ir.canterbury.ac.nz/bitstream/10092/2596/1/12607842_Taylor.pdf, accessed July 2014. Article is associated with 7th Annual Corporate Insolvency Conference, 17–18 Oct 2007, Auckland, New Zealand. Tomasic, R. (1995) ‘Phoenix companies and rogue directors: A note on a program of law reform’, Australian Journal of Corporate Law, Vol. 5, pp. 474–480. Tomasic, R. (1996) ‘Phoenix companies and corporate regulatory challenges’, Australian Journal of Corporate Law, Vol. 6, pp. 461–465. United States (USA) Criminal Code at Title 18, Part 1, Chapter 9: Bankruptcy, ss.150–158. Walsh, K. (2013) ‘Tax Office sets sights on phoenix operators’, Australian Financial Review (AFR), 16 July, Melbourne. Waters, C. (2012) ‘FWO report reveals phoenix activity costs Australia around $3 billion a year: Eight ways to spot a phoenix company’, available at www. smartcompany.com.au/legal/050528-fwo-report-reveals-phoenix-activity-costsaustralia-around-3-billion-a-year-eight-ways-to-spot-a-phoenix-company.html. WaterWheel Holdings Ltd. (2000) ‘The directors placed the companies into voluntary administration on 17 February 2000, after announcing a loss of $6.7 million for the year to December 1999’ in ASIC Media Release 03-144, ‘Court finds against Water Wheel directors’, 5 May 2003. Available at http://www.asic.gov. au/asic/asic.nsf/byheadline/03-144+Court+finds+against+Water+Wheel+director s+?openDocument#

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Education is by far the most important defensive weapon against frauds of all kinds. (Wells, Foreword in Zack, 2012, p. xiv)

THE IGNOMINY OF FRAUD This book examined fraud in regard to published financial statements of a business entity’s economic wherewithal. This is a topical issue for business, its stakeholders, and communities globally, notably, as fraud and the notion of fraud in the delivery of financial statements to stakeholders has the propensity to cause grief to many. Yet recent surveys indicate that the problem is likely to continue to challenge companies, regulators, and law enforcement agencies. In its 12th Global Fraud Survey, Ernst and Young (EY) conveyed that 4 per cent of the 372 chief financial officers’ (CFOs) surveyed indicated they believed that misstating a company’s financial performance can be justified, if the misstatements help a business survive an economic downturn (p. 12). Furthermore ‘39% of respondents reported that bribery or corrupt practices occur frequently in their countries’ (emphasis in original).1 The KPMG 2012 Forensic survey of fraud, bribery, and corruption in Australia and New Zealand found that although fraudulent statements represented only 6 per cent of the total number of major frauds, it represented 20 per cent of the total value of major frauds (KPMG, 2013, p. 18).2 Drawing on various cases of national and international significance it was shown that such deception can, and frequently does, result in untold damage to financial markets and communities worldwide. An array of selected case examples are spread throughout the chapters to focus on, and illustrate, particular conditions that relate to the topic of each specific chapter. This emphasized the circumstances of fraud as opposed those of mismanagement, error, or incompetence that, for example, may result in an unexpected corporate collapse or the insolvent trading of a business organization. It was shown that fraud in financial statements can be very difficult to ascertain.

