The Notion of Creative Accounting - Case Study Example

 Creative Accounting in Maxwell and Corporate Governance 1. Creative Accounting is the practice of presenting the accounts in a manner that makes them appear different from what they actually are. According to Smith, much of the so called growth that occurred in Companies during the 1980s “was the result of accounting sleight of hand rather than genuine economic growth.” (Smith, 1992:4). The notion of Creative Accounting is tied up to the position of its shares, such as (a) when it issues new shares in the market or (b) when it wants its existing shares to be presented in good light in the market so that its shares acquire premium value and (c) payment of high dividends through representing profits in an inflated manner by an over-valuation of assets. Griffiths identifies several such instances where there may be deceptive financial misreporting. Some of these include the practice by so called entrepreneurial Companies to “include capital profits from the sale of properties or shares….as operating profits” although these had not actually been realized and were subject to speculation; booking “unrealized capital gains as operating profit” despite the fact that some of these so called profits were generated in transactions with business associates or within the same firm. (Griffits 1990:122). In such cases, there would often be secret arrangements in place whereby the so called “buyer” in the transaction could later transfer the assets back to the seller, just after the period when the balance sheet had to be generated. Other similar means employed were the reporting of the net profits of associated Companies as a part of their own profits, and keeping an ownership level of the Company at 49 percent, such that group accounts did not have to be consolidated and debts could remain unreported, thereby giving rise to a deceptive perception about its capital structure (Griffiths, 1992: 123). Creative Accounting is therefore a deceptive accounting practice that leaves room for unethical financial practices. In the case of Maxwell Communications Corporations, the Company produced a set of accounts that looked very healthy, yet a few months subsequently, the Company experienced a financial collapse. Pension funds available in the Company were being diverted to purchase companies which the Chairman Maxwell was interested in. Some of the means that were utilized by Maxwell to hide this diversion of funds included inconsistencies in the reporting of extraordinary expenses and exceptional items. Additionally, debt was disguised as equity and this executed hand in hand with tricks of acquisition and disposition accounting. Moreover, costs were capitalized to appear as assets and gains, while depreciation rules were changed in writing back elements of profit.(Smith 1992). As a result of these measures, the profits reported by the Company were in fact inflated and appeared to be much more than what they actually were, since the goal of such inflation of profits on the balance sheet was to provide a deceptive impression that the Company was in a healthy position so that the value of the shares in the market would escalate. Through such creative accounting, Maxwell Communications was bale to manipulate its accounting ratios and inflate profits artificially while simultaneously under reporting losses. It was able to successfully conceal the financial risks from the eye of shareholders and thereby escape shareholder controls. Moreover, despite its inherently weakened position, it was able to gain access to financial sources and raise finances from them on the basis of a falsely financially healthy picture of the Company, thereby circumventing all borrowing restrictions. 2. Auditors play a significant role in corporate governance because they are the ones responsible for providing reliable and up to date accounting information which allows for effective supervision of management activity in a Company by the management (Parkinson, 1993: 161). The function of the auditor is to examine the books of the Company; however since he or she is appointed based upon the director’s recommendation and may also be paid separately for non audit duties, this has posed a conflict in auditor duties. There is a conflict created between the statutory duty of an auditor to the Company’s shareholders as opposed to the commercial relationship with the Company’s management.(Financial Times, 2001). Moreover, as Dezalay has also pointed out, the mega mergers that have been going on among audit firms in the wake of the rise of the international client base has resulted in the emergence of audit firms that provide an increasingly diversified base of services, such that their audit function is subordinated to the other non audit services that are performed by these firms which are more lucrative. (Dezalay 1991: 793). Before many of the accounting scandals erupted, risk assessment standards were considered a separate niche from regulating and auditing standards. However, with the inclusion of Business Risk Assessment as a central part of the audit process, there is now an increased tendency for large corporations to outsource internal control issues, therefore there is scope for big audit firms to extend their jurisdiction and competition for that internal control market of corporations may have intensified with the advent of Business Risk Assessment (Dezaley, 1991). The auditor has the responsibility of identifying weakness in the Company’s accounting systems and the systems of internal control, which might result in a fraud going undetected.(Walters and Dunn, 2000). Such weaknesses as he or she detects need to be reported to the management. However, when an auditor is not an independent agent but is hired by the directors themselves and also performs other lucrative non audit services, and the purpose of creative accounting is to gain control of assets by management, there is often a temptation for the auditor to conveniently refrain from reporting discrepancies, in order to benefit from fees and remuneration received from the directors. In other words, the auditors may eschew their public, statutory duty to the shareholders in favor of encouraging and promoting management fraud in order to benefit from it. In the case of Maxwell, for example, the director Robert Maxwell’s attempts to manipulate profits in 1970 were highlighted in a Government report, yet no steps were taken by the auditors to disqualify or question the Maxwell’s continued Chairman-ship of the Company (Smith 1992). Moreover, the fact that Maxwell was borrowing heavily from pension funds to fund losses in his Companies was also one of the aspects that audit failed to identify and pinpoint. There was failure in vigilance and diligence on the part of the audit Company, Price