Advanced Financial Reporting - Prevalence of Creative Accounting - Essay Example

? Advanced Financial Reporting - Prevalence of Creative Accounting Advanced Financial Reporting - Prevalence of Creative Accounting Introduction Creative accounting is an innovative yet unethical practice that converts the sense of an accounting treatment while being within the scope of treatment prescribed by accounting standards. It can be said that taking advantages of the loopholes present in accounting standards is the other way of explaining creative accounting. This report will be evaluating the reasons that give rise to creative accounting by organizations; the grounds for the nativity of this practice will also be discussed. The evaluation of the efforts made by existing standards and accounting practices in controlling and reducing aggressive accounting will be catered in the report. The levels of success achieved by regulatory bodies will also be discoursed. Increasing the complexity of accounting treatments in such a creative and aggressive way, actually results in deviation from the actual spirit of the suggested treatment. Transactions are treated with a high level of quibble and in a complex manner so as to obtain desired misrepresentation of items present in financial statements, such as assets, liabilities, expenses, revenue, and stock options. It is generally successfully applied over the transactions of inherently complex items of financial statements, for example Derivatives, Hedge accounting, leases, insurance contracts, construction contracts, financial instruments, impairment of assets, revenue recognition and manipulation can easily be made. Reasons for using Creative Accounting Creative accounting aims to manipulate ultimate shareholder’s wealth, showing high paper profits, and hiding right earning figures from stakeholders (Farlex 2011). Those who are involved in creative accounting are usually personnel having excess to accounting documents, or can influence the accounting treatments. The records and accounts are falsified and wangled as to divert the route of organization’s money to individual intended pockets. There are some obvious motivations, which lead to the commencement of creative accounting by managers or directors. The business corporate and other borrowers search for capital beyond their home land; this gives rise to an increase in the foreign investment. The investors must be supported with high level investor protection measure and market integrity because there is a significant gap between the investor and the borrower that increases the chances of and may lead to dishonesty (Security and Exchange Commission 2000). Creative accounting provides assistance to businesses to appear profitable and attract customers, resources, and investors. It proves to be more costly when deceptive accounting leads to drastic consequences. Methods of Creative Accounting In an organization where salaries and incentives are paid on the basis of performance (performance related pay), directors can manipulate the annual sales account by showing high sales value or reduction in the figures of liabilities as to pay themselves high remunerations and incentives. Directors can also create high provisions for remote liabilities and include under the head of assets account remote or possible future assets, this treatment of assets and liabilities will be against the bench marks described by standards but if the liability and asset heads are intensely populated then, it will be difficult to locate this non compliance. Other minor non-compliances in the financial statements can result in a material non-compliance in the aggregated form. Directors can also change the policies relating to share options and take advantages like bed and breakfasting shares. Job security concerns can also cause highly designated individuals to falsify accounts in the periods of unfavorable results. To cover up previous frauds, original accounts become compulsory to be replaced by fake accounts using creative accounting techniques. Above discussed reasons can prove to be the best motivators for creative accounting (Forbes 2011). There are mainly two type of creative accounting techniques. One is “On Balance Sheet” and other is “Off Balance Sheet”. These types can classify into many other types that are: Big Bath Charges: When huge amount incurred in company restructuring, finance is released from balance sheet giving a big bath. The concept of this technique is that when earnings of company fall shorts, the estimated figure becomes income, allowing company to reach its targeted income. Accounting for Creative Acquisition: This technique is use when large amount of acquisition price is taken as “on process” by company. The advantage of this technique is taken in Research and Development because this allocation of amount can be writes-off as one time charge. Round Trip Technique: In this method, the volume of transaction used to rise buying and selling of product at the same time when different companies work with each other. This way, net income of company remains same and similarly, revenues and expenses increases. Off Balance Sheet Financing: The result of off-balance sheet will always be low financing cost and earnings are manage to compensate losses by showing one time gain from selling of big assets. There