Creative Accounting as a Problem in Managerial Accounting - Enron - Case Study Example

Name: Institution: Tutor: Date: Introduction Enron was one of the leading energy companies in the world until its collapse in the year 2001 due to a huge corporate scandal. The collapse of Houston based Enron Corporation led to dissolution of Arthur Andersen. Arthur Andersen was among the five biggest audit and accountancy partnerships around the world. Apart from Enron being the largest bankruptcy reorganization in the history of America, it is also viewed as the largest audit failure. Investigation into the causes of the collapse of Enron cited creative accounting as the major factor that contributed to the failure of the company. The company’s auditor, Author Anderson, which was one of the renowned auditing firms, was greatly involved in manipulative accounting practices. The management of the organization, the Chief Financial Officer and other executives not only misdirected Enron's board of directors and audit committee on high-risk accounting practices, but also forced Anderson to disregard the issues. Through their creative accounting practices they were able to falsely display Enron Corporation as one of the most innovative, fastest growing and effective managed entity within the United States of America. Therefore, by utilizing Enron Corporation as a case study, this paper seeks to evaluate creative accounting as a problem in managerial accounting. Creative accounting as a problem in managerial accounting Creative accounting refers to accounting practices that comply with regulations of accounting standards however in real sense they diverge from the same standards. The practice can also be described as a process where accountants apply their accounting knowledge to maneuver or manipulate reported figures. The practice has for many years proved to be a problem in managerial accounting. Managerial accounting, which mainly concerns with provision of information to managers, has for a long time been affected by creative accounting practices (Warren and Reeve 720). The use of creative accounting practices has for a long time misinformed managers, particularly on matters relating to company’s revenues, profits, assets, inventories and liabilities (Mowen 150). In Enron Corporation, managers were misinformed regarding the performance of the company. Accountants in the company employed creative accounting in a number of ways so as to manipulate profits, revenues, assets and liabilities. One of the ways through which Enron’s accountants and audit firm performed Creative accounting was by creating multiple trading entities. The accountants in Enron created several entities for trading purposes. They divided the company’s operations into sectors that executed specialist functions. Trade was then undertaken among these entities. During the process of trading, costs, expenses and losses of the entities were not recorded, but instead the accountants recorded only income, revenue and profits obtained from the transactions made. The company therefore at this period recorded excellent performance with an attractive increase in revenues, profits and income. However, this was not the real situation in the corporation. The corporation was experiencing huge losses, but through creative accounting, accountants were able to misinform managers that the company was performing well (Kammerer 18). Another way through which Enron’s accountants and audit firm performed Creative accounting was by moving the segments of the business offshore. Enron developed several entities offshore so as to practice creative accounting. The creation of business segments offshore was majorly practiced during accounting and tax planning. Enron’s accountants engaged in this practice so as to minimize the amount of taxes the company pays. The accountants, through creative accounting practices such as tax avoidance and tax evasion, greatly affected managerial accounting and in the process made the corporation to collapse. Offshore entities normally enjoy an increased privacy level. This kind of privacy level normally makes it hard for local governments and auditors to understand the real situation in an organization. Enron Corporation, for a long time, seemed to have successfully managed to hide from auditors, investors and potential whistle-blowers about the company’s real situation until in 2001 when it was realized that the managerial accounting was being affected by some accounting malpractices. The losses incurred by the entities were being recorded away from the financial statements. It was therefore hard for investors and staffs to know about the losses. The room to undertake creative accounting by accountants is usually created when accounting rules gives an organization authority to choose between various methods of accounting. In several countries, for instance, an organization is normally allowed to select between policy of writing off development costs as they happen and amortizing of development expenditure over the life of a given project. By employing this rule, accountants can easily select accounting policy that serves their best interest. Therefore, the adaptation of accounting rules that gives an organization authority to choose among various accounting methods do always make accountants to engage in creative accounting practices. Accountants will try very hard to manipulate books of accounts so as to provide managers with false information, thus affecting managerial accounting (Jones 350). In Enron Corporation, in order for accountants to promote inside trading, they manipulated profits through the use of creative accounting and fraud. The main reason for their action was to affect stock prices. Accountants took advantage of the inside knowledge they had and begun trading on stocks, thus benefiting themselves more from the trade. Creative accounting has a great effect on managerial accounting, particularly on matters pertaining financial reporting. Accountants do always use creative accounting to manipulate financial statements. They usually involve themselves in financial statement manipulation so as to misinform management about the company’s financial stability. According to Amat, one of the outstanding attributes of creative accounting is the manipulation of accounting numbers (52).This sort of manipulation is sometimes practiced within the outlined accounting standards and law, however it is usually against the motive of providing a fair and true picture of the company’s financial position. The manipulation of accounting numbers further results to structuring of transactions in a manner that allows the production of accounting results that are creatively preferred by the accountants. Kammerer provides a case in point of Enron scandal whereby questionable manipulations of accounting numbers were done through accounting adjustments. Enron accountants had adapted a culture of creative accounting whereby attempts were