Why Most Companies Use Creative Accounting - Assignment Example

ACCOUNTING AND FINANCE By of the of the School Contents list Introduction-------------------------------------------------------------------------------3 Part A--------------------------------------------------------------------------------------3 Part B--------------------------------------------------------------------------------------8 Part C-------------------------------------------------------------------------------------12 Conclusion and recommendation------------------------------------------------------17 References--------------------------------------------------------------------------------18 Appendix: calculation of ratios--------------------------------------------------------20 Introduction This report tries to explain why most companies use creative accounting and what shows that accounting profession has legalized creative accounting. It further looks at how specific ratios are calculated and how each can be interpreted. It discusses the purposes of each ratios and their applicability in analyzing the performance of a company. Further, a calculation of net cash flow from operating activities is then looked at. The report concludes by discussing tangible fixed assets and intangible fixed assets as well as the relevant regulations regarding them. Part A a) Creative accounting is a process by which company’s accountant use their knowledge of accounting rules in manipulating reported figures in the business accounts. They therefore transform the financial accounting figures and values from their actual ands true values to the ones they prefer especially by taking advantage of the existing rules (Mulford, 2002, pg. 81). They may even ignore all of them or just a few of them. Basically market and shareholders’ reactions are related to the managers’ actions hence making directors to be judged on growth, profit, and earnings per share. This has necessitated the companies to use the loopholes in the reporting system in manipulating the figures so that they can present the message desired by the investors (Epstein & Lee, 2010, pg.57). Creative accounting is used in financial statements because of various reasons. Other than trying to impress shareholders and the market in general, creative accounting is used in income smoothening. It is used in reporting a steady growth trend in profit instead of showing volatile profits that has a series of dramatic falls and rises hence avoiding raising high expectations in good years that the company cannot deliver what is subsequently required. In addition, the method is used by companies to hide a bad year by forcing an exceptionally good performance in their financials (Jones, 2010, pg. 34). They therefore use creative accounting to ensure that they remain the best in the industry by giving an impression of stable and sustained improvement. This therefore enables them to boost their assets in order to avoid take-over which may result due to bad performance. Companies that make losses therefore seek to maximize the loss reported in that year so that their future years may appear better (Griffiths, 1987, pg. 76). The desire for tax benefits necessitates companies to use creative accounting particularly when the taxable income is measured through accounting numbers. Further, the companies desire to meet external expectations such as long term survival demanded by customers and employees, assurance about payment demanded by suppliers and dividend payout pattern to the analysts, and internal targets such as sales targets and profitability. Both of these require the company to cook their books through creative accounting (Epstein & Lee, 2010, pg.57). Companies use different methods to manipulate the values in their financials. The most common methods include pre-acquisition write down, extraordinary and exceptional items, deferred consideration on acquisition, changes in depreciation method, off balance sheet finance, brand accounting like capitalization of assets, contingent liabilities, capitalization of costs (R&D and interest), currency mismatching between deposition and borrowing and use of pension funds to reduce annual charge among others (Aneirin, 2007, pg. 423). b) Companies basically would wish to succeed in their business endeavors as well as possible. Generally Acceptable Accounting Principles of creative accounting outlines various accounting methods to be selected by companies specifically those that may make their financial statements better. The method provides for legitimate techniques to be employed especially when certain items in the accounts are being computed (Picker, 2013, pg. 97). However, a wide range of accounting methods provided by the GAAPS of creative accounting poses a difficulty in drawing an ethical line. Technically, the estimates employed by the companies are not illegal but gross misrepresentation and inflation of the performance of the true values may be unethical. Creative accounting is therefore legalized impliedly