Creative Accounting

What is meant by Creative Accounting ? 


Introduction :

In the accounting world, the general rule is that accounts should give a true and fair view. Generally, an accountant has a professional responsibility to comply, a corporation has a legal responsibility to comply, auditors have a legal responsibility to give some sort of opinion on compliance, yet frequently this all goes out of the window. Frequently, accountant and businesses are motivated to produce accounts that don't show a true and fair view. Not only this, but auditors rely on sampling and somehow fail to spot there is a problem.

Contents :                          

  1. Meaning of Creative Accounting.
  2. Objectives of Creative Accounting.
  3. Motivations for Creative Accounting.
  4. Examples of Creative Accounting.
  5. Terminology in Creative Accounting.
  6. Creative Accounting by Capitalising Expenditure.

Meaning of Creative Accounting :


Creative accounting is the practice of producing financial accounts that suit a particular purpose but do not really show the true and fair view. Sometimes the accountant may wish to show favorable profits (e.g. to get a bonus) at other times losses (e.g. to pay less tax). Sometimes the accountant may wish to show a healthy balance sheet (e.g. to get a bank loan), at other times an unhealthy balance sheet (e.g. before a management buy-out to get a bargain). Creative accounting often fools auditors and regulators, e.g. Enron, WorldCom, and the recent Madoff case.

Creative accounting is a term referring to accounting practices that may follow the letter of the rules of standard accounting practices but certainly deviate from the spirit of those rules. It is characterised by excessive complication and the use of novel ways of characterising income, assets or liabilities and the intent to influence readers towards the interpretations desired by the authors. The term 'innovative' or 'aggressive' are also sometimes used.
The term is generally understood refers to systematic representation of the true income and assets of corporations or other organisation. Creative accounting is at the root of a number of accounting scandals. Creative accounting always starts with human intervention.

Definition :

Creative accounting is the use of unorthodox message parlour techniques which, while following provisions of GAAP, paint a desired (negative or positive, as the case may be) picture of a firm's finances. For example, selling an asset (Whose market value is high but book value is low) to create non-operating profit that offsets operating loss. Unlike cooking the books, creating accounting is generally legal. It is also called as earnings management.

What are the Objectives of Creative Accounting ?


Creative accounting always starts with human intervention. Rarely can a system, even the most advanced accounting system, create profits and assets out of thin air. Creative accounting can be caused by human error, but statistically, some of these errors would have a positive effect on profits, others would have negative effects.

Objectives of Creative Accounting :


Therefore, a typical creative accounting incident involves both human effort and a bias towards some objective.

1) Increased Profit :
Most typically the objective is increased profits, inflated asset values, understated liabilities, and overstated shareholder value.

2) Management Motivation :
The motivation of management and accountants typically being bonuses, promotion, salary rises, etc.

3) Seeking Promotions :
There can be other objectives of creative accounting. Most managers and accountants perform a given role for two or three years before seeking a promotion. Therefore throughout that period they are motivated to show increases in profitability (year on year growth). This results in a form of creative accounting that smooths out income and costs so that the result over the two or three year period is a growth in profits.

4) Takeover and Acquisitions :
Takeovers and acquisitions also create opportunities for creative accounting. In the year of the takeover, the new management and accountant have a bias to show a dismal picture - low profits, deflated asset values, inflated provisions, and perhaps an impacted stock value (as a result of the poor results if they are made public). Then in the years proceeding the takeover, the assets can be re-inflated, provisions released, all contributing to increased profits and a perception that the new management is doing a great job.
The above technique may also be used before a management buy-out. This helps the new buyers negotiate a lower purchase price, and increases their return after the buy-out.

5) Other Objectives :
There are other objectives of creative accounting. For example :
a) To keep the company's financial results within agreed limits set by creditors,
b) To fulfill public listing requirements,
c) To help negotiations with regulators,
d) To pay less tax,
e) To push the company towards insolvency.


Explain the Motivations for Creative Accounting.


Motivations for Creative Accounting :


There are many motivations for creative accounting.
Here are the most common :

Motivation for Creative Accounting

Explanation

 

Possible Impact on the Financial Accounts

a) Management Desire to Receive a Bonus

 

The bonus is based on profits. The higher the profit, the higher the bonus or the

bonus is only payable if a certain level of profits are achieved.

  • Overstate Income
  • understate Costs and Expenses
  • assets Overstated
  • liabilities Understated

 

b) The Business Seeks to Pay Less Tax.

 

Normally, governments tax profits, so the more profits, the more tax is paid.

  • Income is Understated
  • Costs and Expenses are Overstated
  • Liabilities are Overstated
  • Assets may be Understated

c) The Business Needs a Loan or Wants to Get a Loan at a Favorable Rate.

 

Normally, the less risk perceived by the lender, the lower the interest rate charged by the lender.

  • Minimize Bad Debts
  • Overstate Asset Values
  • Understate Liabilities
  • Overstate Income

d) The managers are involved in a management buyout or significant share purchase and seek to minimise the price they will pay for the business or shares.

When someone is buying a business or shares, they will want to pay the lowest price possible, generally the value of a business is related to its profits so the lower the profit the cheaper the price.

  • Understate Income
  • Delay Income Recognition
  • Overstate Costs and Expenses
  • Bring Forward Asset Purchases
  • Increase Stock Levels
  • Understate Assets
  • Overstate Liabilities


Give the Examples of Creative Accounting.

There can be different reasons and motivations for creative accounting.

