Description
There is signilicam evidence of the practice of creative accounting by large listed corporations. However,
little is known about the process by which such schemes are devised and succeed in escaping legal and
regulatorys anction
Pergamon AccounWag, Organfzatfom and Society, Vol. 21, No. I, pp. 23-39, 1996
copyright 0 1995 Fkvier Science Ltd
Printed in Great Britain. AU rights reserved.
0361-3682/96 $15.00+0.00
0361-36fit2(95)00015-1
CREATIVE COMPLIANCE IN FINANCIAL REPORTING*
ATUL K. SHAH
University of Bristol
Abstract
There is signilicam evidence of the practice of creative accounting by large listed corporations. However,
little is known about the process by which such schemes are devised and succeed in escaping legal and
regulatory sanction. This study examin es this process of creative compliance in the case of complex
convertible securities issued by U.K. listed companies between 1987 and 1990. There was an active
dialectic of creativity in the design of these instruments - a shift from avoidance to rules to avoidance
again. The evidence shows how a small group of professionals in finance, law and accountancy co.
operated in the development of these instruments. They helped the issuers to manage their financial
reporting process in a way in which compliance was assured. Where regulatees are able to command
such creative compliance skills and resources, regulators may find themselves facing an uphill struggle.
In many countries, accounting regulation is
based on a system of detailed rules prescribed
in standards and the law. However, rule-based
systems can rarely be water-tight. There may be
gaps in the rules, and places where the rules
are vague or even incomplete. Of equal, if not
greater significance is the fact that regulatees
may develop schemes which fulfil the letter of
the rules, but undermine their spirit. Regulators
may find themselves constantly lagging behind
the avoidance activities of the regulatees
(McBamet, 1988). In such circumstances, effec-
tive regulation breaks down. Hopwood (1990,
p. 80) observed that:
Corporate financial accounting and the subsequent
audit function are subject to a . . lack of operational
specificity, enabling a certain fluidity to enter into the
corporate accounting domain. Discretion and choice
are thereby made important elements of the accounting
function, providing a zone of strategic choice for man-
agement and a basis for a negotiated rather than purely
procedural audit function.
In the United Kingdom, extensive evidence of
the existence of such “creative accounting”
emerged upon the publication of Accounting
for Growth by Smith (1992). This raised a pub-
lic outcry and the share prices of some of the
companies named by Smith declined at the
time of publication.’
In their study on the effectiveness of legal
regulation of accounting practice, McBamet
and Whelan (1991) explain this process of
“creative compliance” as (p. 848):
l I am grateful to the anonymous reviewers, participants at the 1994 European Accounting Association Annual Congress in
Venice, members of the accounting workshop at the Universities of Bristol and Maryland, and Anthony Hopwood for
comments on earlier drafts. Financial support for the research was obtained from the CATER fund of the Institute of
Chartered Accountants in England and Wales and the Economic and Social Research Council. I am grateful to all the
individuals who cooperated in the interview and gave freely of their time and expertise.
’ The Independent, 7th February 1992, p. 25.
23
24 A. K. SHAH
the active response of those subject to the law, not
just in political lobbying over legislation but inpost hoc
manipulation of the law to turn it - no matter what the
intentions of the legislators or enforcers - to the ser-
vice of their own interests and to avoid unwanted
control.
The aim of this study is to examine further this
process of creative compliance in accounting.
By focusing in detail on one particular scheme
which was popular in the United Kingdom in
the late 198Os, the paper traces the “dialectic
of creativity” - from avoidance to rules to
avoidance again. Particular attention is placed
on the development of the scheme and the
manner in which the process of obtaining
effective compliance is managed and articu-
lated. Despite the significant evidence on the
practice of creative accounting, there is no
study in the literature which traces the process
by which such schemes are developed and
avoid breaching accounting regulations. Tra-
cing this process is the principal aim of this
article. The findings expose the active involve-
ment of those whose very job it is to be familiar
with the rules - lawyers and accountants. This
evidence appears to support McBamet and
Whelan’s (1991, p. 873) central thesis that
effective legal control, particularly of those
with the resources to resist, may not be
attainable.
During the period 1987-90, convertible
securities attracted a lot of attention from
financial engineers (Shah, 1993). At the time,
there were no specific accounting standards
or laws which defined the accounting treat-
ment of convertibles. Thus no rules stated
whether or not convertibles should be classi-
fied as equity from the outset, nor was there
any statement on how the coupon interest
should be treated in the profit and loss
account. It was this gap in the rules which
provided a range of creative accounting
opportunities (Pope & Puxty, 1991). Smith
(1992, Chap. 13) devotes a chapter to one
such instrument - the premium put conver-
tible bond. This study examines the process of
creative compliance through the issuance of
convertible securities.
One of the difficulties of analysing the pro-
cess of creative compliance is the potential
sensitivity of data collection as one of the
most obvious sources of evidence are the
very people who would be implicated by the
evidence. The advantage of studying converti-
bles was that there is a legal requirement for all
issuers to publish an issue prospectus detailing
the terms of the financial instrument, the pro
fessional advisers and costs of issue (London
Stock Exchange, 1992). Other important
sources of evidence were the publications in
trade journals by professionals on various
legal, financial and accounting aspects relating
to convertibles. These articles often made pub-
lic the motivations underlying the instruments
and the extent to which professionals were
willing to go to market their sophisticated
schemes. Evidence on the accounting policies
adopted by the issuers was obtained from the
financial statements. Selective interviews of the
key professionals involved in the innovation
are also reported here, and the responses
were surprisingly candid.
The article is organized as follows. In the
next section, the dialectic of creativity using
convertible securities is outlined. Details of
the key innovators and participants in the
“game” of creative compliance are then pro-
vided, and the evidence shows the extent of
cooperation between different groups of pro-
fessionals in the successful innovation of these
schemes. The commercial gains for the devel-
opers are substantial, and the ensuing section
provides evidence of the extent to which they
went to promote the schemes and generate
new customers. The regulators were not
entirely in the dark, but their reactions to these
schemes were circumvented by the companies
with cooperation from the same group of pro-
fessionals. The following section analyses the
backdrop of accounting regulation during the
period, and explains how the lags between
creative compliance and corrective regulation
fueled the avoidance of accounting regulations.
Finally, the implications of the evidence for
financial reporting are discussed.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 25
A DIALECTIC OF CREATMTY
A conventional convertible security is a com-
bination of a bond and an option to convert the
bond into shares of the underlying company at a
future date. For accounting purposes, the com-
mon treatment in U.K. and North America at the
time (MCIMeS et al ., 1991) was to treat the
bond as debt and the coupon as an expense
until it is converted, whereupon the debt trans-
forms into equity. During 1987-90, there was
considerable innovation in the U.K. convertible
market such that several variants from the con-
ventional convertible were developed (Pope 8~
Puxty, 1991). The Iirst such instrument was the
premium put convertible bond (issued by Bur-
ton Group in January 1987) where the interest
rate was set lower than the coupon for conven-
tional convertibles in the first five years. How-
ever, to compensate for the low interest return,
investors were promised a much larger increase
in the share price. If the increase failed to mate-
rialize, investors had the option to redeem their
bond and collect the back-interest for the pre-
vious five years (hereafter called supplemental
interest). Hence, the central accounting issue
here is whether or not the supplemental inter-
est should be accrued in the annual accounts of
the issuer during the first five years.
In March 1988, a variant of the premium put
convertible bond was invented - the offshore
premium put convertible preference shares
(first issued by United Biscuits). Here, the
unique additional feature was that as the secu-
rities were preference shares, they escaped
debt classification in the early years, hence
improving the gearing position considerably.
In addition, the equity classification helped
issuers to create a signiiicant reserve which
could subsequently be used to write off the
goodwill that arose from the acquisition which
the security was financing. The offshore issu-
ance structure helped ensure that the prefer-
ence dividends did not attract advance
corporation tax and could be offset against
’ Banker B, January 1992.
profits in a manner similar to interest on debt
securities (Hughes & Lubbock, 1989). Thus the
instrument was designed to take advantage of
gaps in both the accounting and the tax rules.
As one senior investment banker explained
when interviewed:2 “ It was a wonderful instru-
ment designed to meet a particular need,”
In April 1989, the Inland Revenue hardened
its attitude on such structures by rewriting the
double tax agreement with the Netherlands
Antilles where the finance subsidiaries were
sheltered and as a result, the preference share
dividends could no longer be offset for tax
purposes (Morgan, 1990). This change in tax
regulations led to the development and issu-
ance of yet another variant of the convertible
security - the Convertible Capital Bond
(CCB). This instrument was designed to bene-
fit from the tax and accounting advantages of
the offshore convertible preference shares and
get around the change in attitude towards the
Netherlands Antilles - it was now issued
through a specially created Jersey subsidiary.
Figure 1 demonstrates the rise and fall of the
different variants of the convertible securities
during the period 1987-90 - from the pre-
mium put convertible bond, to the offshore
convertible preference share and finally the
convertible capital bond. The move from pre-
mium put convertible bonds to offshore con-
vertible preference shares retained the
accounting benefits of the premium put struc-
ture and built on these by structuring the
instrument in such a way as to allow equity
classification. The change from offshore con-
vertible preference shares to convertible capi-
tal bonds was driven by a change in tax
regulations. It is worth noting that each time
a new variant was developed it immediately
phased out the previous instrument. Compa-
nies issued the most beneficial instrument pre-
vailing at the time.
In all, thirty-two large publicly quoted com-
panies issued the above convertibles and raised
$3,584 million of new finance (Shah, 1993). Of
26 A. K. SHAH
0 Convertible capital bonds with puts
m Convertible capital bonds
0 2 4 6 8 10 12 14
Number of new issues
Fig. 1.
these, some fnms made more than one issue of
the security. Most of the issuers were well-
known quoted companies such as British Air-
ways (&320m), Saatchi and Saatchi (&177m)
and Blue Circle (&9Om). The average size of
each issue was &112m. Almost all of these com-
panies had a number of creative accounting
practices according to the analysis presented
in Smith (1992, Chap. 16), the now infamous
“blob index” - which lists the names, types
and range of creative accounting practices
adopted by large listed U.K. companies. The
issuers came from a range of industrial
groups, although companies in food retailing
and stores were amongst the more common
issuers (Shah, 1993 Chap. 5).
During the period 1987-90 there were no
specific accounting standards in the United
Kingdom which dealt with the treatment of
convertibles. Under Statement of Accounting
Practice 2 (Accounting Standards Committee,
1971), which outlines some of the fundamen-
tal accounting concepts, the accruals and pru-
dence concepts would suggest amortization of
the supplemental interest from the date of
3 Interview A, March 1992.
issue. This interpretation was formalized in Jan-
uary 1988, when the Institute of Chartered
Accountants in England and Wales issued a
technical release (TR677) (ICAEW, 1988)
which recommended the accrual of supple-
mental interest for premium put convertibles.
This document did not have the force of an
accounting standard as it was issued by a pro-
fessional body and not the Accounting Stan-
dards Committee. However, its contents act
as an indicator of best practice where no alter-
native pronouncements exist.3 However, there
was no rule or pronouncement relating to the
debt or equity classification of convertibles,
and the latter securities (offshore convertible
preference shares and convertible capital
bonds) were designed specifically to exploit
this gap in the accounting rules (Dow, 1990;
Pope & Puxty, 1991). Debt classification would
project an image of high gearing and hence
greater risk for investors and lenders. Issuers
were keen to obtain equity classification as
this would reduce the perceived gearing ratio
and provide significant benefits for the write-
off of acquisition goodwill (Shah, 1993, Chaps
5 & 6). Through creating “new reserves”
issuers were able to avoid amortizing goodwill
against reported profits which would have
otherwise led to reduced earnings per share.