especially when it achieves the ultimate goals of the company of increasing the value of the stock and also within the ramifications of the law. It should therefore not mislead other users or stakeholders and should also benefit the company both in the short run and in the long run (Hussey & Ong, 2005, pg. 129. Each category of the International Accounting Standards presents different accounting methods to be used by companies, a move that seems to have effectively legalized creative accounting into a regulatory framework. The following examples justify this statement (Needles & Powers, 2010, pg. 79). IAS 1 which deals with presentation of financial statements allows a company to use any format in presenting their financial statements, “IAS 1 does not prescribe the format of the statement of financial position. Assets can be presented current then non-current, or vice versa, and liabilities and equity can be presented current then non-current then equity, or vice versa”. This therefore allows the companies to be creative in presenting their financials so that their goals can be achieved. Any format is therefore allowed provided that it has a net asset presentation column of assets-liabilities. For instance, long term financing approach is used in the UK, fixed assets plus current assets minus short term payables is equal to equity plus long term debt, an indication that creative accounting is legalized in the accounting profession by the International Accounting Standards (Alexander & Archer, 2008, pg. 121. In addition, companies use creative accounting method such as off balance sheet finance to report to keep some items from the balance sheet so that they can report higher financial position hence maintaining or boosting share prices by creating an appearance of good profit trend, a condition that is made possible by the different types of off balance sheet financing. The company therefore increases the desire for the stocks they issue basically by releasing reports that indicate that the officers are being given bonuses as a result of increased sales volume even though there was no real increase in profits from that volume (Mulford, 2002, pg. 81). The business then releases an additional share of stock thereby sending a message to investors that this company is growing hence enticing them to purchase the shares. The increased demand for the stocks increases the shares’ values hence benefiting the company financially (Geoffrey, 2014, pg. 326). This is an indication that creative accounting has been legalized in the accounting field. Further, under inventories, the International Accounting Standards allow the use of a number of methods in inventory valuation. These methods include LIFO, FIFO and weighted average. This therefore implies that the accounting profession has legalized creative accounting. The company’s accountants will use their creativity in valuing their inventories in such a way that their financials may look better than when other methods are used. For instance, companies that are interested in high gross profit and highest closing inventory prefer FIFO method. Even though FIFO increases taxes as a result of increased net income, companies prefer it because it helps them show high earnings which normally attract investors (Greuning & Koen, 2001, pg. 121). However, a company that is interest in los taxes normally uses LIFO method. This is another illustration that creative accounting is legalized by the International Accounting Standards (International Accounting Standards Committee, 2001, pg. 63). IAS 7 outlines two ways of preparing statement of cash flows, direct and indirect methods. Companies are allowed to choose the method that suits their needs. Indirect method takes care of non-cash items while direct method outlines all cash receipts and payments. Companies that might want to report high net cash flow prefers indirect method so that they can attract more investors. These different methods require a company’s creativity in reporting their financials hence indicating that creative accounting is legal in accounting profession. IAS 8 allows for companies to select and apply accounting policies from the available ones. This is an indication that many accounting methods have been legalized so it is the companies that should choose the one which is more appropriate for them. International Accounting Standards have been adopted by many firms in reporting their financial statements so that high performance can be portrayed and also to enjoy some tax benefits as well. Part B (a) Calculate the financial ratios for each of the categories Revenue, Profitability, Liquidity, Efficiency, Gearing and Investment. Summary Calculations of the following ratios are found in the appendix. These ratios show the profitability, liquidity, efficiency investment opportunity, gearing level and revenue generation ability. The ratios calculated under each category are shown below; Profitability ratios This category has ratios such as gross profit margin, net