Upload
others
View
0
Download
0
Embed Size (px)
Citation preview
1
The management of accounting numbers – case study evidence
from the ‘crash’ of an airline
Ann Jorissen (University of Antwerp)
David Otley (Lancaster University Management School)
2
Abstract
Earnings management has usually been analysed by largescale empirical research.
However, the generality gained from such an approach is at the cost of understanding the
rich and complex nature of earnings management in real organizations. Responding to a
plea in the literature that most studies on earnings management did not take an
integrated perspective and generally failed to distinguish appropriately between what is
endogeneous and exogeneous, we adopt a case study approach based on internal
company data to gain more insight into the managerial incentives which drive the
decision to engage in earnings management and the underlying processes which are
triggered by this decisions. Through such a qualitative analysis we are able to uncover
facts which contradict previous findings.
Using a multitheory perspective we observe that the direction of the causation assumed
in the agency framework is often reversed and that managerial incentives to engage in
earnings management are influenced by the strategic choice of the top management team
and the contents of the nonnegotiable contracts of the firm. The case findings provide
insights into a number of additional variables, uncovered by prior empirical studies,
which enlarge the discretion of the CEO to engage in earnings management.
3
Introduction
In the autumn of 2001 two major European airlines, the Swiss airline Swissair and the
Belgian flag carrier Sabena, ceased to exist. These corporate collapses, especially that of
Swissair (part of SAirgroup), came as a surprise to many people. A report undertaken at the
request of the administrator of the SAirgroup was finalized in January 2003 1 and the
accompanying press release stated:
“The unconsolidated and consolidated financial statements for 1999 and, to a much greater
degree, for 2000, did not fairly present the economic and financial situation of the
SAirgroup”.
The group had thus succeeded in presenting information about its financial position and
performance which was substantially different from the true underlying economic performance.
Unfaithful representation of economic performance through accounting numbers (Lee, 2006) or
earnings management, is not a new phenomenon and it has been researched for many years.
However, due to several scandals at the start of the 21sth century (e.g. Enron, Worldcom,
Parmalat, Ahold) research in the broad domain of earnings management has intensified. The
majority of studies adopt the definition of Healy and Wahlen (1999) that “earnings management
occurs when managers use judgment in financial reporting and in structuring transactions to alter
financial reports to either mislead some stakeholders about the underlying economic performance
of the company, or to influence contractual outcomes that depend on reported accounting
numbers (Healy and Whalen, 1999)”
1 (‘The Investigation Report’ ‘Ernst & Young Bericht in Sachen Swissair’)
4
These studies try to understand why managers manipulate earnings, how they do so and what the
influences and consequences of this behaviour are (Mc Nichols, 2000), although they follow
different theoretical paradigms.
First, there is a capital market stream, mostly grounded in the agency theory (Jensen and
Meckling, 1976; Fama and Jensen, 1983) which focuses primarily on the incentives embedded in
the external and internal contracts governing the firm. (e.g. Barth, Elliot & Finn, 1995; De
Angelo, De Angelo and Skinner, 1996; Hunt, Moyer and Shevling, 1995; Degeorge, Patel and
Zeckhauser, 1999; DeFond and Jiambalvo, 1994; Sweeney, 1994; Key, 1997; Han and Wang,
1998; Healy, 1985; Holthausen, Larcker and Sloan, 1995; Bartov, 2001). This stream of research
also tries to identify those situations which lead to inefficient contracting whereby the discretion
provided to managers enables them to increase their wealth by altering the accounting numbers
(e.g. Hope, 2003; Leuz, Nanda and Wysocki, 2003; Donelly and Lynch, 2002; Ball, Kothari and
Robin, 2000). Second, research on earnings management within the critical perspectives
literature concentrates mainly on the contextual variables which facilitate or incite management to
manipulate accounting numbers (e.g. Brillof, 2001, Revsine, 2002, O’Conell, 2004; Benston and
Hartgraves, 2002; Lee, 2006; Williams, 2004). The results of this stream of research emphasize
the importance of improved regulatory enforcement to the provision of better quality financial
information to stakeholders. Third, the governance literature attempts to provide insight into the
role of governance quality and board monitoring in restraining earnings management (e.g. Boyd,
1994; Beasly, 1996; Peasnell, Pope and Young, 2001).
Despite these numereous studies, Fields, Lys and Vincent (2001) argue that only modest progress
has been made because there have been few attempts to take an integrated perspective and also
because accounting research generally failed to distinguish appropriately between what is
endogeneous and exogeneous. Dechow and Skinner (2000) state that the lesson from accounting
5
research is that measures of earnings management devised by academic researchers have not been
very powerful in identifying the practice. Dechow and Skinner (2000) argue therefore that a more
fruitful way to identify firms whose managers practice earnings management is to focus on
managerial incentives. With this paper, we want to respond to these pleas. By adopting a case
study approach based on internal company data and by taking an integrated perspective, we
attempt to shed light on the distinction between which variables are exogeneous and which have
an endogeneous character in relation to earnings management. Next we try to gain additional
insights on the managerial incentives which stimulate the decision to engage in earnings
management through a multitheory lens on the case data. Further we try to uncover mechanisms
facilitating earnings management, in addition to those revealed by agency research.
Most studies of earnings management (especially in the capital market and governance
literatures) adopt a quantitative approach using large scale public archival data bases. A small
minority of articles adopt a different methodology. For example, Nelson (2002, 2003) and
Graham (2005) used survey research in order to detect the drivers of earnings management and
the methods employed to manage accounting numbers. A number of studies in the critical
perspectives literature (Benston and Hartgraves, 2002; Lev, 2002; Arnold and de Lange, 2004;
Baker and Hayes, 2004 ) and Lys and Vincent (1995) and de Jong, De Jong, Mertens and
Roosenboom (2007) situated in the capital market based stream, used a case study approach.
However all these case studies are based on publicly available financial data.We opted for a case
study based on internal company data as it provides for a richer exploration of the
interrelationships among the variables which stimulate or influence earnings management and the
processes which are triggered by the decision to engage in earnings management. Through such a
qualitative analysis we are able to uncover facts which contradict previous research findings.
6
This paper distinguishes itself from other studies by the character of the research methodology
(case study) applied in combination with the data employed (internal company data). It also uses
a multitheory approach which explicitly considers the central role of top management in the
decision to engage in earnings management.
The agency studies implicitly assume that managers make decisions on a rational, economic self
interested basis and that they all react in an identical way to incentives, opportunities and
constraints embedded in the contracts governing the firm. However, the management literature,
grounded in Cyert and March’s ‘behavioural theory of the firm‘ (1963), indicates that managers
are often faced with bounded rationality and that they must act in a social context of multiple and
conflicting goals. Based on Cyert and March’s concept of bounded rationality, Hambrick and
Mason (1984) elaborated upperechelons theory which suggests that an organization becomes a
reflection of its top executives and that the characteristics and functioning of the top management
team have a great influence on organizational outcomes. These complimentary perspectives from
management theories provide a richer theoretical context for a study on the incentives and
methods of earnings management.
The paper is structured as follows. In the next part, the variables which will guide our
framework of analysis will be derived from the literature. In the third part, the research
method and the case company will be outlined. In the fourth part, the case data which relate
to the longitudinal analysis of the strategic choice and the earnings management methods
employed will be presented and discussed. In the final part of the paper we develop the
insights derived from the multitheory approach on the process of earnings management.
The analysis of the case data reveals that the direction of causation assumed by earnings
management studies framed in agency theory is often reversed. When accounting choices are
determined endogeneously with the strategic choices of top management, a reverse causation for
7
those contracts of the firm which top management is able to renegotiate is observed. The non
negotiable contracts of the firm in combination with the strategic choice of top management
shape the adopted reporting strategy. Further the case results indicate that mainstream
empirical research has not uncovered all the variables embedded in the organization and its
environment which create discretion and opportunities for earnings management. On addition to
the variables already revealed by agency research namely: company characteristics and
institutional variables, we observe the need for the CEO to create the necessary internal discretion
by altering a number of internal organizational and management variables such as: the
composition of the dominant coalition in the firm, the organizational structure, the investment
characteristics and the management control systems of the company.
8
2. Literature review
This review of the literature will outline the content and limits of prior research and point to gaps
in the existing literature that our study will address. Second , a framework for analysis will be
developed which will guide the choice of events to analyse in the case study.
2.1. Overview of the accounting literature
As mentioned in the introduction we define earnings management using the widely adopted
definition of Healy and Wahlen (1999). If we analyze this definition of earnings management
and relate it to the extant literature, we make two major observations. First, the definition of
earnings management encompasses the management of balance sheet numbers as well as the
management of earnings numbers. The majority of studies in the literature however constrain
earnings management exclusively to the management of the earnings numbers. Only a few studies
examine the management of balance sheet numbers (Shevling, 1987; Ely, 1995; Bauman, 2003)
despite their importance, for example, in connection with covenants and credit ratings.
Second we notice that the definition of Healy and Wahlen allows two possible methods for
influencing accounting numbers. We distinguish accounting earnings management (or accruals
management i.e. manipulations by reference to selective interpretation of accounting regulations)
from real earnings management (i.e. management operating decisions made to achieve desired
accounting numbers). Most studies to date have analyzed earnings management by studying only
accruals management (Dechow, Sloan and Sweeney, 1995; Beneish, 1997; Mc Nichols, 2000).
Only a limited number of studies have studied the practice of real earnings management (see
Roychowdury 2006, Wayne, Hermann and Inoue, 2004). In addition, a few studies analyze
9
earnings management by capturing the overall impact of both methods on the earnings figure of a
company by using “distributional” studies, which test whether the distribution of earnings around
benchmarks differs in some predicted way from what would be expected in the absence of
earnings management (Burghstahler and Dichev, 1997; Degeorge, Patel and Zeckhauser 1999;
Beatty and Petroni, 2002).
This observation implies that only research on earnings management through accruals is well
developed. However analytical studies (Ewart and Wagenhofer, 2005) and recent survey research
(Nichols, Elliot and Tarpley. 2002, 2003; Graham, 2005) provide evidence that corporate
management uses both methods to influence the accounting reports. Nichols et al. (2002)
suggests that detailed guidance in accounting standards reduces earnings management achieved
through management judgments (=accounting earnings management or accruals management)
and increases earnings management achieved through transaction structuring (= real earnings
management). In this study we will consider both accounting and real earnings management as
methods employed by corporate managers to influence earnings as well as balance sheet
numbers.
We now consider the research stream which tries to uncover the drivers of earnings management.
Evidence is available that listed firms have an incentive to show a recurrent and increasing stream
of earnings (Barth, Elliot and Finn, 1995; De Angelo, De Angelo and Skinner, 1996) together
with low earnings volatility (Hand 1989; Bartov 1993; Hunt, Moyer and Shevlin, 1995); to avoid
small losses (Burghstahler and Dichev, 1997) and to meet benchmarks or targets (Degeorge, Patel
and Zeckhauser, 1999; Kasznik, 1999). Contracts with debtholders also provide all firms with
stimuli to engage in earnings management in order to avoid violation of debt covenants and in
order to obtain a favourable credit rating (De Fond and Jiambalvo, 1994; Sweeney, 1994;
Dechow, Sloan and Sweeney; 1996). Further research indicates that contracts with regulatory
10
authorities provide an incentive to earnings management to avoid regulatory intervention (Key,
1997; Han and Wang, 1998) or to minimize taxation (Beatty, Chamberlain and Magliolo, 1995;
Guenther, Maydew and Nutter, 1997) .
Earnings management is also stimulated by the implicit and explicit internal contracts of the firm.
The threat of a performancerelated CEO turnover creates incentives to match industry
performance (De Fond and Park, 1997; Fudenberg and Tirole, 1995). The incentive to perform
stimulates new CEOs to engage in big bath accounting in their first year of office (Pourciau,
1993; Murphy and Zimmerman, 1993; Godrey, Mather and Ramsay, 2003). Further, ample
evidence is available that reward and bonus plans, which represent the explicit internal contracts
of the firm, drive earnings management (Healy, 1985; Gaver, Gaver and Austin, 1995;
Holthausen, Larcker and Sloan, 1995; Guidry, Leone and Rock, 1999; Bartov, 2001).
A feature of all these studies in this stream of research is that they assume that the incentives for
earnings management are embedded in the contracts governing the firm and that these are
independent variables, which are exogeneous in relation to earnings management.
Prior literature (both capital market based literature focusing on inefficient contracting and the
critical literature) has uncovered opportunities for top management to engage in the management
of accounting numbers. This research indicates that the degree of ownership concentration affects
the nature of contracting and that accounting informativeness declines as ownership concentration
increases (Dempsey, Hunter & Schroeder, 1993; Warfield, Wild & Wild, 1995; Donelly &
Lynch, 2002; Fan & Wong, 2002). Further evidence shows that institutional characteristics such
as the quality of accounting standards (Pope & Walker, 1999; Ball, Kothari & Robin; 2000; Ali &
Hwang, 2000), the degree of investor protection (LaPorta, LopezdeSilanes, Shleifer & Vishny,
1997; LaPorta, LopezdeSilanes & Shleifer, 1998), the risk of litigation (Ball, Kothari and
11
Robin, 2000; Leuz & Verrechia, 2000) and the degree of enforcement (Hope, 2003) all create
opportunities for earnings management. Research which focuses on board characteristics and its
relation to earnings management, provides evidence that when the quality of board monitoring is
impaired by the presence of CEOduality, interlocking CEOs and internal or grey directors further
opportunities for earnings management arise.
The findings of the accounting literature on earnings management are summarized in Figure 1
below. The relationships presented here will also guide our analysis of the case data in part four
of the paper.
