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CREATIVE ACCOUNTING

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INTRODUCTION

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

Misleads users of financial statements

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INTRODUCTION

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 depends more and more on managers' actions and directors are increasingly judged on profit and growth.

So company present a report to investors to and at times like 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-over

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Creative Accounting methods/categories

Allow company to choose between different accounting methods.

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

Artificial transactions can be used to manipulate balance sheet.

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

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How accounting regulators curb Creative Accounting ?

Reduce scope for choice of accounting methods.

Minimize 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

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Is creative accounting ethical?

Proponents of creative accounting GAAPs give various accounting methods to

select from and when applying certain methods, companies 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 accounting Creative 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