Thus, not only were the initial designs
geared toward accounting and tax avoidance,
but when there was a change in the rules, the
market was quick to respond and retain the
previous advantages despite the new rules.
There was a dialectic of creativity. The princi-
pal factor driving the innovations was the crea-
tivity of the professionals and the attitude of
the Inland Revenue. Standard accounting rules
did not change during this period so they were
not a problem,4 although the “discovery” of the
“offshore” preference shares (which could be
classified as equity) helped significantly in por-
4 We will see later that there was a technical release issued by a professional body relating to the accounting treatment of
the supplemental interest. However, this did not have the force of a standard.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 27
traying a strong financing position (i.e. lower
indebtedness). Changes in tax rules meant a
redrafting of the terms of the convertibles to
retain the original tax advantages. It has been
suspected that regulators are always behind in
the “game” of creative compliance, and this
may mean that effective rule-based regulation
is unachievable in practice (McBamet & Whe-
lan, 1991). In the case of convertibles, the reg-
ulatees appear to be always ahead in the
“game” of creative compliance. In the next
section, we examine the role of various profes-
sionals in the design of these instruments.
PROFESSIONAL PLAYERS IN THE GAME OF
CREATIVE COMPLIANCE
As this article centres on the role of profes-
sionals, it is important to clarify the meaning of
the concept as it is used here. The term “pro-
fessionals” refers to members of a recognized
professional body, e.g. the Institute of Char-
tered Accountants in England and Wales for
accountants, the Law Society for lawyers, and
the Institute of Bankers for bankers. Their pri-
mary role is the administration of rules and the
provision of specialist advice. In the United
Kingdom, auditors have a “quasi-regulatory”
role in that they have to certify whether finan-
cial statements comply with law and account-
ing standards. Similarly, lawyers are bound by
their ethical code and are publicly expected to
uphold state legislation and not to undermine
it. Thus “professionals” are those people spe-
cializing in the service industry with specific
skills and bound by an ethical code. Arguably,
unqualified professionals can develop avoid-
ance schemes, but without the networks devel-
oped by the large law and accountancy firms
and investment banks, it is unlikely that such
schemes could be given the necessary credibil-
Bankers Trust
Union Bank of
Salomon Brothers
Morgan Grenfell
Fig. 2.
ity.5 Qualified professionals can provide the
credibility that is needed in ambiguous areas,
and develop the dialogue with regulators that is
needed to successfully implement these
schemes (McBamet, 1991).
Figure 2 shows the lead bankers to the
issuers. There were three major firms
involved: S.G. Warburg, Barings, and Credit
Suisse First Boston. The remaining advisers’
individual share of issues was relatively small
as can be seen from the figure. An examination
of the legal advisers to the issuers in Fig. 3
shows that Linklaters and Paynes advised on
nearly half the issues and three other large
firms were also involved: Slaughter & May,
AlIen & Overy, and Freshfields. All these firms
have international networks and are well estab-
lished in the legal field.
Thus there were very few large banking and
law firms providing most of the professional
advice to the issuers. This can be interpreted
in terms of an oligopolistic supply, and one
lawyer interviewee said that the underlying
technology behind such schemes cannot easily
be copied by competitors or non-professionals
simply by reading the published prospectus or
any trade journal articles. One of the lawyer
interviewees explained:6
’ Investment banker B, January 1992 (fuIl quote disclosed later).
6 Interviewee L, March 1992.
28 A. K. SHAH
Clifford Chance
Rowe and Maw
Lovell, White
and King
Freshfields
Linklaters and Paynes
Fig. 3.
There is usuaIly a lot of underlying technology which
cannot be understood sImpIy from the prospectus. The
prospectus provides the answers but the reader would
not know which are the relevant questions to ask.
Hence “reverse engineering” is difficult.
As a result, innovators could earn monopoly
profits, and this was a principal attraction’
(examined more fully in the next section).
From the interview and documentary evi-
dence, it appears that no more than fifteen
individuals initiated the creative compliance
process using convertible securities. Hence
successful implementation of such schemes
does not require mass involvement and sup
port from professionals.
When interviewed about the relative roles of
lawyers, accountants and bankers in the design
of complex convertible securities, these were
some of the comments received.
An Investment Banker M said:8
It has really gone hand in hand. There is close discus
sion with the Iawyers and the auditors who have to
approve the accounting treatment In advance.
A partner in one of the law firms stated:9
We invented both the offshore preference share and the
convertible capital bond in conjunction with S.G. War-
burg. Our tax department is closely involved and as a
lawyer, I have the task of documenting the transaction.
The bankers usually say we have come up with the
following structure what do you think about it? We
then look at it both from the tax perspective and the
company law perspective.
When asked whether the lawyers deal
directly with the auditors, he said:
Yes, for the convertible capital bonds, we had to. It is
important that it was not accounted for as a liability In
the issuers bakutce sheet. Tber%z Ls very close co-opera
tion u&b the accountants. The analysts were invited to
treat the CCBs as deferred equity, and therefore, for the
purposes of caIcuIatIng gearlng, CCBs were ignored.
Evidence on the close involvement and collu-
sion of professionals in the development of the
convertibles also emerged Erom a number of
articles published in professional journals
aimed at corporate treasurers and tax practi-
tioners. At least fifteen articles relating to
’ Investment Banker M, February 1992.
s February 1992.
9 March 1992.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 29
some aspect of the accounting and tax issues of
complex convertibles were published in the
journals during the period. Examples of such
articles are Blackie (1988), MacDonald & Sel-
bie (1988), Morgan (1990), and Prior-Palmer
& Spain (1989). In the articles, the authors
mention the consultation undertaken with
auditors at an early stage and discuss some of
the intricate legal features. Articles published
in The Tm J our nal by lawyers, such as Savory
(1989a,b), Beare (1990) and Chapman
(1990a,b), expose the close involvement of law-
yers in the structuring of the convertibles. An
article by Big Six accountants Hughes and Lub-
bock (1989) discusses the salient accounting
features of convertibles and suggests ways in
which the accounting objectives of companies
can be satisfied through the convertibles. A
statement made by United Biscuits Finance
Director and quoted in Adam (1988, p. 50)
discloses the close involvement of auditors in
the sanctioning of the accounting policy prior
to the issuance of the offshore convertible pre-
ference share.
From the above, we can see that close co-
operation is a pre-requisite for the successful
implementation of such schemes. If auditors
do not approve a particular accounting
choice, the effectiveness of an elaborate
scheme is destroyed. In areas where there are
no accounting standards, auditors act as “quasi-
regulators” and as we have seen above, provide
the necessary regulatory clearance. The fact
that many Big Six firms have started specialist
corporate finance advisory departments,” sug-
gests that there is a significant potential for
conflict of interest between the auditing func-
tion and the advisory function. Hughes and
Lubbock (1989) writing as partners in the Capi-
tal Markets Group of a Big Six firm state expli-
citly that (p.43):
In order to avoid the adverse tax consequences and
achieve the accounting objectives it is necessary for
the preference share issue to be via an off-shore subsidi-
” Wailer (1991).
at-y rather than a U.K. subsidiary which would result in
increased cost due to the tax treatment of dividends
paid by U.K. companies.
In the article, they marketed the accounting
advantages of convertibles, and explained in
detail how careful attention to the structure
of the convertibles can provide these benefits.
Another Big Six Iirm produces a special “Mer-
gers & Acquisitions” newsletter which covers:
topical issues relevant to acquisitions and financing,
particularly those which relate to accounting, taxation,
regulations and the other fields where we provide ser-
vices to acquirers, their advisers and financiers.
Freedman and Power (1991) speak of the
increasing overlap between accountants and
lawyers in their professional duties as commer-
cial transactions often require combined
advice. Here we see evidence of such co-opera-
tion in practice. Although multidisciplinary par-
terships are prohibited for lawyers in the
United Kingdom, the Big Six accounting firms
are becoming increasingly multidisciplinary
through their involvement in tax and manage-
ment consultancy services (Dezaley, 1991).
Investment banks specialize in corporate
finance advisory services and often recruit qua-
lified accountants and lawyers as corporate
finance advisors (Wailer, 1991). Hence,
although direct partnership between the
accounting and law professions is prohibited
in the United Kingdom, the above evidence
of collaboration shows that in practice, these
restrictions can be circumvented. There are
active joint ventures which get around the pro-
fessional partnership restrictions, to the detri-
ment of some regulatory objectives. We now
turn to examine the commercial stakes
involved and the promotional efforts underta-
ken in the game of creative compliance.
30 A. K
COMMERCIAL STAKES AND THE ACTIVE
MARKETING OF CREATIVE COMPLIANCE
TO NEW CUSTOMERS
The average issue costs of all the above com-
plex convertible issues were 2.7%’ ’ of the
finance raised, equating to some 53m for an
average sized issue. This is 51.9m in excess of
the costs of an unsophisticated bond issue - a
significant amount. When interviewed about
this, Investment Banker M commented:‘*
The fees are very profitable for the lead banks, and 2.7%
is much higher than the fees they would earn on unso-
phisticated bond issues which would be about 1%. In
a~Ution, lawyers charge their own fees which can also
be substantial. I think the two top law firms specializing
in the area made a lot of money from complex conver-
tible issues by keeping the technology to themselves.
He went on to explain why issuers were pre-
pared to pay such high costs:
Between 1988 and 1991, firms were so excited about
the accounting benefits that they did not look at the
pricing of these issues. In my opinion, quite often the
issues were under-priced and the investors got a good
deal, but issuers did not care about this.
From the above evidence, issuers seemed
willing to pay significant amounts in order to
obtain the accounting and tax avoidance bene-
fits from convertibles. The thesis that those
with the resources to resist regulations are
unregulatable (McBarnet & Whelan, 1991)
appears to be supported, at least in this case.
It is also very likely that once the instrument is
invented by a bank, subsequent issues are more
profitable as all the initial research has been
done. When asked about this aspect, Banker
B did not deny it and commented:13
We can recover a good proportion of the development
costs from the first issue - the client bears a large
SHAH
proportion, as they understand the extra costs involved
in these things.
Thus the relative profitability of each type of
security appears to increase with time - later
issues earn greater proportional profits as the
development work is mostly completed in
advance. This helps to explain the zeal with
which professionals openly marketed the
advantages of convertible securities.
What emerged from the interviews and the
documentary evidence was a sense that this
group of “creative compliance” experts were
not necessarily working on the command of
issuing companies. Often, especially after a
scheme was developed, they openly marketed
the scheme to new companies. For example, in
an article in The Tax Journal, Mr Tony Beare of
Slaughter & May, an international law firm,
wrote (1990, p. 4):
For a group seeking to borrow money, a real concern is
the adverse effect which this wiil have on its consoli-
dated balance sheet. For this reason, advisers are regu-
larly asked to consider possible ways in which a
borrower’s gearing will not be affected by the debt in
question. one solution was to issue preference
shares out of a wholly owned subsidiary resident in a
low tax jurhdiction, such as the Netherlands AntiUes,
and to lend the proceeds of the share issue back to the
United Kingdom. By doing this, the United Kingdom
group retained the tax benefits of a full interest deduc-
tion for servicing the sums provided but was able to
treat them as an accretion to shareholders’ funds in its
consolidated accounts.
the convertible capital bond is the latest attempt
to obtain favourable accounting treatment for borrowed
money.
This is a carefully worded sales pitch by law-
yers emphasizing the accounting advantages.
The Tiax Journal also published an article by
Mr Chapman (1990a) of Slaughter & May
which:
ii This evidence was obtained from ail the prospectuses of all the convertibles issued during the period.
‘a Febtuary 1992.
I3 Interview, January 1992.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 31
. . looks at the definition of ordinary share capital and
explains how to ensure that a preference share issue
does not fall w&hin this category @. 22).
