Fraud or "Creative Accounting"?

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by Will Donworth

Making false and misleading statements; overstating profits to the Markets regarding a company’s status at key financial reporting periods to encourage investment and please shareholders. Is this the new fraud in the accounting world or has it actually been going on for many years. Researching this topic I have been required to use secondary source information such as contemporary newspaper articles which can lead to bias as the writer tends to have either their own view point or newspaper sales and public bias in the back of their mind. However, when utilising those sources I have deliberately stuck with direct statements of fact as reported on such occasion as court cases or parliamentary statements.

Giant companies past and present appear to have done just this to push up share prices, encourage investment, show false profits and gain Government contracts. Essentially “cooking the books”[1] to lead a market in its field. It isn’t a new practise, as I found whilst researching the TESCO scandal of 2013-2015[2].

TESCO reported its first possible decline in profits around October 2012. This was the first fall of profits by the company for more than 20 years. The chief executive at the time, Philip Clarke tried to allay fears as the company had been going through a complete face lift with a cash injection of £1bn to win back shoppers from competitors and modernise. The performance of the UK domestic market was crucial to the company’s success as it accounted for two thirds of the TESCO group total profits.
The second biggest TESCO market was in South Korea and TESCOs US Chain Fresh & Easy. Neither was performing particularly well. As well as this profits were beginning to slump in the Eurozone area. The central European division was dropping off by a fifth. Therefore the UK domestic market was vital. Overall the TESCO Groups trading profit had dropped by 10.5%. Philip Clarke maintained that the UK side of the business was at a crossroads between actual physical shopping and the online shopping market.

To try and initially combat the down turn action was taken to cut the number of new stores being opened. These giant hypermarket like stores were filled with goods that were not being purchased. Consumers were browsing online but not making purchases. This all seemed very worrying for the TESCO group and shareholders needed to be convinced that this was just a temporary glitch, nothing to get overly worried about as plans were in place to improve the situation.

Philip Clarke[3] removed most of his senior team and replaced them with a close knit team described as his “inner caucus”. Sources have suggested that he put pressure on his team to “deliver the numbers”[4].

Chris Bush[5] (UK Managing Director TESCO Jan 2013-Sept 2014) who had been CEO of TESCO Malaysia was brought back in house and took up the position of Chief Operating Officer UK in March 2012. By January 2013 he had been appointed UK Managing Director. Carl Rogberg (UK Finance Director Feb 2013-Sept 2014) joined the team from Thailand. Completing that inner caucus was John Scouler (Tesco Food Commercial Director) who had worked with Bush overseeing TESCOs deals with food suppliers.

TESCO over stated its profits for the second half of that year. It boosted its profits by £263m artificially inflating its bottom line. By August 2014 it had allowed a false market in its shares and bonds to state profits would be £1.1bn. This was all misleading and in reality not the case. When it was exposed in September 2014, just a few weeks after Dave Lewis had taken over from Philip Clarke as chief executive, the shares took a nose dive to 12pc.


How it happened: Payments from suppliers were being misbooked, business costs were glossed over and suppliers were being treated as a source for profit. With a dog fight market when profits were under pressure to perform, especially against its rival competitors, TESCO looked at other sources for upholding these buoyant profits outside of the normal Supplier Sales method.

Focus had shifted to making money rather than Customer Shopping. One method was offering instore promotions for upfront payments. Holding back supplier payments at key financial reporting periods, and in some cases not paying back monies owed, all to show increased profits.

Some complex supplier deals were a complete puzzle in themselves and the commercial income generated from these deals created opportunity for serious accounting abuses.Investors were falsely lead to believe that TESCO was leading the market in its field, highly profitable and therefore worth investing in. Shares and bonds were initially inflated only to plummet when the whole scandal broke.

It all came to light when an anonymous whistle blower within the company reported these abnormal practises to the FINANCIAL CONDUCT AUTHORITY (FCA)[6] and the SERIOUS FRAUD OFFICE (SFO)[7]. The SFO charged three senior individuals Chris Bush, John Scouler and Carl Rogberg with false accounting and fraud. Philip Clarke did not face charges himself as there was insufficient evidence that he had told them to make these changes. To this day the other three are still fighting the accusations through the courts.

The FCA used their powers to force TESCO to pay compensation over “MARKET ABUSE” for making false and misleading statements to the markets. Fines[8] of £235m to settle investigations along with covering all the legal costs and a Compensation Scheme set up for Suppliers of £85m added to the agony.

