Creative Accounting - Essay Example

Creative Accounting Introduction Financial accounting involves the measurement of financial transactions of a firm and its presentation through various reports called financial statements. These financial statements comprising of income statement and balance sheet are prepared in conformity to the Generally Accepted Accounting Standards (GAAP) and other accounting rules framed by Accounting Standard Board constituted by each country. The accounting reports are supposed to present a true and fair view of the state of the affairs of a business in terms of profitability and financial status. The basic intention of financial statements is to portray the financial information before various stakeholders for their decision making. Among the various stakeholders, investors and potential investors constitute the primary group for whom financial statements are basically intended. Investors put their hard earned money with a firm on the basis of the financial information exhibited by statements and their scrutiny. Therefore, accountants are bound to oblige the rules and regulations of accounting practices in the preparation and presentation of financial statements. These rules are framed by accounting bodies of a country in line with international accounting standards. Nevertheless, some accounting standards are violated by accounting professionals/firms for their personal gain. Such practices are illegal and against the ethics of accounting professionalism. Many such practices have been observed from different parts of the world. Such a practice is known as creative accounting. Creative accounting is a sort of accounting scam, which does not follow the accounting rules and principles as such or finds the loop holes in the accounting rules for the benefit of the preparers and those at the helm of the organization. This essay is meant to detail the basics of creative accounting and the reasons thereof. It also tries to throw lights on some of the real life corporate examples of creative accounting and the consequent initiatives of international standards to combat such an illegal and unethical practice. The term 'creative accounting' is commonly understood as the creative process of manipulating the information contained in accounting statements for the benefit of corporate management and its preparers. It is the act of using the skill and knowledge of accounting professionals to make advantage of the loopholes of accounting rules so as to manipulate the financial information and thereby deceive the users of such statements. This term is also coined as aggressive accounting since it involves the destruction of current accounting rules and specifications with the intention of deceiving someone. Though, the ultimate intentions of creative accounting are manifold, the fundamental aim is to give unfair and incorrect information about the company and its operational results. Numerous interpretations have been developed on the term 'creative accounting' by eminent authors. In the words of John Blake and Jack Dowds, creative accounting may be defined as a "process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business" (Blake). Metcalf, L. (US Senate) in his work (The Accounting Establishment, 1977, p.188), interprets " creative accounting is recognized as a synonym for deceptive accounting. Creative accounting methods are noteworthy because they remain in use as generally accepted accounting principles, even though they have been shown to be deceptive in many cases" (Robb, 2007, sl.3). According to Charles W. Mulford, Eugene E. Comiskey in their famous book entitled 'The Financial Numbers Game: Detecting Creative Accounting Practices', "creative accounting practices --a termthe authorschose to encompass any and all steps used to play the financial numbers game -- may be employed in exchange for a variety of expected rewards. These rewards may include a favorable effect on share prices, lower corporate borrowing costs due to animproved credit rating, incentive compensation plans for corporate officers and key employees,and/or political gains" (Mulford, 2002). From the above definitions, it is crystal clear that the source of creative accounting is from within the rules framed by accounting bodies. The practitioners try to bend those rules and seek the loop holes to achieve their vested interests. Factors encouraging creative accounting/ Reasons for creative accounting A large number of factors contribute to the practice of creative accounting. Mostly, this kind of accounting practice is resorted to affect the share price in the market and deceive the investors by either inflating the profit through income statement or window dressing the financial position through position statement. The accounting scams which have been reported across the world so far point out the following reasons by which accounting information are manipulated. Performance -based remuneration It has been found in many studies that mangers' remuneration is one of the crucial factors that influence accounting data to be manipulated. Top executives are in big organizations are paid in line with the performance of the organizations in terms of profitability and financial condition. Naturally, in times of financial crisis and low profitability, they are interestingly indulged in manipulating the figures and bending the rules of accounting. Emphasis on "bottom line" Business organizations are now-a-days placing too much emphasis on bottom line