are two ways where one-time charge works. One is sale of asset and other is business or inventory write-off. The result of sale of asset is a sale from one-time cash flow and it is use only for this purpose. However, write-off can be use in many ways that include timely work for one-time gain having no effect on earning and company can make write-off from the books without giving any attention regarding this issue (Forbes 2011). Effectiveness of Accounting Standards in catering aggressive accounting It is generally seen that creative accounting is more popular in small countries where rules are not strictly applied. However, these practices cannot be legally justified anywhere (Spyros 2004). As in past due to the deficiencies in the legal systems for banking and accounting, governmental regulations and supervisory bodies, there were many practical difficulties in the enforcement of ethical and legal rules and norms. There are numerous examples from the past that led to the growth of creative accounting. Cases like Arthur and Anderson, one of the biggest corporate scandals of all times involved the closure of Arthur Andersen; it was rated as one of the big five audit firms in the world (The Street 2010, Floyd 2002). In 1980s, the firm found it difficult to maintain a balance between growth and audit independence; this resulted in a fraudulent audit of numerous organizations including Asia Pulp & Paper, Enron, and World Com (Quirk and Smith 2004). Reasons for the failure were the disclosure of non-reliable audits in the past. The firm allowed other organizations to use creative and aggressive accounting techniques and did not qualify their financial statements instead; a favor was demanded in return. The favor included next coming year’s engagement and a high audit fee. Unethical behavior by organizations and firm jointly benefited them but deceived shareholders. Around 85,000 employees of firm lost their jobs when this firm ceased its operations that impacted the government adversely (The Street 2010; Floyd 2002). Firm started to lose its clients gradually, clients like Merk and Delta, Kerr-McGee, and other corporate giants started to separate themselves by ending up their engagements with Arthur and Andersen. Another example of poor application of accounting standards and compliance is the case of Enron of 1999, the directors were accused for waiving off the code of ethics and Wall Street bank proved to be guilty for knowing and hiding billion dollars debt of investors. Enron’s Chairman, President and vice President formed a mutual collision (Law Shops 2001). Facts of Enron are as follow. CEO and Chairman was the same person. CFO was inflating profits of Enron by using creative accounting and involved in money laundering as well. Former director was accused for wrongdoing in financial statements. Farmer Chairman of the company was found guilty for security frauds and died in an apparently suicidal way. The audit firm Arthur and Andersen that audited Enron was accused for hiding Enron’s unlawful transactions and matters. Personnel of National Westminster Bank were also found guilty and charged for fraud in self-interest (Law Shops 2001, Petrick 2003). After such huge scandals, the need to amend accounting policies, rules, frames, treatments and ethics became extensively important (Petrick 2003). All standard setting bodies, supervising bodies, legislative and legal systems, have always discouraged creative accounting. Strict measures to address creative accounting and similar accounting issues have been taken by regulations and the standard setting bodies have revised its standards to minimize the loopholes. Principles based approaches are discouraged to be used in the compliance with the code of ethics and strict rules (in some standards) have declared to be mandatory by the legislation to comply with. Standard setting bodies like IASB and FASB have achieved successful results in the reduction of creative accounting, but eliminated the threat of its usage by companies. To get a complete rid of window dressing and creative accounting, IASB and FASB has started a convergence project as well that aims to integrate different standards relating to the treatment of a common head. These integrations are in process since 2002 and modifications are being made to the standards (AICPA 2008). Regulatory Measures and Responses Increasing rate of corporate scandals in US made regulations to work harder on the revision of accounting treatment and practices applied. In 2000 Security Exchange Commission of US had released a concept paper that dealt with the reasons and issues relating to creative accounting for awareness purpose (Security and Exchange Commission 2000). Sarbanes Oxley act was introduces in June 2002 to minimize and control treatments of creative accounting, this act was also referred as self regulations for auditors, as it provides guideline for auditing as well (Coates 2007). The Sarbanes Oxley (SOX) comprises of ten (10) different sections discussing the following. ‘Section 1 provides all the guidance and instructions to organizations to report the information required by Public Company Accounting Oversight Board (PCAOB). It is defined that a board will be monitoring the financial reporting being presented by the directors of the company. Section 2 describes the