profit margin, return on assets, and return on equity. Revenue ratios The revenue ratio also referred to as accounts receivable turnover ratio indicates the length of time it takes a company to collect its accounts receivable. Gearing ratio Gearing ratio is indicated by ratios such as debt to equity ratio, interest cover ratio and long term debt to total capitalization. Liquidity ratios Examples of liquidity ratios include current ratio and acid test ratio. Efficiency ratios This category is also known as asset utilization ratios and comprises ratios such as total asset turnover, fixed asset turnover and average collection period. Investment ratios Investment ratio example includes dividend payout ratio. (b) Discuss the purpose of each category of financial ratios and the Company’s performance for the years 2012 to 2014. Revenue ratios It also represents the time taken by customers to pay their bills. It indicates the number of times company’s credit sales are converted to cash in an accounting period. The company’s revenue ratio has been decreasing over the period, implying that the company’s efficiency in collecting its receivables is decreasing. Profitability ratios Profitability ratios determine the bottom line of a company and the returns it gives the investors. These ratios highlight the company’s overall performance and efficiency. These ratios are categorised into two: returns and margins. Return ratios the company’s ability to measure its overall efficiency particularly by generating the returns to the shareholders. Margin ratios shows the company’s ability translate the dollar sales into profits. These ratios therefore measure the ability of a company to generate its earnings relative to sales, assets and equity (Peterson Drake & Fabozzi, 2012, pg. 196. The company has relatively high margin and return ratios implying that it is profitable and is generating some returns to its investors. This therefore makes it efficient in operations. Liquidity ratios Liquidity ratios highlights the ability of a company to meet or pay for its short term liabilities or short term debt obligations as they fall due. The company’s current ratio is increasing over time showing that the company’s ability is increasing as well. This implies that the company is capable or able to meet its short term liabilities with ease. The company has a quick ratio of less than one showing that its most liquid assets are not high enough to meet its short term obligations. This indicates the over-leveraged nature of the company hence maybe paying its bills too quickly, collecting its receivables slowly, or struggling to grow sales. The increasing trend of the quick ratio shows an increase in the most liquid assets of the company. Efficiency ratios Efficiency ratio measures how effectively a firm is utilizing its assets and or how well it manages its liabilities. These ratios show how efficiently the business assets are working to generate sales. Their main purpose is to show how effective the management of the company is and how efficiency it uses its assets. The company has a high turnover ratios and this indicate that it is using few assets to generate more revenue thus it is very efficient in the operations. The company’s high average collection period shows that receivable collection efficiency is reducing. Gearing ratios This ratio helps a company to compare the company’s equity to the borrowed funds. It shows the company’s activity funded by the borrowed funds in comparison to those funded by its equity. The gearing ratio not only measures the company’s financial leverage but also measures its business risk indirectly. It measures the company’s long term solvency. The company has a high times interest earned ratio showing that it can easily finance its interest on debts. The company is therefore able to meet its long term solvency requirement. Investment ratios This category of ratios illustrates the ability of the company to generate returns to their investors from their operating activities. It indicates the amount of return that is distributed to the shareholders in the form of dividend. It indicates the returns on shareholders’ investment. The company financials and calculations highlights that it has a higher dividend payout ratio of more than one. This clearly shows that the company pays more to shareholders in the form of dividends. (c) Calculate net cash flows from operations using the indirect method and discuss the results in terms of the liquidity of the company to support a larger overdraft or a long term loan. 2013 2014 Net income 101,000,000 92,000,000 Add depreciation 16,000,000 18,000,000 Add decrease in inventory Subtract increase in inventory (73,000,000) 16,000,000 Less increase in receivables (36,000,000) (29,000,000) Less decrease in short term loan Add increase in short term loan 22,000,000 (6000000) Add increase in overdraft 5,000,000 5,000,000 Net cash from operating activities 35,000,000 96,000,000 The net cash flow from operating activities indicates that