In fact, Slaughter and May wrote a weekly col-
umn in this journal and in the April and July
1989 issues there were features on converti-
bles and capital markets by Mr Savory (Sav-
ory, 1989a,b). These articles discussed the
latest changes in the tax rules and new “avoid-
ance” schemes (e.g. the Convertible Capital
Bond issue by Salnsbury’s was explained in
the 20 April 1989 issue). There was also an
article written by another lawyer Dow (1990)
ln Practical Law for Companies, which
described in detail the intricate features and
avoidance advantages of Convertible Capital
Bonds. It may be that these instruments are
made to look complex to reinforce expertise
and help professionals maintain their territorial
claims. The Treasurer, a journal published by
the Association of Corporate Treasurers, had
several “marketing” articles written by direc-
tors of investment banks on complex converti-
bles and their advantages. Examples are Blackie
(1988), Prior-Palmer & Spain (1989) and Mor-
gan (1990).
Where creative compliance schemes are
developed, one would expect the innovators
to keep quiet about them rather than to pub
licize them, especially since there is a risk that
regulators may then close the gaps. However,
the evidence suggests that there was no signifi-
cant threat perceived by the authors and that
they were eager to reap the commercial bene-
fits before the regulators clamped them down.
This exposes the lengths to which profes-
sionals were willing to go to sell the schemes.
This supports the McBamet and Whelan (1991)
analysis that creative compliance stays above
the law, and lawyers are hence not afraid of
publicly marketing such schemes. It also
shows how strong commercial motives can
be as compared to professional ones in the
service industry. The next section focuses on
‘* Banker B, January 1992.
the role of professionals after the securities are
issued - what happens when there is a change
in the external circumstances or regulations
which render some of the original objectives
ineffective? The answer: professionals once
again come to the rescue, for a fee of course!
ENSURING SUCCESSFUL COMPLIANCE
WHEN THERE IS A CHANGE IN
REGULATIONS
One of the main problems with creative
compliance schemes is that there may be a
change in attitude by the regulators as a result
of which the schemes may not achieve their
intended objectives (McBamet, 1991). We
saw earlier what one of the investment bank-
ers felt about accounting standards:‘*
We know fbut it takes years for an accounting stan-
dard to be introduced hence it b not a big worry. It is
usually tax that we are very nervous about. In certain
circumstances, we go for advance clearances from the
Inland Revenue.
As we saw earlier, when the Inland Revenue
hardened its attitude to the tax treatment of
offshore convertible preference shares, the
convertible capital bond was invented to cir-
cumvent the impact of this change and retain
the previous advantages. One accounting
recommendation that emerged during the per-
iod of the study was that the professional body
to which most auditors belonged, the Institute
of Chartered Accountants in England and
Wales, issued a technical release (T&77,
January 1988) which required firms to accrue
the supplemental interest on premium put
convertibles.
However, for issuers of premium put conver-
tibles, the technical release had the potential
effect of reducing reported profits ceteris par-
ibus. In practice, most of the issuers initially
avoided accruing the supplemental interest
despite a significant decline in the share price
32 A. K. SHAH
precipitated by the market crash of October
1987 (Shah, 1993, Chap. 5). When inter-
viewed about this, a partner in a Big Six audit
firm responsible for the revision of TR677
stated: l5
TR677 was a technical release and not a standard, and
was not implemented by many issuers of premium put
convertibles.
In fact, two corporate finance partners in
another Big Six firm stated in an article on
convertibles (Hughes & Lubbock, 1989):
the technical release only gives a suggested treat-
ment as its status is informal guidance and not an
accounting standard.
Hence at least some audit partners did not pub
licly support the best practice suggested by
their own professional body.
One technique by which the accrual of sup
plemental interest was avoided by the issuers
was through a change of terms of the original
issue. This was fn-st Invented by S. G. Warburg
and successfully applied in the case of the Bur-
ton Group. A new rolling put option was intro-
duced whose aim was to increase the
likelihood of conversion as opposed to redemp-
tion and hence avoid the accrual of supplemen-
tal interest (e.g. see Burton Group Annual
Report, 1988). The device appears to postpone
the likelihood of early redemption by giving
bondholders an extra five years in which to
exercise the conversion option. However, in
practice, the rolling put option was a complex
veil which did not necessarily Increase the
chances of conversion. As one Senior Banker
put it:16
I think that it is purely throwing wool over the auditors
eyes. At the end of the Iirst five years, either the share
price does well and the bonds are converted or the
is Interviewee A, March 1992.
i6 Interviewee M, February 1992.
i’ Interviewee A, March 1992.
original put option is exercised. I do not think any
rational investor would want to hold the bond lf the
company has not done well - he would be increasing
his risks at no extra return. But again, the auditors
bought that and allowed companies to maintain their
original accounting policy of not accruing supplemen-
tal interest.
At the same time, some investment bankers
publicly marketed the rolling put option
device as a way out of the current accounting
difliculties, as we will see below.
In an article in April 1989, CSFB directors
Simon Prior-Palmer and Alex Spain actively
marketed the rolling put option scheme as a
means of avoiding accrual of supplemental
interest and wrote (pp. 57-58):
Recently there has been a concern that, should a com-
pany’s stock price fall sharply (as was the case with
many companies following the stock market crash in
October 1987), the likelihood that the put will be exer-
cised may increase to such an extent that the company
believes it prudent to provide for the premium payable
upon exercise of the put option. The concern has been
that provision for the put option at a later date could, as
was the case with Next plc, result in a company having
to make a provision at a time when it can ill-afford a
reduction in profits.
This problem can be addressed by the addition of one
or more supplementary put options.
Hence not only did professionals play a role in
the Initiation and exploitation of the account-
ing and tax loopholes, but they continued to do
so once the instruments were issued. What is
more, at least two bankers admitted the under-
lying motivations publicly, suggesting that they
themselves saw nothing wrong in doing so.
When asked why the rolling put option was
acceptable to auditors, despite its intention to
postpone accrual of supplemental interest, a
Big Six audit partner involved in the revision
of ‘1X677 explained:”
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 33
Even within the audit 6rms, partners are split in terms
of whether or not to take a hard line on companies who
violate important accounting principles. Many partners
have a commercial approach.
The above quote suggests that auditors were
aware of the real motivations, but were happy
to rely on a scheme compiled by other profes-
sionals such as bankers.
In order to lend credence to the equity clas-
sification of offshore convertible preference
shares, an elaborate calculation was invented
by investment bankers - the “Conversion
Probability Factor” (CPF) (Shah, 1993, Chap.
5). The CPF evaluated the likelihood of
redemption or conversion on the basis of alter-
native assumptions about future share price
performance and the relative level of the con-
version premium. The rolling put option was
used as a device to enhance the CPF in order to
support equity classification. However, careful
analysis by MacDonald and Selbie (1988)
showed that “the CPF may not be affected by
the multiple put option.” In addition, Banker M
admitted when interviewed that it was another
“woolly” device and that in reality, the likeli-
hood of conversion of premium put converti-
bles was very low. However auditors accepted
this as adequate justification - none of the
financial statements (all of which did not clas-
sify these issues as debt) were qualified by their
auditors.
One of the main problems with any new
creative compliance scheme is that there is
always a certain amount of uncertainty about
the acceptance by regulators and companies.
The premium put convertible bond was Iirst
issued by Burton Group plc, the offshore con-
vertible preference share by United Biscuits plc
and the convertible capital bond by J. Sains-
bury plc. At the time of issue, all three were
well-respected names in the marketplace.
When asked whether this was a deliberate strat-
I8 February 1992.
I9 March 1992.
egy adopted by the issuing bankers, Banker M
replied:‘”
Yes I think issuance by big names helps the credibility
and popularity of these instruments. Often, the later
issuers use their accounts as a way of bargaining with
the auditors. As a result, the initial rubber stamp has
implications on all the other firms’ accounting choices.
Similarly, Banker B said on the invention of the
Convertible Capital Bond: l9
We are in the business of serving big customers - it is
clearly important that we do not do the first issue for
someone like Polly Peck. To do an issue for Sainsbury’s
-
we were actually very lucky. They wanted to do one
at that time and we analysed the whole scheme very
carefully as a result. It does help our profile to make an
initial issue with a big name.
Hence professionals actively manage the inno-
vation and avoidance process in a way which
ensures maximum acceptability by regulators.
As we saw earlier, in both accounting and tax
matters, advance clearance is sought from the
regulators - auditors in accounting matters and
tax inspectors in tax affairs. To manage the cred-
ibility of the schemes, they prefer to use well-
established clients for the earlier issues.
So far, there has been little discussion on the
role and attitudes of the accounting regulators
during this period. In their review of U.K.
Financial Reporting, Tweedie and Whittington
(1990) had this to say on resolving the pro-
blems of creative compliance (p.96):
One approach is to deal with each (accounting)
problem on a fire Eghting basis. This has of necessity
been the characteristic of much of the earlier efforts of
standard setters. However treating the symptoms
rather than the disease can lead to the problems re-
emerging in a different form, designed to circumvent
the new detailed prescriptions
This is a good explanation of what happened in
the convertibles episode. The next section is
34 A. K. SHAH
devoted to an examination of the regulatory
backdrop during the period and the specific
responses made by the regulatory bodies.
1987-90 was a period of change in the struc-
ture of accounting regulation, as we will see
below.
REGULATORY RESPONSE AND A SHIFTING
OF THE DIALECTIC
The United Kingdom has had a long tradition
of self-regulation in financial reporting (Whit-
tington, 1990). The principal standard setter,
the Accounting Standards Committee (ASC),
was a part-time body comprising primarily of
accountants in professional practice and had
very limited resources. During the midg0s it
was widely criticized for its ineffectiveness in
standardizing accounting practice. Whittington
(1990, p. 196) noted:
With regard to the content of standards, a widespread
criticism is that the ASC has, because of its weak enfor-
cement powers, had to take a consensus view and has
frequently changed its mind or made concessions to
placate pressure groups. More fundamentaIIy, the
ASC has tended to lack a consistent set of centraI con-
cepts which would lend coherence and consistency to
the set of standards as a whole.
Audit partner A, a senior member of the Insti-
tute of Chartered Accountants in England and
Wales, had this to say on U.K. accounting stan-
dards:*’
I think that U.K. accounting standards are amongst the
weakest in the developed world, and there is slgni6cant
scope for subjectivity and creativity.
This regulatory system placed a significant reli-
ance on the auditors’ exercise of professional
judgement in areas where there were no spe-
” Interview, March 1992.
*’ Hughes & Lubbock (1989).
** Interview, March 1992.
cific pronouncements. The “true and fair view”
concept which is unique to U.K. accounting is
an illustration of the belief that auditors are
capable of evaluating the overall picture of
financial performance provided by a set of
financial statements (McGee, 1991). However,
the evidence in this study shows that auditors
provided advance clearances and cooperated
with their clients, permitting the violation of
TR677. Some of them openly critiqued the
importance of TR677’l and those who did
decide to take a stand often felt powerless in
doing so. Audit partner A commented:22
Often when we raise a critical accounting issue with a
&em, they have on their desk two stacks of accounts:
one stack of firms audited by us and another of other
large companies. They Inevitably find one set of
accounts where the accounting policy is very similar
to theirs, and the audit partner has dlflicuhy arguing
against that. Unfortunately, In these dlfficuh times, part-
ners are afraid to lose a client and are under great pres-
sure to compromise.
Hence the combination of self-regulation of
accounting and the emphasis on commercial
values within the auditing firms provides an
antedote for compromise by the “quasi-regula-
tors”. Although the regulatory system places a
strong reliance on auditors, those who wish to
take a stand against their clients often feel
powerless to do so, owing to the lack of inter-
nal agreement within the profession. It is there-
fore no surprise that creative compliance
would thrive in such circumstances.
