Creative Accounting - Essay Example

Creative Accounting Introduction The globalisation regime has brought about many changes to the corporate landscape. Intense amount of competition amongst the rival brands and companies is one such change which has benefitted the consumers in general. But this trend has also resulted in some companies resorting to manipulative practices. The manipulations have taken place in different forms. While analysing the creative accounting in the context of Greek, Baralexis (2004) found out that the manipulation of accounting has been well documented in accounting literatures and there are examples of manipulation in account books dating back to 1920s. It has been pointed out that conflicting interests of shareholders and managers often lead to the use of creating accounting. After having successfully assembled the resources, the company is also required to assure all its stakeholders that it is indeed making good use of the resources in a manner benefitting all the stakeholders. In fact creative accounting is done very much within the legal framework and the prevailing accounting standards, but quite often done to camouflage the actual picture. It won't be an exaggeration if we say that creative accounting is done with the help of the weaker points in the law of the land and the accounting standards. Creating accounting has also been termed as 'window dressing', 'aggressive accounting' or 'fiscal gimmickry' by analysts from time to time. Different ways of Resorting to Creativity in Accounting People from outside the company as well as stakeholders from within the company make use of financial accounting details to arrive at a decision regarding their decision to continue with the company or look for a better opportunity. The shareholders will go through the financial details in order to figure out the profit margins and percentage their own earnings in the form of dividends, interests or bonus shares. Some of the inferences that could be drawn using financial accounting information include; i. Preparing the profit and loss accounts of the company ii. Looking for long-term or short-term targets for the investments being done in the company iii. The strength of the company in taking on the competition and adverse circumstances iv. Figuring out the financial structure, equity pattern, shareholding pattern of the company v. Pointing out the lapses in utilizing the financial resources judiciously vi. Putting a stop to corrupt practices and different types of pilferages taking place within the organization vii. Ensuring that the accounting practices are in tune with GAAP viii. Assessing the need for further inputs in the form of finances, workforce or other resources for ensuring functioning of the organization Creating accounting is therefore an effort to influence all these indicators in order to remain out of immediate trouble. Manipulation in maintaining the account books is one such practice, use of which by some companies has come to light, during the last couple of years. Accounting as such is used for maintaining the account of quantitative information about the transactions involving finances and resources of a company. In other words it is the process of identifying, measuring, handling and communicating the financial information about different economic entities for being used by the concerned parties. Showcasing healthy account books in the public domain certainly helps the company and its management in attracting better reviews and commitments for the future growth of the company. This often results in managements resorting to creative accounting practices, which is mainly done to influence the opinion about the company and sometimes to conceal some unethical practices of the management or the company. Some of the widely used practices for manipulating the account books include; Making use of the depreciation i.e. by profits can be inflated by increasing the useful life of an asset and thus spreading the charge over a longer period of life. For example a company can spread over the useful life of its premises from 25 to 50 years, which will save the all important cost to be incurred on the real estate. Making use of the fair value to come out with a rosy picture. Accounting standards like IFRS make use of the term 'fair value' to seek an indication of the value of an asset, but there are different ways in which 'fair value' is determined by the company, while comparing it to the current book value. Some companies also resort to deflating the profit figures during smoother years of operation, so that they don't have to part with the profits with other shareholders. 