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Further it was stressed that fraud is an intentional act to deceive; that such intent is inherent in the definition of fraud in financial statements; and that underscoring each case is the difficulty in proving intent to defraud. There are various definitions related to FSF that have been advocated by significant national and international authorities.3 Such definitions are of substance, and although they are similar in content, they may hold different meanings and areas of consequence for different people. So for clarity in this book we proffered the following definition for FSF: Fraud in financial statements is an act of deliberate deceit that results in a misleading representation, material misstatement or intended exclusion in a business entity’s financial accounts. The deception is committed with the intent to mislead shareholders and other stakeholders about the financial state of the business entity. The fraud may misleadingly relate financial circumstances, or an otherwise non-financial material fact. With this in mind, Cressey’s theory of the fraud triangle4 formed the theoretical base for discussion and analysis. The basic factors of pressure, rationalization, and opportunity that initially formed the fraud triangle underpinned case scrutiny. Chapter one explained the extended form of the fraud triangle to include fundamental elements of theft, concealment, and conversion.5 Hence the concept of the fraud triangle is twofold (factors and elements) that together facilitate case investigation and discernment of fraudulent activity. In chapter two, linkage to stakeholder theory served to expand, and substantiate the theoretical base: firstly, between the factors and elements of fraud and those who commit, or may commit, the crime. Secondly, the basic factors help establish why fraud might occur (pressure or perceived pressure and identified opportunity), and how the crime might be rationalized. Thirdly, and given that business stakeholders are numerous, stakeholder theory underpinned additional links between the fraudulent act, its financial outcomes, and the many in and across communities who likely suffer from the consequences. Further it provided definition and discourse on primary and secondary stakeholders and why that separatist view was not supported herein. Chapter three drew attention to the significance of quality in financial statement content. In that context, the concept of quality was discussed and defined. Subsequent analysis revealed continuing dilemmas for management in the realm of applying financial accounting procedures, abiding by the law and professional accounting pronouncements. Previous works of Clarke et al. (1997/2003), Clarke and Dean (2001), Margret (2002), Clarke and Dean (2007), Dean et al. (2008), and Margret (2012) were therein most helpful. It was again determined that the notion of quality in a financial statement closely aligned with the serviceability of the details in such a

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report. This preceded and connected to the subject of each of the following chapters four, five, and six. On the subject of quality in reported financials, it is important that debate continues particularly as the monetary cost of fraud escalates worldwide, and confidence in capital markets is diminished, even briefly.6 In chapter four, assets, revenue, and expenses as elements fundamental to financial statements of account were the focus. The manner in which these elements were defined, classified, and subsequently utilized in the construct of financial accounting reports were examined and considered in some depth. This analysis included attention to the numbers reported as monetary equivalents to the asset, revenue, and expense items. Relevant case examples were placed within the chapter to highlight specific concerns with regard to questionable entries, disclosures, and likely misinformation. The cases were of national and international significance and some anecdotal examples were also provided. In line with Clarke and Dean (2007) these observations and analysis showed that by adhering to professional accounting standards and so complying with legal requisites does not always solve our dilemmas. In relation to concerns of governance, disclosure, and quality of financial statement content—and arguably the necessity to move away from compliance per se to more considered applications—Clarke and Dean (2007, p. 213) explained: ‘That likely ineffective switch from external to internal governance fails to recognise the importance of fundamental matters related to financial disclosure. As well as structural and other disclosures there needs to be a rethink of the financial data disclosed by corporate entities, especially when aggregated as a group.’ That the problems associated with disclosure and other fundamentals of accounting will continue is likely. Fallacious accounts of an entity’s financial worth linger widely throughout the business world. It is no wonder that some deceptive publications may not ever be discovered. One area of much concern is with regard to the degree of accumulated debt that a business might attempt to absorb without due consideration for its pending obligations to pay that debt when due and payable. This is an area that can add enormous pressure to the concerns of management and may well lead to the search for an escape route. If there is opportunity readily available to relieve that pressure by manipulating accounting numbers, the action may well be taken and quickly rationalized. So, chapter five places debt, indebtedness, financial obligations, and such, under scrutiny. Selected case examples are included to stress certain areas of concern. They show by observation and analysis that some conventional accounting practices are questionable in that they unwittingly provide opportunities for deceit. Continuing, chapter six adds an important feature to this study. It concentrates on the apparently ever-increasing use of ‘phoenix activity’ within the conduct of business. The concept of the phoenix business is not new but it is somewhat under-examined. It is also possibly misunderstood. Basically there are three types of phoenixing: the innocent, the occupational hazard,