the company is not liquid enough to support the high overdraft but rather can support only the long term loan. The net cash flow from operations is £96,000,000 and can only support the loan (long term) of £ 71,000,000 but cannot support a larger overdraft of £ 110,000,000. This therefore implies that the business faces a risk of bankruptcy from its operations. Part C Tangible fixed assets refer to anything owned by the business which has long term physical existence. They are normally acquired to be used in business operations and not to be sold to customers. In the statement of financial position, balance sheet, of the business, this kind of assets are normally listed as property, plant and equipment or simply plant and equipment (Spurga, 2004, pg. 56). Examples of tangible fixed assets therefore include machinery, equipment, property, plant and land. Unlike intangible assets, this category of assets can be destroyed by hurricane, accidents, fire or other disasters. Basically, this class of assets assists as collateral when raising loans and can be used to raise cash in emergencies because they can be sold easily. This class is covered in details under International Accounting Standards 16. “IAS 16 Property, Plant and Equipment outlines the accounting treatment for most types of property, plant and equipment. Property, plant and equipment is initially measured at its cost, subsequently measured either using a cost or revaluation model, and depreciated so that its depreciable amount is allocated on a systematic basis over its useful life”. This standards deal mainly with how the asset is recognized, how to determine the carrying amounts, recognition of impairment losses and depreciation charges. IAS16 is subdivided into five main parts recognition, measurement, depreciation, Derecognition and disclosures. Recognition Tangible fixed assets are recognized in the balance sheet as assets when they fulfill the following conditions as prescribed by IAS 16. First, they are recognized as assets when it is probable that their future economic benefit will flow to the entity, this imply that the use of the assets should only be for the business and not for an individual hence benefiting the business directly. Second, they are recognized as assets when their cost is capable of being measure reliably. It should be easy to measure the cost and with ease of predictability. The re4cognistion principle caters for all costs associated with the assets for instance, acquisition or construction costs, replacement costs, improvement and servicing costs (Peterson, 2002, pg. 11-15). Measurement The asset’s initial cost should be recorded initially at cost, for instance, the cost necessary to make the asset be able to perform its intended purpose. IAS 16 illustrates that this cost includes original purchase price, installation, handling and deliver, related professional fees as well as the cost of removing, dismantling the asset and restoring the site. Further, it illustrates that in case the asset’s payment is deferred, an interest should be recognized at prevailing market rate (Peterson, 2002, pg. 11-15). Further, IAS 16 indicates that “If an asset is acquired in exchange for another asset (whether similar or dissimilar in nature), the cost will be measured at the fair value unless (a) the exchange transaction lacks commercial substance or (b) the fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up. [IAS 16.24]” After the initial measurement has been done, IAS permits two accounting methods of subsequent measurements. These methods include revaluation model and cost model. Under revaluation model the asset is usually carried at the cost minus impairment and accumulated depreciation (IAS 16.30). Revaluation model on the other hand, indicates that the asset be carried at a revalued amount which is the fair value at the revaluation date less impairment and depreciation (IAS 16.31). However, the fair value should be measured reliably. Depreciation The asset’s depreciable value should be systematically allocated over the asset’s useful life. Derecognition When the asset is disposed, it should be removed from the statement of financial position. Disposal gains or losses on should be recognized in profit and loss (IAS 16.67-71). Intangible assets can be defined as non-monetary assets which have no physical substance yet can be identified (IAS 38) or future economic benefits that arise from assets that cannot be individually identified and recognized separately (IFRS 3). These assets include patents, goodwill, computer software, copyrights, licenses, franchise, import quotas etc. (Bragg, & Bragg, 2007, pg. 137). For instance, when a business worth $5 million is sold for $ 7 million, the excess of the cost is known as the goodwill. Goodwill is the excess value over the cost of the business. Recognition For an intangible asset to be recognizable it should be: i) Identifiable, for instance, it should separated and sold, exchange, transferred, rented, licensed ii) Should be able to be