'Off balance sheet financing' is another way of being creative in accounting. In such cases debt financing is not indicated on the face of the balance sheet. Over-optimistic revenue recognition is also used by some companies to manipulate the account book. This involves redefining the transactions to be termed as 'sales', so that the revenue be recognised as 'revenue earned' or vice-versa'. This aspect differs on a number of factors including the nature of business of the company, the terms of contract with other partners, the changes in tax system etc. The use of exaggerated non-recurring items to be creative in accounting is another subjective practice resorted to by the companies. There are instances when special circumstances lead to special kinds of costs or profits. How these costs and profits are indicated in the account books depends upon how the company wishes to indicate such non-recurring items. The accounting standards like GAAP and IFRS differ on how such items are to be taken into account. While GAAP does mention the term 'exceptional' while indicating how such items are to be indicated, IFRS leaves it to the wisdom of the management1. It is therefore perfectly agreeable that the prevalence of creative accounting in the corporate world is as a result of deficiencies in the legal systems for banking and accounting, inadequacies in the autonomy of governmental regulation and supervision bodies, practical difficulties in enforcing legal and ethical rules due to the slow functioning of the judicial system and the personal greed of top management and owners. Enron, WorldCom and American International Group, Inc. (AIG) are the leading examples of some such companies whose accounting practices led to an intense debate amongst the corporate world about the need to contain the practices of creating accounting. Andersen, the firm which audited the account books of Enron from the very beginning, also appeared to have been taken aback by the sudden developments and even suggested that the failing of Enron is an indication of the failure of the whole profession of accounting (The Economist, 2002). In case of AIG, what began as an investigation into two reinsurance transactions later mushroomed into a growing scandal that tarnished the reputation of one of America's premier corporations. Brady et al (2005) state, "On Mar. 30, AIG acknowledged that it had improperly accounted for the reinsurance transaction to bolster reserves, and detailed numerous other examples of problematic accounting'. Subsequently the company took corrective measures and fortunately for investors, employees and other stakeholders in many countries, continues to conduct all its operations smoothly, unlike ENRON, WorldCom and some other companies. In fact, this was not the first time that AIG was stuck up in controversies. Nature and scale might be smaller but AIG has had a taste of controversies earlier as well. In 2004, the insurer paid $126 million in fines to the Securities & Exchange Commission and Justice Dept. for deals it structured for outside clients that allegedly violated insurance accounting rules, although AIG admitted no wrongdoing. The company also came under the glare of New York Attorney General Eliot Spitzer for its role in bid-rigging with broker Marsh & McLennan Cos., which led to the ouster of Hank's son Jeffrey as CEO there. AIG admitted no wrongdoing, but two of its executives pleaded guilty and had to leave the company. Analysing the failure of Enron, the Economist (2002) came out with the finding that the trend of manipulating account books starting from Maxwell and Polly Peck in Britain, through Metallgesellschaft in Germany, to Cendant, Sunbeam and Waste Management in America in the late 1990s has resulted in restatement of the accounts by more than 700 companies in US. It is widely believed that besides the glossy paperwork and highlighted portions, there could be some dark corners in company's accounts which prove quite meaningful at times. It is believed that companies can show a profit and loss at the same time, by juggling around with figures (BBC, 2005). For a layman it will appear to be quite attractive and perfectly in shape, but for some others, it might prove to be a reason to take out the investments. International Community Takes Note It was after such failures that a need was felt by the international community to look into the creative accounting practices and come out with some standards in accounting. A number of factors are taken into account for effective functioning of any company, business venture or project. How the company is making optimum use of available resources can be ascertained by having a look at the annual report and account books of the company. The company is required to arrange for financial resources from the market, attract talented people during the recruitment drives, enter into strategic alliances with other companies and distributors etc. Therefore, a healthy account book helps in gaining an upper hand in all such ventures. Such an importance to account books makes things quite competitive at times, thus resulting in an urge to go creative. Simms (2009) states that, in these times of credit crunch and recession, when going gets tough, it implies lesser availability of finances for corporate houses. This in turn leads to the need for other ways to improve the financial health of the company. Companies are tempted to adopt such methods with the motive of obtaining credit from suppliers, reassure their customers, attract more investors, invite easy support from financial institutions or to support their share prices. Citing couple of examples in the equity market, Healy and