Investor Skepticism and Creative Accounting: The Case of a French SME Listed on Alternext
Demerens, Frederic, Pare, Jean-Louis, Redis, Jean, International Journal of Business
At a time when the accountancy environment has become much more complex because of the introduction of International Financial and Reporting Standards (IFRS) and accountancy rules are becoming increasingly flexible, financial manipulations designed to concoct more positive financial statements are frequently observed among listed companies. According to the 2005 "Global Economic Survey" produced by Price Waterhouse Coopers, the number of firms reporting fraud is increasing rapidly, and the number of restatements of financial statements increased to 1,195 cases in 2005 (8.5% of U.S. publicly traded companies). Thus, investors must be vigilant of potential accounting manipulations that could threaten their investments. Similar to any other watchdog, investors must be skeptical. In this paper, we will apply a revised definition of a skeptical investor by using the financial statements of a public firm. The skeptical investor, unlike the auditor, will not be able to demand confirmations. The investor arrives at his or her judgment only by analyzing the public information that is disclosed by the firm. Our research question investigates whether skepticism can lead an investor to have presumptive doubts about a firm's financial statements and to make drastic financial restatements.
We adapt the concept of auditors' professional skepticism, as defined by regulators and academics, to the investor. Using the determinants presented by Nelson (2009), we focus on knowledge. We apply a skeptical approach regarding financial statements to a real company that has not yet been charged for financial statement fraud. This "live case" addresses a French services company that is listed on Alternext and has financial statements that seem, from a skeptical point of view, to have been manipulated. Using the available knowledge of financial shenanigans and accounting manipulations, accounting and auditing standards, the company's business model and its financial impact, we conduct a deeper analysis of the economic, legal and financial information that has been disclosed by the company over several years.
We find that skepticism based mainly on knowledge determinants leads to presumptive doubts and drastic financial restatements. Erroneous recognition of income, transfers of current expenses to future periods, overvalued assets and undervalued liabilities are the main "potential" accounting manipulations identified for the company. These operations considerably modify corporate financial indicators.
The contributions of the paper are twofold. First, our paper presents an original application of investor skepticism to a real "live case", which reveals ex-ante presumptive doubt about potential accounting manipulations. Our original methodology allows us to explain how the financial statements of this firm do not comply with its real economic situation. We demonstrate that our methodology contributes to the economic analysis of this firm and that our restatements approach reality. Second, our research questions the ability of legal "watchdogs" to detect manipulations and to bark. No watchdog has suspected any fraud for this company or documented any of our doubts.
The article is divided into four sections. In the first section, we review the literature on creative accounting and investor skepticism. In the second section, we provide our investor skepticism-based methodology. In section III, we present the case of a French company and our restatements of its key financial indicators. Lastly, we discuss our results and highlight the lack of skepticism among the investors of this company.
II. LITERATURE REVIEW ON CREATIVE ACCOUNTING AND INVESTOR SKEPTICISM
A. Creative Accounting: Definitions and Motivations
1. How to define accounting manipulations
The literature frequently makes a distinction between manipulations that conform to legal rules and standards and manipulations that do not. …