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ASSET STRUCTURES AND FRAUD

Flora G. Guidry, Suffolk University
fguidry@acad.suffolk.edu

James O. Horrigan, University of New Hampshire Jane E. Morton, Suffolk University

jmorton@acad.suffolk.edu

ABSTRACT This paper analyzes the potential for fraud inherent in different asset structures and the implications for business ethical codes of conduct. Insights about asset structures drawn from traditional accounting theory, agency theory, and economics transaction costs theory are used as a framework to analyze the potential for fraud posed by different types of assets. It is concluded that firms with liquid, plastic, and redeployable assets are well advised to emphasize theft and personal consumption of business assets in devising a business code of ethics. On the other hand, firms with unique, nonhomogenous products and services, and unusual types of assets would be better advised to emphasize misinformation problems in their ethical codes. In general, all firms are encouraged to broaden their definitions and concepts of assets in order to develop richer ethical codes to address the potential for fraud. INTRODUCTION The purpose of this paper is to analyze the fraud potential associated with different asset structures. The general hypothesis is that the potential for fraud within firms differs according to the nature of their asset structures. An awareness of those differences could be useful for anticipating opportunities for fraud and for promoting an appropriate corporate ethos within firms. More specifically, an understanding of the connection between asset structures and fraud would help firms formulate ex-ante codes of ethics and conduct ex-post fraud audits. (For a good summary of the contents of corporate ethical codes, see Beneish and Chatov, 1993. In a critical analysis of ethical codes, Stevens, 1994, concludes that most codes are preoccupied with law enforcement and self defense and inadequately address values of corporate cultures. However, Mitchell et al.,1996, observe that ethical codes may help reduce legal abuses by creating clearer standards and expectations.) Asset structure may be defined in various ways, according to the particular theoretical lens being used. In this paper, three general theoretical viewpoints traditional accounting theory, agency theory, and economics transaction costs theory are examined for their different insights about the potential for fraud imbedded in assets. Consistent with professional standards, fraud is