Wahlen (1999) suggest that it is very difficult for investors to see through the game plan and minutely analyse the account books of a company entering the equity market with a public issue offer, and in many such cases, creative accounting certainly helps in boosting the stock price of the company. But it is equally true that after a number of scandals were highlighted in the mainstream media and their management/s had to own the responsibility, the trend has become much more risky for the corporate community. Pat Eckersall (2009) states that there are three main disadvantages of using creative accounting; In view of the two major market shocks, namely, the dot com bubble and the credit crunch, the rating agencies have become increasingly edgy in handling the corporate results and they have started examining the corporate results with much more caution. If creative accounting practices are found, such issues get highlighted instead of being camouflaged. The kind of tricks used for creating accounting have been in existence for many years now and investors, credits rating agencies, analysts etc. have been well acquainted with them. Therefore, such things have become increasingly difficult to hide. On the contrary fudging the account books may lead to a negative impact on the reputation of the management and the brand equity of the company. In case a company is required to make use of creative accounting to indicate profits during a slow patch in economy, the management will be required to have a compensating loss creation to make way for balanced account books. But the recessionary trends followed by bankruptcy filing of many companies have made things quite complicated. Some analysts like Williams (2009) even suggest that the expectation of creating accounting giving way to fair accounting is nowhere near fruition. It is argued that under the existing geopolitical situations, the coming 18-24 months are more likely to see cross border accounting scandals. Recent cases of Madoff collapse in US and that of Indian IT giant Satyam Computers have been cited as the examples of such failures. Efforts have also been made to measure the creating accounting. But it being unpublished and hidden practice, gaining factual information on creative account is very difficult. Therefore, analysts resort to approximations to figure out the extent of creative accounting. Explaining about such methods, Bernoth and Wolff (2008) state that two different measures are employed to find out the real extent of creating accounting. Both the measures take recourse to the generally available information sources representing 'news' signals for the financial markets. The first method is termed as stock-flow adjustment in percent of GDP, a noisy measure of creative accounting. This is calculated as the difference between the change in debt level B and the deficit D. This method tries to capture all the events having an effect on the debt level without being recorded in the budget. The data presented in Koen and van den Noord (2005), has been used as a second measure of creative accounting. In this method individual one-off measures taken by the company to window dress the budget are highlighted to analyse the intentions of the company over a period of time. Bodine (2007) contends that creative accounting is gradually giving way to 'strategic accounting'. It has been argued that despite the Enron and Worldcom style debacles, there is still room for professional judgement in preparing the account books, in order to benefit the company and its stakeholders. Bodine (2007) states, "Strategic accounting is the selection of appropriate accounting policies to match a company's strategic goals". How a company will calculate the depreciation on its assets has been advanced as an example to highlight the strategy. A company opting for straight line depreciation for fixed assets or choosing LIFO for inventories to take advantage of government announced tax benefits are stated to be perfectly in line with ethical accounting practices. It therefore appears quite clear that despite the debacles and shortcomings noticed in the accounting field because of 'creative accounting' the phenomenon is far from being over. The growing competition, important role of good media coverage, emphasis on professionalism has made things quite involving for the management to come out with good numbers. Collier (2009) states that creative accounting is not done merely to hide the incompetence of management, but there are instances when such practices take place at macro levels as well. Lofty commitments by political leaders to address the concerns of their political domain so that their vote bank remains intact are other such examples which have been fuelling the creative accounting practices. Collier (2009) cites the example put forward by Thomas Pogge, a professor of philosophy and international affairs at Yale University in New Haven, Connecticut. It pertains to the commitment by some developed nation towards investing millions for improving the health care in an African nation. In this case the millions were spent merely on the visits of consultants to these