Financial Analysts said “A misplaced focus on making money was one of the main factors behind the deterioration in TESCOs UK Trading which had led to a £6.3bn loss in 2015”. The Deferred Payment Agreement (DPA) agreed to grant amnesty to TESCO in exchange to fulfilling certain requirements, possibly because this had happened before to far larger organisations, with catastrophic outcomes.
Was it because TESCO is part of our very fabric, a house hold name, even part of every home in the UK, that it could not be let to go into bankruptcy. Therefore to a certain degree was leniency shown. Would or could it have caused another financial crisis?  

TESCO cooperated with the SFO and have undergone an extensive period of change brought in by Deloitte, who carried out a conduct review[9]. Their willingness to cooperate fully and except these findings was their saving. Far larger companies haven’t been as fortunate.  Corporate titans have been slain for these abuses.  

In 2001 a market giant named ENRON Corporation[10], an American Energy company, hid its actual trading figures from unsuccessful deals and business dealings which amounted to debts of billions of dollars. As the size of the problem unfolded it caused disastrous repercussions for not only itself but also shareholders and Arthur Anderson LLP who were meant to be its accountants and auditors.

The CEO of ENRON Jeffrey Skilling[11], who has been serving a 14 year prison sentence for his part in the whole downfall, formed a group of willing financial executives to help him use accounting loop holes with the purpose of deliberately hiding poor financial reporting. They fenced off an organisation known as an SPE (special- purpose entity) with the purpose of fulfilling the narrow objectives of misleading the Board of Directors and audit committee. With the help of his Chief financial Officer Andrew Fastow, they intimidated their Accountants Arthur Anderson LLP to ignore the auditing issues that were occurring. Effectively ENRON lied about their profits. As the scale of the deception unfolded the share price went from $90.75 to less than $1 by end of November 2001. DYNEGY INC agreed to buy the failing company for a rock bottom price, but when the deal fell through ENRON had no choice but to file for bankruptcy. At the time it was the largest corporate bankruptcy in U.S history. It also brought down Arthur Anderson LLP, who was at the time one of the leading five firms of Accountants and Auditors in the world.

Arthur Anderson LLP had its licence voided to audit public companies for its part in the scandal. It had been found guilty of illegally destroying documents and general malpractice, which caused the company to fold.
The scale of this scandal made the United States of America Supreme Court order reforms to the financial industry and a new Bill was passed called the “Public Company Accounting Reform and Investor Protection Act” and the “Corporate and Auditing Accountability, Responsibility and Transparency Act”. This is known as the SARBANES-OXLEY ACT[12]. This Act states that there will be an increased penalty on destroying, altering and fabricating records in federal investigations or for attempting to defraud shareholders. The SARBANES-OXLEY ACT also increased accuracy of audit firms to remain unbiased and independent of their clients.

However it wouldn’t take long before the ENRON Scandal was eclipsed by the WORLDCOM Scandal[13]. This began in 1999 and came to a head in May 2002. CEO Bernard Ebbers along with his CFO Scott Sullivan, Controller David Myers and Director of Accounting Buford Yates used fraudulent accounting methods to disguise decreasing earnings just to maintain WORLDCOMs stock price. At the beginning of 2000 the telecommunications industry within the US was in decline. WORLDCOM was in talks with SPRINT, another telecommunications company to merge. However the US Justice Department forced them to abandon the merger. Ebbers had been increasing the price of holdings in WORLDCOMs common stock. Also with the assistance of  Sullivan, Myers and Yates all sorts of fraudulent accounting practises were being committed from booking “line cost” as capital expenditures on the balance sheet instead of expenses, as well as inflating revenues with bogus accounting entries from “Corporate unallocated” revenue accounts.  When the stock price dropped he was asked to cover margin calls (demand by a broker that an investor deposit more cash to cover any losses) on his WorldCom stock that was being used to finance his other business interests. By 2001 Bernard Ebbers had persuaded the Board of Executives to give Corporate Loans and Guarantees in excess of $400m to cover these margin calls. The Board agreed to this hoping that it would avert Ebbers from selling his WORLDCOM stock which would have resulted in the stock decreasing. Around the same time Arthur Anderson LLP their accountants and auditors had to withdraw their audit opinion as they had been mixed up in the ENRON Scandal and were being investigated by the SEC. This all failed in April 2002 when Bernard Ebbers resigned. He was subsequently replaced by John Sidgmore former CEO of UUNET Technologies Inc.

