http://orcid.org/0000-0002-6557-7981
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ABSTRACT
This study responds to recent calls in the literature to examine fraud using detailed case studies, extending knowledge beyond individual incentives and capital market reactions towards a more contextualized understanding of the concept. We use an institutional logics perspective to challenge existing assumptions about a universally valid meaning of compliance, fraud, and faithful representation. Presenting the case of the Swedish bank HQ, we show how the interpretation of the accounting standard for option measurement varies across different enforcement bodies because the meaning of compliance is socially negotiated across the institutional logics of markets, financial regulation, and law. The independent decision-making of the different enforcement bodies leads to a systematic variation in the interpretation of principles-based accounting standards without ultimate coordination. To define consistent boundaries of compliance across institutional logics, and thus, to distinguish between fraud and allowable managerial discretion becomes problematic. Faithful representation, in turn, cannot be understood as financial statements reflecting a correct value or as financial statements being prepared in accordance with acceptable practice, as suggested in the earlier literature. Instead, faithful representation itself becomes a contextually bound concept, which can only be defined within an institutional logic.
Acknowledgements
The authors would like to thank Jan Mouritsen, Joanne Horton, two anonymous reviewers and guest editors Daniel Beneish and Ignace De Beelde for constructive and helpful comments..
ORCID
JAN MARTON http://orcid.org/0000-0002-6557-7981
Notes
1 The relevant accounting standard in relation to the measurement of the trading portfolio was the version of IAS 39 in place in 2009, as endorsed by the EU. This version differed from the IASB version of IAS 39 in one paragraph, related to hedge accounting, which has no bearing on this case. IFRS 13 Fair Value Measurement had not been issued at the time FI revoked the charter and was therefore not applicable. In addition to IAS 39, the bank’s compliance with IFRS 7 Financial Instruments: Disclosures was assessed by FI and the court. The court concluded that there were minor deviations from the disclosure requirements, which were not found misleading in a way that could lead to sentencing for swindling (Stockholm District Court, Citation2016). This aspect of the trial, however, is of less relevance for our discussion of the case and we therefore focus our attention on the interpretation of IAS 39.
2 The case of the failed Swedish bank is the first example of a sufficiently severe breach (or non-breach) of the EU IAS/IFRS Regulation (EC/1606/2002) to be brought to a criminal trial in Sweden. To clarify the legal context, we want to highlight that a decision from FI is only normative for the party or parties addressed by the decision; it cannot be used to draw any general conclusions on the interpretation or application of the law. A judgment from a court of law has a higher legal value compared to a decision from an authority. However, as the judgment in the criminal trial of the HQ case has not been tried in a court of appeal, and a judgment from a district court has a very restricted legal value in Sweden, it is difficult to use the judgment as a precedent for how the law should be applied in future cases. The reasoning in the judgment, as well as in the decision by FI, is nonetheless interesting to analyze and compare, to discuss how accounting standards and other regulations are apprehended, construed, and applied by different actors and enforcers. This study therefore discusses the grounds for the judgments of the different parties and not the actual ruling or final decision.
3 In this study, we refer to the concept of fraud as used in an accounting context; that is, we do not restrict the use of the term fraud to the legal definition found in, for example, Swedish criminal law. Brottsbalken (the Swedish Penal Code) defines fraud as:
If a person by deception induces someone to commit or omit to commit some act which involves gain for the accused and loss for the deceived or someone represented by the latter, imprisonment for at most two years shall be imposed for fraud. (the Penal Code, Chapter 9, Section 1, emphasis added)
4 Examples of fictitious accounting transactions include recognition of fictitious sales, inflation of inventory quantities, or fraudulent disbursements.
5 A more specific definition of fraud in the accounting context is presented by Riahi-Belkauoi and Picur (Citation2000). They define fraud as corporate fraud, white collar crimes, and audit failures. In total, the authors present 14 types of corporate fraud. In this study, however, we limit our focus to fraud connected with financial statements.
6 A subsequent civil court trial was concluded in December 2017. Thus, the HQ case gives the opportunity to investigate four types of logic, because criminal law and civil law logic are distinctly different. However, a detailed analysis of the civil court trial lies outside the scope of this study (see Section ‘Epilogue’ for a short introduction to the judgment of the civil trial).