[ insert figure 1 here ]
2.2 The management literature: insights from the upperechelons theory and strategic choice
theory
The extant accounting literature has not taken into account heterogeneity among the
characteristics of top managers and its possible impact on earnings management. We will
combine insights from the “upperechelons” tradition in the organization studies literature with
the findings from the accounting literature in order to take a multiparadigm perspective on why
and how managers manipulate earnings. Upper echelons theory suggests that executives will
make decisions that are consistent with their cognitive base (including values, cognitive models
and personality factors, Hambrick and Mason, 1984) and executive orientation (Finkelstein and
Hambrick, 1996). A fundamental principle of upper echelons theory is that observable
experiences (i.e. demographic measures like tenure, age, functional and educational background)
12
are systematically related to the underlying cognitive orientations and knowledge base. In these
theoretical frameworks, the organization becomes a reflection of its top executives, whereby the
CEO functions as the central strategic decisionmaker who is able to control the composition of
the organization’s top strategy making group (Zahra and Pearce, 1989). A large number of
studies, triggered by Hambrick and Mason’s (1984) paper provide evidence that
differences in CEO characteristics and topmanagementteam (TMT) composition (with
respect to dimensions such as tenure, gender, functional and ethnic background, and age)
have an impact on a range of organizational outcomes such as turnover, innovation,
diversification, and organizational performance (Hambrick and Fukutomi, 1991; Jensen
and Zajac, 2004). This implies that a deeper knowledge of the managerial characteristics of the
CEO and of the factors that determine the distribution of power among corporate managers is
required to advance the knowledge on the presence of earnings management and how it is
achieved. As a result we will consider the following insights from power circulation theory and
strategic choice theory, when we analyse the earnings management process. According to power
circulation theory (Ocasio, 1994; Ocasio, 1999) an inside succession following a CEO’ dismissal
reflects a successful internal power contest against the CEO, and the successor is a contending
executive who has won the support and approval of the board of directors. Because power
contestation and CEO dismissal often occur in periods of poor firm performance (Ocasio, 1994;
Puffer and Weintrop, 1991) contender successors will often be charged with initiating strategic
change and improving firm performance. Insights from strategic choice theory reveal that CEOs
chose to initiate a strategic change which closely matches their prior pattern of strategic choice
and which is consistent with their previous background.
3. Research Method
13
3.1 Framework of analysis
Figure 1 describes the framework used to study the earnings management process in the case
company. It reveals the contracts we need to consider and the variables which might represent
available discretion for corporate management to engage in earnings management. We will look
both for the management of balance sheet numbers and the management of earnings numbers. To
do this we will use the definition of accounting choices articulated by Fields, Lys and Vincent
(2001) and operationalized by Francis (2001). Fields, Lys and Vincent define accounting choices
as any decision whose primary purpose it is to influence (either in form or in substance) the
output of the accounting system in a particular way, including not only published financial
statements , but also tax returns and regulatory filings (Fields, Lys and Vincent, 2001). According
to Francis (2001) these accounting choices can be categorized into the following groups: choices
among equally acceptable rules; judgments and estimates required to implement generally
accepted accounting rules; disclosure decisions; timing decisions of when to adopt a required
accounting rule; choices about display; aggregation decisions; classification decisions; decisions
to structure transactions in certain ways to achieve a desired accounting outcome; real production
and investment decisions. We will adopt this classification to study the accounting choices
applied by the SAirgroup.
It is impossible to study all accounting choices made by the SAirgroup over 10 years. Since we
want to try to go beyond previous research results and challenge some prior hypotheses, we
have chosen a disaggregated approach in the study of accounting choices. According to Francis
(2001) the disaggregated approach features a focus on individual accounting items known to
require substantial managerial judgment and to have a significant impact on reported profitability.
This disaggregated approach has the potential advantage of yielding precise directional
predictions based on the researchers understanding and analysis of how decision makers trade off
14
the incentives associated with the accounting object of the study (Francis, 2001). This implies that
we will combine multiple motives with multiple accounting choices in relation to an individual
accounting item with a substantial impact on the financial statements of the SAirgroup. The key
element in classifying a decision as an accounting choice is the managerial intent, especially with
real decisions; that is, whether the impetus behind the decision is to affect the output of the
accounting system or whether the impetus derives from other motives (Fields, Lys and Vincent,
2001). We will provide evidence of managerial intent using internal company documents.
3.2 The case company and the competitive environment
A case study allows to provide insights into management processes which are difficult to
produce with quantitative research (Gephart, 2004) and can suggest new explanations that
have not been previously considered. The focus on a single group of companies [the
SAirgroup (former Swissair Group)] makes it possible to incorporate the richness and
complexity of the context in a study of accounting choices. The companies involved in the
case are located in different jurisdictions that have different domestic accounting standards,
different levels of investor protection and different degrees of enforcement related to
compliance with accounting standards. This case therefore has the characteristics of a small
natural experiment which allows us to study the opportunities these context specific
influences offered. Further, within the SAirgroup itself, a quasiexperimental setting can be
distinguished since the passenger transport business segment was operating in a more
regulated environment then the other strategic business units of the SAirgroup (such as
catering, ground handling, cargo transport, and information systems).
The data used in this case study are primarily internal archival company data. Access was
gained to internal company documents dealing with strategic decisions, operating decisions,
top management bonus schemes and financial reporting. A list of internal documents used is
15
provided in Appendix A. For triangulation purposes (Yin, 2003; Miles and Huberman,
1998) these archival internal company data are combined with the annual reports of the
SAirgroup, the prospectuses issued by the SAirgroup in the late nineties and publicly
available data from sources outside the group (see also Appendix A). A number of
interviews with members of the management team of the airlines were also held. Given the
judicial enquiries around the bankruptcies of both airlines caution must be exercised in the
interpretation of these interviews and the potential bias in national press reports requires to
be recognized.
From the internal documents we collected data on strategic choices, CEO characteristics,
accounting choices, multiple motives or incentives (i.e. external and internal contracts governing
the firm) and sources of discretion over a time span of 10 years (19912001). Until 1990 Swissair
(or Swiss Air Transport Company Ltd) only published individual accounts in compliance with
Swiss GAAP. From 1991 onwards the Swissair Group published consolidated accounts and
therefore this year is chosen for the start of the longitudinal analysis. Over the total time span of
the study the Swissair/SAirgroup was a listed company, quoted on the Zurich stock exchange,
with dispersed ownership. In order to finance its activities the Swissair/SAirgroup relied on share
issues and issues of public debt as well as issues of private debt.
Within that time frame the competitive and regulatory environment of the airlines in Europe
changed substantially. Despite some deregulation in the US and the European Union, the airline
industry in the 1990s was still characterized by a high degree of regulation. In the EU (except for
the UK where the process began earlier) the first steps towards deregulation appeared at the end
of the 1980s about ten years later than in the US. From 1993 European skies became open for
16
‘community carriers’ 2 . That is, EU airlines are free to operate across national boundaries within
the EU. Switzerland, situated in central Europe, is not a member of the European Union. In the
early nineties there was a possibility that Swissair would enjoy the same rights as EU community
carriers if the Swiss people voted in favor of joining the European Economic Area. Despite a very
active publicity campaign, partly financed by Swissair, in favour of a yesvote the Swiss people
rejected (by a small majority) entry into the European Economic Area in late 1992. Swissair
management was very disappointed by this decision and faced major strategic choices about how
it was to develop its business from its position outside of the EU.
They communicated the consequences of the “no” vote in its subsequent annual reports:
“Switzerland remains aeropolitically isolated at the heart of the continent, and Swissair
and Crossair continue to suffer the disadvantages such isolation brings”.
(Message to the shareholders, Annual Report, 1995).
These national and EU decisions provided a very specific context within which a set of real and
accounting decisions were taken.
4. The analysis of the case data
Since we intend to apply a multitheory analysis on the issue of earnings management, we will
present first the longitudinal analysis of the strategy of the Sairgroup together with the changing
CEOcharacteristics viewed through the lens of the upperechelons theory in combination with
the power circulation theory and strategic choice theory. Then we will analyse the accounting
choices made during a 10 year period along the framework of analysis presented in Figure 1.
4.1. The strategy of an airline: 1990 – 2001
2 An airline qualifies as a ‘community carrier’ under the EU regulation (EC ordinance 2407/92 of July 23, 1993) when the majority of the capital is in the hands (in a direct way or an indirect way) of persons or companies belonging to the European Union.
17
Within this time frame, two CEO turnovers took place. We therefore distinguish three subperiods
within those 10 years.
4.1.1. The Swissair group or a group around the airline Swissair: 1990 1995
Until the start of the 1990s the profits of airlines were secure due to the high degree of
regulation and price agreements. Following deregulation in the early 1990s, the results of
Swissair came under pressure. The CEO in the early 1990s, Otto Loepfe, was a man with an
airline background who had to face the competition created by deregulation in Europe. In
response to these pressures Swissair first tried to form an alliance (under the name Alcazar)
with KLM, Austrian Airlines and SAS. This project was unsuccessful and negotiations were
terminated in November 1993. As a result, Swissair had to look for other means to face the
stronger competition caused by the deregulation in the EU and to circumvent their
“aeropolitical isolation”.
On May 4 th , 1995, Swissair acquired a large minority shareholding of 49.5% in the capital of
Sabena, the Belgian stateowned national flag carrier. The investment deal between Swissair
and Sabena was structured so that it formally complied with the EU regulation on passenger
air transport. Through the EU approval of this acquisition Sabena still qualified as a
‘community carrier’ yet it gave the Swiss airline group access to the EU air transport market.
In addition to the investment of 49.5% in the share capital of Sabena, a loan of 151 million
Swiss francs (CHF) was granted by Swissair to the Belgian government which held the
remaining 50.5% of the share capital. This loan entitled Swissair to raise its equity holding
in Sabena from 49.5% to 62.25% when the bilateral agreements between Switzerland and
the EU would change in the future. Then Sabena would no longer lose its ‘community
18
carrier’ status by having a Swiss majority owner. At the time of the acquisition in mid1995
the aim of the investment in Sabena was stated to be to develop a single airline group
concentrated around the two equal hubs of Zurich and Brussels. The airlines were considered
to be the core business of the Swissair group although other airlinerelated activities were
performed.
4.1.2 The transition of the Swissair group into the SAirgroup: 19962000
Due to the weak results of Swissair an unplanned performancerelated CEO turnover took place
early 1996. Philippe Bruggisser was chosen as successor. In the early 1990s he had successfully
implemented a growth strategy in the legally independent division, Swissair Associated
Companies (SAC), of the Swissair Group which was active in the catering and the hotel business.
Although the succession was an intragroup succession, he was not an intraairline industry
replacement. as he had a financial background. Before running the SAC, he had worked for a
Swiss bank in the 1980s. Research in the management literature suggests that people with a
financial background typically regard firms as a collection of assets that need not be associated
with a single line of business (Jensen and Zajac, 2004). Given the functional background of the
new CEO, and perhaps the fact that at the time of succession he had less airline expertise,
Philippe Bruggisser diversified the corporate strategy of the Swissairgroup by launching his
“dual” strategy. An event which can be interpreted as supporting a variant of the abilitymatching
model which suggests that a CEO may attempt to increase his value to the firm by changing the
business mix of the firm to one for which his managerial skills are uniquely well suited (Shleifer
and Vishny, 1989).
The dual strategy formally separated the airline business (= passenger transport) from the
support activities surrounding it. The message to the shareholders in the Annual Report of
19
1996 gave more details about the new company structure, the new company name and the
contents of the dual strategy:
“Swissair has moved from its traditional structure as an airline to become a corporate
group that conducts airlinerelated activities in addition to actual airline operations. The
new group structure, named the SAirgroup will underscore the diversity of the new
corporation. ….SAirgroup – more than just an airline. The group is divided into four
general areas of emphasis in spring 1996. The airline activities are bundled together in
the SAirlines division. Aircraft maintenance and handling, information technology and
real estate administration are all part of the SAirServices division. SAirLogistics is
responsible for the marketing, sale, handling and warehousing of cargo and offers our
customers global logistic solutions. SAirRelations focuses exclusively on gastronomy, the
hotel trade and the travel retail business.”
The launch of the dual strategy was accompanied by a drastic change in the organizational
design of the group. After the creation of the new holding structure and the organizational
redesign, the legal entity of the airline Swissair remained responsible only for passenger
transport and had to buy all related services from companies which now belonged to other
strategic business units (SBU) in the SAirgroup. Even ownership of the aircraft was
transferred to a new legal entity, Flightlease, which provided leasing services from 1998 on
to other airlines in which the SAirgroup had equity holdings and third party customers. The
legal entity Swissair representing passenger transport was only left with intangible (but
valuable) assets such as traffic rights, slots at airports and a dominant position at its hub
airport, Zurich.
The “dual strategy” (referred to the airline as the ‘first pillar’ and to the support services or
airlinerelated services as the ‘second pillar’) was launched by the new CEO as a growth
strategy to be pursued by acquisitions and organic growth in all four SBUs of the SAirgroup
20
(SAirlines, SAirservices, SAirrelations and SAirlogistics). Graph 1 reflects the steep rise in
revenue of the SAirgroup following the new dual strategy.
[Insert graph 1 about here]
Acquisitions in the support service or airlinerelated business took place from 1996 and
continued during the following years. Most of the acquisitions were characterized by an
acquisition of a majority of the shares.
In the first pillar of the SAirgroup, i.e. passenger transport, growth through acquisitions
started in 1998, when SAir management started to implement the “Hunter Strategy,”which
was developed at the end of 1997 in cooperation with a well known worldwide consulting
company, and foresaw alliances with other European national airlines:
“The intended expansion of Swissair was focused on countries, airports and markets with
large growth potential (Belgium, Austria, Finland, Hungary, Portugal and Ireland), and
not on the mature markets as Germany, France and Italy. In addition, the Zurich airport
was to be used as a central hub and expanded. The hunter strategy was conceived as a
moderate investment strategy with clearly minority investments (10%30%) and defined
capital requirements (CHF 300 million).” 3
The first acquisitions following adoption of this strategy took place in the fall of 1998 and
were followed by further acquisitions in 1999. However, the type of companies acquired and
the terms of acquisition did not match the originally conceived strategy (see citation above),
as shown in Table 1 .