As a result of the public concerns about the
effectiveness of accounting regulation, a new
regime of accounting regulation was devel-
oped by the Dearing committee in 1988 (Dear-
ing, 1988), and the revised structure had more
resources and comprised full-time staff. It was
not mandatory for companies to comply with
the standards issued by the Accounting Stan-
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 35
dards Board, but directors were required to
report any deviations and the Financial Report-
ing Review Panel had the power to take dissen-
ters to court. This provided the new regime
with some degree of legal backing. In 1989, a
new Accounting Standards Board was estab-
lished under the oversight of the Financial
Reporting Council.
It was against this backdrop of turmoil and
self-regulation in the accounting standard set-
ting process that the present case study is set.
At the time these instruments were developed,
many of the “creative compliance experts” saw
through direct experience that there was little
to fear in the way of effective reprisals from the
accounting regulators. As one senior invest-
ment banker who developed the convertibles
stated when interviewed:23
On the accounting side, there is usually a lot of discre-
tion as the rules are not all clearly detined. The clients
get their assurance from their auditors - clearly stan-
dards can change but that is the risk that clients have to
take. We know that it takes years for an accounting
standard to be introduced - hence ft is not a big
worry.
Hence the weakness of the accounting regula-
tory regime during 1987-90 was exploited by
the financial engineers. When the audit partner
involved in the revision of TR677 was asked
about the chaos surrounding the accounting
policy for convertibles, he explained:**
I think that the profession is split on the issues. Many
technical partners are concerned about creative
accounting, but other partners are not. However, the
new ASB structure seems to be an interesting develop
ment, and the Review Panel has some force. I do think
that the profession needs some sort of outside regula-
tion or backing - in the long run, it will help us.
The regulators were not entirely unaware of
the abuses (e.g. TR677 was issued in January
*’ Banker B, January 1992.
24 Auditor A, March 1992.
*5 Interview, January 1992.
1988). However, they were generally slow to
respond - it took another three years for an
exposure draft to be issued, which would still
be a precursor to an accounting standard. In
February 1991, a further technical release on
the treatment of the supplemental interest
TR827 was issued by the Institute of Chartered
Accountants in England and Wales (ICAEW,
1991) which required that all companies
should provide for the supplemental interest
without exception. In December 1991, the
newly formed Accounting Standards Board
made the convertibles problem a priority and
issued a detailed and lengthy discussion paper
(Accounting Standards Board, 1991). This pro-
posed standard clamped down on premium put
convertibles, requiring amortization of supple-
mental interest and the debt classification of
convertible capital bonds. It took another two
years until November 1993 before this discus-
sion paper was finally converted into a manda-
tory
accounting standard (Accounting
Standards Board, 1993).
From the above, we can see that within the
space of four years, there were four different
accounting pronouncements made by the pro-
fession or standard setters. This is evidence of
the length of time it takes regulators to react to
accounting abuses, and the difficulty of obtain-
ing consensus on the issues. The need for con-
sultation also provides an opportunity for
lobbying by professionals and companies to
obtain the accounting treatment which is
favourable to them.
When asked for comments on the Account-
ing Standards Board discussion paper, Banker B
stated:25
1 have a colleague who is closely looking at the discus-
sion paper. We think the day of having your cake and
eating it too is probably coming to an end with the new
36
A. K.
regime. The regulators have problems because compa-
nies have pushed it a bit too far.
Hence now the fault lies with companies. In
fact such was the interest in this proposed
standard that it hit number one in the Accoun-
tancy Age bestseller list. The release of the dis-
cussion paper did have one noticable effect -
it stopped the issuance of convertible capital
bonds or any other type of sophisticated con-
vertibles for a while.26 It was interpreted by the
financial engineers as a signal of tighter regula-
tion, and the new Accounting Standards Board
was also receiving positive media coverage
owing to the creative accounting abuses of
the 1980s. However, in 1993, one training
lirm IBC Legal Services, started running
courses on “Off Balance Sheet Finance and
Capital Instruments”. The lectures were deliv-
ered by senior professional auditors, bankers,
tax practitioners and investment analysts. This
one day course covered the new discussion
papers and proved very popular. The advertise-
ment for the third such course stated in the
accompanying letter from the producer
(dated November 1993):
Attendance at this event should update your knowledge
so you can:
. assess current schemes and processes;
. respond to the standards;
l create new beneficial schemes.
Hence the field had already moved on to a
hitherto unregulated area. For a fee of &345,
participants could meet the experts and learn
the latest avoidance devices, for which profes-
sional co-operation would then be required for
implementation.
CONCLUDING REMARKS
The practice of creative accounting under-
mines the very credibility of accounting prac-
tice. To date, there has been a significant
__
SHAH
amount of literature on the variety of abuses
and whether or not the stock market is capable
of seeing through accounting numbers. There
has also been speculation about the existence
of creative compliance (Tweedie St Whitting-
ton, 1990, p.96). However, there is no study
in the literature which examines the mechan-
isms by which creative compliance in account-
ing is achieved in practice. Tracing this process
of creative compliance was the principal aim of
this study. Examination of financial engineering
in convertible securities exposed the close co-
operation between various groups of profes-
sionals - lawyers, accountants and bankers
-
in the development of the schemes. Compa-
nies were willing to subscribe to these schemes
at a significant cost, and for a while, successful
creative compliance was attained. Regulators
were slow to respond, and when they did
make pronouncements, companies once again
circumvented the rules with the help of various
professionals. Auditors compromised their
position as quasi-regulators and permitted com-
panies to circumvent best practice.
This study documented the close co-opera-
tion of auditors and also exposed the involve-
ment of lawyers in the design of these
instruments, suggesting that creative compli-
ance schemes require direct co-operation
from professionals who are familiar with the
existing regulations and can provide the neces-
sary credibility to the new schemes. It was
interesting to see that only a small group of
professionals were involved in the design and
execution of the schemes, and such were the
perceived commercial benefits that they went
on to market them to new potential clients
with the hope of enhancing their profits. A
driving force behind the market for creative
compliance is the ability and willingness by
companies to pay the significant costs charged
by these innovators.
During the period of the study, accounting
regulation was undergoing a process of instabil-
ity and reform, and this weakness was
” Evidence obtained from examination of new issues in 1991 and 1992
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 37
exploited. The importance of accounting infor-
mation to reporting companies and their stake-
holders provides a vibrant demand for creative
compliance schemes by management if the
(unadjusted) accounting numbers fail to por-
tray a desired picture of financial perfor-
mance. In the field of taxation, both lawyers
and accountants in the United Kingdom have
been actively involved in developing and mar-
keting tax avoidance schemes (McBarnet,
1991). The fact that these skills could be trans-
ferred to the accounting arena for potentially
lucrative returns is perhaps a more recent dis-
covery. It is worth noting that even though the
Accounting Standards Board developed tough
new rules, it did not act directly against this
practice of creative compliance and the profes-
sionals involved. It may be that one way of
achieving legal control is to regulate more
directly the activities of these professionals,
although the mechanisms for doing so are
beyond the scope of the present study.
The phenomenon of obtaining advance
clearances (from auditors in the case of
accounting and from the Inland Revenue in
the case of tax uncertainty) indicates a degree
of complicity by the regulators in the develop
ment of successful creative compliance. The
self-regulatory environment in the U.K. and
the dual role of auditors as professional advi-
sers as well as quasi-regulators helps explain
the accountants’ role in providing advance
clearances. However, the role of tax inspectors
is somewhat more curious. McBamet (1991, p.
331) reports how this process of obtaining rev-
enue clearance is actively managed in such a
way that only partial elements of the scheme
are disclosed at any one time to an inspector. It
is also worth noting that just as creative com-
pliance schemes in accounting cannot easily be
developed and implemented by the companies
acting alone, in a similar way professionals act
as mediators in the negotiation of tax payments
to the Inland Revenue (McBamet, 1991).
Advance clearances reduce the uncertainty
which might otherwise surround the success
of a creative compliance scheme.
It may be argued that by developing or co-
operating in the development of such creative
compliance schemes, professionals are being
unethical. At a personal level, there was no
hint of fear of reprisal from the regulators or
the professional bodies for the individuals con-
cerned. None of the professionals interviewed
for this study felt that what they were doing
was unethical, probably due to the fact that
no single individual or firm devised and mar-
keted the scheme in its entirety. Groups of
professionals acted in concert.
The study also exposes a wide divergence
between market influences on the methods of
conducting business and the structure of regu-
latory bodies. The barriers between account-
ing, law, taxation and finance are fast
disappearing in the modem world, yet the reg-
ulatory institutions are quite distinct. For exam-
ple, in the United Kingdom, tax regulation
comes under the ambit of the Inland Rev-
enue, accounting regulation under the
Accounting Standards Board and finance regu-
lations are determined by the London Stock
Exchange. In the case of convertibles, had the
three bodies cooperated much earlier on,
there may have been a clearer overview of
the intentions of these instruments, and it is
possible that immediate sanctions could have
been exercised. As Dezaley (1991) notes, mar-
ket forces are encouraging the break-up of pro
fessional barriers and this may be time for a
substantial rethink of the roles and effective-
ness of regulatory institutions.
In addition, the globalization of professional
firms and financial institutions makes it easier
for them to identify and exploit differences
between regulations in different countries. In
this case study, we saw how as soon as the
Inland Revenue hardened its attitude to the
Netherlands Antilles offshore tax haven, the
schemes were restructured and exploited
another offshore tax haven - Jersey. Thus
not only national but international differences
in regulations can also be actively exploited,
making localized regulatory institutions appear
helpless in preventing such avoidance.
38 A. K. SHAH
BIBLIOGRAPHY
Accounting Standards Board, PRS4: Accounting for Capital Instruments (London: Accounting Standards
Board, November 1993).
Accounting Standards Board, D&ussion Paper Accounting for Capital Instruments (London: Account-
ing Standards Board, December 1991).
Accounting Standards Committee, Statement of Standard Accounting Practice No. 2: Disclosure of
Accountfng Polkies (November 1971).
Adam, N., Lung Ilve the Converdble, i%e BanJzer (May 1988) pp. 50-51.
Beare, T., Convertible Capital Bonds, ?%e Ta.z Journal (20 September 1990) pp. 4-6.
Blackie, H., Convertible Bonds An End to the Controversy, The Treasurer (September 1988) pp. 72-
73.
Burton Group PLC, Annual Report: Year ended 3 September 1988 (London: Burton Group, 1988).
Chapman, A., The Meaning of Ordinary Share Capital, flbe Tax Journal (11 January 199Oa) pp. 22-23.
Chapman, A., In the Group but off the Accounts, The Tax Journal (11 January 1990b) pp. 8-9.
Dearing, R., Z&e Making of Accounting Standards (London: Institute of Chattered Accountants in
EngIand and Wales, 1988).
Dezalcy, Y., TerritoriaI Battles and Tribal Disputes, The Modern Law Review (November 1991) pp. 792-
809.
Dow, R., Convertible Capital Bonds: The New Financing Solution, Practicul tiw for Companies (August
1990) pp. 7-14.
Freedman, J. &Power, M., Law and Accounting: Ttansition and Transformation, T&e Modwn Law Reufew
(November 1991) pp. 769-791.
Hopwood, A., Ambiguity, Knowledge and Territorial Claims: Some Observations on the Doctrine of
Substance over Form: A Review Essay, BtlNsb Accounting Revkw (March 1990) pp. 79-87.
Hughes, N. & Lubbock, E., Euroconvertible Preference Shares, The Treasurer (April 1989) pp. 43-45.
Institute of Chartered Accountants in England and Wales, TR677 - Accounting for complex capid
issues, Accountancy @nuary 1988) pp. 147-148.