nations, attending some conferences and their stay in five-star hotels. At best these consultants would later come out with a report on the state of affairs in the poor African nation. This has been termed as 'creative accounting' by Pogge. Efforts are being made by a civil society grouping in Canada to include poverty eradication as an agenda point in the forthcoming G8 summit to be held in Huntsville, Ontario, in June 2010. Nicci Stein, executive director of the Interagency Coalition on AIDS and Development, comes out with some of the glaring examples, in which the G8 leaders have made huge commitments to the third world nations and how defaults worth billions is being committed by these leaders, without any brouhaha amongst the world community. The economist (2009) also highlights the scope of creative accounting in the payments and perks drawn by the parliamentarians in UK. Comparing the basic salary drawn by an MP ranging about 63,291 with that of the corporate world, it is stated that this salary might appear modest in comparison, but the scope of 'creative accounting' while calculating the payments to them for staff, communication, computers etc., provisions for cars and the payment on their ejection from the House. This has given rise to intense debate on many public forums and accordingly Gordon Brown has ordered review of the entire expenses system amongst the parliamentarians. A long time advisor to Daewoo of Korea said after the fiasco at Daewoo that, "All the people we started working with are now in jail" (The Economist, 2002a). When, some western companies started to look out towards taking over well-off companies in the Asian subcontinent, it was found that some of them started raising doubts about the decision and the basis of this doubt was the quality of accounting and audit methods adopted by these companies. It was only after Enron scandal came to surface that the corporate world started believing that the creative accounting is not an Asian Speciality. Role of Newer Accounting Standards It has also been argued by experts that recent developments in accounting standards, coupled with renewed emphasis on ethical standards, have reduced the incidents of creative accounting. International Financial Reporting Standards or IFRS are the standards which are being adopted by many countries the world over, in an effort to bring about more transparency in the accounting practices. These standards have in fact evolved over the years with inputs from other prevailing standards and some of the shortcomings noticed over the years. Uniformity in adopting financial standards also helps in understanding the nature of business and standings in a better way. Though the international financing standards are being changed from time to time in order to make the accounting practices contemporary, yet the full version of IFRS came into being in the year 2005 when more than 8000 companies in the EU region decided to adopt these standards (Banerjee, 2008). More than 100 countries have formally accepted IFRS as the standards for preparing financial statements and to become compatible with each other. IFRS are issued by the International Accounting Standards Board (IASB), a private sector international body. In fact IASB itself is a new body, which emerged on the international scene in the year 2001, by replacing the International Accounting Standard Committee (IASC). With the increasing acceptance of these standards around the world, it appears all the more necessary for multinational enterprises (MNE) and countries with global presence, that they should adopt the IFRS in order to make their functioning more acceptable in these areas. This will not only help the MNEs to save on their resources, but it will also help them in making use of similar modular and portable systems for accounting. There are many countries where the IFRS are not yet in use, but even in such countries IFRS inspired standards are now being used. This helps in making fullest use of the globalisation and liberalisation practices. Therefore it is in the interest of US companies that they should adopt the IFRS in all sincerity and make the best use of the available opportunities. In fact adopting uniform standards will also help in tracking financial irregularities and thinking of appropriate solutions. Key benefits of going for IFRS include; i. Streamlining of reporting of the financial health of the company ii. Cost reduction - as companies will be able to make standard packages iii. Consistency in operations and financial details iv. Comparison with international competitors becomes easier. v. Better opportunities for accessing capital markets. But despite these benefits, the transition from GAAP to IFRS also presents couple of challenging situations for companies and governments. For example; i. The process of conversion from GAAP to IFRS itself is a delicate balancing act requiring utmost precaution in order to avoid setbacks. ii. The IFRS put greater emphasis on treating the financial statements as strategic tools instead of the traditionally held view. This mandates proper mechanism for taking feedback and prepare strategic plans iii. IFRS puts