Table 1: Overview of the investments made under the Hunter Strategy
Year Country Company % of shareholdings
1998 Germany LTU 49,90 % 1998 France Air Litoral 49,00 % 1998 Italy Air Europe 49,90 %
3 See press release accompanying the report ‘Results of the investigation regarding Swissair’.
21
1998 Italy Volare 34,00 % 1999 France AOM 49,50 % 1999 Poland LOT 37,60 % 1999 South Africa SAA 20,00 % 2000 Italy Volare Group
out of Air Europe and Volare
49,79 %
Source; Annual Reports of the SAirgroup 19982000
It can be seen that most acquired airlines were in the more mature markets, and most stakes
exceeded the 30% threshold defined in the espoused strategy, although they were always less
than a formal majority holding.
The published net income up until 1999 ( as demonstrated in graph 2) communicated a successful
turnaround of the Swissair Group into the SAirgroup due to the strategic change initiated by the
new CEO.
[insert graph 2 about here]
If we analyze Bruggisser’s strategy of the early nineties in the catering business, which brought
him celebrity and the top position in the SAirgroup, we notice that it consisted of two items,
namely acquisitions of other catering companies (e.g. the catering division of British Airways)
and the restructuring of the catering activity of Swissair. From 1993 onwards Swissair had to buy
catering services from the SAC instead of providing them internally. The underlying business
model of the dual strategy launched in 1996 was a copy of his strategy of the early nineties. The
2 nd pillar SBUs of the SAirgroup grew through acquisitions and the delivery of services to the
airlines in which the SAirgroup had an equity stake. The dual strategy was a growth strategy
22
which required substantial financial resources and a record of financial success to support further
fundraising.
4.1.3. The return to Swissair: 2001
Despite these promising accounting numbers in the years 1997, 1998 and 1999, financial
problems emerged openly for the first time in mid 2000. In January 2001 the CEO of the
SAirgroup, who had launched the dual strategy in 1996, was dismissed. The new
management team pinpointed the cause of the serious financial problems of the SAirgroup in
the first pillar of the SAirgroup, namely passenger transport, and more specifically in the
foreign airlines in which the SAirgroup had invested. The letter of the new Chairman
communicated this view in the following message in the 2000 Annual Report (page 4)
“In the annals of our company’s history the 2000 business year will be remembered as a
poor one. The SAirgroup did not meet the targets established for the airline sector. The
substantial losses stemming from our airline equity holdings were responsible for a very
inadequate result. The SAirLogistics, SAirServices and SAirRelations divisions, forming
the second pillar of our dual strategy, have either met or surpassed their performance
targets.”
The result of the SAirgroup had reached a dramatically low level in 2000, and the problems
intensified in 2001. In July 2001 the SAirgroup divested the two French airlines and in
August 2001 the relationship with Sabena was renegotiated. On October 2nd 2001,
following the events of 9/11, the SAirgroup holding company, SAirlines, the airline Swissair
and Flightlease all filed for bankruptcy. Consequelntly the SAirgroup did not fulfill
agreements it had concluded with Sabena on a capital injection meant to take place in
October 2001. Sabena was declared bankrupt on November 7, 2001. Thousands of
employees lost their jobs in Switzerland, Belgium and in other countries in which the two
airline groups were active.
23
4.2. A longitudinal analysis of accounting choices in the SAirgroup: 1991 – 2001
The accounting numbers presented in graph 1 (revenue) and 2 (net income) together with graph 3
below, indicate that the accounting numbers for the years 1997, 1998 and 1999 had characteristics
(increasing revenue and increasing earnings combined with low volatily of earnings) which are
appreciated by the capital market.
[Insert graph 3 about here]
The financial structure of the SAirgroup improved as well over that time period (19971999).
The increase in the equity/total debt ratio was needed in order to obtain a favorable credit rating
when public debt was issued in 1999 and early 2000.
Table 2: evolution of the equity/total debt ratio over 1996 – 2000
1996 1997 1998 1999 2000
Equity/total
debt
17,8 % 19,3% 20,3% 24,1% 5,7%
Source: Financial Statements of the SAirgroup 1996, 1997, 1998, 1999 and 2000
The huge loss of 2000, despite the still increasing revenue (see graph 1), and the bankruptcy in
the autumn of 2001, seem to be in total contradiction to the financial information published in
the years before. The report requested by the Administrator of the bankrupt airline revealed that:
24
“The unconsolidated and consolidated financial statements for 1999 and, to a much greater
degree, for 2000, did not fairly present the economic and financial situation of the
SAirgroup”.
Using a disaggregated approach we will chose an accounting item which has a major impact on
the financial statements in order to examine how this divergence between the underlying
economic performance and the published performance represented by the accounting numbers
arose. Because the new management team of 2001 blamed the foreign airlines in which the
SAirgroup invested for the financial problems of the SAirgroup (see citation in 4.1.3), we will
concentrate on the accounting choices made by SAirgroup in its consolidated accounts for the
investments it undertook in foreign airlines. Using the classification of Francis (2001) we will
discuss the choice among the accounting methods or rules, the judgments and real decisions in the
text. The other choices which relate to display, aggregation, classification and disclosure will be
presented in table format ( see section 5.1).
4.2 The accounting choices of the Swissair group: 19901995
Up until 1995 the consolidated accounts of the Swissair Group were prepared in accordance with
the 4th and 7 th EU Directives on company financial reporting and with the provisions of the Swiss
Law. (Note 1 of the Group Accounts of the Swissair Group, 1991 until 1995). In Switzerland
under Swiss GAAP, as in several other countries influenced by the conservative German view of
accounting, income smoothing is formally permitted by law and substantial hidden reserves can
be created. According to Dumontier & Raffournier (1998) most Swiss companies make
considerable use of hidden reserves by recognizing excessive depreciation of assets or creating
unjustified provisions. In the individual accounts published by Swissair in the 1980s we notice
that in all years except 1986, substantial amounts of supplementary depreciation had been
25
recorded and hidden reserves were created when the actual aircraft load factor was above the
breakeven aircraft load factor. These “hidden reserves” were released in the opposite situation,
which occurred in the early nineties (19911994) 4 . So the flexibility of Swiss GAAP thus allowed
Swissair management in the 1980s and early 1990s to smooth income and to shift earnings into
the later years, providing the perception of smooth and continuing good performance (see graph
2).
In relation to its investment in Sabena mid1995, the essence of the acquisition was to
foresee in the contracts a framework which made it possible to take control over Sabena,
without violation of the EU Regulation on passenger air transport. The consulting report
“Flair”, prepared by a wellknown consulting firm at the request of Swissair in relation to
this acquisition, pointed to this critical element in making the acquisition successful.
Through the terms of the different agreements namely the Shareholders’ and Management
Agreement between Swissair and the Belgian State, dated 4 May 1995, on the one hand and
the Cooperation Agreement between Swissair and Sabena, dated 24 July 1995, on the other
hand Swissair would be able to obtain a substantial amount of management power and
effective control 5 and the documents were drafted to formally comply with the EU
regulation on transport.
4 When hidden reserves are released this has to be disclosed in the notes to the annual accounts according to article 663 par 8 of the Swiss Company Law 5 The SMA stipulated that the Board of Directors of Sabena consisted of 12 members from which at least 7 had to be EUcitizens. Six out of those 12 directors were chosen by the Belgian government, five were appointed by the Swissair/SAirgroup and one director namely the Chairman of the Board had to be chosen in consensus by the Belgian government and the Swissair/SAirgroup. If no consensus could be reached the Swiss shareholder could appoint a candidate (art. 7 of the SMA). For the removal of the directors a special majority was needed, this implied that a Belgian director representing the Belgian government could not be removed without the approval of the Swiss shareholder. The addendum of 12 June 1995 to the SMA stated further that the appointment of a CEO had to be approved by the majority of the members of the Board of directors. The CFO and the middle management of Sabena could be proposed by Swissair (addendum 7 to the SMA). Further according to the SMA the decision to hire and fire top managers in the Sabena Group was in the hands of the CEO of Sabena, who needed the approval of the Board to execute these decisions.
26
For the valuation of the investment in Sabena in the books of the Swissairgroup, the group also
needed to comply with the 7 th EU Directive, which contains standards for consolidated accounts.
If a standard is considered as a total body of principles and rules that apply to a given
accounting issue (Nelson, 2003), the standards which deal with the issue of control, embedded in
the 7 th Directive, have a strong rulesbased character (see Appendix B). Rulesbased standards
deal with specific settings and are defined in detail. As a result rulesbased standards allow
creative managers to create innovative transactions (Kershaw, 2005) and provide an opportunity
for preparers to engineer their way around the intent of the standard. Whether or not a transaction
can be structured as such to evade the rules, depends on the precision of the accounting standard.
If this method of real earnings management is pursued, financial reporting that is not
representationally faithful to the underlying economic substance of transactions can follow. In
order to counterbalance the rulesbased character of the 7 th EU Directive, the Directive contains
a true and fair override which allows companies and auditors not to follow a standard if its
application results in financial statements which do not present a true and fair view of the
company’s financial position, results and cash flow. In continental Europe the true and fair
override was seldom applied ( Benston, Bromwich and Wagenhofer, 2006).
So Swissair, based on the legal form of the Shareholders’ and Management Agreement chose to
account for Sabena using the equity method 6 . Full consolidation of Sabena in the books of
Swissair could have been interpreted by the EU as evidence that Swissair was controlling Sabena,
so it appears that the equity method was used to avoid such a risk. At this stage the choice of the
equity method instead of full consolidation did not create any difference with regard to the
published net result of the Swissair Group. Only the debt structure of the Swissair Group
6 the choice between the full consolidation and equity method can have a major effect on the group accounts of the investor. Under full consolidation the investor takes all assets and liabilities of the investee into its consolidated accounts. Under equity accounting the invester shows the investment in its consolidated accounts at the accounting value of that investment in the investee’s books.
27
benefited from this choice, since it enabled the Swissair Group to keep the liabilities of Sabena
off their own balance sheet.
In accordance with the application of the equity method 49.5% of the loss incurred by Sabena in
1995 influenced the profit and loss account of the Swissair Group in 1995 under the single line
item ‘share in the result of associated enterprises’, which is the prescribed classification practice
if one accounts for an investment under the equity method. Graph 3 and Graph 4 (Sabena group)
indicate that both groups realized an operating profit in 1995, whereas the net result was negative.
However, in both groups these losses were mainly the result of accrual decisions.
[Insert graph 4 about here]
“The extraordinary expenditure relates almost entirely to provisions made for planned
corporate restructuring activities”
(Annual Accounts Swissair Group 1995, page 10, Note 9).
In the annual accounts of Sabena an extraordinary depreciation item was recorded in order to
harmonize the fleet with the SAirgroup in the years to come:
“The group result for 1995 remained in the red to the tune of BEF 1,620 million. This includes
an exceptional provision of BEF 1,090 million for the renewal of the fleet”
(Annual Report Sabena Group, 1995, page 5).
4.2.2 The accounting choices of the SAirgroup 1996 2000
In 1996 the SAirgroup switched to the IAS standards promulgated by the IASC for the
preparation of its group accounts. These IAS standards are more principlesbased. Further the
conceptual framework of the IASC, which defines the characteristics of accounting information
28
states explicitly that transactions should be accounted for in compliance with their economic
substance rather than with their legal form. Contrary to the 7 th Directive, the International
Accounting Standards define the principle of control in general and explain the idea further in
IAS 27 (see Appendix C). IAS 27 (par 4) defines the principle of control as: “the power to govern
the financial and operating policies of an entity so as to obtain benefits from its activities.”
4.2.2.1 Accounting choices in relation to the investment in Sabena
In 1996 the SAirgroup started to use the possibilities foreseen in the Shareholders’ and
Management Agreement as well as in the Cooperation Agreement for taking control over Sabena,
despite having only a minority stake. From early 1996 onwards the position of CEO and CFO of
Sabena were occupied by employees of the SAirgroup who had their incentive and reward
contracts tied to the results of the Swissair/Sabena Steering Committee, the committee where
strategic and operating decisions affecting both airlines were taken. Further early 1996 new
subcommittees were created to the Board of Directors of Sabena and SAir employees played an
important role in those. In the finance committee SAir employees held 50% of the votes and in
the remuneration committee SAir employees held the majority of the votes.
Although IAS 27 states explicitly that control can exist even when the parent owns less than one
half of the voting power of an enterprise but when there is the power to govern the financial and
operating policies of the enterprise under statute or agreement (para 12), the valuation method for
Sabena remained the equity method under the principles based International Accounting
Standards applied for the preparation of the consolidated accounts of the SAirgroup.
29
As soon as the Swiss CEO, together with a number of SAir employees, occupied executive
management positions in the Sabena group 7 and SAirGroupemployees held the majority in the
Steering Committee, the SAirgroup started to outsource airline related activities from Sabena to
the SAirgroup. From the second half of 1996 on, the airlinerelated activities of Sabena were
restructured and gradually outsourced to the 2 nd pillar of the SAirgroup and this outsourcing
process increased over the years (see also contracts in Appendix A). In 1995 the share of
‘services and goods bought’ in relation to total operating revenue of Sabena was 47%; in 2000
this share had increased up to 73% (Annual Report Sabena Group, 1995 2000). These services
(e.g. ITservices, catering services, and ground handling services) had now to be bought from the
SBUs of the second pillar of the SAirgroup at inflated transfer prices. Our first example is the
outsourcing of the ITactivities of Sabena to the SAirgroup:
“Atraxis’ first year as an independent information technology company of the SAirgroup was
very challenging… Several reservations and handling systems were delivered to third party
customers and made operational, including the complete migration of the Sabena booking and
handling system.”