7 The twofold enforcement system for the banking industry is not specific to Sweden but is found in most advanced economies in the world.
8 We acknowledge that a distinction must be made between the consolidated financial statements issued by the parent company with relevance for the stock exchange and the corresponding enforcement, and the separate financial statements relevant for banking supervision. However, in this case, the two levels of financial statements relate to the same accounting standards, and the basis for interpretation of the standards is therefore the same.
9 To give an indication of the resources spent in the case: the defense attorneys alone were granted 37 million SEK (about 4 million EUR) by the district court for expenses related to the case.
10 The focus of investigation therefore lies in the interpretations of the standard by the different actors (i.e. compliance), not in the analysis of the actual decision by FI or the judgment by the court.
11 See Jones (Citation2011) for an expanded overview of the different definitions.
12 See Cooper et al. (Citation2013) for a detailed overview of existing themes in the current fraud literature.
13 There is no generally agreed upon definition of an institution. For this study, we use the general definition provided in old institutional economics because it includes both ordering of thought and activity: ‘a way of thought or action of some prevalence and permanence, which is embedded in the habits of a group or the customs of a people’ (Hamilton, Citation1932, p. 84; cited in Scapens, Citation1994, p. 306). Friedland and Alford (Citation1991, p. 243) provide a similar definition of the institution, adding that institutions are also symbolic systems through which actors order reality and render time and space meaningful.
14 The analysis in this case study is based on the criminal trial and therefore focuses on the relationship between economic, regulatory, and criminal law logic. Civil law logic is briefly discussed in the epilogue to this study.
15 The Rule of Law refers to a set of principles considered fundamental for any democratic society, foremost that all citizens, including those persons that create and enforce the law, are equally subject to publicly disclosed legal codes and processes, and that the law has a constraining authority upon the behavior of the government.
16 We use the word ‘regulator’ to refer to FI in its role as banking supervisory authority. Other regulators, such as securities market regulators, may have a logic that is aligned with that of equity investors.
17 States have limited positive exposure but potentially negative exposure without a clear limit (Bushman & Williams, Citation2012). Creditors and states exhibit a similarity in economic exposure and arguments on financial statement usefulness are therefore similar in the two cases.
18 Interestingly, the Swedish government came to a similar conclusion in relation to accounting for taxation purposes. In the Swedish government bill to implement the IAS/IFRS Regulation in Sweden (Proposition 2004/05:24), the issue of mandating or allowing IFRS in single company financial statements was discussed. As Sweden maintains a link between financial reporting in single company accounts and taxation (Marton, Citation2017), the bill concludes that IFRS cannot be allowed for single company financial statements because IFRS is focused on international equity investors and do not consider local legal and tax issues. Despite this statement, FI required IFRS with only minor exceptions in the individual financial statements of Swedish banks from 2005.
19 This section is based on data obtained from Neurath (Citation2011), Stockholm District Court (Citation2016), FI (Citation2010), and HQ’s 2009 financial statements which were the last annual statements issued before the closure of the bank.
20 In Sweden, the enforcement of the IAS/IFRS Regulation has been delegated by FI to the stock exchanges. In accordance with the FI decision, the Stockholm Stock Exchange (SSE) concluded on 19 May 2011 that HQ did not apply IAS 39 correctly, and a fine was issued (SSE, Citation2011).
21 In detail, RN concluded that the auditor correctly ascertained that HQ had a reasonable method of determining whether markets were active or not and that the interpretation of observable market data in the measurement was within the boundaries of IAS 39. RN elaborated that there were minor, not material, deviations from IFRS and that not all specific disclosure requirements in IFRS 7 were followed, but that the notes in the annual report were transparent on an aggregate level. RN therefore gave the auditor only a minor reprimand for weaknesses in the documentation of the audit.
22 The listed parent company HQ AB applied IFRS in the preparation of consolidated financial statements in accordance with the IAS/IFRS Regulation. All trading activity took place in the consolidated subsidiary HQ Bank AB. The individual financial statements of HQ Bank AB were also prepared in accordance with IFRS (endorsed by the EU), based on Swedish FI Regulations. The district court judgment referred to the consolidated financial statements, while the FI decision on the bank charter referred to the individual financial statements. However, both decisions refer to the same accounting standards and the same transactions.