Institute of Chartered Accountants in EngIand and Wales, TR827 - Convert&&? Bonds
There is signilicam evidence of the practice of creative accounting by large listed corporations. However,
little is known about the process by which such schemes are devised and succeed in escaping legal and
regulatorys anction
Pergamon AccounWag, Organfzatfom and Society, Vol. 21, No. I, pp. 23-39, 1996
copyright 0 1995 Fkvier Science Ltd
Printed in Great Britain. AU rights reserved.
0361-3682/96 $15.00+0.00
0361-36fit2(95)00015-1
CREATIVE COMPLIANCE IN FINANCIAL REPORTING*
ATUL K. SHAH
University of Bristol
Abstract
There is signilicam evidence of the practice of creative accounting by large listed corporations. However,
little is known about the process by which such schemes are devised and succeed in escaping legal and
regulatory sanction. This study examin es this process of creative compliance in the case of complex
convertible securities issued by U.K. listed companies between 1987 and 1990. There was an active
dialectic of creativity in the design of these instruments - a shift from avoidance to rules to avoidance
again. The evidence shows how a small group of professionals in finance, law and accountancy co.
operated in the development of these instruments. They helped the issuers to manage their financial
reporting process in a way in which compliance was assured. Where regulatees are able to command
such creative compliance skills and resources, regulators may find themselves facing an uphill struggle.
In many countries, accounting regulation is
based on a system of detailed rules prescribed
in standards and the law. However, rule-based
systems can rarely be water-tight. There may be
gaps in the rules, and places where the rules
are vague or even incomplete. Of equal, if not
greater significance is the fact that regulatees
may develop schemes which fulfil the letter of
the rules, but undermine their spirit. Regulators
may find themselves constantly lagging behind
the avoidance activities of the regulatees
(McBamet, 1988). In such circumstances, effec-
tive regulation breaks down. Hopwood (1990,
p. 80) observed that:
Corporate financial accounting and the subsequent
audit function are subject to a . . lack of operational
specificity, enabling a certain fluidity to enter into the
corporate accounting domain. Discretion and choice
are thereby made important elements of the accounting
function, providing a zone of strategic choice for man-
agement and a basis for a negotiated rather than purely
procedural audit function.
In the United Kingdom, extensive evidence of
the existence of such “creative accounting”
emerged upon the publication of Accounting
for Growth by Smith (1992). This raised a pub-
lic outcry and the share prices of some of the
companies named by Smith declined at the
time of publication.’
In their study on the effectiveness of legal
regulation of accounting practice, McBamet
and Whelan (1991) explain this process of
“creative compliance” as (p. 848):
l I am grateful to the anonymous reviewers, participants at the 1994 European Accounting Association Annual Congress in
Venice, members of the accounting workshop at the Universities of Bristol and Maryland, and Anthony Hopwood for
comments on earlier drafts. Financial support for the research was obtained from the CATER fund of the Institute of
Chartered Accountants in England and Wales and the Economic and Social Research Council. I am grateful to all the
individuals who cooperated in the interview and gave freely of their time and expertise.
’ The Independent, 7th February 1992, p. 25.
23
24 A. K. SHAH
the active response of those subject to the law, not
just in political lobbying over legislation but inpost hoc
manipulation of the law to turn it - no matter what the
intentions of the legislators or enforcers - to the ser-
vice of their own interests and to avoid unwanted
control.
The aim of this study is to examine further this
process of creative compliance in accounting.
By focusing in detail on one particular scheme
which was popular in the United Kingdom in
the late 198Os, the paper traces the “dialectic
of creativity” - from avoidance to rules to
avoidance again. Particular attention is placed
on the development of the scheme and the
manner in which the process of obtaining
effective compliance is managed and articu-
lated. Despite the significant evidence on the
practice of creative accounting, there is no
study in the literature which traces the process
by which such schemes are developed and
avoid breaching accounting regulations. Tra-
cing this process is the principal aim of this
article. The findings expose the active involve-
ment of those whose very job it is to be familiar
with the rules - lawyers and accountants. This
evidence appears to support McBamet and
Whelan’s (1991, p. 873) central thesis that
effective legal control, particularly of those
with the resources to resist, may not be
attainable.
During the period 1987-90, convertible
securities attracted a lot of attention from
financial engineers (Shah, 1993). At the time,
there were no specific accounting standards
or laws which defined the accounting treat-
ment of convertibles. Thus no rules stated
whether or not convertibles should be classi-
fied as equity from the outset, nor was there
any statement on how the coupon interest
should be treated in the profit and loss
account. It was this gap in the rules which
provided a range of creative accounting
opportunities (Pope & Puxty, 1991). Smith
(1992, Chap. 13) devotes a chapter to one
such instrument - the premium put conver-
tible bond. This study examines the process of
creative compliance through the issuance of
convertible securities.
One of the difficulties of analysing the pro-
cess of creative compliance is the potential
sensitivity of data collection as one of the
most obvious sources of evidence are the
very people who would be implicated by the
evidence. The advantage of studying converti-
bles was that there is a legal requirement for all
issuers to publish an issue prospectus detailing
the terms of the financial instrument, the pro
fessional advisers and costs of issue (London
Stock Exchange, 1992). Other important
sources of evidence were the publications in
trade journals by professionals on various
legal, financial and accounting aspects relating
to convertibles. These articles often made pub-
lic the motivations underlying the instruments
and the extent to which professionals were
willing to go to market their sophisticated
schemes. Evidence on the accounting policies
adopted by the issuers was obtained from the
financial statements. Selective interviews of the
key professionals involved in the innovation
are also reported here, and the responses
were surprisingly candid.
The article is organized as follows. In the
next section, the dialectic of creativity using
convertible securities is outlined. Details of
the key innovators and participants in the
“game” of creative compliance are then pro-
vided, and the evidence shows the extent of
cooperation between different groups of pro-
fessionals in the successful innovation of these
schemes. The commercial gains for the devel-
opers are substantial, and the ensuing section
provides evidence of the extent to which they
went to promote the schemes and generate
new customers. The regulators were not
entirely in the dark, but their reactions to these
schemes were circumvented by the companies
with cooperation from the same group of pro-
fessionals. The following section analyses the
backdrop of accounting regulation during the
period, and explains how the lags between
creative compliance and corrective regulation
fueled the avoidance of accounting regulations.
Finally, the implications of the evidence for
financial reporting are discussed.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 25
A DIALECTIC OF CREATMTY
A conventional convertible security is a com-
bination of a bond and an option to convert the
bond into shares of the underlying company at a
future date. For accounting purposes, the com-
mon treatment in U.K. and North America at the
time (MCIMeS et al ., 1991) was to treat the
bond as debt and the coupon as an expense
until it is converted, whereupon the debt trans-
forms into equity. During 1987-90, there was
considerable innovation in the U.K. convertible
market such that several variants from the con-
ventional convertible were developed (Pope 8~
Puxty, 1991). The Iirst such instrument was the
premium put convertible bond (issued by Bur-
ton Group in January 1987) where the interest
rate was set lower than the coupon for conven-
tional convertibles in the first five years. How-
ever, to compensate for the low interest return,
investors were promised a much larger increase
in the share price. If the increase failed to mate-
rialize, investors had the option to redeem their
bond and collect the back-interest for the pre-
vious five years (hereafter called supplemental
interest). Hence, the central accounting issue
here is whether or not the supplemental inter-
est should be accrued in the annual accounts of
the issuer during the first five years.
In March 1988, a variant of the premium put
convertible bond was invented - the offshore
premium put convertible preference shares
(first issued by United Biscuits). Here, the
unique additional feature was that as the secu-
rities were preference shares, they escaped
debt classification in the early years, hence
improving the gearing position considerably.
In addition, the equity classification helped
issuers to create a signiiicant reserve which
could subsequently be used to write off the
goodwill that arose from the acquisition which
the security was financing. The offshore issu-
ance structure helped ensure that the prefer-
ence dividends did not attract advance
corporation tax and could be offset against
’ Banker B, January 1992.
profits in a manner similar to interest on debt
securities (Hughes & Lubbock, 1989). Thus the
instrument was designed to take advantage of
gaps in both the accounting and the tax rules.
As one senior investment banker explained
when interviewed:2 “ It was a wonderful instru-
ment designed to meet a particular need,”
In April 1989, the Inland Revenue hardened
its attitude on such structures by rewriting the
double tax agreement with the Netherlands
Antilles where the finance subsidiaries were
sheltered and as a result, the preference share
dividends could no longer be offset for tax
purposes (Morgan, 1990). This change in tax
regulations led to the development and issu-
ance of yet another variant of the convertible
security - the Convertible Capital Bond
(CCB). This instrument was designed to bene-
fit from the tax and accounting advantages of
the offshore convertible preference shares and
get around the change in attitude towards the
Netherlands Antilles - it was now issued
through a specially created Jersey subsidiary.
Figure 1 demonstrates the rise and fall of the
different variants of the convertible securities
during the period 1987-90 - from the pre-
mium put convertible bond, to the offshore
convertible preference share and finally the
convertible capital bond. The move from pre-
mium put convertible bonds to offshore con-
vertible preference shares retained the
accounting benefits of the premium put struc-
ture and built on these by structuring the
instrument in such a way as to allow equity
classification. The change from offshore con-
vertible preference shares to convertible capi-
tal bonds was driven by a change in tax
regulations. It is worth noting that each time
a new variant was developed it immediately
phased out the previous instrument. Compa-
nies issued the most beneficial instrument pre-
vailing at the time.
In all, thirty-two large publicly quoted com-
panies issued the above convertibles and raised
$3,584 million of new finance (Shah, 1993). Of
26 A. K. SHAH
0 Convertible capital bonds with puts
m Convertible capital bonds
0 2 4 6 8 10 12 14
Number of new issues
Fig. 1.
these, some fnms made more than one issue of
the security. Most of the issuers were well-
known quoted companies such as British Air-
ways (&320m), Saatchi and Saatchi (&177m)
and Blue Circle (&9Om). The average size of
each issue was &112m. Almost all of these com-
panies had a number of creative accounting
practices according to the analysis presented
in Smith (1992, Chap. 16), the now infamous
“blob index” - which lists the names, types
and range of creative accounting practices
adopted by large listed U.K. companies. The
issuers came from a range of industrial
groups, although companies in food retailing
and stores were amongst the more common
issuers (Shah, 1993 Chap. 5).
During the period 1987-90 there were no
specific accounting standards in the United
Kingdom which dealt with the treatment of
convertibles. Under Statement of Accounting
Practice 2 (Accounting Standards Committee,
1971), which outlines some of the fundamen-
tal accounting concepts, the accruals and pru-
dence concepts would suggest amortization of
the supplemental interest from the date of
3 Interview A, March 1992.
issue. This interpretation was formalized in Jan-
uary 1988, when the Institute of Chartered
Accountants in England and Wales issued a
technical release (TR677) (ICAEW, 1988)
which recommended the accrual of supple-
mental interest for premium put convertibles.
This document did not have the force of an
accounting standard as it was issued by a pro-
fessional body and not the Accounting Stan-
dards Committee. However, its contents act
as an indicator of best practice where no alter-
native pronouncements exist.3 However, there
was no rule or pronouncement relating to the
debt or equity classification of convertibles,
and the latter securities (offshore convertible
preference shares and convertible capital
bonds) were designed specifically to exploit
this gap in the accounting rules (Dow, 1990;
Pope & Puxty, 1991). Debt classification would
project an image of high gearing and hence
greater risk for investors and lenders. Issuers
were keen to obtain equity classification as
this would reduce the perceived gearing ratio
and provide significant benefits for the write-
off of acquisition goodwill (Shah, 1993, Chaps
5 & 6). Through creating “new reserves”
issuers were able to avoid amortizing goodwill
against reported profits which would have
otherwise led to reduced earnings per share.