(Page 18 Annual Report SAirgroup 1996)
In the outstations Sabena was forced to take Swissport (handling) and Gate Gourmet (catering) as
suppliers (Moser ,2001). The price paid to the SAir units could by agreement deviate 5% of the
current market price for those services at these outstations. In the Brussels hub Swissair, Crossair
(a subsidiary of Swissair) and Swisscargo benefited from very low tariffs charged by Sabena
handling. Further Sabena catering had to pay a fee for technical services to Gate Gourmet (a
subsidiary of the SAirgroup), which was above market rates.
7 An email request of the Secretary General of the Sairgroup to the Secretary General of the Sabena group on 10/4/2001 with regard to which SAirGroup employees did serve on the Board of Sabena or on the Executive Management or on lower but important management functions revealed this information. Besides the CFO, the project leader for the business development plan 19982000 of Sabena and the Vice President Marketing and Product were also SAirGroup employees.
30
Another example of the structuring of operations is the takeover of the cargo activity of Sabena
by the SBU SAirlogistics of the SAirgroup, in particular Swisscargo.
“On December 16 1996, Swisscargo and Sabena signed an agreement whereby Swisscargo’s
distribution network would market the entire freight capacity of Sabena’s fleet of aircraft as of
January 1, 1997. Swisscargo thereby enlarged its freight capacity by almost one quarter and is
taking full advantage of the chance to create a cargo hub in Brussels”.
(Page 20, annual report SAirgroup 1997)
In practice this meant that Swisscargo earned revenue from transporting the cargo in the “belly
space” of Sabena aircraft. Sabena received a reimbursement which did not even cover the direct
costs of transporting the cargo.
In the examples cited above a transaction between business units of the two groups took place at
a certain transfer price. These operating decisions would have been normal operating decisions, if
they had been carried out at arm’s length transfer pricing. The use of notatarm’s length transfer
pricing enabled the SAirgroup to shift benefits from Sabena to the shareholders of the SAirgroup
and as a result the profit attributable to the shareholders of the SAirgroup was increased. So these
are in fact examples of related party transactions at non at arms’ length transfer prices which
contribute to the enhancement of the accounting numbers of the SAirgroup and as a result create a
perception of successful economic activity.
These outsourcing decisions using not at arm’s length transfer pricing did not represent normal
economic operating decisions and can thus be classified as accounting choices. The managerial
intent of transferring benefits is admitted in the agreement signed on the 2 nd of August 2001 by
the SAirgroup, the Belgian State and Sabena.
“Agreement of the 2 nd of August 2001between the Belgian State, The SAirgroup and Sabena
Article 6.3
31
The parties and their respective subsidiaries mutually, irrevocably and definitively waive any and
all rights or claims, actual or potential, which they may have against each other and each other’s
directors, officers, employees, agents and representatives for funding or other obligations or
liabilities in relation to (i) any decision adopted or actions taken by the Board of Directors of
Sabena prior to the date hereof regarding the renewal or expansion of Sabena’s fleet; (ii) any
transfer of assets or provision of services between Sabena or any of its subsidiaries and
SAirgroup or any of its subsidiaries prior to the date hereof which purportedly was not effected
on arm’s length terms or otherwise not in the best interest of any said parties; (iii) any decisions
adopted or actions taken prior to the date hereof which purportedly deprived Sabena or
Sairgroup or any of their respective subsidiaries from a corporate opportunity; and (iv) any
purported acts or conduct prior to the date hereof as de facto director (“administrateur de fait”)
of Sabena.”
Related party transactions at non at arms’ length transfer pricing is classified in the finance and
economic literature under the heading ‘private benefits of control’. In the extract from the
Agreement of the 2 nd of August we find a number of examples of what is called in the finance
literature ‘private benefits of control’. Theoretical work on private benefits of control is well
developed (see e.g. Grossman and Hart, 1988; Bebchuck, 1999; Schleifer and Wolfenzon, 2002,
Johnson, La Porta, LopezdeSilanes and Shleifer, 2002). However, empirical evidence on the
private benefits of control is scarce, by its very nature (Dyck and Zingales, 2004). The
mechanism of transfer pricing is mentioned in the agreement of 2001, but the agreement refers to
other mechanisms of extracting private benefits of control whereby benefits are transferred
without transfer prices being charged from one entity to the other entity. Given that evidence on
private benefits of control is scarce we provide two examples of the latter techniques.
32
During the winter of 19971998 the Hunter strategy was developed (see section 1). Besides
investments in airlines, the Hunter strategy also foresaw a change of the “hub concept” of the
group. When the Swiss group invested in Sabena in 1995, it was foreseen that passenger transport
would be organized around two hubs (Zurich and Brussels, whereby intercontinental travel was
organized from the two hubs onwards – see section 4.1.1), the Hunter strategy foresaw only one
central hub for the whole group, namely Zurich. The essence of the Hunter strategy with regard to
network management was increasing intercontinental travel from the Zurich hub (implying use
of the Swissair fleet and increasing Swissair’s passenger revenue). It should be noted that inter
continental flights are the most profitable routes for ‘traditional’ airline companies. Several
consulting reports prepared in relation to the Hunter strategy foresaw in this mechanism. A
report, prepared in october 1997 stated that passengers can be induced to take less natural choices
through e.g. price advantages or loyalty schemes. This possibility is confirmed in internal
company documents: ‘There is significant additional potential to be exploited with the Hunter
strategy by rerouting passengers through the Zurich hub’ (Executive Board Meeting, 19 January
1998).
In order to execute this idea the main activities of the airlines Swissair and Sabena in relation to
passenger transport (= marketing, sales, network planning and revenue management) were
centralized in the new Airline Management Partnership [AMP] from mid 1999 onwards.
Employees of the SAirgroup occupied leading positions in the AMP. By controlling network
management, pricing decisions and promotion (i.e. awarding frequent flyer miles) AMP
management was able to influence the buying behavior of customers. As a result, through the
rescheduling of timetables, changing the fare structure of the tickets 8 and awarding of miles,
8 By imposing the same sales price for business class flights from 1999 on in the two carriers (Sabena and Swissair), a passenger could now be switched between two airlines without incurring a price difference on those destinations which were served by both airlines. It is important to note that the “quality perception”
33
many passengers (especially business passengers) now boarded Swissair intercontinental flights
instead of Sabena intercontinental flights. These mechanisms made passenger revenue which
was accounted for directly in the books of the two (still separate) airlines, shift from Sabena to
Swissair. The direct operating costs for flying to those destinations remained with the individual
airlines. The impact of this mechanism can be derived from SAirgroup’s information provided in
the prospectuses 9 . In prospectus issued by the Sairgroup for placements of public debt ( 11
november 1999 US $ 350, 000 , 000 – 7,5 per cent guaranteed notes due 2004) SAir
management described the vehicle of AMP as “project Diamond: A virtual merger of Swissair
and Sabena”.
Another example of these private benefits of control relates to the diversion of corporate
opportunities from one entity to another. Sabena Technics, the unit of the Sabena Group
responsible for fleet and engine maintenance was a profitable business unit. They had a reliable
reputation and specialized in maintenance of Boeing aircraft and engines, having a substantial
number of third party customers. The future revenue generating power of Sabena Technics
became seriously threatened through two decisions concerning SAiR Technics, the maintenance
company of the SAirgroup. First, in 1997, it was decided that the Sabena fleet was to be
harmonized with the SAirfleet, which meant that the Boeing fleet of Sabena would be quickly
replaced by Airbus aircraft. As a result an important part of the maintenance of the Sabena fleet
was taken over by SAiR Technics, since they enjoyed Airbus expertise. Due to this loss of
maintenance work for their own Boeing fleet, the knowledge base of Sabena Technics for Boeing
of the two airlines differed. The market gave a higher quality rating to the business class of Swissair than to that of Sabena ( De Zitter (2001), see also Airtrack Surveys). 9 Prospectus SAirgroup 5 october 2000, € 400, 000,000 – 6,625% guaranteed bonds due 2010 – page 43: The very nature of the airline business is such that a carrier’s operations are highly leveraged. Each flight has fixed costs such as fuel, fees and labour, while revenue from the flight depends entirely on the number of passengers or cargo carried and the fares paid. This means that any decrease in the number of passengers or cargo carried and/or fares paid results in a disproportionately greater decrease in ptofits. On the other hand, any increase of customer demand which significantly exceeds planning may, in connection with a limited extension of capacity, lead to substantially higher average proceeds per flight.
34
aircraft would diminish which threatened their business with third party customers. Second, only
SR Technics was allowed to perform the maintenance of the new generation engines, which
would replace the current engines used by airlines in the years to come. This decision also
seriously threatened Sabena Technics’ longterm survival in the engine maintenance market.
In the early years (19961998) notatarm’slength transfer pricing for services between the
SAirgroup and Sabena was the mechanisms for transfering profits. Later on the system for
transferring benefits became more sophisticated and mechanisms besides transfer pricing were
created to transfer benefits from Sabena to the SAirgroup subsidiaries. In neither of the last two
examples (passenger revenue and the maintenance of aircraft and their engines) did transactions
take place involving transfer prices. In these examples, revenues and costs were altered through
controlling operating and strategic decisions. So evidence of the extraction of private benefits of
control is much harder to detect. Only a careful reading of internal documents reveals the
mechanisms used and this source of information is unavailable to external stakeholders.
Leuz, Nanda & Wysocki (2003) show that the presence of private benefits is an incentive for
earnings management and that earnings management serves to mask the extraction of private
benefits. The negative impact of the transfer of these benefits on the financial statements of
Sabena was to a large extent hidden by several accounting choices in the accounts of Sabena over
the period 19961999. Substantial provisions and extraordinary depreciations in 1996, in
combination with smaller provisions and depreciations in 1995 and 1997, frontloaded a large
part of the capacity costs of the fleet of Sabena. It was communicated in the Annual Reports of
Sabena in 1995 and 1996 that the restructurings were necessary to safeguard to return to
profitability in 1998 for Sabena.
“In order to smooth the return to profitability the Board of Directors has decided to introduce
some major oneoff charges in 1996 to cover restructuring costs in the Horizon ’98 plan and
35
further depreciation for the longdistance fleet. – The Horizon ’98 plan points the way to a return
to profitability in 1998”
(Annual Report Sabena Group,1996, message of the BOD, page 5).
Subsequently real decisions were taken in 1998 and 1999 (e.g. sale and lease back of the
remaining Boeing fleet which was going to be phased out by 2003, sale of fuel hedge and
currency hedge contracts in 1999, together with a sale of investments (Equant shares)) to improve
the reported results in 1998 and 1999 (see graph 4). The underlying weak economic performance
of the Sabena Group was not apparent from its financial statements of 1998 and 1999.
The losses incurred by Sabena would negatively influence the result of the SAirgroup under full
consolidation as well as under the equity method, with an amount equal to the percentage of the
shareholding (=49,5%) multiplied with the loss of Sabena. Through an accounting choice made in
1996 SAir management was able to avoid this negative impact of the losses of Sabena on the
SAirgroup accounts for the years after 1996. The accounting choice consisted of a complete
writedown of the value of the investment in Sabena in the books of the SAirgroup in 1996. This
write down made the net profit of the SAirgroup plummet in 1996 (see graphs 2 and 3); however,
the message in the annual report appears designed to reassure the shareholders:
”In financial terms, the 1996 business year does not yet reflect the broadbased internal progress
that has been made. Nonetheless, a substantial improvement in operating profit, net profit and
cash flow were achieved. The complete write down of the equity stake in Sabena and provisions
for future structural adjustments led to a substantial overall Group loss.
(Annual Report 1996, page 5)
Through this writedown in 1996 a situation “technically similar” to IAS 28 (para 22)
was created which allows for an investor’s share of losses of an associate no longer to be
36
recognised on its annual accounts if they equal or exceeds the carrying amount of an
investment. Although the loss made by Sabena in 1996 was indeed substantial (see graph
4), the share in the loss of Sabena would not have reduced the investment in Sabena in
the books of the SAirgroup to zero in 1996.
The SAirgroup’s accounting decision to completely writedown the investment in Sabena was
accompanied with press releases (in Switzerland and in Belgium) that the writeoff did not imply
that the SAirgroup would terminate its cooperation with the Sabena Group, but rather that further
integration was planned. The managerial intent of shielding the total result of the SAirgroup from
the losses of Sabena in the future with this writedown was further revealed in internal company
documents (the original text in French is included in appendix D ).
When Swissair will write down the value of its investment in Sabena in its books, this event is
solely an “accounting” event; it does by no means imply that Swissair will divest from Sabena.
The only objective of this operation is to shield the result of the SAirgroup from future losses of
Sabena. (extract from the letter of the Secretary General of Sabena with approval of the CEO of
SABENA in order to response to questions raised by members of the Belgian parliament – 19th of
March 1997)
‘From an accounting point of view, this writedown allows a company not to include any longer
its share in the losses or profits in the investee. From a strategic point of view, this writedown
does not imply a sale of the Sabena investment nor a withdrawal. (extract from a letter of the
Secretary General of Sabena with consent of the CEO of Sabena to the Cabinet of the Minister of
Transport – 15 March 1997)
37
4.2.2. Accounting choices in relation to the Hunter strategy
The investments made by the Sairgroup in the airlines acquired in the frame of the Hunter
Strategy allow us to carry out a crosscase analysis between the accounting choices made in
relation to the Sabena investment and the accounting choices made in relation to the “Hunter”
investments. The purpose of the cross case analysis is to investigate similarities and differences
and try to uncover identical patterns.