After Ebbers resignation a small team of internal auditors uncovered the fraudulent accounting practises that had been taking place to the sum of $3.8bn. Action was taken immediately and by the end of 2003 it was estimated that the stock and assets had been grossly inflated by approximately $11bn. The company was charged to pay $750m to wronged investors. Also the SEC (Securities and Exchange Commission) agreed a civil penalty of $2.25bn. The company was subsequently sold off, changed its name to MCI Inc and is a subsidiary of VERIZON.

More recently and closer to home BT[14] has suffered its own serious problems with its BT Italy division Scandal. In 2017 when it was revealed that BT Italy chief executive Gianluca Cimini and his managers hid a £530m fraud scandal. It was exposed when three BT employees raised suspicions to their supervisors who subsequently informed BTs head of European sales, Jacinto Cavenstany back in 2015. As the news broke, the markets dramatically dropped. Once again the old problem of exaggerating profits. This caused a panic and shares were quickly sold wiping £8bn off BTs value[15].

The method of fraud and deception was not sophisticated, faked contracts, invented purchase orders to suppliers with no intention of receiving goods, bogus transactions for invented invoices and over stated revenues for BT installed phone lines just to meet targets. All designed to disguise the actual financial performance of the Italian branch of company. Not only was deception being carried out but a culture of bullying for those not meeting these targets. More worrying was the intimidation of suspicious employees.

None of this sounds very complicated, so why wasn’t it picked up before 2016 internally, and becoming public knowledge in 2017. The investigation which is still active and ongoing by the Financial Reporting Council (FRC), the UKs accountancy watchdog is looking into years 2015-2017.
Why did it only come to light when employees raised the alarm? In each case study I have looked at, the fraud or deception has come to the surface when an employee reported it.  Are these giant global organisations losing sight of their operations home and abroad? Do they not ask questions as long as they are being given the information they want to hear. Even more concerning is that they may well be content to turn a blind eye as long as their own rewards from the company are met. Once again is it because all that matters is the bottom line.

Throughout my research into the TESCO scandal 2013-2015 and how that has led me to look into ENRON Scandal, WORLDCOM scandal and finally the BT Italy Scandal, accounting fraud and market abuse has played a large part in giant corporates down falls. Greed and risk has obviously played a large part where the likes of WORLDCOM were concerned. Yet in the case of TESCO, ENRON and BT were they so caught up in making sure the bottom line enabled them to post glowing profits that they lost touch with the reality that they were committing fraud and would eventually be caught. Surely all these companies know the laws that govern accounting regulations as set out by the FCA, SFO and FRC[16]. Most of the financial executives at the top tier in a company will have been to Business school or studied Finance and Accounting even Financial Law. These executives will have been chosen to take up their positions within the respective company because of their business acumen and knowledge of their field. Yet at no time is it ever permissible to practise fraud, falsify figures or manufacture imaginary profits unless they have been asked to. Worse still is for one’s own personal financial gain.

Do we have to look more closely at the reasons why such risks are being taken considering the reputations that are put at stake?  Not just individual people but trusted household corporations like TESCO. Are these industries becoming so big and merged that the lines are becoming blurred?
Not only that, it appears to still be going on. Further deferred prosecution agreements (DPA) that the SFO[17] are currently dealing with include (Standard Bank £20m 2015) (Company XYC £7m July 2016) (Rolls Royce £497m Jan 2017).

 As for TESCO itself, under the Financial Services and Markets Act (Section 384) the FCA[18] has now got the powers to make a listed company like TESCO pay compensation for this Market Abuse. In the case of TESCO Scandal 2013-2015 a Deferred Prosecution Agreement (DPA)[19] has been met. Money has been put aside in a compensation pot.  Under the compensation scheme each purchaser of Tesco shares and bonds has the right to make a claim for the period between the dates when the false impression applied. This compensation scheme has been administered by KGMG[20] on behalf of TESCO. By accepting their liability and responsibility which was also in the public interest TESCO have moved forward.

PGS EXTEND 2018 – Will C Donworth

FCA – Financial Conduct Authority
SFO – Serious Fraud Office
FRC – Financial Reporting Council
DPA – Deferred Prosecution Agreement

[10] https://en.wikipedia.org/wiki/Enron dated September 4 2018

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