reporting in which the social, environmental and economic results are analyzed and exhibited. Organizations that prepare their statements in accordance with the bottom line principles are likely to attract more public opinion than those which follow conventional accounting practices (Barry, 2007). Emphasis on EPS One of the most vital considerations in investment decision is Earnings Per Share (EPS) maintained by the company over the years. Evaluation of EPS for investment decisions is increasingly relied upon by market as it reflects the earning potential of a firm. This leads to the indulgence of practicing aggressive accounting by manipulating accounting figures. Emphasis on steady growth Apart from the one time EPS evaluation, investors heavily rely on stable growth attained over the years that indicate the future prospects and progress of the business. The assets and liabilities are arranged in such a manner that portrays a financial position that is totally different from the actual. Deficiencies in the legal systems for banking and accounting Besides the greed of the management and owners of a business organization, the loop holes in the prevalent accounting and other relevant rules also contribute to the practice of accounting fraud. In a recent study undertaken by Mine Omurgonulsen and Ugur Omurgonulsen in Turkey in the banking sector (e.g. BCCI, Barings, Allied Irish Bank and Baninter) finds that the problem of creative accounting is associated with its legal and illegal aspects among other things (Omurgonulsen, 2008). Inadequacies in the autonomy of governmental regulation and supervision bodies The government also has little control over framing of accounting rules and monitoring the adherence to these rules by business. One of the studies in the Greek context to explore the creative accounting practices documents that despite the detailed accounting regulations in the country, the inadequate government rules have an important bearing upon the practice of accounting scandal (Baralexis, 2004). Practical difficulties in enforcing legal and ethical rules due to the slow functioning of judicial system Even though there are numerous legal and ethical rules that prescribe the ways accounting fraud can be prevented, the practical problems with respect to the implementation of these rules owing to the slow functioning of judicial system can also be a reason for a number of accounting scandals. It is evident from the study in Turkish case (i.e. the Imarbank Scandal) that finds that "practical difficulties in enforcing legal and ethical rules due to the slow functioning of the judicial system are significant reasons for creative accounting practices in addition to the personal greed of both owners &top management of Imarbank and its customers" (Omurgonulsen, 2008). Accounting Scams- Reported Cases In creative accounting, accounting practitioners try to manipulate their financial statements by exhibiting a profitability and financial position different from the actual ones. Many such scandals have been reported across the world and many big companies have been collapsed as a result of such unethical and illegal practices. WorldCom, Enron, Global Crossing, Tyco, and Adelphia are only some of the notorious instances. Many forms of creative accounting practices have been witnessed over the years; however, the most commonly seen is the 'off-balance sheet' items and the major off-balance sheet item is borrowings such as lease agreement which cannot be considered as borrowing for legal purposes (Hey, 2002, p. 38). The history of accounting scams is as old as accounting and in the past it was mostly, if not all, unintentional and less crooked. But, when fraudulent accounting practices were found as a means to favorably convert financial information, efforts were started to think seriously about the techniques of misstating the statements and intentionally deceive the stakeholders, especially investors. The accounting scams in the US such as Enron and WorldCom have attracted the attention of professionals as well as general public from every nook and corner of the world. The collapse of Enron, the seventh largest corporation in the country, as a result of accounting scams, was a real shock to the entire business community in general and accounting professionals in particular and the first of its type in the history of the country. The WorldCom, one of the biggest telecommunication corporations was found committed accounting fraud during 1990s and that led to its eventual bankruptcy. In March 2002, the U.S. Securities and Exchange Commission (SEC) enquired for information on accounting practices and the loans it extended to the officers from WorldCom. In April 2002, Standard & Poor's, Moody's and Fitch downgraded WorldCom's credit ratings soon after the company cut 3,700 jobs. The U.S. Justice Department has launched an independent probe into the WorldCom scandal and it finally came out with the stunning report that many of the accounting practices of the company were of crooked and deceptive in nature (Sridhar, 2002). Some of the reported corporate scandals are exhibited in the following Corporate Scandal Sheet (Patsuris, 2002). Corporate Scandal Sheet Company When Scandal Went Public Allegations Investigating agencies Latest Developments Company Comment Adelphia Communications Apr-02 Founding Rigas family collected $3.1 billion in off-balance-sheet loans backed by Adelphia; overstated results by inflating capital expenses and hiding debt. SEC; Pennsylvania