independence and faithfulness of the auditor’s necessary to conduct and audit, and measures to be taken where independence is at any threat. Section 3 of the SOX provides insight about the realization of social and corporate duty and responsibility of an organization, and to present a true and fair view of the financial statements. Section 4 deals with the enhanced and extended financial disclosure required to be made by the directors of an organization. In section 5,6 and 7 provide guidance of the possible conflict of interest between stakeholders and directors, shareholders and mangers, financers and runners are identified and measures are suggested to align these conflicts, commission resources that are engaged and authorities, and the study and reports that are linked with the directors. All types of corporate and criminal frauds and offenses are discussed in detail in the section 8. Section 9,10 and 11 provides information about the penalties that are to be charged to personnel, named as white- collar penalties, taxes and all sort of corporate tax returns that a company can claim, and defines that companies will be set accountable for all the corporate frauds being made (The University of Cincinnati College of Law 2002). For board of directors instructions are given about responsibility, eligibility, tenure, power, and function is made. Furthermore, information regarding board meetings and list of significant issues that directors are required to raise is provided. Related party disclosure and transactions are required to be disclosed by directors. For company CFO and CEO guidance is given, their tenure, appointment, qualification and responsibilities are thoroughly discussed (SECP 2002). The information provided in Sarbanes Oxley act was highly detailed and mandatory to follow. There was some compliance issue with SOX faced by smaller businesses, because this extended compliance requirement proved to be very costly for smaller organization and became a threat for their survival, and the manipulation of accounting treatments, policies, estimates, has an ultimate direct impact on profits and losses of organizations (Smith 1988). There is a sufficient evidence of creative accounting being applied by multinational companies but there is a little knowledge of how these practices are being applied. The used methods and techniques have not been revealed completely (Shah 1996) .The past corporate scandals can be taken as the best real examples of the disasters brought by creative accounting. After the revision of accounting practices, there were still some issues faced by the corporate world, which arise after the successful application of SOX. Not only in US the accounting standards and compliance policies were revised but it was a global act. In UK, Pricewaterhouse Coopers had issued the patterns of the treatments relating to sensitive transactions, such as bank’s financial statements, contingent assets and contingent liabilities, group accounting and other similar areas (Pricewaterhouse Coopers 2001) to provide assistance to the users of International Accounting Standards (IASs) and guidelines provided by Corporate Governance Codes of Ethics also extended. IAS 27 Consolidated and Separate Financial Statements was revised in January 2008 and was implemented from January 2011, this IAS dealt with the Big Bath Charges technique of creative accounting, company’s reorganization patterns and methods (Professional Development Network 2009). The application of IAS 39 to investment contract liabilities was revised in 2004 to eliminate the ambiguities (SOA 2004). IAS 18 Revenue Recognition was revised in 2001 and provided an extended prescription for the treatment of revenues generated by organizations. There is an ongoing Convergence Project (AICPA 2008) that is working on the harmonization of standards internationally. Audits Standards were also put in the phase of revision for this purpose (ISBN 2001). International Accounting standards (IASs) were further revised and improved as per the requirements of the time (Deloitte 2012). Keeping in mind these lessons from the history nearly all Professional Studies has incorporated modules of Corporate and professional ethics in their curricula (ACCA 2012), and defined qualification as a set of education, ethics, and experience. These modules provide knowledge of all the corporate cases that held in past, the reason for providing knowledge to the young accountants is to avoid corporate world a safe future. Affects of Regulatory Measures, Responses and Recent Developments After all the necessary measures taken, corporate scandals have been reduced significantly but the threat of wrong full treatment of accounts has not been eliminated completely. Regulatory bodies have achieved high success levels in establishing controls over the accounting treatments being made by companies; however, there are some issues that emerged in the corporate world after the further development processes. Scandals like American international Group (AIG) was world’s largest financial services and insurance company with 93000 engaged employees and operating in 130 countries. American International Group was found guilty for treating accounts bogusly and provision of aggressive accounts to the stakeholders (Spitzer 2009). Methods like off balance sheet financing