Thus, not only were the initial designs
geared toward accounting and tax avoidance,
but when there was a change in the rules, the
market was quick to respond and retain the
previous advantages despite the new rules.
There was a dialectic of creativity. The princi-
pal factor driving the innovations was the crea-
tivity of the professionals and the attitude of
the Inland Revenue. Standard accounting rules
did not change during this period so they were
not a problem,4 although the “discovery” of the
“offshore” preference shares (which could be
classified as equity) helped significantly in por-
4 We will see later that there was a technical release issued by a professional body relating to the accounting treatment of
the supplemental interest. However, this did not have the force of a standard.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 27
traying a strong financing position (i.e. lower
indebtedness). Changes in tax rules meant a
redrafting of the terms of the convertibles to
retain the original tax advantages. It has been
suspected that regulators are always behind in
the “game” of creative compliance, and this
may mean that effective rule-based regulation
is unachievable in practice (McBamet & Whe-
lan, 1991). In the case of convertibles, the reg-
ulatees appear to be always ahead in the
“game” of creative compliance. In the next
section, we examine the role of various profes-
sionals in the design of these instruments.
PROFESSIONAL PLAYERS IN THE GAME OF
CREATIVE COMPLIANCE
As this article centres on the role of profes-
sionals, it is important to clarify the meaning of
the concept as it is used here. The term “pro-
fessionals” refers to members of a recognized
professional body, e.g. the Institute of Char-
tered Accountants in England and Wales for
accountants, the Law Society for lawyers, and
the Institute of Bankers for bankers. Their pri-
mary role is the administration of rules and the
provision of specialist advice. In the United
Kingdom, auditors have a “quasi-regulatory”
role in that they have to certify whether finan-
cial statements comply with law and account-
ing standards. Similarly, lawyers are bound by
their ethical code and are publicly expected to
uphold state legislation and not to undermine
it. Thus “professionals” are those people spe-
cializing in the service industry with specific
skills and bound by an ethical code. Arguably,
unqualified professionals can develop avoid-
ance schemes, but without the networks devel-
oped by the large law and accountancy firms
and investment banks, it is unlikely that such
schemes could be given the necessary credibil-
Bankers Trust
Union Bank of
Salomon Brothers
Morgan Grenfell
Fig. 2.
ity.5 Qualified professionals can provide the
credibility that is needed in ambiguous areas,
and develop the dialogue with regulators that is
needed to successfully implement these
schemes (McBamet, 1991).
Figure 2 shows the lead bankers to the
issuers. There were three major firms
involved: S.G. Warburg, Barings, and Credit
Suisse First Boston. The remaining advisers’
individual share of issues was relatively small
as can be seen from the figure. An examination
of the legal advisers to the issuers in Fig. 3
shows that Linklaters and Paynes advised on
nearly half the issues and three other large
firms were also involved: Slaughter & May,
AlIen & Overy, and Freshfields. All these firms
have international networks and are well estab-
lished in the legal field.
Thus there were very few large banking and
law firms providing most of the professional
advice to the issuers. This can be interpreted
in terms of an oligopolistic supply, and one
lawyer interviewee said that the underlying
technology behind such schemes cannot easily
be copied by competitors or non-professionals
simply by reading the published prospectus or
any trade journal articles. One of the lawyer
interviewees explained:6
’ Investment banker B, January 1992 (fuIl quote disclosed later).
6 Interviewee L, March 1992.
28 A. K. SHAH
Clifford Chance
Rowe and Maw
Lovell, White
and King
Freshfields
Linklaters and Paynes
Fig. 3.
There is usuaIly a lot of underlying technology which
cannot be understood sImpIy from the prospectus. The
prospectus provides the answers but the reader would
not know which are the relevant questions to ask.
Hence “reverse engineering” is difficult.
As a result, innovators could earn monopoly
profits, and this was a principal attraction’
(examined more fully in the next section).
From the interview and documentary evi-
dence, it appears that no more than fifteen
individuals initiated the creative compliance
process using convertible securities. Hence
successful implementation of such schemes
does not require mass involvement and sup
port from professionals.
When interviewed about the relative roles of
lawyers, accountants and bankers in the design
of complex convertible securities, these were
some of the comments received.
An Investment Banker M said:8
It has really gone hand in hand. There is close discus
sion with the Iawyers and the auditors who have to
approve the accounting treatment In advance.
A partner in one of the law firms stated:9
We invented both the offshore preference share and the
convertible capital bond in conjunction with S.G. War-
burg. Our tax department is closely involved and as a
lawyer, I have the task of documenting the transaction.
The bankers usually say we have come up with the
following structure what do you think about it? We
then look at it both from the tax perspective and the
company law perspective.
When asked whether the lawyers deal
directly with the auditors, he said:
Yes, for the convertible capital bonds, we had to. It is
important that it was not accounted for as a liability In
the issuers bakutce sheet. Tber%z Ls very close co-opera
tion u&b the accountants. The analysts were invited to
treat the CCBs as deferred equity, and therefore, for the
purposes of caIcuIatIng gearlng, CCBs were ignored.
Evidence on the close involvement and collu-
sion of professionals in the development of the
convertibles also emerged Erom a number of
articles published in professional journals
aimed at corporate treasurers and tax practi-
tioners. At least fifteen articles relating to
’ Investment Banker M, February 1992.
s February 1992.
9 March 1992.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 29
some aspect of the accounting and tax issues of
complex convertibles were published in the
journals during the period. Examples of such
articles are Blackie (1988), MacDonald & Sel-
bie (1988), Morgan (1990), and Prior-Palmer
& Spain (1989). In the articles, the authors
mention the consultation undertaken with
auditors at an early stage and discuss some of
the intricate legal features. Articles published
in The Tm J our nal by lawyers, such as Savory
(1989a,b), Beare (1990) and Chapman
(1990a,b), expose the close involvement of law-
yers in the structuring of the convertibles. An
article by Big Six accountants Hughes and Lub-
bock (1989) discusses the salient accounting
features of convertibles and suggests ways in
which the accounting objectives of companies
can be satisfied through the convertibles. A
statement made by United Biscuits Finance
Director and quoted in Adam (1988, p. 50)
discloses the close involvement of auditors in
the sanctioning of the accounting policy prior
to the issuance of the offshore convertible pre-
ference share.
From the above, we can see that close co-
operation is a pre-requisite for the successful
implementation of such schemes. If auditors
do not approve a particular accounting
choice, the effectiveness of an elaborate
scheme is destroyed. In areas where there are
no accounting standards, auditors act as “quasi-
regulators” and as we have seen above, provide
the necessary regulatory clearance. The fact
that many Big Six firms have started specialist
corporate finance advisory departments,” sug-
gests that there is a significant potential for
conflict of interest between the auditing func-
tion and the advisory function. Hughes and
Lubbock (1989) writing as partners in the Capi-
tal Markets Group of a Big Six firm state expli-
citly that (p.43):
In order to avoid the adverse tax consequences and
achieve the accounting objectives it is necessary for
the preference share issue to be via an off-shore subsidi-
” Wailer (1991).
at-y rather than a U.K. subsidiary which would result in
increased cost due to the tax treatment of dividends
paid by U.K. companies.
In the article, they marketed the accounting
advantages of convertibles, and explained in
detail how careful attention to the structure
of the convertibles can provide these benefits.
Another Big Six Iirm produces a special “Mer-
gers & Acquisitions” newsletter which covers:
topical issues relevant to acquisitions and financing,
particularly those which relate to accounting, taxation,
regulations and the other fields where we provide ser-
vices to acquirers, their advisers and financiers.
Freedman and Power (1991) speak of the
increasing overlap between accountants and
lawyers in their professional duties as commer-
cial transactions often require combined
advice. Here we see evidence of such co-opera-
tion in practice. Although multidisciplinary par-
terships are prohibited for lawyers in the
United Kingdom, the Big Six accounting firms
are becoming increasingly multidisciplinary
through their involvement in tax and manage-
ment consultancy services (Dezaley, 1991).
Investment banks specialize in corporate
finance advisory services and often recruit qua-
lified accountants and lawyers as corporate
finance advisors (Wailer, 1991). Hence,
although direct partnership between the
accounting and law professions is prohibited
in the United Kingdom, the above evidence
of collaboration shows that in practice, these
restrictions can be circumvented. There are
active joint ventures which get around the pro-
fessional partnership restrictions, to the detri-
ment of some regulatory objectives. We now
turn to examine the commercial stakes
involved and the promotional efforts underta-
ken in the game of creative compliance.
30 A. K
COMMERCIAL STAKES AND THE ACTIVE
MARKETING OF CREATIVE COMPLIANCE
TO NEW CUSTOMERS
The average issue costs of all the above com-
plex convertible issues were 2.7%’ ’ of the
finance raised, equating to some 53m for an
average sized issue. This is 51.9m in excess of
the costs of an unsophisticated bond issue - a
significant amount. When interviewed about
this, Investment Banker M commented:‘*
The fees are very profitable for the lead banks, and 2.7%
is much higher than the fees they would earn on unso-
phisticated bond issues which would be about 1%. In
a~Ution, lawyers charge their own fees which can also
be substantial. I think the two top law firms specializing
in the area made a lot of money from complex conver-
tible issues by keeping the technology to themselves.
He went on to explain why issuers were pre-
pared to pay such high costs:
Between 1988 and 1991, firms were so excited about
the accounting benefits that they did not look at the
pricing of these issues. In my opinion, quite often the
issues were under-priced and the investors got a good
deal, but issuers did not care about this.
From the above evidence, issuers seemed
willing to pay significant amounts in order to
obtain the accounting and tax avoidance bene-
fits from convertibles. The thesis that those
with the resources to resist regulations are
unregulatable (McBarnet & Whelan, 1991)
appears to be supported, at least in this case.
It is also very likely that once the instrument is
invented by a bank, subsequent issues are more
profitable as all the initial research has been
done. When asked about this aspect, Banker
B did not deny it and commented:13
We can recover a good proportion of the development
costs from the first issue - the client bears a large
SHAH
proportion, as they understand the extra costs involved
in these things.
Thus the relative profitability of each type of
security appears to increase with time - later
issues earn greater proportional profits as the
development work is mostly completed in
advance. This helps to explain the zeal with
which professionals openly marketed the
advantages of convertible securities.
What emerged from the interviews and the
documentary evidence was a sense that this
group of “creative compliance” experts were
not necessarily working on the command of
issuing companies. Often, especially after a
scheme was developed, they openly marketed
the scheme to new companies. For example, in
an article in The Tax Journal, Mr Tony Beare of
Slaughter & May, an international law firm,
wrote (1990, p. 4):
For a group seeking to borrow money, a real concern is
the adverse effect which this wiil have on its consoli-
dated balance sheet. For this reason, advisers are regu-
larly asked to consider possible ways in which a
borrower’s gearing will not be affected by the debt in
question. one solution was to issue preference
shares out of a wholly owned subsidiary resident in a
low tax jurhdiction, such as the Netherlands AntiUes,
and to lend the proceeds of the share issue back to the
United Kingdom. By doing this, the United Kingdom
group retained the tax benefits of a full interest deduc-
tion for servicing the sums provided but was able to
treat them as an accretion to shareholders’ funds in its
consolidated accounts.
the convertible capital bond is the latest attempt
to obtain favourable accounting treatment for borrowed
money.
This is a carefully worded sales pitch by law-
yers emphasizing the accounting advantages.
The Tiax Journal also published an article by
Mr Chapman (1990a) of Slaughter & May
which:
ii This evidence was obtained from ail the prospectuses of all the convertibles issued during the period.
‘a Febtuary 1992.
I3 Interview, January 1992.
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 31
. . looks at the definition of ordinary share capital and
explains how to ensure that a preference share issue
does not fall w&hin this category @. 22).