23 Sven Hagströmer, the other founder, was no longer involved in the bank, and therefore not part of the trial.
24 The DAX index reflects the 30 largest equities on the Frankfurt stock exchange and the OMX30 includes the 30 largest equities on the Stockholm stock exchange.
25 The Black-Scholes valuation model is an algorithm that produces an option value based on certain inputs. If the value and all but one input variable are known, the remaining input variable can be calculated. For options traded on active markets – where a value is readily available – this method can be used to calculate the market’s expected volatility, called ‘implied volatility’. Historic volatility is calculated by simply looking at the actual volatility of the index for a specific historic period preceding the measurement date.
26 The documentation of the court trial exposes substantial discussion inside the accounting firm showing no general agreement with HQ’s valuation technique. This could be interpreted as an indication that the technique was controversial. However, it could also be interpreted as a natural part of applying principles-based standards in an area characterized by a high level of judgment.
27 The indication of reliability through a clean audit opinion is limited because of the difficulty of auditing fair value measurements (Power, Citation2010). Nevertheless, a Big Four audit still sends a clear sign of assurance to the financial markets.
28 The establishment of an error is linked to the boundaries of the accounting standard – a procedural assessment – and not to the resulting total amounts of the measurement, a view indirectly expressed by the judge in the criminal court case. The dissenting board member was called as a witness. Because she stated that she had deep knowledge of option valuation, but no knowledge of accounting or of IAS 39, her testimony was not effective in convincing the court that a measurement error had occurred.
29 Prudence is used here in a broad sense, meaning lower risk taking and having adequate reserves. It is not meant to equal accounting conservatism, in terms of an asymmetric valuation of assets and liabilities, and gains and losses, respectively.
30 All these crimes – with the possible exception of faulty bookkeeping – would fit the definition of fraud used in this study and in the accounting literature. In accordance with Swedish law, none of them were actually defined as fraud. The court’s response was an acquittal of the defendants in all cases. The first plea, for faulty bookkeeping, was rejected on a technicality because the Swedish law referred to does not apply to accruals but only to transactions with outside parties.
31 There were four parts to this plea: 1. incorrect profit and loss accounting, as immediate gains and losses were recognized even though the measurement technique partly relied on unobservable inputs; 2. HQ’s own rule to determine whether markets were active or not was not consistently applied; 3. regarding recognition of immediate gains and losses, HQ refrained from disclosing in the financial statements a reason for this deviation from IFRS; and 4. HQ did not follow the disclosure requirements in IFRS 7 or provide an explanation for the deviation.
32 The interpretation and application of the principles-based regulation are more flexible than rules-based regulation. A strict reading of principles-based accounting standards is not possible in the same way as for other legal requirements of the Swedish Penal Code in the criminal law context, which is more rules-based. In other legal contexts, such as civil law, principles-based regulation allows substantial room for different opinions. In the case of HQ, the court in the civil case found the measurement practice non-compliant with the standard (see epilogue).
33 Although there are aspects of IAS 39 that arguably are rules-based (e.g. effectiveness of hedge accounting), the standard is principles-based in relation to the fair value measurement of index options. As we have shown in this study, substantial judgment is required to determine whether markets are active or not, and to estimate the volatility expected by the market.
34 The standard setter argued for faithful representation because verifiability requires an agreed upon referent in the form of readily available market data (a transaction or quoted market price), but even if a value is not readily verifiable, it might still be relevant for market participants (IASB Conceptual Framework, BC2.62).
35 An interesting side effect of this tension is that the role of auditors becomes more complex as well, because auditors form part of the enforcement system while at the same time relying on market logic.
36 As discussed in the epilogue, this issue becomes even more prominent when taking into account that the legal context contains more than one institutional logic, because criminal law logic and civil law logic are distinctly different in their underlying assumptions and requirements.
37 The actual outcome of the trial was that the plaintiffs lost the case regardless of HQ’s non-compliance with IAS 39. The judgment by the court was based on the reasoning that the measurement error was not the proximate cause of the plaintiffs’ losses.
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