The airline investments under the hunter strategy took place in 1998 and 1999 (see table 1).
Similar to the Sabena investment deal, the SAirgroup in fact controlled these airlines through
agreements.
“The starting point led Swissair to formally comply with the EU ordinance, but de facto to
circumvent this regulation. In order to obtain direct management control immediately as well
as to formally insure the subsequent takeover of a majority interest, the Group had to resort to
complex and difficult management structures, call/put options, portage solutions, guarantee
commitments, as well as multiple tiered and nontransparent intermediate financing “.
(Investigation undertaken at the request of the Administrator of the SAirgroup regarding
Swissair, press release).
Despite the situation of effective control, the acquisitions were valued using the equity method.
Through the equity method the debt of these acquired companies is not shown on the balance
sheet of the SAirgroup. We notice further that LTU and Air Europe were valued at cost in 1998,
the year of their acquisition. All ‘nearly majority’ acquisitions were written down once they were
accounted for according to the equity method. (Air Litoral in 1998, LTU and AOM in 1999 and
in 2000 the investments in the Volare Group followed). In contrast to the presentation of the
write down of Sabena as a singleline exceptional item. The impact of these writedowns on the
result of the SAirgroup in 1998 and especially in 1999 was counterbalanced through positive
38
accrual decisions in relation to other financial assets and the release of half of the provision for
restructuring created in 1996 (see citation from the Annual Report 1996, page 5) and the
aggregated result of these accounting choices was presented under a single line item “results from
operational investments” on the profit and loss account.
After the investment in Sabena was completely written down in 1996, the restructuring of the
operations of Sabena started. A similar pattern is observed in relation to the airlines acquired
under the Hunter strategy. A few citations from the Annual Report of the SAirgroup are listed as
examples below:
“The SAirgroup has amalgamated the charter activities of Balair, Sobelair, LTU, Air Europe
and Volare into the European Leisure Group. The creation of Leisure Cargo GmbH to market
the cargo capacity of the European Leisure Group airlines should make up for the lack of
attention that this segment has received in the past”.
(Annual Report, 1999, page 15)
“In France, the newlyfounded SR Technics France began building a total care organization
for the fleets of AOM and Air Liberté”
(Annual Report, 2000, page 35)
Further it was planned that the acquired airlines would join the AMP later.
We thus observe an almost identical pattern of choices (i.e. accounting method choice, accrual
decisions, presentation and structuring of activities, except for the classification of the write
down (operational versus exceptional item) in relation to all nearly majority acquisitions in EU
airlines. This may be interpreted as the repeated application of a reporting strategy that had been
shown to be useful so far in transferring benefits to the SAirgroup, despite depleting the
economic resources of the acquired airlines.
4. 2. 3 Accounting choices before the final crash
39
The analysis of the accounting choices over the period 19961999 reveals that the prosperous
image communicated by the SAirgroup through its accounting numbers depended to a
considerable extent on accounting choices which had a favourable impact on both earnings and
balance sheet numbers. The underlying economic performance of the SAirgroup was much
weaker than its communicated performance. While the operating result of 2000 almost matches
the levels of prior years operating results, the SAirgroup showed a large bottom line loss (see
graph 2 and 3).
When the financial statements for the year 2000 were finally prepared in March 2001 by the new
CEO, large negative accrual decisions, which were communicated as solutions for the future,
turned the positive operating result turn into a highly negative overall result.
“The realignment of our Group’s overall business thrust requires corrective action in
balancesheet terms, with the charging of extensive depreciation and provisions to the 2000
results. This will enable the Swissair Group to focus on its new corporate objectives free of the
financial burdens of the past.
(Annual Report, 2000, page 5)
In the message of the CEO in the 2000 Annual Report, the new management team appointed
early in 2001 blamed the foreign airlines in which the SAirgroup had invested for the weak
results (see quotation in section 1). However the operating revenue, the operating profit and the
cash flow of the SAirgroup in 2000 still benefited from the combination of different accounting
choices carried out in the years before. The new CEO even stresses the fact that the 2 nd pillar
SBUs or airlinerelated SBUs met or even surpassed their targets (see citation in section 1)
40
however the benefits of the 2 nd pillar SBUs were heavily interrelated with profits being
transferred from the airlines of the 1 st pillar and the airlines in which the SAirgroup had invested
to the 2 nd pillar.
If we analyze the subcomponents of the operating profit of the SAirgroup from the launch of the
dual strategy in 1996 up until 2000, we observe that the item ‘gains on the sale of assets’
contributed substantially to the steep increase in operating profit from 1996 to 1997 (see graph 6),
and also to the fact that in the financial year 2000 the operating profit almost matched prior year
figures (19971999). The CEO in charge at the balance sheet date [31.12.2000] had discretion
over these real decisions (he was under threat of a performancerelated CEO turnover); a few
weeks after the balance sheet date he was dismissed, and the new CEO was restricted to
accounting earnings management methods to affect how the results of the financial year 2000
were reported.
[Insert graph 6 about here]
We observe that both CEOs influenced the result of the year 2000 (see graph 3 and graph 6);
however, each operated in opposite directions (a positive influence through a gain on the sale of
assets of the CEO at balance sheet date versus a negative influence through large negative
accrual decisions of the CEO appointed after the balance sheet date but before the authorization
of the accounts).
4.3 Concluding remarks on the longitudinal analysis of accounting choices
41
The corporate collapse of the SAirgroup came as a surprise to many people. The report
undertaken at the request of the administrator of the SAirgroup was finalized in January
2003 10 and the accompanying press release stated:
“The unconsolidated and consolidated financial statements for 1999 and, to a much greater
degree, for 2000, did not fairly present the economic and financial situation of the
SAirgroup”.
This longitudinal analysis of accounting choices shows that the “foundations” for this unfaithfull
representation of the economic activity were laid in 1996. The disconnection between the
published accounting numbers on firm performance and its financial position and the underlying
economic performance and financial position was marginal at the start, but the gap enlarged
rapidly between 1997 and 1998, and widened drastically in 1999 once the Hunter strategy had
been fully implemented. The disconnection was achieved by a combination of accounting
earnings management and real earnings management.
Studying the reporting deceit that led to this misrepresentation of the economic activity (Lee,
2006) we notice that the accounting choices enumerated above display a significant heterogeneity
in their effect on income. Some choices have both an immediate and a long term effect on income
(e.g write down of the investment in Sabena, choice of the equity method), whereby a long term
choice affects the over time pattern of reported income. Other choices affect the components of
income, period by period (e.g. provision created in 1996, release in 1999).
One could wonder whether the CEO of the SAirgroup had this in mind when he wrote in the
Annual Report of 1996.
“The measures that we have introduced form the basis for a stronger and healthier SAirgroup.
We believe that we have the foundation in place that will enable us to achieve substantially
10 (‘The Investigation Report’ ‘Ernst & Young Bericht in Sachen Swissair’)
42
better results in the coming years, providing an appropriate return on invested capital and
allowing our staff to take advantage of the profitrelated bonus scheme that we have created.”
(Annual Report 1996, page 6)
The simulation presented in Appendix E illustrates the impact of the accounting choices on the
published accounting numbers. Three situation are illustrated namely full consolidation of an
investment, equity accounting for an investment and equity accounting combined with a write
down of the investment. The simulation shows that the choices made by the SAirgroup are the
most favourable for the accounting numbers which represents the performance of the firm and the
financial position.
The behaviour of the SAirgroup in relation to the switch from rulesbased standards to principles
based standards confirm the results of the academic literature, which indicates that the two
different approaches to accounting standards alter neither the incentives nor the ability of
management to report opportunistically; only that the nature and characteristics of opportunistic
reporting vary depending on the nature of the standard. (AAA Financial Accounting Standards
Committee, 2003)
5. Discussion
The purpose of this case study was to gain additional insight into the incentives and methods of
earnings management by using a multitheory perspective and to deepen our understanding on the
causes and processes which are triggered by this decision to engage in earnings management. In
43
the first part of this discussion section we will analyse the results of the longitudinal analysis on
accounting choices through a multitheory lens. Next we will turn our attention to the
endogeneity versus the exogeneity discussion. Subsequently we will focus on all the variables
which need to be in place in order to give the CEO the necessary discretion to influence the
accounting numbers in such a manner that his strategic choice was communicated as a successful
one.
5.1 The results of the longitudinal analysis of accounting choices (19912000): a multitheory
perspective on earnings management
If we present the strategic choices and the accounting choices in a timeordered manner in table 3
(Miles and Huberman, 1998), we observe that most changes in the accounting choices coincide
with the ascent of a new CEO.
Table 3: time ordered presentation of strategic and accounting choices
1991 – 1995: CEO 1 1996 – 2000: CEO 2 2001: CEO 3 Strategic choice airlinefocused
strategy Dual strategy Return to the airline
focused strategy, but divestment in the foreign airlines
Choice of accounting methods or rules
Equity method Equity method Equity method
Judgment Writedown of the investments (1996 for Sabena 1998 and 1999 for the hunter airlines Large provision in 1996 for restructuring of airline activities Release of half of the provision in 1999
Large provision for restructuring of airline activities
Real transactions structuring of
44
operations which allow a transfer of benefits to the SAirgroup structuring of investment contracts (substance versus legal form)
Presentation of the results of the foreign airlines on the profit and loss account of the Sairgroup
As a single line item – share in the results of associated companies
Hidden under a single line item ‘results from operational investments’ the writedown of Sabena in 1996 as an exceptional single line item the write down of the Hunter airlines aggregated with positive accrual decisions under operating results
As a single line item – share in the results of associated companies
Classification of the results of the foreign airlines on the profit and loss account of the Sairgroup
Classified below the operating results
Classified among the operating results
Classified below the operating results
Disclosures in relation to airline activities
Detailed statistics on the airline activities
Disappearance of the detailed statistics creative segment reporting: Swissair (passenger transport) and Flightlease (aircraft leasing) were combined into one segment
Airline statistics appear again seperately from the results of Flightlease
If we combine insights from the upperechelons theory and strategic choice theory with the
results of the longitudinal analysis of the accounting choices, we notice that the reporting strategy
and accompagning accounting choices are determined simultaneously with the new corporate
strategy. The analysis of the managerial background of the CEO and his career path provides us
with a deeper understanding of the origin of the strategic choice and the interplay with accounting
45
choices which were necessary to present this strategy as successful. We notice that negative
accruals decisions which relate to decisions of the predecessor CEO are classified as single line
items on the profit and loss account, whereas negative accrual decisions with regard to their own
strategic decisions are made less or unvisible through aggregation exercises with accounting
choices with a positive impact. We observe endogeneity between the strategic choice and the
accounting choices, which are part of the strategy implementation process all along the execution
of this strategy.
The longitudinal case data reveal further endogeneity between the voluntary disclosure choices,
the mandatory accounting and disclosure choices and the reporting strategy of presenting the dual
strategy as a successful one.
Taking into account the strategic choice initiated by the CEO provides us with more insight on
the accounting choices adopted by the top managemesnt of a firm. The managerial incentives to
engage in earnings management are simultaneously influenced by the contracts of the firm and
the strategic choice adopted.
5.2 The incentives towards earnings management and the contracts of the firm: the
question of exogeneity versus endogeneity
5.2.1 the external contracts of the firm
In large scale empirical research, authors usually assume that the incentives embedded in the
contracts of the firm have an exogeneous character. We will confront this assumption with our
46
case results. Over time the period studied, the external contracts of the firm did not change. In the
time span of 19912000 the EU regulations on the definition of a community carrier did not
change (see section 3.2). Due to the high financing needs of the Sairgroup, the importance of the
contracts with the shareholders and the debtholders increased. The top management of the
SAirgroup learnt in 1997 (minutes of the Finance Committee, 18 august 1997)from a report
prepared by a professor of a Swiss university that in order to receive a favourable credit rating on
the debt market in the coming years it needed to obtain an equity/total debt ratio of 25% up to
35%. The finance committee was told that the situation in 1997 (= equity/total debt ratio : 17,8%)
was unfavourable.
We observe that the accounting choices applied by the SAirgroup since the launch of the dual
strategy make sure those financial figures appreciated by the capital markets and the debt markets
were produced. (see graph 1, 2 and 3 and Table 2). The constant concern for the credit rating of
the SAirgroup in the bond market induced top management to use as many offbalance sheet
financing techniques as possible (e.g. equity method for accounting for the EUairline
investments, operational lease contracts). The target ratio with regard to the financial structure
(0,25% equity/total debt ratio) was attained in 1999 (see table 2), and the concern to adhere to this
target financial structure is found in several internal documents of the Sairgroup as well as in the
external communication. The CEO of Sabena, an employee of the SAirgroup wrote in the
summer of 2001, the following to a Belgian Judge.
Currently Sabena’s balance sheet contains a liability of 98 Billion BEF. This is the main reason
why Swissair cannot consolidate Sabena because the market capitalisation of Swissair is at the
level of 1.2 billion Swiss Francs. (extract from a letter of the CEO of Sabena to the President of
the Commercial Court in Brussels on 28.6.2001)
47
The case data allow us to conclude that the contracts with the capital markets, the debt market and
the regulatory authorities are exogeneous in relation to earnings management in the case of the
SAirgroup, but what about the internal contracts?
5.2.2 The internal contracts of the firm
We observe the constant pressure of the implicit contracts of the firm. CEOs are to deliver results
above average industry performance otherwise they are threatned with a CEOreplacement.
Philippe Bruggisser kept operating profit levels almost constant over the years with the use of
gains on the sale of assets. So the implicit internal contracts remain unchanged over the time span
studied and have an exogeneous character.