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and the careerist offender. Each are explained and defined in chapter six. The inadequacy of phoenix definitions (in accounting and the law) is highlighted. This is partly due to the difficulty of differentiating between that which might be a legal phoenix activity and that which is illegal. Some advocate that phoenix activity is constrained to small- and medium-sized (family-, owner-operated) businesses only.7 We do not agree. In that vein we provide two specific case studies that show clearly the obscure boundaries that may separate the legal from the illegal. Although neither of these cases was deemed to be fraudulent, the circumstances of their changing corporate form and asset shifting reveal the complex and at times indistinct precincts of business’ restructure. The following provides a concise hypothetical view of the birth of a phoenix company. EXAMPLE: A PHOENIX RISING Briefly, say company (A) finds itself in financial distress. Its directors believe, however, that with some company restructuring they can alleviate, even fix the problem. The restructure requires the directors start a new company (company B) with the same or a similar name, and likely with the same directors. This new company is the phoenix. Company (B) is intended to carry on the business of the old company (A) and to do so in much the same style. Usually company A’s assets are transferred or sold to company B. The price at which those assets are transferred or sold is crucial to the phoenix situation. That is whether the assets are sold or transferred at a “fair” and agreed price, and/or at market price in an arm’s length transaction. If not, the transaction is probably questionable. Nonetheless the set-up of the new company B will more than likely leave company A laden with debt and with little to no assets to cover its debt obligations. Furthermore all or some of the employees of company A may be switched to the new company B. Hence the employees might be content, and unaware of the unfolding situation, as they have continuity of employment. In the transition, however, from one company to the next, they may well have lost some, if not all, of their employee entitlements. This may not be made clear to the employees at the time. Moreover, some if not all creditors of the old company A, are left in a dubious situation with regard to the repayment of debt owing to them. A number of perhaps ‘favoured’ creditors may have been paid their dues in the transition and been carried into the operations of the new company B. This would be done to also help the new company B to retain the old company A’s accumulated goodwill. Thus a phoenix company is one that rises ‘from the ashes,’ that is, shortly after the demise of the original company—and it does so in much the same form as the original company. Depending on prevailing circumstances this type of company re-structure may be legal (innocent or an occupational hazard) or (likely) illegal (that of a careerist offender).

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Questionable Tactics Notwithstanding the risks of doing business, and remaining in business, the tactics of phoenixing are somewhat questionable. Hence, the exact circumstances of each case must be investigated and explored in depth. As discussed and examined in chapter six, the difficulties of discerning that which might be illegal from the legal and “normal” activities of restructuring a business to enable it to survive is problematic. Always the pertinent feature is the underlying intent which forms the basis of the initiated strategy. A major contribution of this work to the fight against fraudulent activities in business and FSF in particular has regard for phoenix activity and that which may be deemed to be illegal phoenix activity. Hence, the lack of appropriate and generally accepted definition of illegal phoenix activity internationally, is of grave concern to all business stakeholders, and possibly for communities in general. Moreover, the lack of reliable numerics, including believable statistics, related to legal phoenix activities as opposed to illegal operations warrant investigation. The latter would require a generally agreed and legally backed definition of illegal phoenix activity—and preferably one that would surmount borders. As mentioned in chapter one, the many, varied, and continuing cases of unexpected business failure and fraud are reason enough for continued research and further studies into the constructs that underpin FSF. In this book we explore and analyse various but fundamental elements of business that form an inherent and important part of financial accounting reports. The content of which at times may contribute to, if not sustain, fraud in financial statements. In this vein we determine that continued education, widespread discussion, and determined rejection of FSF globally will mitigate its existence.

ACCOUNTING AND ANALYTICAL ANOMALIES Analysis, in part, incorporated a determined but constructively critical view of the elements of accounting financials. It is arguably not helpful to accept without question the habitual practice of (say) the capitalization of expenses, the matching of revenues and expenses, and other such fundamentals that form the constructs of accounting reports. From time to time, the method used and how the financial elements within are devised should be investigated to ascertain their relevance to prevailing circumstances. Professional disciplines are surely not hesitant to question, explore, and revise from time to time, the underpinning forces that form their foundation. As Wolnizer (1987, pp. 162, 163) astutely explained: Professionalism entails a theoretical understanding of the nature of matters in respect of which skills and judgements are to be exercised. The