and New York federal grand juries Three Rigas family members and two other ex-executives have been arrested for fraud. The company is suing the entire Rigas family for $1 billion for breach of fiduciary duties, among other things Did not return repeated calls for comment. Enron Oct-01 Boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships; manipulated the Texas power market; bribed foreign governments to win contracts abroad; manipulated California energy market DOJ; SEC; FERC; various congressional committees; Public Utility Commission of Texas Ex-Enron executive Michael Kopper pled guilty to two felony charges; acting CEO Stephen Cooper said Enron may face $100 billion in claims and liabilities; company filed Chapter 11; its auditor Andersen was convicted of obstruction of justice for destroying Enron documents. No Comment Xerox Jun-00 Falsifying financial results for five years, boosting income by $1.5 billion SEC Xerox agreed to pay a $10 million and to restate its financials dating back to 1997 We chose to settle with the SEC in April so we can put the matter behind us. We have restated our financials and certified our financials for the new SEC requirements WorldCom Mar-02 Overstated cash flow by booking $3.8 billion in operating expenses as capital expenses; gave founder Bernard Ebbers $400 million in off-the-books loans. DOJ; SEC; U.S. Attorney's Office for the Southern District of New York; various congressional committees The company stunned the Street when it found another $3.3 billion in improperly booked funds, which will bring its total restatement up to $7.2 billion, and that it may have to take a goodwill charge of $50 billion. Former CFO Scott Sullivan and ex-controller David Myers have been arrested and criminally charged, while rumors of Bernie Ebbers' impending indictment persist. WorldCom is continuing to cooperate with all ongoing investigations (Source: Corporate Scandal Sheet- Patsuris, 2002) International Accounting Standards and Creative Accounting Since accounting professionals started deviating from the real meaning and intent of accounting rules, internationals standards have been criticized owing to its deficiencies in detecting and preventing the fraudulent practice. As a matter of fact, GAAP should be able to find ways to keep away the manipulators by reducing the chances of malpractices and possibilities for rule bending. The international accounting standards are supposed to ensure efficient adherence by accounting professionals and business originations to standards set from time to time. The Accounting Standard Review Committee (1978) remarks in this respect that "the proper object of standards is to reduce this permissiveness and it has long been said by the leaders of the profession that the diversity of accounting rules should be reduced" (Clarke, 2003, p. 25). Moreover, International Accounting Standard (IAS 1) stipulate that accounting policies and the changes thereto must be disclosed in the financial reports as disclosures as explanations to the financial statements for the proper understanding of the same. The accounting rules in a country are framed in line with those set by International Accounting Standards, Accounting Standard Board of the country, company law, stock exchange specifications for listed companies etc. in the United Kingdom, the Department of Industry is the authority to frame rules for companies, listing requirements are framed by London Stock Exchange, and they are found in what is termed as 'Yellow Book' (Hey, 2002, p. 324). However, the recent announcements of International Accounting Standards have succeeded in reducing the number of scandals in financial reporting by corporations. References Barry A. Colbert & Kurucz Elizabeth C., 2007, Three Conceptions of Triple Line Business Sustainability and the role for HRM- Magazine Article from High Beam Research, Online, Viewed 13 February, 2009, from Blake John & jack Dows, The Ethics of Creative Accounting, Econ papers: Economics at your finger tips, econpapers.repec.org. Viewed 13 February, 2009, from Clark L. Frank, G.W. Dean & Kyle Gaius Oliver, 2003, Corporate Collapse: Accounting, Regulatory and Ethical Failure, Edition: 2, illustrated, revised, Cambridge University Press, 2003, 383 pages Hey David, 2002, Financial Statements Demystified, Edition: 3, illustrated, revised, Allen & Unwin, 2002, 368 pages Mulford W. Charles & Eugene E. Comiskey, (2002), The Financial Numbers Game: Detecting Creative Accounting Practices, Published by John Wiley and Sons, 2002, 395 pages Omurgonulsen Mine & Ugur Omurgonulsen, 2008, Critical Thinking about creative accounting in the face of a recent scandal in the Turkish banking sector- Critical papers on accounting, Online. Science direct, Viewed 13 February, 2009, from Patsuris Penelope, 2002, The Corporate Scandal Sheet- Accounting, Online- Forbes.com. viewed 14 February, 2009, from Robb Alan, 2007, A Journalist's Guide to .seeing through creative accounting- NZ Journalists Training Organization Seminar on 17th April, 2007, Viewed 13 February, 2009, from http://www.journalismtraining.co.nz/publications/200704seminars/creativeaccounting.pdf Spyros Baralexis, 2004, Creative Accounting in Small Advanced Countries: The Greek Case- Managerial Auditing Journal, 2004, Volume 19, Issue 3, page 440-461, Emerald Group Publishing Limited. Sridhar V., 2002, The WorldCom Collapse- Corporate Affairs, Frontline, Volume 19, Issue 15- August 02, 2002, viewed 14 February, 2009, from Read More