and Waterhouse in reporting discrepancies in accounting statements. For example, one senior partner of the audit Company, John Cowling, failed to failed to qualify the accounts of one of the businesses held by Maxwell – the London and Bishopsgate Investment (Smith 1992). This occurred despite the fact that the business had failed to maintain adequate control systems and proper recording of accounts, neither did it bother to effect a reconciliation of the money belonging to clients. It failed to question several aspects and failed to provide evidence on whether management was questioned about discrepancies and what explanations were provided, thus resulting in a failure of audit duties and adequate and responsible discharge of audit duties. Ans 3: In my opinion, creative accounting is not much different from fraud because through an inaccurate presentation of accounts which is done deliberately, a false picture is presented from that which is the reality. For example in the case of WorldCom, the company showed a profit of $1.4 billion in 2001, but this was done by showing actual costs incurred as long term investments.(Krantz, no date). This is in fact an expense, but it has been shown as a gain, which is an outright deception. While an expense would be deducted from the accounts, by adding it instead, the Company is showing a gain while there is actually a loss. Moreover, deliberately leaving out certain debts and expenses so that they do not appear on the profit and loss statements amounts to a Company incurring debt, yet deliberately not reporting them, which is equivalent to fraud. Moreover, most creative accounting is done for the purposes of showing falsely inflated picture of profits for the Company and the prices of shares are conditioned by such accounting figures. Since members of the public and investors buy shares in Companies on the basis of these accounting reports, presenting false figures is equivalent to making members of the public buy shares in a failing Company, so that they will be forced to suffer the losses when the Company crashes, while the actual profits are funneled away elsewhere. Therefore the Company is guilty of selling a fraudulent product by presenting its shares at values in the market which are not a reflection of their actual true value as per the accounting statements. However, as also pointed out by Kantz (no date) creative accounting may not be really harmful in some cases, because the motivation for such accounting is to generally presented a healthy balance sheet, therefore some minor measures can be implemented, such as putting off big purposes till just after the issue of the balance sheet, in order that the amount is not reflected. Such manipulated cannot be said to account to fraud because the amounts will be reported, the only thing is they are reported a little later. Such creative accounting does not strictly amount to fraud because it is more akin to adjustment. This is the kind of creative accounting that may be done at most firms and may not be harmful. It may be argued that such accounting practices do not account to fraud and that they are standard practice adhered to by firms. However, in my view while such instances may not be akin to fraud, there is a thin line that could easily result in such manipulations slipping into the area of fraud, such as those measures outlined before, when actual expenses are reported as gains, or when capitalization gains that have not actually been realized are reported as gains on the balance sheet. This is akin to reporting income that does not actually exist, just as inflating the value of shares pushes the share value to in the market to one which does not represent its true value. Therefore, such instances would, in my view constitute fraud rather than creative accounting. Ans 4: Ansari and Bell (1991) have argued that problems of control that arise within a firm which often lead to accounting deception and malpractice should not be examined merely within the context of whether or not the firm is a private or public Company. Rather there is a need to examine failures of internal controls within a firm in the context of economic regulations that may exist as well as the complex aspects that may surround firms and society. Creative Accounting does affect corporate governance within a firm, because it propels individual greed at the expense of the duty to the shareholders and the public. When auditors do not perform an independent audit report, then there is a risk that their greed for consultancy fees could result in then closing their eyes to discrepancies that exist within the firm, where losses are not being properly reported and artificial gains are being posted. The Cadbury report has pointed out that one of the salient aspects of good corporate governance is the need to include auditor regulations and controls and establish parameters whereby auditors will be required to work as independent agents rather than performing both audit and consultancy services for a single firm. (Cadbury report, 1992:38). Without adequate corporate governance, there has been a general failure in the capacity for financial statements to adequately predict when a Company is likely to crash. Corporate governance also emphasizes the need to maintain tighter and more stringent internal systems of control in order to monitor a firm’s financial performance, through using agents who are not directly connected to the firm and in a position to pocket profits due to personal greed. The role of non directors is especially important in firms, in ensuring that some system of internal control is maintained. Voting by shareholders before entering into major business investment decisions is yet another way in which corporate governance can function, including the establishment of more rigid, generalized accounting standards that will be applicable internationally. References * Ansari, S.L. and Bell. J, 1991. “Symbolism, Collectivism and Rationality in Organisational Control”, Accounting Auditing and Accountability, 4(2): 4-27. * Committee on the Financial Aspects of Corporate Governance, 1992 “Report with code of best Practice” (Cadbury Report) London: Gee Publishing, p.38 , para 5.7 * Krantz, Matt, No Date. “Capitalizing on oldest trick in book.” USA Today, [online] Retrieved August 13, 2007 from: http://www.usatoday.com/educate/college/business/casestudies/20030128-accountingfraud1.pdf * Griffiths, Ian, 1992. “Creative Accounting: How to make your profits what you want them to be.” London: Routledge * Parkinson, J.E. 1993. “Corporate power and responsibility” Oxford: Clarendon Press * Smith, Terry, 1992. “Accounting for growth.” London: Century Business * Walters, D and J . Dunn, J, 2000. “Student ' s Manual of Auditing the Guide to UK Auditing Practice” Thomson Business Read More