In fact, Slaughter and May wrote a weekly col-
umn in this journal and in the April and July
1989 issues there were features on converti-
bles and capital markets by Mr Savory (Sav-
ory, 1989a,b). These articles discussed the
latest changes in the tax rules and new “avoid-
ance” schemes (e.g. the Convertible Capital
Bond issue by Salnsbury’s was explained in
the 20 April 1989 issue). There was also an
article written by another lawyer Dow (1990)
ln Practical Law for Companies, which
described in detail the intricate features and
avoidance advantages of Convertible Capital
Bonds. It may be that these instruments are
made to look complex to reinforce expertise
and help professionals maintain their territorial
claims. The Treasurer, a journal published by
the Association of Corporate Treasurers, had
several “marketing” articles written by direc-
tors of investment banks on complex converti-
bles and their advantages. Examples are Blackie
(1988), Prior-Palmer & Spain (1989) and Mor-
gan (1990).
Where creative compliance schemes are
developed, one would expect the innovators
to keep quiet about them rather than to pub
licize them, especially since there is a risk that
regulators may then close the gaps. However,
the evidence suggests that there was no signifi-
cant threat perceived by the authors and that
they were eager to reap the commercial bene-
fits before the regulators clamped them down.
This exposes the lengths to which profes-
sionals were willing to go to sell the schemes.
This supports the McBamet and Whelan (1991)
analysis that creative compliance stays above
the law, and lawyers are hence not afraid of
publicly marketing such schemes. It also
shows how strong commercial motives can
be as compared to professional ones in the
service industry. The next section focuses on
‘* Banker B, January 1992.
the role of professionals after the securities are
issued - what happens when there is a change
in the external circumstances or regulations
which render some of the original objectives
ineffective? The answer: professionals once
again come to the rescue, for a fee of course!
ENSURING SUCCESSFUL COMPLIANCE
WHEN THERE IS A CHANGE IN
REGULATIONS
One of the main problems with creative
compliance schemes is that there may be a
change in attitude by the regulators as a result
of which the schemes may not achieve their
intended objectives (McBamet, 1991). We
saw earlier what one of the investment bank-
ers felt about accounting standards:‘*
We know fbut it takes years for an accounting stan-
dard to be introduced hence it b not a big worry. It is
usually tax that we are very nervous about. In certain
circumstances, we go for advance clearances from the
Inland Revenue.
As we saw earlier, when the Inland Revenue
hardened its attitude to the tax treatment of
offshore convertible preference shares, the
convertible capital bond was invented to cir-
cumvent the impact of this change and retain
the previous advantages. One accounting
recommendation that emerged during the per-
iod of the study was that the professional body
to which most auditors belonged, the Institute
of Chartered Accountants in England and
Wales, issued a technical release (T&77,
January 1988) which required firms to accrue
the supplemental interest on premium put
convertibles.
However, for issuers of premium put conver-
tibles, the technical release had the potential
effect of reducing reported profits ceteris par-
ibus. In practice, most of the issuers initially
avoided accruing the supplemental interest
despite a significant decline in the share price
32 A. K. SHAH
precipitated by the market crash of October
1987 (Shah, 1993, Chap. 5). When inter-
viewed about this, a partner in a Big Six audit
firm responsible for the revision of TR677
stated: l5
TR677 was a technical release and not a standard, and
was not implemented by many issuers of premium put
convertibles.
In fact, two corporate finance partners in
another Big Six firm stated in an article on
convertibles (Hughes & Lubbock, 1989):
the technical release only gives a suggested treat-
ment as its status is informal guidance and not an
accounting standard.
Hence at least some audit partners did not pub
licly support the best practice suggested by
their own professional body.
One technique by which the accrual of sup
plemental interest was avoided by the issuers
was through a change of terms of the original
issue. This was fn-st Invented by S. G. Warburg
and successfully applied in the case of the Bur-
ton Group. A new rolling put option was intro-
duced whose aim was to increase the
likelihood of conversion as opposed to redemp-
tion and hence avoid the accrual of supplemen-
tal interest (e.g. see Burton Group Annual
Report, 1988). The device appears to postpone
the likelihood of early redemption by giving
bondholders an extra five years in which to
exercise the conversion option. However, in
practice, the rolling put option was a complex
veil which did not necessarily Increase the
chances of conversion. As one Senior Banker
put it:16
I think that it is purely throwing wool over the auditors
eyes. At the end of the Iirst five years, either the share
price does well and the bonds are converted or the
is Interviewee A, March 1992.
i6 Interviewee M, February 1992.
i’ Interviewee A, March 1992.
original put option is exercised. I do not think any
rational investor would want to hold the bond lf the
company has not done well - he would be increasing
his risks at no extra return. But again, the auditors
bought that and allowed companies to maintain their
original accounting policy of not accruing supplemen-
tal interest.
At the same time, some investment bankers
publicly marketed the rolling put option
device as a way out of the current accounting
difliculties, as we will see below.
In an article in April 1989, CSFB directors
Simon Prior-Palmer and Alex Spain actively
marketed the rolling put option scheme as a
means of avoiding accrual of supplemental
interest and wrote (pp. 57-58):
Recently there has been a concern that, should a com-
pany’s stock price fall sharply (as was the case with
many companies following the stock market crash in
October 1987), the likelihood that the put will be exer-
cised may increase to such an extent that the company
believes it prudent to provide for the premium payable
upon exercise of the put option. The concern has been
that provision for the put option at a later date could, as
was the case with Next plc, result in a company having
to make a provision at a time when it can ill-afford a
reduction in profits.
This problem can be addressed by the addition of one
or more supplementary put options.
Hence not only did professionals play a role in
the Initiation and exploitation of the account-
ing and tax loopholes, but they continued to do
so once the instruments were issued. What is
more, at least two bankers admitted the under-
lying motivations publicly, suggesting that they
themselves saw nothing wrong in doing so.
When asked why the rolling put option was
acceptable to auditors, despite its intention to
postpone accrual of supplemental interest, a
Big Six audit partner involved in the revision
of ‘1X677 explained:”
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 33
Even within the audit 6rms, partners are split in terms
of whether or not to take a hard line on companies who
violate important accounting principles. Many partners
have a commercial approach.
The above quote suggests that auditors were
aware of the real motivations, but were happy
to rely on a scheme compiled by other profes-
sionals such as bankers.
In order to lend credence to the equity clas-
sification of offshore convertible preference
shares, an elaborate calculation was invented
by investment bankers - the “Conversion
Probability Factor” (CPF) (Shah, 1993, Chap.
5). The CPF evaluated the likelihood of
redemption or conversion on the basis of alter-
native assumptions about future share price
performance and the relative level of the con-
version premium. The rolling put option was
used as a device to enhance the CPF in order to
support equity classification. However, careful
analysis by MacDonald and Selbie (1988)
showed that “the CPF may not be affected by
the multiple put option.” In addition, Banker M
admitted when interviewed that it was another
“woolly” device and that in reality, the likeli-
hood of conversion of premium put converti-
bles was very low. However auditors accepted
this as adequate justification - none of the
financial statements (all of which did not clas-
sify these issues as debt) were qualified by their
auditors.
One of the main problems with any new
creative compliance scheme is that there is
always a certain amount of uncertainty about
the acceptance by regulators and companies.
The premium put convertible bond was Iirst
issued by Burton Group plc, the offshore con-
vertible preference share by United Biscuits plc
and the convertible capital bond by J. Sains-
bury plc. At the time of issue, all three were
well-respected names in the marketplace.
When asked whether this was a deliberate strat-
I8 February 1992.
I9 March 1992.
egy adopted by the issuing bankers, Banker M
replied:‘”
Yes I think issuance by big names helps the credibility
and popularity of these instruments. Often, the later
issuers use their accounts as a way of bargaining with
the auditors. As a result, the initial rubber stamp has
implications on all the other firms’ accounting choices.
Similarly, Banker B said on the invention of the
Convertible Capital Bond: l9
We are in the business of serving big customers - it is
clearly important that we do not do the first issue for
someone like Polly Peck. To do an issue for Sainsbury’s
-
we were actually very lucky. They wanted to do one
at that time and we analysed the whole scheme very
carefully as a result. It does help our profile to make an
initial issue with a big name.
Hence professionals actively manage the inno-
vation and avoidance process in a way which
ensures maximum acceptability by regulators.
As we saw earlier, in both accounting and tax
matters, advance clearance is sought from the
regulators - auditors in accounting matters and
tax inspectors in tax affairs. To manage the cred-
ibility of the schemes, they prefer to use well-
established clients for the earlier issues.
So far, there has been little discussion on the
role and attitudes of the accounting regulators
during this period. In their review of U.K.
Financial Reporting, Tweedie and Whittington
(1990) had this to say on resolving the pro-
blems of creative compliance (p.96):
One approach is to deal with each (accounting)
problem on a fire Eghting basis. This has of necessity
been the characteristic of much of the earlier efforts of
standard setters. However treating the symptoms
rather than the disease can lead to the problems re-
emerging in a different form, designed to circumvent
the new detailed prescriptions
This is a good explanation of what happened in
the convertibles episode. The next section is
34 A. K. SHAH
devoted to an examination of the regulatory
backdrop during the period and the specific
responses made by the regulatory bodies.
1987-90 was a period of change in the struc-
ture of accounting regulation, as we will see
below.
REGULATORY RESPONSE AND A SHIFTING
OF THE DIALECTIC
The United Kingdom has had a long tradition
of self-regulation in financial reporting (Whit-
tington, 1990). The principal standard setter,
the Accounting Standards Committee (ASC),
was a part-time body comprising primarily of
accountants in professional practice and had
very limited resources. During the midg0s it
was widely criticized for its ineffectiveness in
standardizing accounting practice. Whittington
(1990, p. 196) noted:
With regard to the content of standards, a widespread
criticism is that the ASC has, because of its weak enfor-
cement powers, had to take a consensus view and has
frequently changed its mind or made concessions to
placate pressure groups. More fundamentaIIy, the
ASC has tended to lack a consistent set of centraI con-
cepts which would lend coherence and consistency to
the set of standards as a whole.
Audit partner A, a senior member of the Insti-
tute of Chartered Accountants in England and
Wales, had this to say on U.K. accounting stan-
dards:*’
I think that U.K. accounting standards are amongst the
weakest in the developed world, and there is slgni6cant
scope for subjectivity and creativity.
This regulatory system placed a significant reli-
ance on the auditors’ exercise of professional
judgement in areas where there were no spe-
” Interview, March 1992.
*’ Hughes & Lubbock (1989).
** Interview, March 1992.
cific pronouncements. The “true and fair view”
concept which is unique to U.K. accounting is
an illustration of the belief that auditors are
capable of evaluating the overall picture of
financial performance provided by a set of
financial statements (McGee, 1991). However,
the evidence in this study shows that auditors
provided advance clearances and cooperated
with their clients, permitting the violation of
TR677. Some of them openly critiqued the
importance of TR677’l and those who did
decide to take a stand often felt powerless in
doing so. Audit partner A commented:22
Often when we raise a critical accounting issue with a
&em, they have on their desk two stacks of accounts:
one stack of firms audited by us and another of other
large companies. They Inevitably find one set of
accounts where the accounting policy is very similar
to theirs, and the audit partner has dlflicuhy arguing
against that. Unfortunately, In these dlfficuh times, part-
ners are afraid to lose a client and are under great pres-
sure to compromise.
Hence the combination of self-regulation of
accounting and the emphasis on commercial
values within the auditing firms provides an
antedote for compromise by the “quasi-regula-
tors”. Although the regulatory system places a
strong reliance on auditors, those who wish to
take a stand against their clients often feel
powerless to do so, owing to the lack of inter-
nal agreement within the profession. It is there-
fore no surprise that creative compliance
would thrive in such circumstances.