The explicit internal contracts of the firm however have changed over the years. We focus first on
the explicit internal contracts with management. The remuneration contracts changed twice over
the time span studied. Each time the altered remuneration contract applies from the second year
that the new CEO is in office. We observe that the first year of a CEO is characterized by
accounting choices with a long term impact. These choices will have a favourable impact on the
indicators embedded in the incentive schemes which become effective the year after (see also
citation in 4.2.3). For example from 1997 on the bonus scheme of top executives of the
SAirgroup was determined mainly by the following two indicators, the EBIT of the SBU in which
a manager was active and the net group result of the SAirgroup. Both indicators were favourably
influenced by the accounting choices applied (equity method with writedown and non at arm’s
length transfer pricing and control of corporate opportunities) Next to the bonus, top managers
enjoyed from 1997 on the benefits of a stock option plan of which the rights were exercisable
after a period of three years. The new CEO of the Sairgroup who came into office in 2001 had
48
developed a new remuneration system, which would have become operative from 2002 onwards.
This system benefited from accounting choices he had taken in 2001.
Agency research usually assumes that the reward system in place creates the incentives to make
specific accounting choices in order to obtain the desired personal wealth effects for managers in
line with the existing plan. As such the incentives embedded in the remuneration contract are
assumed to be exogeneous. The case data show that in order to ensure that accounting choices are
made in line with the reporting strategy (or at least not opposed to it), the reward system itself and
the incentive embedded in the remuneration contract becomes the dependent variable. This
implies a reversed causation in order to allow the necessary accounting choices which will
provide the desired accounting numbers when the internal contract is adapted.
5.2.3 .the contract with the Board of Directors: the quality of board monitoring
Some authors consider the relationship between the Board of Directors as an internal contract.
We will thus analyse this contract and find out whether we observe changes over the time span
analysed (19912000). At the end of 1998 a revision of the Swiss Federal Aviation Act abolished
the need for board representation by the public institutions and paved the way for a reduction of
the Board of Directors. The large majority of the Board members saw their directorship come
finally to an end early in 1999. This implies that when hunter investments had to be approved by
the Board, many of the members were at the end of their mandate. The shortterm horizon
problem, which is studied in relation to CEOs, might also be an issue in the governance process
by boards. “Short term horizon” in relation to boards might not imply an extra incentive to
manage earnings, but might point to the conclusion that their desire to monitor might be less.
Further the fact that two acquisitions (LTU and Air Europe at the end of 1998) are presented
49
according to the cost method to this outgoing Board might point at endogeneity between board
events and accounting choices (see accounting choices in relation to the hunter strategy).
The study of the Board characteristics provides another example of this causality reversal. Under
the agency paradigm, earnings management is expected to be greater when board monitoring is
weak. The case data provide evidence however that the composition of the board may be adapted
in advance to allow a range of decisions, including earnings management, to take place (see
change of the Swiss Aviation Act which resulted in changes of the Board composition and
structure). Further large companies are more influential than small companies with regard to
shaping regulation or codes issued by regulatory authorities (e.g. change in Swiss Aviation Act).
As such regulation (which is an external contract) might be endogeneous for large firms, whereas
the same regulation has an exogeneous character for the smaller firms.
The case data reveal that the exogenous or endogenous character of the variables
involved driving earnings management, depend on whether or not a firm is able to
renegotiate or influence the contract.
5.3 Variables influencing the available discretion to engage in earnings management
Traditional agency research revealed a number of company characteristics and institutional
characteristics which create discretion for earnings management purposes (see literature review).
If we turn our attention to company characteristics and agency costs we observe that all EU
hunter airline investments were made in nonlisted companies. After the investment deal with the
SAirgroup, the ownership structure of the Hunter airlines was changed into a concentrated
ownership structure with two major shareholders. Agency research shows that the degree of
50
ownership concentration affects the nature of contracting and research results are available that
demonstrate that accounting informativeness declines as ownership concentration increases
(Dempsey, Hunter & Schroeder, 1993; Warfield, Wild & Wild, 1995; Donelly & Lynch, 2002;
Fan & Wong, 2002).
If we consider institutional elements we notice that the Sabena investment and the EUhunter
investments were made in countries which are characterized by low quality accounting
standards (Pope & Walker, 1999; Ball, Kothari & Robin; 2000; Ali & Hwang, 2000), a
low degree of investor protection (LaPorta, LopezdeSilanes, Shleifer & Vishny, 1997;
LaPorta, LopezdeSilanes & Shleifer, 1998), a low risk of litigation (Ball, Kothari and
Robin, 2000; Leuz & Verrechia, 2000) and a low degree of enforcement (Hope, 2003).
We therefore conclude that we not only observe a pattern of identical reporting choices made by
the SAirgroup in relation to Sabena and the EUhunter airlines, but that we also observe that the
ownership characteristics and the institutional environment of these airlines are virtually identical.
Extant research points almost exclusively at available discretion which is created by
environmental, institutional and firm characteristics. The case data however reveal that in order to
pursue his reporting strategy a CEO needs to create internal company discretion as well. In order
to present the dual strategy and the Hunter strategy as successful, accountting choices were part
of the implementation process of the strategy. These choices did not only involve accounting
earnings management decisions; they involved real decisions as well facilitating the transfer of
benefits from certain entities of the group to other entities. This implies that the corporate CEO
needs a lot of discretion or at least no resistance for his policy from the CEOs of the different
SBUs of the group. This discretion was achieved by changing the degree of centralization, by
changing the task responsibilities of top managers of the SBUS and by adapting the incentive and
51
reward systems of those individual SBU managers together with replacements of top team
members.
A number of decisions critical to the transfer of benefits were being centralized in the hands of
the corporate CEO. For example from 1999 on, all operational decisions with regard to the
airlines Sabena and Swissair (i.e. network and revenue management, marketing and sales) are
centralized in the newly created Airline Management Partnership. The CEO in charge of the
AMP became Philippe Bruggisser, the corporate CEO of the SAirgroup, and he decided on the
structure of ticket pricing between the two airlines and imposed the same fares on Sabena and
Swissair which made business passenger revenue shift from Sabena to Swissair (see section
4.2.1). This centralization changed drastically the task responsibilities of the CEOs of the
individual airlines. When the American CEO of Swissair resigned mid 2000, his complaint was
that he never received the authority and responsibility to run the airline as he wished:
“Find the best person in the world to replace me. But give him the necessary responsibilities
so that he can run the airline like he wants. Do not underestimate the importance of this point.
The fact that I was not able to stay in the company was due to the fact that this leadership
question was not taken care of.
(Translated from Luchinger, page 260, extract from the resignation letter of J. Katz).
The need for accounting discretion over a business unit will not only have an impact on the
degree of centralization and the division of task responsibilities between top team executives, but
also the choice of the performance indicator in the bonus plan of that executive will be influenced
by the need to make certain accounting choices in view of the reporting strategy. The incentive
schemes for the individual top team members were constructed in such a way that the CEOs of
the SBUs would not oppose the earnings management policy of the corporate CEO. In case of a
detrimental impact of a choice necessary to pursue the overall strategy (reporting strategy
inclusive) on their business unit results, the CEOs of the SBUs were shielded to a certain degree
52
(which could vary) from this negative impact (e.g. a part of the bonus plan of the top executives
of Sabena was tied to the net result of the SAirgroup and the top executives of Sabena took also
part in the share option plan of the SAirgroup, like the SAirexecutives). When the accounting
choices were beneficial for the units, the top team members benefited from both the real decisions
and from the ‘pure’ accounting decisions through their bonus plan.
So the analysis of the case data allows us to uncover additional elements of discretion on top of
the results of the agency literature. The data indicate that in order to implement the “necessary”
accounting choices the following variables needed to be adapted namely the composition of the
dominant coalition, the organizational design, the design of the management control system
(degree of centralization, the division of task responsibilities and the incentive and reward
structures) and a change in the characteristics of the investments under the hunter strategy.
If we summarize the findings of this case study and combine them with the insights from the
extant accounting literature, then figure 2 presents the contribution of our study in terms of
managerial incentives which drive the decision to engage in earnings management and the
creation of the necessary discretion to do so to the existing literature in a schematic way.
[ insert Figure 2 here ]
53
5. CONCLUSIONS
In this paper we have attempted to broaden the perspectives taken in studying earnings
management, responding to earlier critiques of the lack of progress it has made (Fields, Lys and
Vincent, 2001), and the call for more fieldbased work (Bernard and Skinner, 1996). Using a
case study we have tried to gain more insight into the drivers of earnings management and the
underlying process by an indepth analysis of the reporting strategy and the use of accounting
choices by a single group of companies over a time span of 10 years. To advance our
understanding of earnings management we have studied the reporting strategy and the
accompagning accounting choices from a multitheoretic perspective. This multitheory lens has
provided us with findings in relation to the extant agency literature which conflict with some of
its underlying assumptions as well as with additional insights into the process of earnings
management.
First, earnings management research, although being a mature research area, has generally failed
to distinguish whether accounting choices have an endogenous or an exogenous role (e.g. Fields,
Lys & Vincent, 2001). Using a multitheoretical perspective we find that the direction of the
causation assumed in the agency framework is often reversed. A number of incentives embedded
in contracts become dependent on the reporting strategy and accompanying accounting choices
which are endogenously determined with the strategic choice of the top management team of the
company. The data provide evidence that when contracts of the firm can be rewritten the direction
of the causality is reversed whereby the reporting strategy and accompanying accounting choice
becomes the independent variable and the incentive embedded in the contract of the firm becomes
the dependent variable.
54
Second the data reveal that the earnings management strategy with the accompagning accounting
choices are determined simultaneously by the nonnegotiable contracts of the firm and the
strategic choice of top management. When reporting choices are part of the corporate strategy,
the disconnection between the published performance and the underlying economic performance
can continue as long as real operational decisions and pure accounting choices are able to mask
the situation. Terminating earnings management in these situations requires a complete re
orientation of the strategy, restructuring of activities, redesign of the organization and changing
the management control systems back to those required to meet real business needs in terms of
the available market opportunities.
Third, this multitheory analysis has uncovered a number of additional variables, which might
enlarge the discretion of the CEO to engage in earnings management. These variables include the
composition of the top team of executives, the organizational design, the investment
characteristics and the management control system. Several different aspects of the management
control system might be influenced (e.g. the degree of centralization, the division of task
responsibilities and the choice of the measures used in the incentive systems).
Finally the case results reveal the limitations of current research methods employed to study
earnings management. Most models assume a oneyear impact of accounting earnings
management decisions in response to incentives. The case data reveal that accounting choices
consists of a portfolio of choices with long term effect on the pattern of income over time in
combination with choices with short term effect. These more fundamental types of earnings
management cannot be detected and studied using current research designs. This implies that we
55
only have acquired knowledge of a fraction of the totality of earnings management techniques
which can be used to suggest that company performance is better than it actually is.
We believe that earnings management is an important economic issue and requires to be
studied using a wider range of methods and techniques, including further casebased
work. Managers appear to use a wide variety of techniques, involving both real decisions
and accounting decisions, to enhance their reported performance and to potentially
extract private benefits unrelated to the underlying economic performance of the
organizations they manage. Studying only accruals methods of earnings management
allows us to see just the tip of the iceberg.
56
BIBLIOGRAPHY
AAAFinancial Accounting Standards Committee. (2003) “Evaluating conceptsbased versus rulesbased approaches to standard setting”, Accounting Horizons, 17, (1): 73 – 89.
Ali, A. and Hwang, L.S. (2000). CountrySpecific Factors Related to Financial Reporting and the Value Relevance of Accounting Data. Journal of Accounting Research 38, (1) : 121.
Arnold, B. and de Lange, P. (2004). “Enron: an examination of agency problems.”, Critical Perspectives on Accounting. 15: 751 765
Ball, R., Kothari, S.P. and Robin, A. (2000). The effect of international institutional factors on properties of accounting earnings. Journal of Accounting and Economics 29 : 151.
Baker, R. and Hayes, R. (2004) “Reflecting from over substance: the case of Enron Corporation”, Critical Perspectives on Accounting. 15: 767 – 785.
Barth, M., Elliot, J. and Finn, M. (1995). Market rewards associated with increasing earnings patterns. Working paper, Cornell University.
Bartov, J. (2001). Does the use of financial derivatives affect earnings management decisions? The Accounting Review, 76 :126.
Bauman, M. (2003) “The impact and valuation of offbalance –sheet activities concealed by equity method accounting”, Accounting Horizons. 17(4): 303314.
Beasly, M. (1996). An empirical analysis of the relation between the board of director composition and Financial statement Fraud. The Accounting Review, 71 : 443465.
Beatty, A., Chamberlain, S.L. and Magliolo, J. (1995) “Managing Financial Reports of Commercial Banks: The Influence of Taxes, Regulatory Capital and Earnings”, Journal of Accounting Research. 33 (2) : 231261.
Beatty, A. and K. Petroni.(2002) “Earnings management to avoid earnings declines across publicly and privately held banks”, The Accounting Review. July: 515546.
Bebchuk, L. (1999) “A rentprotection theory of corporate ownership and control” NBER working paper 7203 National Bureau of Economic Research, Cambridge, MA.
Beneish (1997) “Detecting GAAP Violation: Implications for Assessing Earnings Management among Firms with Extreme Financial Performance”, Journal of Accounting and Public Policy, vol 17 : 271309
Benston, G. and Hartgraves, A. (2002) “Enron: what happened and what we can learn from it”, Journal of Accounting and Public Policy. 21 : 105127
Benston, G., Bromwhich, M. and Wagenhofer, A. (2006) “Principles versus rulesbased accounting standards: the FASB’s standard setting strategy”, Abacus. 42(2), : 165 188
Bernard, V and Skinner, D. (1996). What motivates managers’ choice of discretionary accruals. Journal of Accounting and Economics 22 :313325.