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possession of specialized skills per se is not the hallmark of a profession. Rather, the distinguishing feature of a profession is the continual pursuit of reliable knowledge about the nature of the things to which those skills are to be applied. In accounting, this is significant for the discipline to retain its professional status. It is also worthwhile in terms of comprehending the magnitude of the fundamental financial elements of a business and how they may affect its actual and its reported financial state. These factors have particular regard to the outcome of business operations and the reporting of same. They also link directly to the possibility of stakeholders enduring a fallout from an unexpected financial corporate collapse or ensuing chaos from fraudulent entries in financial statements. With regard to convention, the use of accounting techniques, and the spectacular demise of WorldCom, Clarke and Dean (2007, p. 680) remarked: The conventional accounting system is essentially expenditure capitalisation with an impairment override in which expenditures are capitalised and gradually leeched into the income statement as an everyday application of the accrual-based ‘matching’ system. All that WorldCom, for example, did was over-step the mark according to the regulators. (emphasis added) This serves as a warning to all accounting professionals. It may be deemed particularly so to those with expertise in accounting for, and reporting on, the financial state of a business or corporate entity. Hence the cases as detailed in this book, and in other publications herein and elsewhere referenced, of unexpected collapse, management manipulation of accounting systems and reported financials, or any intentional acts of financial deceit are important. Their significance is in what we learn from their circumstances and how we apply that knowledge to progress the conduct of business into the future. Why is because as an international community we seek harmony in and between all nations, and an improved standard of living across the globe. Fraud in all matters financial serves only to decimate—to destroy. IN SUM Clearly there are three areas of concern in these findings. Firstly, that anomalies continue to exist in conventional and dated financial statements of a business entity’s published financial state. Secondly, that the concept of quality with regard to the fundamental elements inherent in those accounting reports, and the problematic nature of some, necessitates that they continue to be examined, debated, and explored. Thirdly, that phoenix activity and the notion of phoenix companies within the restructure of business

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organizations requires considered thought, careful reasoning, and debate to clarify that which is legal from that which is an illegal form. We provided a brief account throughout the literature that such problems have been inherent in conventional financial statements for some time. Previous studies explored defects in traditional financial statements with regard to accounting fundamentals and quality (serviceability) of the content.8 Underpinning analysis of each major case was attention to the subject of the chapter. The method of enquiry was then formed on systematic observations and critical analysis of same that enabled a practical approach to the investigation. The cases revealed a number of tricky instances of financial accounting that persistently arise in unravelling fraud in financial statements. Principally, this work reconsidered the constructs of financial accounting with particular regard to the problems associated with fraud in financial statements. It demonstrated through case analyses that conventional and publicly available financial accounting statements are easily flawed. Without the continued pursuit of clarity, constructive debate, and informed change to enhance and mandate the serviceability of reported financials, it is unlikely that instances of FSF will diminish. NOTES 1. Refer to the report ‘Businesses continue to face a challenging economic environment’, available at www.ey.com/GL/en/Services/Assurance/Fraud-In vestigation—Dispute-Services/Global-Fraud-Survey—a-place-for-integrity, accessed July 2014. 2. Refer KPMG Forensic—2012 Survey of fraud, bribery and corruption in Australia and New Zealand, published February 2013, p. 18. 3. See chapter one. 4. Cressey, Donald, R. (1919–1987); see www.acfe.com/fraud-triangle.aspx, accessed May 2014. Details in Cressey, D. R. (1973) Other People’s Money: A study in the social psychology of embezzlement, Patterson Smith Publishing, Montclair, New Jersey. 5. As also explained in Albrecht et al. (2012, pp. 151, 152). 6. See, for instance, Albrecht and Searcy (2001); Williams (2011). 7. For instance MacKenzie (2008, p. 20). 8. Including Canning (1929); MacNeal (1939); Chambers (1966); Sterling (1970); Wolnizer (1987); Clarke et al. (1997/2003); Clarke and Dean (2007); Margret (2012).

BIBLIOGRAPHY Albrecht, W. S. and Searcy, D. J. (2001) ‘Top 10 reasons why fraud is increasing in the U.S.’, Strategic Finance, May, pp. 58–61. Albrecht, S. W., Albrecht, C. O., Albrecht, C. C., and Zimbelman, M. F. (2012) Fraud Examination, 4th edition, South-Western Cengage Learning, Mason, Ohio. Canning, J. B. (1929) The Economics of Accounting: A critical analysis of accounting theory, Ronald Press Company, New York.