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defined as activities within a firm which fall into one of two categories misappropriation of assets and fraudulent financial reporting. The remainder of this paper is organized in three sections. First, the three theoretical viewpoints of asset structures are discussed. Next, the potential for misappropriation of assets and fraudulent financial reporting associated with the asset structures suggested by traditional accounting theory, agency theory, and economics transaction costs theory is analyzed. The final section presents some general conclusions and suggestions for future research. THEORETICAL VIEWPOINTS OF ASSET STRUCTURE Traditional Accounting Theory In traditional accounting theory, several different asset structures are hypothesized. They are somewhat taxonomical in that they describe assets along a continuum of a defined characteristic. One of the basic hypotheses used in accounting to describe assets is a competing distinction of current versus fixed assets. This distinction is essentially a usage timeframe viewpoint. Current assets are expected to be used within one normal operating cycle of a firm, but fixed assets are expected to be used over some longer strategic timeframe that is not necessarily characterized by cycles. Accounting theory also views assets as a continuum of perfect liquidity to some penultimate state of non-liquidity. Liquidity is defined as the relative nearness of an asset to becoming cash or the relative ease by which it can be converted to cash. This liquidity dimension is usually employed to develop a sequence of asset listings within the previously described current versus fixed asset distinction used in financial reporting. In general, traditional accounting theory suggests that it is useful to view assets in regard to their 1) usage timeframe, and 2) liquidity. Agency Theory In agency theory, asset structures are hypothesized according to their susceptibility to certain types of problems, which are described as moral hazard or adverse selection problems. (See Bowie and Freeman, 1992, for a collection of articles about the ethical aspects of agency theory.) These problems are created by the separation of the firm from its various stakeholders, such as owners, creditors, and customers. The focal point of agency theory is typically the owners, who have separated themselves from the firm by entrusting its operation to managers, which creates agency problems for themselves as well as for other stakeholders. Two types of agency problems related to a firms assets are generally postulated. The first is that information about a firms asset structure my not be shared openly and equally among the firms various stakeholders. This implies that assets can be characterized by the asymmetry of their information content and suggests that information may be deliberately withheld. The second type of agency problem is that some existing assets may be prone to personal consumption by managers,
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or managers may acquire assets that appear to be for business use, but are in fact managerial perquisites. In general, agency theory views asset structures from the perspective of their 1) potential for asymmetric information, and 2) susceptibility to being consumed as perquisites. Economics Transaction Costs Theory In economics transaction costs theory, asset structures are viewed along a continuum of general purpose through special purpose assets. (See Williamson, 1985, for a comprehensive presentation of economics transaction costs theory.) Special purpose assets, while possibly cost effective, are considered relatively risky because they may not be redeployed to other uses without a loss to the firm. This degree of asset specificity can vary according to such characteristics as the site of an asset, the physical nature of an asset, the human content of an asset, or the contractual dedication of the asset. But, in general, if an asset can be removed or redirected without a significant loss in value, it is redeployable. Overall, transaction costs economics is concerned with the trade-off between asset cost savings and the strategic hazards of asset non-redeployability. Another very interesting insight from economics transaction costs theory is the asset plasticity concept developed by Alchian and Woodward, 1988. Plasticity is the degree to which assets are vulnerable to moral hazard exploitations, such as the type described above in the agency theory discussion, and the degree to which high monitoring costs are necessary to overcome that vulnerability. Plastic assets are resources that can be used for a wide range of discretionary uses. Non-plastic assets may require large sunk costs and are generally immune to moral hazards because they are used for a specific purpose. Cash is considered to be the most plastic asset conceivable, although its monitoring costs are not necessarily high in all cases. A special purpose steel mill would be an example of a non-plastic asset. Overall, economics transaction costs theory views asset structures according to the degree of 1) redeployability, and 2) plasticity. ASSET STRUCTURES AND FRAUD Misappropriation of Assets In a survey of 300 companies, KPMG Peat Marwick, 1993, found that misappropriation of assets, i.e. theft of a companys assets, accounted for approximately two-thirds of the incidents of fraud in the respondent companies. The most common response to those incidents was to establish a code of ethics for the firm. Misappropriation of assets takes many forms, from outright theft of a companys assets by employees for monetary gain to the personal consumption of business assets. The potential for misappropriation of assets varies directly with the nature of the asset structure. In terms of traditional accounting theorys view of asset structure, current assets are more susceptible to misappropriation than fixed assets for a number of reasons. First, because fixed assets by their nature tend to be physically larger, their theft would likely be more difficult to conceal.