57
Boyd, B. (1994) “Board Control and CEO Compensation”, Strategic Management Journal. 15 : 335344
Briloff, A. (2001) “ Garbage In/Garbage Out: a critique of fraudulent financial reporting: 1987 – 1997 (The COSO report and the SEC Accounting Regulatory Process”, Critical Perspectives on Accounting12 : 125148.
Burghstahler, D. and Dichev, I. (1997) “Earnings management to avoid earnings decreases and losses.”, Journal of Accounting and Economics. 24 : 99126.
Cyert, R. and J. March. (1963). A Behavioral Theory of the Firm. Prentice Hall
DeAngelo, H., DeAngelo and L., Skinner, D. (1996) Reversal of fortune: Dividend signaling and the disappearance of sustained earnings growth. Journal of Financial Economics, 40 : 341371
Dechow, P., Sloan, R. and Sweeney A. (1995). “Detecting Earnings Management”, The Accounting Review. 70 (2) : 193 – 225.
Dechow, P., Sloan, R. and Sweeney A. (1996). “Causes and Consequences of Earnings Manipulation: An analysis of Firms Subject to Enforcement Actions by the SEC”, Contemporary Accounting Research. 13 (1): 193225
Dechow, P. and Skinner, D. (2000), “Earnings Management: Reconciling the views of Accounting Academics, Practioners and Regulators, Accounting Horizons, 14 (2) : 235 – 250.
DeFond, M. and Jiambalvo, M. (1994) “Debt Covenant Violation and Manipulation of Accrulas.”, Journal of Accounting and Economics. 17 : 145 – 176.
DeFond, M. and Park, C (1997) “Smoothing Income in Anticipation of Future Earnings.”, Journal of Accounting and Economics. 23: 115139.
Degeorge, F, Patel, J. and Zeckhauser, R. (1999) “Earnings Management to Exceed Thresholds”, Journal of Business. 27 : 133.
De Jong, A., DeJong, D., Mertens, G. and Roosenboom, P. (2007) “Investor relations, reputational bonding, and corporate governance: The case of Royal Ahold”. Journal of Accounting and Public Policy. 26 : 328 – 375.
Dempsey, S., Hunt, H. and Schroeder, N. (1993). Earnings management and corporate ownership structure: an examination of extraordinary item reporting. Journal of business finance and accounting 20, (4) : 479 500
Donnelly, R. and Lynch C. (2002). The ownership structure of UK firms and the informativeness of accounting earnings. Accounting and Business Research, 32, (4),: 245257.
Dumontier, P. and Raffournier, D. (1998). Why firms comply voluntarily with IAS: an empirical analysis with Swiss Data. Journal of International Financial Management and Accounting, 9, (3): 216245.
58
Dyck, A. and L. Zingales. (2004). “Private Benefits of Control: An international comparison” The Journal of Finance LIX :537 600.
Ely. (1995) “Operating Lease Accounting and the Market’s Assessment of Equity Risk”, Journal of Accounting Research. 33 (2) : 397415.
Ewert, R and A. Wagenhofer.(2005) “Economic effects of tightening accounting standards to restrict earnings management”, The Accounting Review. , vol 80, N° 4: 11011124.
Fama, E. and Jensen, M. (1983). Separation of ownership and control. Journal of Law and Economics 26: 301325
Fan, J. P.H. and Wong, T.J. (2002). Corporate ownership structure and the informativeness of accounting earnings in East Asia. Journal of Accounting and Economics 33 : 401425
Fields, T., Lys, T. and Vincent, L. (2001). “Empirical research on accounting choice.” Journal of Accounting and Economics 3 : 255307
Finkelstein, S. and D. Hambrick. (1996). Strategic Leadership: Top Executives and their Effects on Organizations. St. Paul.
Francis, J. (2001). “Discussion of empirical research on accounting choice”, Journal of Accounting and Economics. 31: 309 – 319
Fudenberg, D., & Tirole, J., (1995). A theory of income and dividend smoothing based on incumbency rents. Journal of Political Economy,103: 75 – 93.
Gaver, J., Gaver, K. and Austin, J. (1995). “Additional Evidence on Bonus Plans Income Management.”, Journal of Accounting and Economics. 19: 328.
Gephart, R.P.,”Qualitative research and the Academy of Management Journal” Academy of Management Journal, 2004, vol 47, N° 4: 454462
Godfrey, J., Mather, P. and Ramsay, A. (2003) “Earnings and Impression Management in Financial Reports: The Case of CEO Changes”, Abacus.39 (1) : 95123.
Graham, J, Harvey, C and Rajgopal, S. (2005) “The economic implications of corporate financial reporting”, Journal of Accounting and Economics vol 40 : 3 75
Grossman, S. and O. Hart. (1988). “One shareone vote and the market for corporate control.”, Journal of Financial Economics 20 : 175202.
Guenther, D., Maydew, E and Nutter, S. (1997). “Financial Reporting, TaxCosts and BookTax Conformity”, Journal of Accounting and Economics. 23: 225248.
Guidry, F. Leone, A and Pock, S. (1999) “EarningsBased Bonus Plans and Earnings Management by Business Unit Managers”, Journal of Accounting and Economics. 26: 113142.
Hambrick, D. and P. Mason. (1984). “Upper Echelons: the organization as a reflection of its top managers.” Academy of Management Review 9 : 194206.
59
Hambrick, D., & Fukutomi, G. (1991). The seasons of a CEO’s tenure. Academy of Management Review. 16: 719742.
Han, J. and Wang, S. (1998). “Political Costs and Earnings Management of Oil Companies during the 1990 Persian Gulf Crises”, The Accounting Review. 73: 103 – 117.
Hand, J. (1989).”Did firms undertake debtequity swaps for an accounting paper profit or true financial gain? The Accounting Review. 64: 587 – 623.
Healy, P. (1985). “The effects of Bonus Schemes on Accounting Decisions”, Journal of Accounting and Economics.7: 85107
Healy, P. and J. Wahlen. (1999). “A review of the earnings management literature and its implications for standard setting.” Accounting Horizons 13 : 365 – 383.
Holthausen, R., Larcker, D. and Sloan, R. (1995) “Annual Bonus Schemes and the Manipulation of Earnings”, Journal of Accounting and Economics. 19: 29 – 74.
Hope, O.K. (2003). Disclosure Practices, Enforcement of Accounting Standards, and Analysts’ Forecast Accuracy: An International Study. Journal of Accounting Research 41(2) : 235 – 272
Hunt, A., Moyer, S. and Shevlin, T. (1995). Earnings volatility, earnings management, and equity value. Working paper, University of Washington.
Jensen, M. and Meckling, (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3 : 305360.
Jensen, M. and E. Zajac. (2004). “Corporate elites and corporate strategy: how demographic preferences and structural position shape the scope of the firm” Strategic Management Journal 25 : 507524.
Johnson, S., R. La Porta, F. LopezdeSilanes and A. Shleifer. (2002). “Tunneling” American Economic Review 90 : 22 – 27.
Kasznik, R. (1999) “On the Association between Voluntary Disclosure and Earnings Management”, Journal of Accounting Research. 37 (1): 5781
Kershaw. “Evading Enron”, Modern Law Review. 2005, vol 68, N° 4
Key, K. (1997) “Political Cost Incentives for Earnings Management in the Cable Television Industry.”, Journal of Accounting and Economics. 23 (3): 309337.
La Porta, R., F. LopezdeSilanes, A. Schleifer and R. Vishny (1997). Legal determinants of external finance. Journal of Finance 52 : 11311150.
La Porta, R., F. LopezdeSilanes, A. Schleifer and R. Vishny (1998). Law and finance. Journal of Political Economy 106 :1113 1155.
Lee, T. (2006) “The war of the sidewardly mobile corporate financial report” Critical Perspectives on Accounting.17: 419 – 455.
60
Leuz, C. and Verrecchia, R.E. (2000). “The Economic Consequences of Increased Disclosure.“ Journal of Accounting Research 38. suppl. : 91124.
Leuz, C., D. Nanda and P. Wysocki. (2003). “Earnings management and investor protection: and international comparison.” Journal of Financial Economics 69 : 505 – 527.
Lev, B. (2002). «Where have all Enron’s intangibles gone ? », Journal of Accounting and Public Policy. 21: 131 – 135.
Lys, T. and Vincent, L. (1995) “An analysis of value destrruction in AT&T’s acquisition of NCR”, Journal of Financial Economics., 39: 353378.
McNichols, M. (2000). Research Design Issues in Earnings Management Studies , Journal of Accounting and Public Policy. Vol 19: 313 – 345.
Miles, M. and Huberman, A. (1998) Qualitative data analysis, an expanded sourcebook. London, Sage Publications.
Murphy, K. and Zimmerman, J. (1993) “Financial Performance Surrounding CEO Turnover”, Journal of Accounting and Economics. 16: 273 – 316.
Nelson, M. , Elliot, J. and R. Tarpley. (2002) “Evidence from Auditors about Managers’ and Auditors’ Earnings Management Decision”, The Accounting Review, vol 77, supplement: 175 202
Nelson, M., Elliot, J and R. Tarpley (2003) “How are earnings managed? Examples from auditors” Accounting Horizons. Supplement: 1735.
Occasio, W., (1994). “Political dynamics and the circulation of power: CEO succession in U.S. industrial corporations, 19601990.” Administrative Science Quarterly 39: 285312.
Occasio, W. (1999). “Institutionalized action and corporate governance: the reliance on rules of CEO succession.” Administrative Science Quarterly 44: 384 – 416.
O’Connell, B. (2004). Enron.Con:”He that filches from my good name… makes me poor indeed”. Critical Perspectives on Accounting, 15 :733749.
Peasnell, K.V., Pope, P.F. and Young, S. (2001). The characteristics of firms subject to adverse rulings by the Financial Reporting Review Panel. Accounting and Business Research, 31. (4): 291311.
Pope, P. and Walker, M., (1999). International differences in the timeliness, conservatism, and classification of earnings. Journal of Accounting Research, 37 (Suppl.): 5387
Pourciau, S. (1993). Earnings management and nonroutine executive changes. Journal of Accounting and Economics 16: 317336.
Puffer, S. and J. Weintrop. (1991) “Corporate performance and CEO turnover: the role of performance expectations.” Administrative Science Quarterly 36 : 119
61
Revsine, L. (1991) “The Selective Financial Misrepresentation Hypothesis”, Accounting Horizons, december:16 27
Revsine, L. (2002). “Enrond: sad but inevitable”, Journal of Accounting and Public Policy. 21 :137145.
Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting & Economics, 42 : 335370.
Shevlin, T. (1987) “Taxes and offbalance sheet financing: Research and Development limited partnerships.”, The Accounting Review.62 : 480509.
Shipper, K. “Principlesbased accounting standards”, Accounting Horizons. 2003, March, vol 17, N°1: 61 72
Shleifer, A. and R. Vishny. (1989). “Management Entrenchment: the case of managerspecific investments” Journal of Financial Economics 25 : 123139.
Shleifer, A. and D. Wolfenzon. (2002). “Investor protection and equity markets” Journal of Financial Economics. 66: 328.
Sweeny, A. (1994) DebtCovenant Violations and Managers’ Accounting Responses , Journal of Accounting and Economics. 17 : 281308
Warfield, T., J. Wild and K. Wild. (1995). “Managerial ownership, accounting choices, and informativeness of earnings” Journal of Accounting and Economics 20: 6191.
Wayne, T., Herrmann, D and Inoue, T. (2004) “Earnings Management through Affiliated Transactions”, Journal of International Accounting Research 3 (2): 1 25.
Williams, P. (2004) “Recovering accounting as a worthy endeavour”, Critical Perspectives on Accounting 15 (4/5): 513517.
Yin, R. (2003) Case Study Research Design Methods London, Sage Publication: Applied Social Research Methods Sciences
Zahra, S. and J. Pearce, (1989) “ Boards of Directors and corporate financial performance: a review and itegrative model.” Journal of Management,15 : 291334.