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Chambers, R. J. (1966) Accounting Evaluation and Economic Behavior, Prentice-Hall, Englewood Cliffs, NJ; reprinted Scholars Book Company, Houston, TX, 1974. Clarke, F. L. and Dean, G. (2001) ‘Corporate Collapses Analysed’, Part 11, Chapter 3, in Collapse Incorporated: Tales, safeguards and responsibilities of corporate Australia, CCH Australia, North Ryde, NSW, pp. 72–98. Clarke, F. L., Dean, G., and Oliver, K. G. (2003) Corporate Collapse: Accounting, regulatory and ethical failure, Cambridge University Press, New York. Originally printed (1997) with the sub-title: ‘Regulatory, accounting and ethical failure’. Clarke, F. L. and Dean, G. (2007) Indecent Disclosure: Gilding the corporate lily, Cambridge University Press, Melbourne. Cressey, D. R. (1973) Other People’s Money: A study in the social psychology of embezzlement, Patterson Smith Publishing, Montclair, New Jersey. Dean, G., Clarke, F., and Margret, J.E. (2008) ‘Solvency Solecisms: Corporate officers’ problematic perceptions’, Australian Accounting Review, Vol. 18, No. 1, March, pp. 1–10. Ernst and Young (2012) ‘Businesses continue to face a challenging economic environment’, available online at www.ey.com/GL/en/Services/Assurance/Fraud-Inves tigation—Dispute-Services/Global-Fraud-Survey—a-place-for-integrity, accessed July 2014. Reported as part of the ‘Growing Beyond’ program. KPMG (2013) Forensic—Survey of fraud, bribery and corruption in Australia and New Zealand, 2012. MacNeal, K. (1939) Truth in Accounting, University of Pennsylvania Press, Philadelphia. Margret, J. E. (2002) ‘Insolvency and Tests of Insolvency: An analysis of the “Balance Sheet” and the “Cash Flow” Tests’, Australian Accounting Review, Vol. 12, No. 2, pp. 59–72. Margret, J. E. (2012) Solvency in financial accounting, Routledge/Taylor Francis Group, New York. Sterling R. R. (1970) Theory of the Measurement of Enterprise Income, University Press of Kansas, Lawrence. Reprinted by Scholars Book Company, Houston, Texas, 1979. Williams, C. (2011) ‘Financial Statement Fraud—Chinese Style’, Association of Certified Fraud Examiners, 2011 ACFE Asia-Pacific Fraud Conference, Singapore, 23–25 October, pp. 1–13. Available at www.acfe.com/uploadedFiles/ACFE_ Website/Content/asiapac/presentations/catherine-williams-cpp.pdf, accessed February/July 2014. Wolnizer, P. W. (1987) Auditing as Independent Authentication, Sydney University Press, Sydney, Australia. Zack, G. M. (2012) Financial Statement Fraud: Strategies for detection and investigation, Wiley, Hoboken.

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Glossary

Accounting data: Numeric information disclosed in the financial statements of an entity from which assumptions or inferences can be made with regard to the financial characteristics of conducting business. Conventional financial statement: Accounting report prepared under generally accepted accounting principles (GAAP). Otherwise may be considered as a statement that follows accounting convention of what has been done generally and habitually for some time. Dated financial statement: The term is used to draw attention to the date of the financial statement. The separate financial components of the statement should directly relate to the date as well as to the title of the statement. Entity: A business unit, centre, department, being, or individual. Excellence: That which surpasses a standard accepted generally as good or of merit. Financial: Of money and money-related matters. Financial attribute: A characteristic that directly relates to money and its purchasing power. Financial data: Units that relate to money. Financial information: Collective data that enlightens interested parties about money and what can be achieved with money. Data may be considered details that become truly informative only when they are serviceable to and for the recipient, particularly with regard to the problem at hand. Financial statement: A report on money and money-related matters. Financial worth: An entity’s accumulated wealth determined by its net monetary state. Fraud: That which is done with intent to deceive and to steal from another. Any type of entity can and may be involved in a fraudulent act. Fraudster: It is herein determined that there is not a particular profile of a fraudster. Any individual or group given the opportunity—under a perceived and insurmountable “pressure”, or perception of same, may well rationalise the criminal act of fraud. Fraudulent financial statements (FSF): There are many definitions available for FSF, and they are all similar. In this book we align with the particular that is given in chapter one: “Fraud in financial statements is an act of deliberate deceit that results in a misleading representation, material misstatement or intended exclusion in a business entity’s financial accounts. The deception is committed with the intent to mislead shareholders and other stakeholders about the financial state of the business entity. The fraud may misleadingly relate financial circumstances, or an otherwise non-financial material fact.” GAAP: Generally accepted accounting principles. Governance: A genuine concern and forbearance for the employees and the other stakeholders of a business organisation. Governance correlates with altruism