made to manipulate numbers in every financial quarter to a close variance between the targeted incomes and the actual results, in order to provide a nonexistent financial position of the company (28). Creative accounting has proved to be a problem in managerial accounting since they can be employed by accountants to undervalue the company’s liabilities without management’s knowledge. Accountants do always find it easier to manipulate pension and contingent liabilities. Pension liabilities are normally easier to manipulate without being detected by managers because they are experienced in future. Apart from pension liabilities being incurred in future, their valuation is usually done through estimation. This therefore gives accountants an opportunity to manipulate the liabilities so as to misinform the management about company’s progress. Most accountants do always use this opportunity to make aggressive estimations so as to improve the short term earnings and develop a false impression of the financial stability (Heitger 280). Contingent liabilities refer to obligations that rely on future activities to verify the existence of an obligation, the amount of money owed and the payee or the date payable. For instance, a warranty liability or forecasted litigation loss can be considered a contingent liability. As a way of undervaluing liabilities, companies can creatively record these obligations. The creative recording of contingent liabilities is usually done by underestimating their materiality. Failure to provide reasonable estimation and recording of contingent liabilities that are more likely to occur will result into undervaluation of liabilities and overvaluation of company’s net income or equity of shareholders. Undervaluation of liabilities can also be attained through application of pension accounting. Companies such as Enron Corporation employed pension accounting in manipulation of short-term earnings. This is usually done through alteration of net benefit cost or the expected return on pension plan assets and on the income statement. Even though estimates need to be roughly similar to discount rate, accountants in an organization do always make aggressive estimates which will in turn affects the income statement. Enhancing expected return on plan assets will in most cases minimize the pension expense in income statement and increase net income. How to minimize creative accounting practices There are several ways through which creative accounting practices can be minimized. The most effective way of reducing creative accounting practices is through the selection of independent audit committees. Independent audit committees have for a long time proved to play a great role in reducing creative accounting practices. The committee, if introduced in an organization, will ensure that the company’s auditors are selected, monitored and compensated effectively. They will also ensure that the procedures that handles complaints pertaining accounting, internal control and auditing are well implemented. The establishment of audit committees normally safeguards the integrity process of financial reporting by protecting external auditor from probable management pressure. Jones argues that the current frauds and continuous increase in number of earnings restatements display the endless need for improving controls within the process of financial reporting. Therefore, by introducing audit committees, management and auditors will be controlled effectively so as to reduce any creative accounting practices within an organization (322). Another way of detecting and reducing creative accounting practices is through concentrating on cash flow rather than income numbers. In case the company’s top management concentrates closely on cash flow, they will make it hard for accountants to hide numbers. The impossibility of hiding numbers will leave accountants without an option of manipulating figures and instead force them to freely disclose any information to mangers, thus improving managerial accounting. The two major ways of interfering with financial statements are usually either through creation of fictitious revenues or through shifting of revenues or expenses to a different period. By concentrating on cash flow and check statements, it is very easy for top management and auditors to verify dates and compare figures (Mulford and Comiskey 210). Putting more than one individual to be in charge of accounting department is also a way of reducing creative accounting in an organization. Instead of having one person or couples working in a shared office, it is advisable for an organization to implement a step system, in which the analysis and processing of financial statements are done by a series of different individuals in separate areas within an organization. This normally makes it hard for an individual to alter figures without being detected. Creative accounting can be controlled by not allowing investors and partners to mix the company’s business with personal investments. It is always easy for a partner to buildup revenues if he or she is investing the money to purchase shares or if he or she is financing purchases that finally benefits the company (Dray 1). Conclusion From the discussion, it is clear that creative accounting is a problem in managerial accounting. The use of creative accounting practices has for a long time misinformed managers, particularly on matters relating to company’s revenues, profits, assets, inventories and liabilities. Accountants practice creative accounting in several ways. In Enron Corporation, for instance, creative accounting was undertaken through creation of multiple trading entities and through development of several entities offshore. These practices greatly affected the corporation’s managerial accounting which resulted into the collapse of Enron. Creative accounting assists mischievous accountants to undervalue the company’s liabilities without management’s knowledge. It is also clear from the discussion that there are several ways of reducing creative accounting practices. The most effective way of reducing creative accounting practices is through selection of independent audit committees. Cited Works Amat Orial. Creative accounting: nature, incidence and ethical issues, Oxford Brookes University, 2004. Dray Sarah. How to Prevent Creative Accounting, 2011. Heitger Dan. Fundamental Cornerstones of Managerial Accounting. Cengage Learning, 2007. Jones Michael. Creative Accounting, Fraud and International Accounting Scandals. John Wiley and Sons, 2011. Kammerer Mathias. Creative Accounting, the Enron Case and Its Impact on Corporate Governance. GRIN Verlag, 2009. Mowen Maryanne. Cornerstones of Managerial Accounting. Cengage Learning, 2011. Mulford Charles and Comiskey Eugene. The financial numbers game: detecting creative accounting practices. John Wiley and Sons, 2002. Warren Carl and Reeve James. Financial and Managerial Accounting. Cengage Learning, 2008. Read More