An overview of the concept of cosmetic accounting - Essay Example

? Cosmetic Accounting/ Creative Accounting Outline: An overview of the concepts of cosmetic accounting. Cosmetic accounting as blessing or curse. Causes of Cosmetic accounting. Techniques of cosmetic accounting. Effects of Cosmetic accountings. Solutions of Cosmetic accounting. An overview of the concept of cosmetic accounting: Cosmetic or creative accounting is a process where accountant use their knowledge about accounting rules to change or manipulate the reported figures of the company’s business accounts. Cosmetic accounting can be describe in different ways like it is referred as the terms of income smoothing , earning management , earning smoothing or somewhere as financial engineering. The term cosmetic accounting is used when ,accepted accounting techniques those are not allow to use as to report financial results of a company, and with the help of creative accounting those prohibited techniques are used to manipulate accurate picture of the company. The methods of creative accounting are noteworthy because they remain in use as generally accepted accounting principal. As an author every company is fiddling its profit, every sets of published accounts are based on books which have been gently cooked or completely roasted. This deception is all in perfectly good taste. It is creative accounting. (Griffiths 1992:1) Creative accounting also based on some unethical elements like as accounting details of a restaurant can be anything (true and fair). The creativity in such details is like showing a half glass of water as half-full instead of presenting it as half-empty. Both statements are correct but both can paint different pictures and create different images in user’s mind. Sometimes, creativity accounting can be described as accounting manipulation. Accounting manipulation further defined as when accountants of companies intentionally misstate financial information to represent the good position of the entities. In addition in the case of non-profits organizations manipulate their reported program-spending to get more donations and incentives. Cosmetic accounting can also be represented by the income smoothing technique. This consists in deliberate using of accounting policies to report the series of income as low from one period to another for the purpose of showing low wealth to shareholders. This way, the management can reduce the net income’s fluctuations from one period to another. An explanation why cosmetic accounting is considered as blessing or curse: Cosmetic accounting can be considered as blessing when it contributes to clear or maintain the existing accounting system. And it can become a curse when it is used un-ethically to treat unfairly a specific group of users of financial statements. Most of the accountants believe that cosmetic accounting can be used as both of blessing and curse. According to a survey only 10% respondent think that this technique could be a blessing and 21% think that it is a curse. Cosmetic accounting can be used in two ways Positive Negative Simply the positive one can treat as blessing as to represent the true and fair position of the company. It can use to polish the account interests, but also as an accounting engineering consist on agreed accounting policies. As according to International Accounting Standard 1, “Companies can chose any procedure for maintaining their accounting records from the set of procedure those are declared true and fair” Negative form of cosmetic accounting is when this technique is used unethically to damage a specific group of users of financial statements. For example Companies can use a technique to include capital profits as operating Profits from the sale of properties and shares. Companies can record unrealized capital gains as operating profit. Companies can include the profits of their associated companies as their own profits to make the better financial position. In short the Positive one recognizes genuine changes in the business accounting practices while the Negative one reflects undesirable window-dressing to manipulate or change the financial information. And this is normally referred to as creative or cosmetic accounting. Describe the causes, techniques and effects of cosmetic accounting: Causes of cosmetic accounting: The main causes of cosmetic accounting are based on the conflict of interest among the various interest groups. For example Shareholder’s interest: Shareholders are interested to get more dividends and gains. Employee’s interest: Employees are interested to get better salaries, bonuses and more payment for extra working hours. Government and Regulatory bodies: Government and Regulatory bodies such as HMRC (UK) would like to collect more taxes. And with the help of cosmetic accounting, one or more groups can gain more advantage on the expense of others. This situation leads to a dangerous way for both of user and the company. There are some causes that why companies use creative accounting: When companies float its shares to attract investors to subscribe to shares on at par or at a premium, to make better company’s future records and prospectus. When companies are listed at stock exchange and want to make attractive pictures of their financial position. They can quote their shares at premium with the help of cosmetic accounting. Companies those are listed at stock exchange may declare to pay high dividends based on manipulated profits with overvaluation of asset, under valuation of liabilities and to change the system of stock valuation to polish the image of the company in short term. Techniques of creative accounting: There are some main areas are considered as the root for the creative accounting. Some of these are “flexibility in rules and regulations, lack of regulations, scope for management that assumed targets for the future, the use of artificial transactions, timing of some transactions, manipulate the records for financial statements and income smoothing technique” Flexibility in rules regulations: Accounting regulation permits flexibility in choosing a policy to follow. As International Accounting Standards the financial managers can choose between depreciated historical value and residual value in the valuation of the non-current assets of the company. The management may decide the change of the policies, and these methods are difficult to be identified. In addition It was also proved, that even in highly regulated countries such as USA the accounting environment afford, a great deal of flexibility (Largay, 2002; Mulford and Comiskey, 