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Glossary

and a sincere concern for others. It denotes a consideration that far exceeds compliance only. Monetary fact: A statement pertaining to a cash balance or cash-equivalent of a non-cash item. Monetary position: Money (financial) state of an entity at a certain point in time. Monetary worth: Money equivalent. Quality: A generally agreed ‘degree of excellence’. Quality in financial statements: Serviceable details that truly inform stakeholders about the financials of a business organization. Refer also to financial information. Tone at the top: Denotes corporate culture; the behaviour that emanates from the top to, and through, the lower levels of the organization.

Index

access to cash 90, 91 accountability 35, 43, 124 accounting 59 accounting anomalies 6 accounting data 11 accounting fiction 67 accounting practice 60 accounting system 41, 43 accounts receivable 75, 76, 77 adaptive 60 Adelphia Communications Corporation 99 Alcoa World Alumina 54 allocation of cost 61 analytical anomalies 6 areas of concern 137 Assetless Administration Fund (AAF) 112 assets 64, 65, 66, 67, 69 Australian Wheat Board (AWB) 26 balance sheet 10, 40, 41, 65, 67 balance sheet approach: solvency 70 bonus schemes 2 book-keeping 59 book value 63 book-value 60 bribery and corruption 35, 45, 51 business continuity 24, 25, 31, 125 business ethics 33, 34 business failure(s) 10, 32 business outcomes: short-term v. longterm 23 business reconstruction(s) 115, 116 Business Roundtable 29 capitalization of expenses 7, 45, 72 Capital One Financial Corporation 70 case study approach 12

cash flow statement 40 change analysis 40 classification 60, 86, 87 code of conduct 33, 42, 43, 46, 48, 96 commercial bribery 45 Committee of Sponsoring Organisations of the Treadway Commission (COSO) 73 compliance and accountability 28 conduct of business 21 construct of accounts 61 contingent debt 85, 88 contingent liability 85, 88, 89 conventional accounting practice 134 conventional financial statements 35, 45, 138 corporate veil: limited liability 112 corporate culture 26 corporate ethics 26 corporate governance 28 corporate social responsibility 23, 32 cost allocation 73 creative accounts 64 Cressey’s theory of the fraud triangle 1, 2, 133 critical analysis 59 critical thought 32 critical view 136 culture 25 Daimler AG 55 dated financial state 59 debt obligations 115, 125 debt paying ability 42 define FSF 1 depreciation 44, 61, 63, 90 disclosure 94, 98, 134 disclosure fraud 75, 93, 94, 118 dispute resolutions 66