Example :

The accountant is working on his computer one day and it suddenly stops working. He makes a phone call, someone takes his computer away, one week later he receives an invoice for Rs. 1,000.
He is a great accountant but not very good with computers. He believes that someone fixed his computer. The word 'fixed' is important, it has a very similar meaning to 'repair' and the accountant quickly finds a general ledger account (a place where accountants record financial transactions) named 'repairs and renewals', this is an expense account in the Income Statement (also known as the Profit & Loss Statement). The accountant allocates the invoice to this account. The result is:

• a Rs. 1,000 increase in costs (bad news)
• a Rs. 1,000 decrease in profits (more bad news)
For accountants, the journal entry due to the above is :

Account Description

Debit

Credit

Repairs & Renewals A/C

To Bank A/C

1,000

 

 

1,000

This ignores tax and the purchase ledger system.

Time for Creative Accounting :

Some weeks later the accountant's boss, the chief accountant, is reviewing the financial performance of the company. The chief accountant argues that the above costs represent an addition to the fixed assets of the company (rather than a revenue expense).
He argues that the computer must be a new piece of equipment and will last many years: therefore, having the characteristics of a fixed asset. The journal above is reversed and a new one prepared :

Account Description

Debit

Credit

Fixed Assets Addition A/C

To Bank A/C

1,000

 

 

1,000

This also ignores tax and the purchase ledger system.

By reversing the first journal and using the second journal the effects are :

• Costs are reduced by $1,000 (good news)
• Increased profits of $1,000 (more good news)
• Increased assets of $1,000 (typically good news).

How correct this new treatment is depends on a number of factors :

• What do the actual documents from the computer repairer indicate? (repair or
replacement)
• What is the company policy on computer repairs and computer purchases?
• What do the relevant accounting standards (GAAP) prescribe?

The creative solution may turn out to be correct; however, there would be further journals required that would impact negatively on profits :

• If a new computer is added to fixed assets, then the old one should be disposed of in the accounts (assuming it is now either taken by the computer firm or in the garbage).
• The new computer will need to be depreciated. Typically for computer equipment this is heavy due to the short lives of computer equipment.

Give the Terminology in Creative Accounting.


In order to understand creative accounting it helps to be familiar with some following accounting terminology.

Terminology in Creative Accounting :


Terminology

Explanation

Account

 

This is the most vague word used to describe the work that an accountant may prepare. There are many different accounts that this word could refer to the most common are financial accounts and management accounts.

Profit and Loss or Income Statement

This shows the income, sales, costs, and expenses. Towards the end of this report, there should be a figure for the profit or loss for the period.

Balance Sheet 

 

This shows the assets and liabilities at a particular point in time. It may also be described as the financial position of the business.

Financial Accounts

 

These are the accounts prepared for legal and regulatory purposes. There are strict rules known as accounting standards that must be followed.

Management Accounts

 

These accounts are prepared for the businesses own purposes. The objective is usually to give management an idea of how the busyness is performing and its financial health.

Set of Financial Statements

 

This would include the Profit and Loss statement (or Income Statement), the Balance Sheet, and the notes that support them. It may also include other statutory sections; plus, any optional information the management decide to include.

Statutory Accounts or Stats

This is the set of accounts that must be prepared and submitted to comply with statutory and regulatory requirements.

Accounting Standards

 

These are the rules that must be followed when preparing Financial Accounts and Statutory Accounts. Sometimes a country has its own standards, sometimes a country or business can adopt International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS).

GAAP

Generally Accepted Accounting Principle.

True and Fair View 

Accurate, reliable, free from error and omissions.

Appears Satisfactory 

Often an accountant or auditor will not want to go as far as to say that a matter is "correct" or "accurate" so they use the phrase "appears satisfactory".

Explain Creative Accounting by Capitalising Expenditure.


Creative accounting can, in one simple journal, increase the value of assets and increase profitability.
Capitalising expenditure involves posting transactions to the fixed assets in the Balance Sheet rather than the expenditure section in the Profit & Loss.
For example : 
Suppose you have an item that is purchased for $20,000 and you are debating whether to post this to the fixed asset account or the expenses account.

Creative Accounting by Capitalizing Expenditure :


If the true and fair view would be to post it to the expenses (and there is no element of subjectivity) then to post it to fixed assets (i.e. to capitalize it) could be classed as creative accounting - it could also be classed as incompetence, error, user-error (if a system could be partly blamed), or fraud, depending on how far you go.

a) Without Creative Accounting - Posted to Expenses :
If this is classified as an expense in the accounts it would appear as shown below :

Statements

Account

Before Expense 

After

Balance Sheet 

 

Profit and Loss 

 

Fixed Assets

Liabilities

Income

Expenses

Profit

100

(40)

200

(120) (20)

80

100

(40)

200

(140)

60

This has the following impacts :
  • Increased Expenses (from 120 to 140) 
  • Reduced the profit (from 80 to 60)
b) With Creative Accounting - Capitalization (Posted to Fixed Assets) :

Now look at the results if the same item is capitalized, i.e. classed as a fixed asset

Statements

Account

Before Expense 

After

Balance Sheet 

 

Profit and Loss 

 

Fixed Assets

Liabilities

Income

Expenses

Profit

100 (20)

(40)

200

(120) 

80

120

(40)

200

(120)

80

This has very different impacts :
  • the expenses and profit are unchanged, and
  • the fixed assets have increased.
There are some negative impacts that are often overlooked :
  • There will be increased depreciation whilst you carry the fixed asset (so reduced profits for future periods).
  • Increased asset values are not always a good thing; for example, the return on capital employed (ROCE) will decrease. There are various measures of this (ROCE is just one); most importantly, the higher the asset values become, without a proportionate increase in income, then return on assets decrease.