62
Appendix A: Overview of documents and publications consulted
Minutes of Meetings
Minutes of the Board of Directors of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (october) Minutes of the Management Committee (konzernleitung) of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (october) Minutes of the Finance Committee of the SAirgroup and agenda with accompagning documents: 1995 – 2001 (August) Minutes of the Executive Committee of the Board of Directors of the SAirgroup (Ausschus der Verwaltungsrat): 1996 – 1999 (april) Committee was abolished in april 1999 due to the reform of the Board of Directors Minutes of the Board of Directors of Sabena and agenda with accompagning documents: 1994 – 2001 (november) Minutes of the Management Committee of Sabena and agenda with accompagning : 1994 – 2001 (november) Minutes of the Workers’ Council Meetings : 1994 – 2001 (november) Minutes of the Steering Committee SAir/Sabena: May 1995 – March 1998 Minutes of the Steering Committee Diamond – 1999 (n° 1 – n° 9) Minutes of the AMP (Airline Management Partnership) Management Committee Meeting (october 1999 – october 2001)
Contracts
Shareholders’ and Master Agreement between the state of Belgium and Swissair Swiss Air Transport Company LTD – 4 May 1995 Loan Agreement between Société Féderale d’Investissement (Belgium) and Swissair – 24 July 1995 Global Warrant Certificate and Terms of Warrants – 25 july 1995 Cooperation Agreement between Sabena and Swissair, Swiss Air Transport Company – 24 july 1995 Codeshare beyond Agreement between Swissair and Sabena, 1 june 1997 Frame Agreement between Swissair Swiss Airtransport Ltd and Sabena NV concerning the cooperation in the area of cargo transportation – 16 december 1996 Cooperation Agreement between Sabena NV and Swisscargo Ltd concerning the cooperation in the area of cargo transportation – 12 august 1997 Fleet Cooperation Agreement, 18 december 1997 between Swissair, SAirgroup, SR Technics, Sabena, DAT and Sobelair (the latter two are subsidiaries of Sabena) Technical Assistance and Service Agreement (TASA) between Sabena and Gate Gourmet Internationa Ltd (subsidiary of SAirgroup) on 5 february 1997 (relates to catering) Swissair/ Sabena Airline Management Partnership (legal establishment of the UK partnership) – Allan & Overy, London 31sth of July 2000
63
Consulting Reports
Report prepared on a possible acquisition – Flair Report – (24 May 1994) – Mc Kenzie Report on a multipartnership strategy – (3 october 1997) – Mc Kenzie Several reports on the Hunter Strategy – (30 october 1997, 1 december 1997, 14 january 1998, 3 february 1998) Several reports on project Diamond – (april 1999, June 1999,december 1999) – Mc Kenzie Several reports on project Diamond, exclusively on the cost benefit sharing model under project Diamond = AMP (july 1999 – november 1999) – Roland Berger Several consultancy report on AMP (december 1999 – january 2000) – Mc Kenzie AMP – Clean Slate report – march 2000 – Mc Kenzie Strategic options for Sabena Technics – 16 september 1997 – Mc Kenzie Situation of SR/SN prepared for Sabena – 7 november 1997 – Mc Kenzie Development and Evaluation of Strategic Options catering – Sabena 26 august 1997 ICARUS – consulting AG: Development and Evaluation of Strategic Options cargo handling – 26 August 1997 ICARUS – consulting AG: Strategic Options for Sabena Ground Handling – 16 september 1997 – Mc Kenzie PWCValuation of the maintenance division – Sabena Technics – 1 january 1999 Report for the financing of Aircraft – Sabena – March 1999 Crédit Lyonnais – Transportation Advisory Group Selecting the best strategy to value the state participation in Sabena – report for the Board of Directors of Sabena november 1999 – Boston Consulting Group Project Nightfly : strategic perspective on shareholder negotiations – (december 1999 – March 2000), ING Bearings – report ordered by the Minister of public companies Project Daylight – ING Bearings – May 2001 Blue Sky – several consulting reports prepared for Sabena – by the Boston Consuling Group (spring 2000 – march 2001). Warburg Dillon Read – comments on financial guidelines of the SAirgroup – 29 september 1999 CSFB – comments on financial guidelines of the SAirgroup – november 1999 Project Shield – october 2000 – Mc Kenzie Risk assesment and strategy – March 2001 CSFB
Reports of Auditors
Management letters of the auditor of Sabena (KPMG) (1995, 1996, 1997, 1997, 1998, 1999, 2000) Sabena Opinion on the proposed capital increase – december 11, 2000 KPMG Report of STG Coopers and Lybrand to the Finance Committee and to the Board of the SAirgroup (1995, 1996, 1997) Management Report of PWC to the Finance Committee and to the Board of the SAirgroup(1998, 1999, 2000) Financial Exposure Report of PWC to the Board of the SAirgroup – february 2001
64
Audited Results for the half year to 30 june 2001 to the Board of the SAirgroup of KPMG
Prospectusses issued by the SAirgroup
. SAirGroup – SAirGroup Finance (NL) B.V. –– € 400,000, 000 – 4.375 per cent Guaranteed Bonds due 2006 Guaranteed by SAirgroup – date 11 th of November 1999 . SAirGroup – SAirGroup Finance (NL) B.V. – U.S. $ 350,000,000 Guaranteed Notes due 2004 – Guaranteed by SAirgroup – date 11 th of November 1999 . Prospekt SAirgroup 2000 – 2007 von CHF 300 000 000, 41/4% Anleihe (loan) SAirgroup – date 25 th of Januar 2000 . SAirGroup – SAirGroup Finance (NL) B.V. € 400,000,000 – 6.625 per cent. Guaranteed Bonds due 2010 – Guaranteed by SAirgroup – date 5 th of October 2000
other documents Correspondence of the CEO, the Secretary General and the legal deparment of Sabena 19952001 The Annual Reports of Swissair/ SAirgroup 1945 2000 The Annual Reports of Sabena 1990 – 2000 Financial Statement Swissair Group for the 6 months ended 30 june 2001 Sabena Development Plan 1998 – 2000 Sabena Development Plan 2000 2002 Remuneration contracts of CEO Sabena 1996 2000 and 2000 – 2001, CEO SAirgroup 1996 – 2000, CFO SAirgroup 1997 – 2000, CEO Swissair 19971999 (details of the remuneration contracts of the other SBU CEOs were found in the Ernst & Young Report – complete version) Bonus and stock option plan SAir Executives 1997 – 2000 Bonus and stock option plan Sabena – Executives – 1999 2000 Presse maps of Sabena and SAirgroup – 1995 2001
Reports, documents, articles and books
Chambre des Représentants de Belgique. (2003) ENQUÊTE PARLEMENTAIRE visant à examiner les circonstances qui ont conduit à la mise en faillite de la Sabena, de déterminer les éventuelles responsabilités et de formuler des recommandations pour l’ avenir. DOC 50 1514/003 and DOC 50 1514/004 Decraene, S., Denruyter and P., Sciot, G. (2002) De crash van Sabena. Leuven, Uitgeverij Van Halewyck Lüchinger, R. (2001). SWISSAIR l’histoire secrète de la débâcle. Lausanne, Editions Bilan, Moser, S. (2001). Bruchlandung, wie die Swissair zugrunde gerichtet wurde Zürich, Orell Füssli Verlag Presse Report of Ernst and Young ‘investigation in Sachen Swissair’ Ernst and Young Report – complete version ‘investigation in Sachen Swissair’ report undertaken at the request of the administrator of the SAirgroup Slits, V. (2004)., “Comment Swissair a pillé la Sabena.” La Libre Belgique, 17 th of November 2004, 1:1819.
65
T.M. and D. M. (2004). “La théorie du complot, ou la tentation de réécrire l’histoire.” Le Temps – Quotidien Suisse édité à Genève” 17 th of November 2004, n° 2034, 3.
66
Appendix B: Definition of Control in the 7 th Directive
the concept of legal control defined by the 7 th Directive in Section 1, article 1 point 1.
A member state shall require any undertaking governed by its national law to draw up
consolidated accounts and a consolidated annual report if that undertaking (a parent
undertaking):
(a) has a majority of the shareholders’ or members’ voting rights in another undertaking
(a subsidiary undertaking); or
(b) has the right to appoint or remove a majority of the members of the administrative,
management or supervisory body of another undertaking, (a subsidiary undertaking)
and is at the same time a shareholder in or member of that undertaking; or
(c) has the right to exercise a dominant influence over an undertaking (a subsidiary
undertaking) of which it is a shareholder or member, pursuant to a contract entered
into with that undertaking or to a provision in memorandum of articles of association,
where the law governing that subsidiary undertaking permits its being subject to such
contracts or provisions. A Member State need not prescribe that a parent undertaking
must be a shareholder in or member of its subsidiary undertaking. Those Member
States the laws of which do not provide for such contracts or clauses shall not be
required to apply this provision, or
(d) is a shareholder in or member of an undertaking, and: (aa) a majority of the members
of the administrative, management or supervisory bodies of the undertaking (a
subsidiary undertaking) who have held office during the financial year, during the
preceding financial year and up to the time when the consolidated accounts are drawn
up, have been appointed solely as a result of the exercise of its voting rights; or (bb)
controls alone, pursuant to an agreement with other shareholders in or members of the
undertaking ( a subsidiary undertaking), a majority of shareholders’ or members’
voting rights in that undertaking. The Member States may introduce more detailed
provisions concerning the form and the contents of such agreements.
The Member states shall prescribe at least the arrangements referred to in (bb) above.
They may make the application of (aa) above dependent upon the holding’s representing
20% or more of the shareholders’ or members’ voting rights. However (aa) above shall
67
not apply where another undertaking has the rights referred to in subparagraphs (a), (b) or
(c) above with regard to that subsidiary undertaking.
Next to the concept of legal control the 7 th directive foresaw the option for the member
states to implement the concept of effective control in their laws. The case of effective
control has a residual character. This implies that the legal power of control and effective
control cannot be combined in the same subsidiary. The 7 th Directive states in section 1,
article 1, point 2: “Apart from the cases mentioned in paragraph 1 above and pending
subsequent coordination, the Member States may require any undertaking governed by
their national law to draw up consolidated accounts and a consolidated annual report if
that undertaking (a parent undertaking) holds as participating interest as defined in article
17 of Directive 78/660/EEC in another undertaking ( a subsidiary undertaking), and: (a) it
actually exercises a dominant influence over it; or (b) it and the subsidiary undertaking
are managed on a unified basis by the parent undertaking. “ Only a few Member States
in Europe Union have introduced the concept of effective control in their national laws.
68
Appendix C: Definition of Control in the International Accounting Standards in the nineties
In the 1990s the definition of control of the International Accounting Standards was
embedded in IAS 22 ‘Business Combinations’ as well as in IAS 27, ‘Consolidated and
seperated financial statements’. Both definitions were identical and defined the concept
of control as follows: Controll is the power to govern the financial and operating policies
of an entity so as to obtain benefits from its activities (par 4 – IAS 27). In order to allow
preparers of financial statements to judge whether or not control existed in a relationship
between investor and investee the following principles were included in IAS 22 and IAS
27 (again these principles are identical). These principles are the following (IAS 27 – par
13):
Control is presumed to exist when the parent owns, directly or indirectly through
subsidiaries, more than half of the voting power of an entity unless, in exceptional
circumstances, it can be clearly demonstrated that such ownership does not constitute
control. Control also exists when the parent owns half or less of the voting power of an
entity when there is:
(a) power over more than half of the voting rights by virtue of agreement with other
investors;
(b) power to govern the financial and operating policies of the entity under a statute or
agreement;
(c) power to appoint or remove the majority of the members of the board of directors or
equivalent governing body and control of the entity is by that board or body; or
(d) power to cast the majority of votes at meetings of the board of directors or equivalent
governing body and control of the entity is by that board or body.
69
Appendix D:
S’il est possible que Swissair amortisse la valeur de sa participation en SABENA, il est acquis
qu’un telle opération purement comptable n’entraînera en aucune manière le retrait de Swissair.
Cette opération aurait pour seul objectif de ne plus faire intervenir les résultats de la SABENA
dans la consolidation des résultats du groupe. (extract from the letter of the Secretary General of
Sabena with approval of the CEO of SABENA in order to response to questions raised by
members of the Belgian parliament – 19th of March 1997)
‘Sur le plan comptable, l’amortissement d’une participation permet à une entreprsie de ne plus
devoir consolider cette participation, et donc de ne plus inclure dans ses résultats les profits ou
les pertes de cette participation – Sur le plan stratégique, cet amortissement ne signifie pas une
vente ou un retrait’ (extract from a letter of the Secretary General of Sabena with consent of the
CEO of Sabena to the Cabinet of the Minister of Transport – 15 March 1997)
70
Appendix E: Illustration of the impact of the accounting choices of the SAirgroup
The following accounting methods will be applied to an example of two individual companies A and B, whereby A holds an investment in B of 49%. The group accounts will be prepared under three different sets of accounting choices: set (1) full consolidation, set (2) equity method and set (3) equity method whereby the investment was written down in the prior year.
Individual accounts A
Individual accounts B
Group accounts
Group accounts
Group accounts
Full consolidation
Equity method
Equity method with write down
Tangible Assets
600 700 1300 600 600
Investment 196 172 Current Assets 504 350 854 504 504 Total Assets 1300 1050 2154 1276 1104 Capital 500 400 500 500 500 Reserves 200 200 200 4 Result of the year
50 (50)
Group result 26 * 26 50 Minority interests
178
Long term debt
400 500 900 400 400
Trade creditors
150 200 350 150 150
Total liabilities + Equity
1300 1050 2154 1276 1104
Equity/(Equity + total debt
33 % 56 % 50 %
Return on Equity
3,7 % 3,7 % 9,9 %
Return on total assets
1,2 % 2 % 4,5 %
* group result = 50 – 24 (= share of the loss of B) = 26
71
Figure 1
72
Figure 2
73
Graph 1: Operating Revenue Swissair/Sairgroup 19842000 in CHF mio
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
2000 1998 1996 1994 1992 1990 1988 1986 1984
Individuele accounts Swissair
Group accounts Swissair/SAIR group
Hunter strategy
Dual strategy
___ operating revenue
74
Graph 2: Net income Swissair/SAirgroup19842000 in CHF mio
3500
3000
2500
2000
1500
1000
500
0
500
1000
2000 1998 1996 1994 1992 1990 1988 1986 1984
Net Income
Source: Financial Statements Swissair Group/SAirgroup
75
3000
2500
2000
1500
1000
500
0
500
1000
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Graph 3: Swissair/SAirgroup operating result and net result in mio CHF
operating result net result
Source: Financial Statements Swissair Group/SAirgroup
76
Graph 4: Overview of the operating result and the net result of the Sabena Group in mio BEF
14.000
12.000
10.000
8.000
6.000
4.000
2.000
0
2.000
4.000
6.000
1992 1993 1994 1995 1996 1997 1998 1999 2000 operating result
net result
Source: Financial Statements of the Sabena Group
77
Graph 5: Evolution flight revenue versus other revenue in mio CHF of the Swissair/SAirgroup
0 2000 4000 6000 8000 10000 12000 14000 16000 18000
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Flight revenue Other revenue Total revenue
Source: Financial Statements Swissair Group/SAirgroup
78
Graph. 6: The impact of "gain on sale of assets" on group operating profit in mio CHF.
0
100
200
300
400
500
600
700
800
1995 1996 1997 1998 1999 2000
group operating profit excl. gain on sale of assets
gain on sale of assets
group operating profit
Source: Annual Reports Swissair/ SAirgroup