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Second, it is likely that stolen fixed assets would be more difficult to sell to an outside party without arousing suspicion than would smaller items of inventory, for example. In terms of liquidity, clearly the more liquid the asset, the greater the potential for misappropriation. Agency theory has captured this aspect of fraud with its notion that business managers often pay themselves with non-monetary rewards regarded as perks. For example, they may use company funds to buy private club memberships, elaborate transportation equipment, or exotic vacations. Managers often rationalize that these perks are available in lieu of higher cash salaries. In the end, however, any diversion of business assets to personal use without the firms permission is tantamount to theft. Agency theory suggests that elaborate monitoring systems and executive compensation contracts help resolve this problem, but a heightened sense of ethical concern on the part of managers would seem to be a more effective and desirable response. Finally, economics transaction costs theory of asset redeployability and plasticity also suggests that the greater the degree of redeployability and plasticity of assets, the greater will be the temptation, a priori, to steal them. Assets that are redeployable and highly plastic are easier to sell for cash or divert to personal use. Given that the annual cost of employee theft has been estimated to range from $60 to $100 billion (Dye, 1993), it is concluded that firms with liquid, plastic, or redeployable assets are well advised to emphasize the problem of misappropriation of assets, including both theft for monetary gain and personal consumption of business assets, in their ethical codes and training programs. Fraudulent Financial Reporting Fraudulent financial reporting involves the deliberate misrepresentation of the value of a companys assets to financial statement users. Such misinformation about a firms assets is subject to upward or downward bias by management. However, the usual expectation would be an upward bias because managers intent on misinforming stakeholders about the firm would more likely attempt to make things appear better, especially in regard to the firms earnings. Most asset inflows are revenues and most asset outflows are expenses, so there would be a bias toward overstating revenues and understating expenses. The result of both types of misstatements would be an overstatement of existing assets relative to the values that would otherwise be reported. Given the complexities of accounting for the myriad of events occurring within firms, the possible forms of asset misinformation seem limitless. However, certain distinctive practices are considered signals that deception may be taking place. The following practices are likely areas of fraudulent financial reporting which will serve as the area of discussion here: 1) inappropriate revenue recognition and 2) inventory overstatements. The first area, inappropriate revenue recognition, is potentially the most serious source of asset misinformation. Dechow, Sloan, and Sweeney, 1996, found that overstatement of revenues was the most frequent reason for SEC investigations of alleged violations of generally accepted accounting principles during 1982-1992. This type of misstatement can range from premature recording of sales transactions to outright fraudulent recording of nonexistent transactions on the massive scale of fraud cases such as ZZZ Best or Equity Corporation. The less dramatic situations, where revenue recognition is loosely interpreted in order to improve reported earnings, may actually
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be the more pernicious form of asset misinformation because it can continue longer without detection. In general, this type of asset misinformation is likely to occur in firms that sell unique or nonhomogeneous products or services because it may be easier to rationalize premature transactions and cover up large fictitious transactions than when firms sell mass-produced homogeneous products. The second area, inventory overstatement, involves at least three types of departures from conventional accounting practices, including ambiguous cut-off procedures for recognition of sales or purchases, inadequate recognition of obsolete inventory, and questionable procedures for determining which costs should be included in inventories. Once again, the potential for this kind of asset misinformation is greatest where nonhomogeneous or specialized products are involved. Informational asymmetries often result because stakeholders have less comparative and prior experience from which to judge the reasonableness of the reported inventory values. In terms of the three theoretical viewpoints of asset structure, even though asset misinformation can be an artifact of traditional accounting theory, it is typically not a function of usage timeframe or liquidity. The theme in the above discussion is that the potential for fraudulent financial reporting is greatest in firms that hold distinctive, unusual assets. This theme is closely related to the information asymmetry problem in agency theory because the potential for the moral hazard problem is greatest when managers possess unusual information that would be difficult to ferret out through financial statement analysis by external parties. Likewise, economics transaction costs theory of asset non-redeployability and specificity seem to be positively related to the distinctiveness and uniqueness of a firms assets, while plasticity is inversely related. In summary, firms with unique, nonhomogeneous products and services and unusual types of assets are advised to emphasize misinformation problems in their ethical codes. CONCLUSION A theme that has emerged in this analysis is that different asset structures have different implications for the potential for fraud. This in turn implies that somewhat different emphases are necessary in ethical codes, insofar as firms differ by their asset structures. A likely area for future research is the development of ethical codes derived and built upon asset structures. Firms with liquid, plastic, or redeployable assets should emphasize misappropriation of assets in their ethical codes, while firms with unique or unusual assets should emphasize fraudulent financial reporting. In general, all firms are encouraged to broaden their definitions and concepts of assets in order to develop richer ethical codes to address the potential for fraud.

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REFERENCES Alchian, A.A. & S. Woodward (1988). The firm is dead; Long live the firm: A review of Oliver E. Williamsons The Economic Institutions of Capitalism. Journal of Economic Literature, 26, 65-79. Beneish, M.D. & R. Chatov (1993). Corporate codes of conduct: Economic determinants and legal implications for independent auditors. Journal of Accounting and Public Policy, 12, 3-35. Bowie, N.E. & R.E. Freeman (1992). Ethics and Agency Theory: An Introduction, New York: Oxford University Press. Dechow, P.M., R.G. Sloan & A.P. Sweeney (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement by the SEC. Contemporary Accounting Research, Spring 1996. Dye, T. (1993). Dishonest workers stealing billions. Las Vegas Review Journal, A36. KPMG Peat Marwick (1993). Fraud Survey Results, 6-12. Mitchell, T.R., D. Daniels, H. Hopper, J. George-Falvy & G. Ferris (1996). Perceived correlates of illegal behavior in organizations. Journal of Business Ethics, 15, 439-455. Stevens, B. (1994). An analysis of corporate ethical code studies: Where do we go from here? Journal of Business Ethics, 13, 63-65. Williamson, O.E. (1985). The Economic Institutions of Capitalism, New York: The Free Press.

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