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Index

double-entry system 60 drivers of fraud 84 due diligence 50 economic and social outcomes 27 economic decisions 33, 43, 94 economic returns 24 effective governance 50 elements of financial statements 66 elements of fraud 2 Emerson Industries 110 ethical behaviour 32, 34 ethics and economics 27 expenses 77, 78 expenses improperly capitalized 62 Facilitation Payments 52 fallacious accounts 4, 134 financial accounting constructs 9 financial accounting data 13 financial capacity 59 financial condition 4, 86 financial constructs 120 financial data 42, 134 financial distress 44, 120 financial outcome 40 financial performance 40, 42, 132 financial position 40, 42 financial ratios 87 financial reporting 7 financial reports 5 financial state 24, 34, 40, 43, 61 financial statement fraud 1, 21 financial statement fraud (FSF) defined 1 financial statements: critical view 6 financial state of affairs 41 fraudster: characteristics 22 fraudulent behaviour 33 fraudulent phoenix activity 110 fundamental elements 5, 59 fundamental financial statements 40 generally accepted accounting procedures 10 generally accepted accounting practice (GAAP) 33, 40, 86 generally accepted accounting reports 40 GlaxoSmithKline 54 global financial crisis (GFC) 87, 98 Global Financial Crisis (GFC) 29

Global Fraud Survey 132 good governance 29, 30 goodwill 69, 71, 72, 114, 115 governance 25, 28, 29, 30, 51, 97, 134 habitual practice 136 heritage assets 66, 75, 76 HIH Limited 97 HIH Royal Commission Report 97 historical cost accounting (HCA) 59 historical cost accounting methods 10 illegal phoenix activity 114, 117, 136 indebted 85 insolvent trading 11, 60, 68, 119, 132 intangible assets 69, 72 internal control environment 4, 31, 34, 43, 50, 96 Kleenmaid 11 ledger accounts 41 ledger balances 68 Lehman Brothers 87 liabilities 84 limited liability 116, 124 liquidity 91 loan brokers 67 management fraud 2, 24, 42, 43 maximize financial returns 25 method of enquiry 138 Microsoft Corporation 89 misleading disclosures 31 mismanagement 8, 44, 97 monetary equivalents 134 money economy 29 moral principles 46 Navistar International Corporation (Navistar) 95 New Zealand Stevedoring Limited 124 Note Printing Australia Limited (NPA) 46 not-for-profit organization 75, 76 obligation 84, 85 off-balance sheet 100 Organisation for Economic Cooperation and Development (OECD) 52 organizational behaviour 34 organizational structure 43

Index organization’s culture 4, 31 oversight responsibilities 50 parallel entity 119 Parmalat Finanziaria S.p.A 91 perceived altruism 5 perceived pressure 2, 43 performance indicators 43 phoenix activity 5, 108, 115, 116 phoenix activity, defined 109, 113 phoenix company 109 phoenix phenomenon 5 professional ethics 33 profile of a fraudster 2 profit and loss statement 40 public policy perspective 3 published financials 43 published financial statements 35, 43, 108, 132 purchasing power 42, 70 qualitative characteristics 8 quality 10, 34, 98, 126 quality in financial statements 3, 42, 133 quality of the financial statements 55 realisable value 63 recognition and measurement 7 recorded financial details 43 recorded financials 42 reinsurance arrangements 97 relevance and reliability 8 relevant 41, 42, 50 reliable 41, 50 reported financial position 89 reported financial state 64 reported financials 134 reported level of debt 87 reported profits 42 repurchase agreements 86, 87 Reserve Bank of Australia (RBA) 46 revenue recognition 73, 74 Rio Tinto 55 Rite Aid Corporation 101 Rolls Royce Company 79

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Royal Commission 26 Satyam 79 Satyam Computer Services Ltd. 92 Securency International 46 securities fraud 92 serviceable 3, 42, 45, 50, 60 serviceability 34 shareholder approach 13, 25 side agreements 62 smoothing revenue 90 social responsibility 27 solvency 91 stakeholder approach 13, 25, 27 stakeholder groups 27 stakeholders 21 stakeholder theory 13, 27, 133; contrasting views 22 statement of financial position 41, 67 substance over form 29 sustainable business 99 sustainable business practice 32 systematic fraud 61 tactics of phoenixing 136 theory of a business firm 31 theory of business 32 theory of the fraud triangle 46 tone at the top 31 traditional financial statements 10 Treadway Commission 1 true and fair 41, 45 truth in financial statements 41 unallocated costs 65 unexpected business failure 60, 108 unexpected corporate collapse 5, 8, 61, 132 UN humanitarian programme 26 waste management 44, 62 Waste Management Inc. 61 Water Wheel 11 WorldCom 78