controlled by the business or entity iii) Able to generate future economic benefits to the owner or entity iv) Its cost be able to be reliably measured For example, for accounting purposes, an intangible asset is recognized whether self-created or purchased at cost if and only if it meets the following conditions: first, its cost should be able to be measured reliably; and when is it likely that the assets future economic benefits linked to it will flow to the business. This is possible to both externally and internally acquired intangible assets. Conversely, when the two conditions are not met, the IAS 38 indicates that the expenditure on them should be recognized as an expense particularly when it is incurred. Measurement Just like tangible assets. They are measured at cost in initial measurements while subsequent measurements are done using cost model, initial cost minus any impairment or amortization or by using revaluation model, fair value minus any impairment or amortization. The three main rules that deal with tangible and intangible assets as per International Accounting standards include IAS 16 that deals specifically with Property. Plant and equipment, IAS 38 that particularly deal with intangible assets and IAS 36 that deals with the impairment of both category of assets. Conclusion and recommendation In as much as the creative accounting is encouraged, care should be taken in using it to ensure that the company’s performance in maintained both in the short run and in the long run. Companies should avoid unethical book cooking which may affect their long run performance. References Alexander, D Britton, A and Jorissen, A (2011) ‘International Financial Reporting and Analysis’ (5th Edition), Cengage Learning. Alexander, David, & Archer, Simon. (2008). International Accounting/Financial Reporting Standards Guide 2009. Chicago, CCH. Aneirin, O. (2007). Accounting for Business Studies. Routledge Bragg, S. M., & Bragg, S. M. (2007). Wiley GAAP policies and procedures. Hoboken, N.J., John Wiley & Sons. Duchac, J. E., Reeve, J. M., & Warren, C. S. (2007). Financial accounting: an integrated statements approach. Mason, OH, Thomson/South-Western. Elliot, B; Elliott, J (2013) ‘Financial Accounting and Reporting’, (15th Edition) Prentice Hall Epstein, M. J., & Lee, J. Y. (2010). Advances in management accounting. Volume 18 Volume 18. Bingley, Emerald. Geoffrey, W. (2014). Profitability, Accounting Theory and Methodology: The Selected Essays of Geoffrey Whittington. Routledge Greuning, H. V., & Koen, M. (2001). International accounting standards: a practical guide. Washington, DC, World Bank. Griffiths, I. (1987). Creative accounting: how to make your profits what you want them to be. London, Unwin Paperbacks. Hussey, R., & Ong, A. (2005). International financial reporting standards desk reference: overview, guide and dictionary. Hoboken, NJ, Wiley. International Accounting Standards Committee. (2001). International accounting standards explained. New York, Wiley. Jones, M. (2010). Creative accounting, fraud and international accounting scandals. Chichester, John Wiley & Sons. Mulford, C. W. (2002). The Financial Numbers Game Detecting Creative Accounting Practices. New York, John Wiley & Sons Needles, B. E., & Powers, M. (2010). International financial reporting standards: an introduction. Mason, Ohio, South-Western Cengage Learning. Peterson Drake, P., & Fabozzi, F. J. (2012). Analysis of financial statements. Peterson, R. H. (2002). 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Appendix Ratio 2012 2013 2014 Gross profit margin =GP/net sales 286/841 =34.01% 336/991 =33.91% 327/925 = 35.35% Net profit margin =NP/net sales 79/841 = 9.39% 101/991 = 10.19% 92/925 =9.95% Return on assets =net income/total assets 79/604 = 13.08% 101/746 = 13.54% 92/768 = 11.98% Return on equity =Net income/equity 79/299 =26.42 101/300 = 33.67% 92/292 = 31.51% Revenue ratio =sales/receivables 841/103=8.1650 =8.2times 991/139= 7.1295 =7.1times 925/168= 5.5060 =5.5 times Interest cover ratio = EBIT/interest expense 113/8 =14.125times 143/8 =17.875times 132/9 = 14.67times Debt to equity=total liabilities/ total shareholder’s equity 305/299 = 1.02 446/300 = 1.487 476/292 = 1.63 Long term debt to total capitalization = long term debt/ (long term debt + total equity). 75/374 = 19.79% 97/397 = 24.43% 91/383 = 23.76% Current ratio= current assets/current liabilities 392/230 = 1,704 500/273 = 1.832 504/272 = 1.853 Quick ratio= (current assets-inventory)/current liabilities 157/230 = 0.6826 192/273 = 0.7033 212/272 = 0.7794 Total asset turnover = net sales/total assets 841/604 = 1.392times 991/746 =1.328times 925/768 = 1.204times Fixed asset turnover = net sales/fixed assets 841/212 = 3.967times 991/246 = 4.028times 925/264 = 3.504times Average collection period= Accounts Receivable/ (Sales/365) 103/(841/365)= 44.70 = 45days 139/(991/365) =51.2 = 52days 168/(925/365) =66.3 = 67days Dividend Pay-out Ratio = Dividend / Net Income 100/79 = 1.266 100/101 = 0.990 100/92 = 1.087 Read More