Accounting Fraud, Earnings Manipulation, and Creative Accounting - Research Paper Example

Accounting Fraud, earnings manipulation, and creative accounting Introduction Overtime, there have been high profile cases detailing fraudulent financial reporting such as those at Enron and WorldCom. This has heightened concerns on the credibility of the U.S. financial reporting process, and also put into doubt the role played by management, regulators, auditors, and analysts in preventing accounting fraud. Businesses employ deceptive or fraudulent accounting practices such as creative accounting to match the expectations. Accounting fraud refers to an intentional and inappropriate falsification of a company’s accounting records such as the stating of sales revenue and/or expenses. Accounting fraud is geared towards making a company’s financial performance (operating profit) appear better than it is. The motivation for misrepresentation of accounting records hinges on the profit motive and sourcing a favorable financing and dodging debt obligations. Companies commit accounting fraud through activities such as failing to record prepaid expenses or other incidental assets, failing to show certain classifications of current assets and/ or liabilities, or collapsing both short-term and long-term debt into a single amount (Jones 3). Overstatement of sales revenue is one of the techniques employed in committing accounting fraud. Overstatement of sales arises from activities such as channel stuffing and delaying recording of products returned by clients. This is directed at avoiding recognition of those offsets against sales revenue within the current year. Other means by which businesses commit accounting fraud include under-recording expenses such as depreciation expense. In some instances, businesses fail to record the cost of goods sold expenses in order to make gross margins appear higher (Rezaee and Riley 82). Similarly, accounting fraud occurs when a business fails to state asset losses that ordinarily should be identified such as uncollectible accounts receivable or not writing down inventory under the lower of cost or market rule. In addition, a business may fail to record the full amount of liability for an expense. Accounting fraud may also feature abuse of corporate funds and overstating of the corporate assets (Tirole 300). Creative Accounting Creative accounting (aggressive accounting) details accounting practices that are not necessarily considered illegal, but which are potentially misleading to investors and considered as unethical, regardless of the fact that the strategy is well within the letter of the law (Shah, Butt and Tariq 531). The resultant financial statements do not reflect the “true and fair” view of the company accounts. For instance, a firm may want to paint a perception that it is financially stronger whereas it has achieved little or no growth at all. Most businesses use creative accounting to enhance desire for stock issued so as to drive up the value of the shares and amass benefits to the business. Examples of creative accounting include off balance sheet financing, overoptimistic revenue recognition or application of overstated nonrecurring items. Motivations for Accounting Fraud The prominent cited motivations for accounting fraud encompass the urge to meet internal or external earnings expectations. Thus, there is an attempt to conceal an entity’s deteriorating financial condition. In addition, financial fraud is motivated by the need to raise a company’s stock price as well as the urge to bolster a company’s financial performance owing to a pending equity or debt financing. Similarly, accountants engage in financial fraud so as to enhance management compensation based on financial results. The two most common techniques employed in fraudulently misstating the financial statements encompass improper revenue recognition and asset overstatements, primarily by overvaluing the present assets or capitalizing expenses. Other tricks employed in committing financial fraud include understatement of expenses and liabilities, improper revenue recognition, and misappropriation of assets (Tirole 299). Description Accounting Fraud Techniques Companies utilize the following techniques to manage and manipulate earnings; recording revenues too soon, recording bogus revenue and reinforcing income by employing one-time or unsustainable activities, changing current expenses to a later period, instituting techniques to conceal expenses or losses, shifting current income to a later period, and shifting upcoming expenses to an earlier period. “Cookie-jar” Reserves This refers to situations in which a firm establishes additional expense accruals so as to minimize the liability to generate earnings, especially in the future when needed. This practice affects accounting practices such as accrual of expenses or reserves, especially in fields such as insurance and banking, which rely on estimates. Capitalization Practices When allowed to capitalize, the costs of internally developed assets such as software may be amortized over an erroneous useful life. The capitalization process of companies is prone to manipulation as some assets are intangible and grounded in judgment. Therefore, a company may allot extra expenses to an event that can be capitalized to diminish current operating expenses. “Big bath” or One Time Charges Non-recurring charges such as writing down assets and establishment of restructuring reserves are not part of a firms ongoing operations or operating income. Firms use nonrecurring charges as a technique of avoiding the maze of over aggressive accounting practices. As the ability of a firm to sustain earnings growth decreases, firms may seek events that can be categorized as a one-time event and “burden” the expenses characteristic to the event. Other fraudulent accounting practices include modifying the