were used with an intention of fraud and insurance transactions were recorded to reduce liabilities. $1.2 billion were wrongly accounted with an intension of smoothing profits. No proper disclosure were financial statements were used as a tool that can mislead investors (Greider 2010; Hilsenrath et al. 2008; Chittum, 2012). Another failure of the measure can be seen in the case of Lehman Brothers in 2010,the company was found guilty for treating accounts aggressively by applying creative accounting and to disclose transactions to investor. By using the methods of off-balance sheet financing, assets were moved to other accounts to manipulate leverage and other accounting rations. Intensions behind were to reduce the bank’s debt levels. Directors and managers were involved mutually in the creative accounting and manipulation of financial statements (Huff Post Business Newspaper 2010; Chittum 2010). Evaluation of Regulatory Measures Accounting scandals were present before the revision of accounting standards and practices and principles and these are found to be alive in corporate world even after the revising standards and practices patterns setting bodies are making numerous efforts to reduce the risk of creativity in accounting and off balance sheet financing. Efforts have been made and success has been achieved in most of the cases but the fact cannot be ignored that there are some inherent limitations associated to the standards and accounting practices. SOX have catered most of all the areas that were weak and spaces were open for fraudulent appropriations. The issues faced by US in the past corporate cases were focused and an attempt to cover up those issues was made by SOX. SOX emphasized on extensive disclosures and reporting patterns so that treatments applied and followed by companies can be easily seen in their respective disclosure so that risk of aggressive accounting, wrong doing gets reduced and a fair presentation can be achieved. For example in the case of Enron, World Com, creatively accounted heads of accounts were the reasons for downfall. However, there are some scandals going on in the corporate world despite of the presence of SOX and International standards setting bodies like IASB. For example issue like Lehman Brothers (Huff Post Business Newspaper 2010) and American International Group (Spitzer 2009) have proven that there is a room for improvements in the standards and accounting practices. As principles are not covering those pigeonholes that are being taken advantage of by unfaithful members of the organizations. Measures to control corporate world’s suffering are taken by legislative authorities and have focused on the ground roots of the problems. Such as, learning and trainings have been introduced in the form of continuous professional development (CPD) that can provide a sense of responsibility to the leading management personnel. Actions are being taken globally to reduce creative accounting, which shows that aggressive accounting is a global issue Conclusion and Recommendations In the past as discussed above, corporate world has suffered from many unethical and disciplinary problems such as application of creative and aggressive accounting, off-balance sheet financing, window dressing and other techniques used to manipulate the actual accounting figures. Cases like Enron, World Com, Arthur and Andersen, and Polly Peck have cracked the backbone of accounting principles and treatments through following aggressive and creative accounting. Creative accounting is seen on those places where there is a conflict of interest between directors and shareholders, management and Investors and where individualism is preferred more than collectivism. Managers that bear a fiduciary duty to take care of shareholder’s investments in their absence, start to work for their own interest. There has always been a need of alignment of interest in all organizations and this is the duty of management and regulatory bodies to properly observe if there is any indication of such conflict in the organization. Regulatory bodies are trying their level best to overcome these issues. Regulations have improved the level of principles and guidelines to be followed by organizations and are considering any further required changes, as the world is developing day by day; new methods of fraudulent treatments are also developing. Accounting ethics play an important role in controlling creative accounting issues. Standards have been revising by regulatory bodies and projects are going on like Convergence Project between IASB and FASB standards, it aims to integrate accounting standards and harmonize standards (FASB 2012). Regulatory bodies have achieved a great success in controlling creative accounting issues but the corporate scandals can still be found in world. As in 2009, Hewlett-Packard Perma-Scandal is example of poor corporate governance (The Street 2012). And Lehman Brothers were accused for off balance sheet financing. It can be seen that despite of all the measures taken rigorous efforts made to overcome corporate world’s problems, there are still some issues that are continuously arising. Creative accounting can be stopped only if professional individuals realize the value of ethics and become loyal to shareholders. 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