great emphasis on use of IT, which implies that companies will have to upgrade their existing systems Some of the features of IFRS include; I. Framework for the Preparation and Presentation of Financial Statements The Framework for the Preparation and Presentation of Financial Statements helps in understanding the basic rules and principles for IFRS. This way we get to know how to prepare financial statements using IFRS. This framework also helps in locating a solution of some of the problems which otherwise might not be possible in the prevailing IASB rules. The framework as such will also replace the SAC3 and SAC4, which will be withdrawn once the IFRS comes into practice. This contains a number of guiding principles for carrying out the accounting in ethical and truthful manner, so that the company doesn't feel the urge to creative. I. IAS1 Presentation of Financial Statements2 The key objective of IAS 1 (revised in 1997) is to prescribe the basis for presentation of general purpose financial statements, for ensuring comparability with the previous years of the same company as well as with the competitor companies. In order to make it comprehensive the IAS1 require that; A complete set of financial statements comprises: a) The balance sheet must be ready b) Income statement must also be prepared c) Statements reflecting adequate changes in equity of all types d) Readily available cash flow statement e) Proper notes on accounts describing summary of accounting policies etc. On the face of it, these stipulations do not appear to be any different from earlier rules, but the fact that these standards have taken the pains to describe methods of preparing different reports will help a company in guiding it to ethical standards. II. IAS8 Accounting Policies, Changes in Accounting Estimates and Errors3 The main objective of this standard is to set in place criteria which standardises the selection and change in accounting policies. This standard also formalises the accounting treatment and disclosure of changes in accounting policies together with changes in correction of errors and estimates. This mechanism helps in better interpretation of the financial statement and makes it more reliable not only for the insiders but to outsiders as well who have a stake in the company. This standard also enlists the kind of accounting treatment that we should offer to accounting policies. References; 1. Banerjee, C (2008). Journey to IFRS - A guide on transition to IFRS. Ernst & Young Pvt. Ltd. and CII Publication. 2. Baralexis, Spyros (2004). 'Creative accounting in small advancing countries-The Greek case'. Managerial Auditing Journal. Vol. 19 No. 3, 2004. Emerald Group Publishing Limited. 3. BBC (2005). Deciphering Company Accounts. Available online at http://news.bbc.co.uk/2/hi/programmes/working_lunch/4299357.stm (Jan 27, 2010) 4. Bernoth, Kerstin and Wolff, Guntram B. (2008). Fool the markets Creative Accounting, Fiscal Transparency and Sovereign Risk Premia'. Scottish Journal of Political Economy, Vol. 55, No. 4, September 2008. 5. Bodine, Stephen W. (2007). Forget "Creative Accounting" Go Strategic!. For Practicing Accountants ... By Practicing Accountants November2007. National Society of Accountants. 6. Brady, Diane, Vickers, Marcia, McNamee, Mike (2005), AIG: What Went Wrong, Business Week, 4/11/2005, Issue 3928. Available online at http://www.businessweek.com/magazine/content/05_15/b3928042_mz011.htm (Jan 26, 2010) 7. Collier, Roger (2009). G8 nations must end "creative accounting" on foreign aid. Canadian Medical Association Journal (CMAJ), DECEMBER 8, 2009, 181(12) 8. Eckersall, Pat (2009). 'Feeling Creative' Accountancy Age. 17 September 2009. Incisive Media. Available online at http://mobile.vnunet.com/accountancyage/features/2249650/feeling-creative (Jan 25, 2010) 9. Healy, P.M. and Wahlen, J.M.: 1999 'A review of the creative accounting literature and its implications for standard setting', Accounting Horizons, Vol. 13, No. 4, pp. 365-83. Cited in Amat, Oriol and Gowthorpe, Catherine (2004). 'Creative Accounting: Nature, Incidence and Ethical Issues'. Available online at http://papers.ssrn.com/sol3/papers.cfmabstract_id=563364 (Jan 26, 2010) 10. IASB (2009). International Accounting Standards Board. Available online at http://www.iasb.org/Home.htm (Jan 26, 2010) 11. Koen, V. and Van Den Noord, P. (2005). Fiscal Gimmickry in Europe: One-Off Measures and Creative Accounting, OECD Economics Department Working Paper, 2005(4). 12. Schlosser, Julie (2005) CNN, CNNMoney.com (May 30, 2005), 'The risky rewards of AIG' http://money.cnn.com/magazines/fortune/fortune_archive/2005/05/30/8261252/index.htm (Jan 26, 2010) 13. Simms, Jane (2009). 'Creative Accounting'. People Management, Chartered Institute of Personnel & Development. January 2009. 14. The Economist (2002). Enron and auditing - The lessons from Enron. Feb 7th 2002 15. The Economist (2002a). 'South Korean takeovers - Dead deals walking'. Feb 7th2002. 16. The Economist (2009). 'Parliamentary sleaze - Disallowed allowances'. Mar 26th 2009 17. Williams, Peter (2009). Accounting - Feeling Exposed. Financial Director. February 2009, Incisive Media. Read More