2002). Lack of regulations: In most countries accounting regulation is limited in some areas, for example in some countries there is few mandatory requirements for transactions with futures and stock options or for the recognition of liabilities, the rules of defer taxation are not properly distinguished from general rules. And with the help of this companies can manipulate their records easily. Lack of Control Procedure: The system of control of the functions of company is not common in present accounting system. And with the advantage of this the managers can make amendments artificially in rules according to their wish to make up the account’s figure. Scope for management for future targets: Management can use their manipulated position in order to obtain the financial position and stability. For example, as stated in (McNichols and Wilson 1988), the managers decide the increase or reduce of the provisions for bad debt. With the use of this technique managers can reduce or increase the account receivable figures easily by changing the desired level of bad debts to achieve future targets. Use of artificial transactions: Artificial transactions are used in order to manipulate the amount of statement of financial position or to move the profits between accounting periods. With the help of artificial transactions managers of the companies can make fake entries in the book of accounts to change the original figures to desired level. Timing of transactions: The timing of some transactions can offer the management the opportunity to increase the revenues, when the profits are not satisfactory, this technique can help to create the good impression of the companies in the book accounts. And good impression simply means that companies can able to get more outsiders’ investment. Manipulation of records: In cosmetic accounting companies can manipulate artificially the amounts in order to obtain good level of profitability, liquidity, gearing or leverage ratios. As explained by Niskanen and Keloharju (2000): ‘the idea behind this behavior is that humans may perceive a profit of, say, 301 million as abnormally larger than a profit of 298 million’. Their study and others (e.g. van Caneghem, 2002) have indicated that some minor massaging of figures does take place in order to reach significant reference points. Income smoothing technique: One of the creative accounting aims is represented by the income smoothing technique. According to this method polices can be used in his way to reduce the level of income from one period to another, in this way the management reduce the net income’s fluctuations from one period to another. Effects of Cosmetic Accounting: Effect on Investors: Companies those are listed on the stock exchange and show inflated profit and better financial position with the help of cosmetic accounting statements to attract investors; this can create confusion and misguide the user in relation with right decision. Prospectuses issue: Every listed company has to issue the prospectus which contains the detail of company’s accounts. And companies’ prospectuses may not always depict the reality of the financial positions because of cosmetic accounting techniques. Effect on company’s long term operations: Techniques used in cosmetic accounting have directly effect on company’s long term goals. Cosmetic statements may bring untrue hopes to investors for a shorter period but cannot continue to succeed for a longer period. Effect on Position: Companies listed in the stock exchange and involved in cosmetic accounting may collapse and the investors lose confidence in them and stock market. This directly affects the company’s position because Investor’s confidence is the root of a successful company. Solutions of Cosmetic Accounting: The accounting standard bodies such as Security and Exchange commission must develop ways to detect and prevent the dangers of creative accounting methods. And for this purpose strict measures should be taken by the regulatory bodies. And in the case of any fraudulent behavior take immediate action on no discrimination basis. Ethical codes need to be given more importance. Because in current economic situation ethical codes should must be followed for sound accounting system. Fraud in financial reporting should be prevented. And this can be done by making strict rules for the preparation of these statements. All companies should have to clear the accounting policies that they used in the preparation of financial statements. Regulatory bodies have to make strong changes in auditing standards in relation with cosmetic accounting. This can lead in detection of any technique related to cosmetic accounting in during auditing procedures. Accountancy courses should be properly updated with the concept and proper guidance of cosmetic accounting. This measure can help the new accountants to develop the understandings of cosmetic accounting on initial level. References: AMAT, O., BLAKE, J., & OLIVERAS, E. (1999). The struggle against creative accounting: is "true and fair view" part of the problem or part of the solution? Bosch, H. (1990), The Working of a Watchdog (Melbourne: Heinemann) Fatt, James Poon Teng (1995), “Ethics and the Accountant,” Journal of Business Ethics, Kluwer Academic Publishers, The Netherlands, Vol. 14: 997-1004. Niskanen, J. and Keloharju, M.: (2000), Earning cosmetics in a tax-driven accounting environment: evidence from Finnish public firms, The European Accounting Review, Vol. 9:3, pp. 443-452. MULFORD, C. W., & COMISKEY, E. E. (2002). The financial numbers game: detecting creative accounting practices. New York, Wiley. INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE. (1992). International accounting standards. International Accounting Standards Committee. JONES, M. (2011). Creative accounting, fraud and international accounting scandals. Chichester, West Sussex, England, John Wiley & Sons. Griffith, Creative Accounting, Unwin Hynemen Ltd., London. Brown, R & Steele, T 1999, „The economics of accounting for growth?, Accounting and business research, vol. 29, no 2 Schipper, K 1989, „Commentary on creative accounting?, Accounting Horizons, December, pp. 91-102. TORRE, I. D. L. (2009). Creative accounting exposed. Basingstoke [England], Palgrave Macmillan. Schiff, David (1993), The Dangers of Creative Accounting Worth (March): 92-94. MCGAHRAN, K. T., & MENSAH, Y. M. (1988). The effectiveness of cosmetic income-smoothing on cross-sectional risk assessment. New York, NY, Graduate School of Business, Columbia University. 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