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Creative Accounting

& Earnings Management

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Contents1. Creative Accounting

Introduction Definitions Why use creative accounting? Creative accounting methods/categories and how to

curb Reasons for creative accounting Some common methods of accounting manipulation Is creative accounting ethical? Conclusion

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Contents

2. Earnings Management (EM) Why manage earnings How do managers manage earnings EM and accounting fraud Argument against EM 5 most abusive types of EM Detecting EM Is EM bad or good

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Creative Accounting – Intro. A term used to describe the practice of

applying inappropriate accounting policies or entering into complex or “special purpose” transactions with the objective of making a company’s financial statements appear to disclose a more favourable position, particularly in relation to the calculation of certain ‘key’ ratios

Undesirable as it is intended to mislead users of financial statements

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Creative Accounting – Intro.

Following the law (regulations), the standards (IASs, IFRSs) and the recommended practice, and even with the results audited by external companies, the scope for creative accounting remains large

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Definitions

The accounting process consists of dealing with many matters of judgment and of resolving conflicts between competing approaches to the presentation of the financial events and transactions ….this flexibility provides opportunities for manipulation, deceit and misrepresentation (Michael Jameson 1988)

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Definitions

A process whereby accountants use knowledge of accounting rules to manipulate figures reported in the accounts of a business (Blake, Amat & Dowds 1998)

Transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of existing rules and/or ignoring some or all of them (Kamal Naser 1993)

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Why use creative accounting?

The shareholder and market reaction is related more and more to managers' actions and directors are increasingly judged on profit, growth and EPS and have large bonuses at stake. So companies (and directors) want to use the report to present the message they want investors to see, and at times this needs creative accounting.

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Creative accounting used to:

Hide a particularly bad year for the company Force an exceptionally good year Continue the pressure to always be the best Smooth out results to give an impression of

stability or sustained improvement Boost assets to avoid take-overNB. To distort in one year often increases the need to distort the next

year too

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Creative accounting methods/categories

Allow company to choose between different accounting methods such as writing of development costs or amortising it

Certain entries in the account involve unavoidable degree of estimation, judgment and prediction

Artificial transactions can be used to manipulate balance sheet and move profits between accounting periods

Genuine transactions can be timed to give desired impression in the accounts

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How accounting regulators curb creative accounting above? Reduce scope for choice of accounting

methods Minimise use of judgment/ reduce scope for

estimate Invoke concept of substance over form Prescribe revaluation

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Reasons for creative accounting

Income smoothing Report a steady trend of growth in profit rather than to

show volatile profits with a series of dramatic rises and falls

Avoids raising expectations so high in good years that company is unable to deliver what is required subsequently

May conceal long-term changes in profit trend Big bath – company making a bad loss seeks to

maximise the reported loss in that year so that future years will appear better

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Reasons (cont’d)

Manipulate profit to tie in with forecast Keep an income-boosting accounting policy

change to distract attention from unwelcome news

To maintain or boost share price by reducing apparent levels of borrowing and by creating appearance of a good profit trend

To delay release of information for market (if engage with insider dealing)

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Some common methods of accounting manipulation (Rees 1995, p 60-61)

Excessive provision (revised) Extraordinary items (not allowed anymore) Off balance sheet finance Capitalised cost Non-trading profits Brand accounting Etc.

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Is creative accounting ethical? There are legitimate techniques that can be

employed when computing certain items in accounts

How creative can managers and accountants be before their actions are considered unethical?

Difficult to draw an ethical line on creative accounting because GAAP often allow multiple accounting methods that a company

can choose from Estimates are employed

Technically not illegal but could fall into unethical area if the true values are grossly misrepresented and inflating the performance.

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Is creative accounting ethical?

Proponents of creative accountingGAAPs give various accounting methods to

select from and when applying certain methods, companies are going to choose the ones that make their financial statements better. This is the nature of business – to make company succeed as well as possible. Creative accounting assists in this endeavor.

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Is creative accounting ethical?

Opponents of creative accountingCreative accounting is “accounting

manipulation”To get desired results in short run but hurts

the ultimate goal of increasing stock value

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Conclusion

Creative accounting should be used if it is within the ramifications of the law and achieves the company’s ultimate goal of increasing stock value. Must benefit company in the short run and long run.

Not to mislead users of F/S

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Earnings Management

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Definitions A strategy used by the management to

deliberately manipulate the company's earnings so that the figures match a pre-determined target

Purposeful intervention by management in the earnings determination process, usually to satisfy selfish objectives

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Earnings Management (EM)

Manage or smooth the behaviour of reported earnings over time provide useful information (more accurate

picture of company’s performance) or to mislead users?

Manage earnings to achieve desired income statement financial reporting result/ meet analysts’ expectations Increase income Big bath Income smoothing

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Why manage earnings? Contracting incentives Stock price effects Bonus plans Income smoothing A pattern of earnings growth Meeting analysts’ forecasts

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How do managers manage earnings?

Accounting Method Choice Accounting Estimates

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Earnings Management and Accounting Fraud

Though earnings management is legitimate, managers may go beyond earnings management techniques and simply record earnings that do not exist

Present reports that are intended to mislead users constitutes accounting fraud

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Arguments against Earnings Management (EM)

An erosion in the quality of earnings and therefore, quality of financial reporting

Managing may be giving way to manipulation

Integrity may be losing out to illusion

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5 most abusive types of EM

Big bath restructuring charges Creative acquisition accounting Cookie Jar Reserves Immaterial misapplications of

accounting principles Premature recognition of revenue

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Detecting EM Cash flows that are not correlated with

earnings Recog. sales in inappropriate periods, make

sales to non-creditworthy customers or record fictitious sales

Receivables that are not correlated with revenues

Allowances for uncollectible accounts that are not correlated with receivables

Reserves that are not correlated with balance sheet items

Questionable acquisition reserves Earnings that consistently and precisely

meet analysts’ expectations

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Is EM bad or good? Primary objective of financial reporting –

info. asymmetry Same GAAP rules may not provide most

useful information in all circumstances – allow flexibility and judgment

Investors are provided with enough info. To understand exactly what financial reporting actions managers have taken – should not be “fooled” by accounting choices