timing of operating activities and using significant events such as merger and acquisition activities to restructure one-time charges (Jones 86). Although accounting practices within the United States have improved significantly, there are still plenty of means that companies can manipulate their financial results. Companies exploit weaknesses within financial reporting system to overstate assets or underreport liabilities. Companies manipulate their balance sheet so as enhance their earning power and shape an appearance of strong financial position. How Conflict of Interest Contribute to the various Frauds Conflict of interest plays a significant role in accounting fraud. Arrangements between management, auditors, investment bankers, and Wall Street analysts may pose serious conflict of interest issues. Conflict of interest may lead to persons asserting the fear of jeopardizing the relationship between the parties, which has the capacity of impairing the ability of parties such as auditors to carry out their duties diligently and independently (Jones 5). This is especially critical if the task hinges on examining the company’s statements for accuracy. How Laws, Penalties and Oversight, have changed to Protect Investors in the Future Legislation such as Sarbanes-Oxley Act eliminated conflict of interest arising from instances such as an auditing entity transacting non auditing activities with the same company. In addition, new laws reinforce a company’s directors’ fiduciary duty of faith and loyalty to their clients. Company directors are expected to exercise independent judgment, especially in areas of audit control mechanisms to insure the accurateness of financial reporting. Sarbanes-Oxley Act now demands that senior executives attest the accuracy of their firm’s financial reporting (Coates 92). In addition, Sarbanes-Oxley Act demands securities analysts to reveal conflict of interest linked to any stock that the analysts recommend to the public. The Act has revolutionized the manner in which companies interact with their external auditors. The Difference between pushing the Accounting Limits and Committing Accounting Fraud As with many cases of misrepresentation, pushing accounting limits tells a portion of the truth, downplaying any element that may alter the perception that the firm wishes to portray. Pushing accounting limits may not necessarily be an intentional fraud, but a result of a sequence of aggressive elucidation of accounting practices. This ultimately results to material misstatement of financial results. Accounting fraud, on the other hand, is an intentional manipulation of a company’s accounting records to conceal the true state of affairs (Shah, Butt and Tariq 532). Sarbanes-Oxley Act Sarbanes Oxley of 2002 is a comprehensive legislation and a response to a number of concurrent significant corporate fraud, conflict of interest and accounting scandals that have had a damaging effect on investors’ confidence (Coates 91). The Act avails fresh levels of auditor independence, personal accountability for executives, supplementary responsibility for corporate boards, enhanced criminal and civil penalties in cases of securities violations, enhanced disclosure regarding executive compensations, insider trading and financial statements, and provision of certification of internal audit work executed by external auditors. The Act was directed at bolstering accounting, internal control, and auditing standards within public corporations. The accounting malpractices that led to legislation of the Act also put into question the feasibility and responsibility of the corporate governance system and reliability of security markets. The Act heralded sweeping mandatory provisions to improve corporate internal auditing and financial reporting control measures to ensure that fraud can be easily detected. This came in the backdrop of collapse of shares of Enron and WorldCom owing to deliberate manipulation of stock price, and fraudulent and deceptive accounting practices (Shah, Butt and Tariq 535). Conclusion Fraudulent financial reporting has extensive consequences on organizations, stakeholders, as well as public confidence in the capital markets. It is crucial to reinforce measures directed at prevention, deterrence, and detection of fraudulent financial activities such as accounting fraud. There should be close examination of revenue accounting and related fraud tricks to ensure that a better understanding is achieved, detailing how revenue recognition is employed to distort financial statements information. In addition, valuation issues should be closely addressed to ensure that assets are given the right categorization given that a majority of the frauds stem from asset overstatement. The concern should be doubled given that financial reporting valuations are dependent on fair value accounting. Steps should be taken to reduce the occurrence of cases such as accounting fraud, earnings manipulation, and creative accounting. This can be accomplished via implementation of regulations directed at making it difficult for firms to “doctor financial statements” and exhibit a financial position that is not reflective of the accurate financial position. Works Cited Coates, John. “The Goals and Promise of the Sarbanes-Oxley Act.” The Journal of Economic Perspective 21.1 (2007): 91-116. Print. Jones, Michael. Creative Accounting, Fraud and International Accounting Scandals. West Sussex: John Wiley & Sons, 2011. Print. Rezaee, Zabihollah and Riley Richard. Financial Statement Fraud: Prevention and Detection. New Jersey: John Wiley & Sons, 2010. Print. Shah, Syed, Butt Safdar and Tariq Yasir. “Use or Abuse of Creative Accounting Techniques.” International Journal of Trade, Economics and Finance 2.6 (2011): 531-536. Print. Tirole, Jean. The Theory of Corporate Finance. New Jersey: Princeton University Press, 2006. Print. Read More