As a result of the public concerns about the
effectiveness of accounting regulation, a new
regime of accounting regulation was devel-
oped by the Dearing committee in 1988 (Dear-
ing, 1988), and the revised structure had more
resources and comprised full-time staff. It was
not mandatory for companies to comply with
the standards issued by the Accounting Stan-
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 35
dards Board, but directors were required to
report any deviations and the Financial Report-
ing Review Panel had the power to take dissen-
ters to court. This provided the new regime
with some degree of legal backing. In 1989, a
new Accounting Standards Board was estab-
lished under the oversight of the Financial
Reporting Council.
It was against this backdrop of turmoil and
self-regulation in the accounting standard set-
ting process that the present case study is set.
At the time these instruments were developed,
many of the “creative compliance experts” saw
through direct experience that there was little
to fear in the way of effective reprisals from the
accounting regulators. As one senior invest-
ment banker who developed the convertibles
stated when interviewed:23
On the accounting side, there is usually a lot of discre-
tion as the rules are not all clearly detined. The clients
get their assurance from their auditors - clearly stan-
dards can change but that is the risk that clients have to
take. We know that it takes years for an accounting
standard to be introduced - hence ft is not a big
worry.
Hence the weakness of the accounting regula-
tory regime during 1987-90 was exploited by
the financial engineers. When the audit partner
involved in the revision of TR677 was asked
about the chaos surrounding the accounting
policy for convertibles, he explained:**
I think that the profession is split on the issues. Many
technical partners are concerned about creative
accounting, but other partners are not. However, the
new ASB structure seems to be an interesting develop
ment, and the Review Panel has some force. I do think
that the profession needs some sort of outside regula-
tion or backing - in the long run, it will help us.
The regulators were not entirely unaware of
the abuses (e.g. TR677 was issued in January
*’ Banker B, January 1992.
24 Auditor A, March 1992.
*5 Interview, January 1992.
1988). However, they were generally slow to
respond - it took another three years for an
exposure draft to be issued, which would still
be a precursor to an accounting standard. In
February 1991, a further technical release on
the treatment of the supplemental interest
TR827 was issued by the Institute of Chartered
Accountants in England and Wales (ICAEW,
1991) which required that all companies
should provide for the supplemental interest
without exception. In December 1991, the
newly formed Accounting Standards Board
made the convertibles problem a priority and
issued a detailed and lengthy discussion paper
(Accounting Standards Board, 1991). This pro-
posed standard clamped down on premium put
convertibles, requiring amortization of supple-
mental interest and the debt classification of
convertible capital bonds. It took another two
years until November 1993 before this discus-
sion paper was finally converted into a manda-
tory
accounting standard (Accounting
Standards Board, 1993).
From the above, we can see that within the
space of four years, there were four different
accounting pronouncements made by the pro-
fession or standard setters. This is evidence of
the length of time it takes regulators to react to
accounting abuses, and the difficulty of obtain-
ing consensus on the issues. The need for con-
sultation also provides an opportunity for
lobbying by professionals and companies to
obtain the accounting treatment which is
favourable to them.
When asked for comments on the Account-
ing Standards Board discussion paper, Banker B
stated:25
1 have a colleague who is closely looking at the discus-
sion paper. We think the day of having your cake and
eating it too is probably coming to an end with the new
36
A. K.
regime. The regulators have problems because compa-
nies have pushed it a bit too far.
Hence now the fault lies with companies. In
fact such was the interest in this proposed
standard that it hit number one in the Accoun-
tancy Age bestseller list. The release of the dis-
cussion paper did have one noticable effect -
it stopped the issuance of convertible capital
bonds or any other type of sophisticated con-
vertibles for a while.26 It was interpreted by the
financial engineers as a signal of tighter regula-
tion, and the new Accounting Standards Board
was also receiving positive media coverage
owing to the creative accounting abuses of
the 1980s. However, in 1993, one training
lirm IBC Legal Services, started running
courses on “Off Balance Sheet Finance and
Capital Instruments”. The lectures were deliv-
ered by senior professional auditors, bankers,
tax practitioners and investment analysts. This
one day course covered the new discussion
papers and proved very popular. The advertise-
ment for the third such course stated in the
accompanying letter from the producer
(dated November 1993):
Attendance at this event should update your knowledge
so you can:
. assess current schemes and processes;
. respond to the standards;
l create new beneficial schemes.
Hence the field had already moved on to a
hitherto unregulated area. For a fee of &345,
participants could meet the experts and learn
the latest avoidance devices, for which profes-
sional co-operation would then be required for
implementation.
CONCLUDING REMARKS
The practice of creative accounting under-
mines the very credibility of accounting prac-
tice. To date, there has been a significant
__
SHAH
amount of literature on the variety of abuses
and whether or not the stock market is capable
of seeing through accounting numbers. There
has also been speculation about the existence
of creative compliance (Tweedie St Whitting-
ton, 1990, p.96). However, there is no study
in the literature which examines the mechan-
isms by which creative compliance in account-
ing is achieved in practice. Tracing this process
of creative compliance was the principal aim of
this study. Examination of financial engineering
in convertible securities exposed the close co-
operation between various groups of profes-
sionals - lawyers, accountants and bankers
-
in the development of the schemes. Compa-
nies were willing to subscribe to these schemes
at a significant cost, and for a while, successful
creative compliance was attained. Regulators
were slow to respond, and when they did
make pronouncements, companies once again
circumvented the rules with the help of various
professionals. Auditors compromised their
position as quasi-regulators and permitted com-
panies to circumvent best practice.
This study documented the close co-opera-
tion of auditors and also exposed the involve-
ment of lawyers in the design of these
instruments, suggesting that creative compli-
ance schemes require direct co-operation
from professionals who are familiar with the
existing regulations and can provide the neces-
sary credibility to the new schemes. It was
interesting to see that only a small group of
professionals were involved in the design and
execution of the schemes, and such were the
perceived commercial benefits that they went
on to market them to new potential clients
with the hope of enhancing their profits. A
driving force behind the market for creative
compliance is the ability and willingness by
companies to pay the significant costs charged
by these innovators.
During the period of the study, accounting
regulation was undergoing a process of instabil-
ity and reform, and this weakness was
” Evidence obtained from examination of new issues in 1991 and 1992
CREATIVE COMPLIANCE IN FINANCIAL REPORTING 37
exploited. The importance of accounting infor-
mation to reporting companies and their stake-
holders provides a vibrant demand for creative
compliance schemes by management if the
(unadjusted) accounting numbers fail to por-
tray a desired picture of financial perfor-
mance. In the field of taxation, both lawyers
and accountants in the United Kingdom have
been actively involved in developing and mar-
keting tax avoidance schemes (McBarnet,
1991). The fact that these skills could be trans-
ferred to the accounting arena for potentially
lucrative returns is perhaps a more recent dis-
covery. It is worth noting that even though the
Accounting Standards Board developed tough
new rules, it did not act directly against this
practice of creative compliance and the profes-
sionals involved. It may be that one way of
achieving legal control is to regulate more
directly the activities of these professionals,
although the mechanisms for doing so are
beyond the scope of the present study.
The phenomenon of obtaining advance
clearances (from auditors in the case of
accounting and from the Inland Revenue in
the case of tax uncertainty) indicates a degree
of complicity by the regulators in the develop
ment of successful creative compliance. The
self-regulatory environment in the U.K. and
the dual role of auditors as professional advi-
sers as well as quasi-regulators helps explain
the accountants’ role in providing advance
clearances. However, the role of tax inspectors
is somewhat more curious. McBamet (1991, p.
331) reports how this process of obtaining rev-
enue clearance is actively managed in such a
way that only partial elements of the scheme
are disclosed at any one time to an inspector. It
is also worth noting that just as creative com-
pliance schemes in accounting cannot easily be
developed and implemented by the companies
acting alone, in a similar way professionals act
as mediators in the negotiation of tax payments
to the Inland Revenue (McBamet, 1991).
Advance clearances reduce the uncertainty
which might otherwise surround the success
of a creative compliance scheme.
It may be argued that by developing or co-
operating in the development of such creative
compliance schemes, professionals are being
unethical. At a personal level, there was no
hint of fear of reprisal from the regulators or
the professional bodies for the individuals con-
cerned. None of the professionals interviewed
for this study felt that what they were doing
was unethical, probably due to the fact that
no single individual or firm devised and mar-
keted the scheme in its entirety. Groups of
professionals acted in concert.
The study also exposes a wide divergence
between market influences on the methods of
conducting business and the structure of regu-
latory bodies. The barriers between account-
ing, law, taxation and finance are fast
disappearing in the modem world, yet the reg-
ulatory institutions are quite distinct. For exam-
ple, in the United Kingdom, tax regulation
comes under the ambit of the Inland Rev-
enue, accounting regulation under the
Accounting Standards Board and finance regu-
lations are determined by the London Stock
Exchange. In the case of convertibles, had the
three bodies cooperated much earlier on,
there may have been a clearer overview of
the intentions of these instruments, and it is
possible that immediate sanctions could have
been exercised. As Dezaley (1991) notes, mar-
ket forces are encouraging the break-up of pro
fessional barriers and this may be time for a
substantial rethink of the roles and effective-
ness of regulatory institutions.
In addition, the globalization of professional
firms and financial institutions makes it easier
for them to identify and exploit differences
between regulations in different countries. In
this case study, we saw how as soon as the
Inland Revenue hardened its attitude to the
Netherlands Antilles offshore tax haven, the
schemes were restructured and exploited
another offshore tax haven - Jersey. Thus
not only national but international differences
in regulations can also be actively exploited,
making localized regulatory institutions appear
helpless in preventing such avoidance.
38 A. K. SHAH
BIBLIOGRAPHY
Accounting Standards Board, PRS4: Accounting for Capital Instruments (London: Accounting Standards
Board, November 1993).
Accounting Standards Board, D&ussion Paper Accounting for Capital Instruments (London: Account-
ing Standards Board, December 1991).
Accounting Standards Committee, Statement of Standard Accounting Practice No. 2: Disclosure of
Accountfng Polkies (November 1971).
Adam, N., Lung Ilve the Converdble, i%e BanJzer (May 1988) pp. 50-51.
Beare, T., Convertible Capital Bonds, ?%e Ta.z Journal (20 September 1990) pp. 4-6.
Blackie, H., Convertible Bonds An End to the Controversy, The Treasurer (September 1988) pp. 72-
73.
Burton Group PLC, Annual Report: Year ended 3 September 1988 (London: Burton Group, 1988).
Chapman, A., The Meaning of Ordinary Share Capital, flbe Tax Journal (11 January 199Oa) pp. 22-23.
Chapman, A., In the Group but off the Accounts, The Tax Journal (11 January 1990b) pp. 8-9.
Dearing, R., Z&e Making of Accounting Standards (London: Institute of Chattered Accountants in
EngIand and Wales, 1988).
Dezalcy, Y., TerritoriaI Battles and Tribal Disputes, The Modern Law Review (November 1991) pp. 792-
809.
Dow, R., Convertible Capital Bonds: The New Financing Solution, Practicul tiw for Companies (August
1990) pp. 7-14.
Freedman, J. &Power, M., Law and Accounting: Ttansition and Transformation, T&e Modwn Law Reufew
(November 1991) pp. 769-791.
Hopwood, A., Ambiguity, Knowledge and Territorial Claims: Some Observations on the Doctrine of
Substance over Form: A Review Essay, BtlNsb Accounting Revkw (March 1990) pp. 79-87.
Hughes, N. & Lubbock, E., Euroconvertible Preference Shares, The Treasurer (April 1989) pp. 43-45.
Institute of Chartered Accountants in England and Wales, TR677 - Accounting for complex capid
issues, Accountancy @nuary 1988) pp. 147-148.
Institute of Chartered Accountants in EngIand and Wales, TR827 - Convert&&? Bonds