Creative Accounting
-Dr N N SENGUPTA
1 The old jokes are the best jokes
Chairman of the board: How much profit did we make last year?
Finance director :What profit do you want us to have made? You can take your pick from the following profit figures
2 Creative Accounting
3 Creative Accounting
Creative Accounting is the transformation of financial accounting figures from what they actually are to what preparer desires by taking advantage of the existing rules and/ or ignoring some or all of them”.
“Purposeful intervention in the external financial reporting process with the intent of obtaining some exclusive gain”.
4 Introduction
Creative Accounting allows a manager to change the financial results or the financial statements without deviating from the rules, laws and requirements of accounting by using techniques, options and loopholes left by accounting regulations.
In other words, an attempt is made to change the profit either by increasing or decreasing or by misrepresenting the financial statements through grouping of procedures. Creative Accounting was basically developed due to the ever increasing demand of the users of the financial information.
The Creative Accounting helps to solve many problems which are faced by the management in today’s complicated and dynamic business environment. It helps in various decisions making and forms the base for solving many issues.
In Creative Accounting the manager uses the accounting knowledge to present the accounting data, figures and statements in such a manner which seems attractive to the stakeholders instead of showing the real position or performance of the company but all this is done within the parameters of accounting laws and rules. 5 Two Quotes
“How do you explain to an intelligent public that it is possible for two companies in the same industry to follow entirely different accounting principles and both get a true and fair audit report?” M. Lafferty
“Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse….. In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting.” (Ian Griffiths, 1986:1)
6 Presence of Creative Accounting in India
According to a Research Report – 50 Good market cap size companies are indulged in creative accounting practices and investors have to carefully examine the books of accounts, its profits and cash flows. After the news of Satyam, question is raised on all the giant firms which were directly or indirectly related with company. India is developing economy where corporate sector is contributing a major part in national income, and it is spreading its wings all over world where they get lots of opportunities to go for creative accounting as all countries have different accounting system which creates ambiguity in investor’s mind. And thus number of accounting scandals is increasing in India.
Creative accounting is prevailing in almost all the companies in India, the reason might be the increasing level of competition and dearth of sustain in the market. Loopholes or weaknesses in Indian accounting standards are facilitating the corporate sector to indulge in creative accounting practices
7 Presence of Creative Accounting in India (Contd.)
•1. Revenue manipulation: •a) Recording revenues ahead of time; A research report •b) Booking fictitious sales: highlighted the •2. Expense manipulation common manipulations •3 Cash manipulation in accounting records in •4. Invisible restatement of prior period accounts Most of the India: companies in India are taking undue advantage of weaknesses of accounting principles. Like as mentioned by Nobel Research report companies tend to show revenue which is not earned.
This is also considered as aggressive accounting technique whereby revenue is shown in the books of accounts before the project is completed in effect of which revenue increases. Cash manipulation is one of the common practices followed by most of the companies.
8 Motivation for Creative Accounting
Healy and Whalen [1999] summarize the major motivations to manage earnings which include Public offerings, Regulation, Executive compensation, and financial liabilities. Schipper [1989] provides a conceptual framework for analyzing earnings management from an informational perspective.
Burgstahler and Eames [1998] conclude that firms manage earnings to meet financial analysts’ forecasts. The managers are motivated for fixing financial statements for either managing position or profits.
9 Motivation for Creative Accounting (Contd.)
Following are important concerns for managers:
(a) To meet internal targets: The managers want to cook the books for meeting internal targets set by higher management with respect to sales, profitability and share prices.
(b) Meet external expectations: Company has to face many expectations from its stakeholders. The Employees and customers want long term survival of the company for their interests.
(c) Provide income smoothing: Companies want to show steady income stream to impress the investors and to keep the share prices stable.
(d) Window dressing for an IPO or a loan: The window dressing can be done before corporate events like IPO, acquisition or before taking a loan.
(e) Taxation: The creative accounting may also be a result of desire for some tax benefit especially when taxable income is measured through accounting numbers.
(f) Change in management: There is another important tendency of new managers to show losses due to poor management of old management by some provisions Dahi (1996) found this tendency in US bank managers. 10 Techniques of Creative Accounting
The potential for creative accounting is found in six principal areas: regulatory flexibility, a dearth of regulation, a scope for managerial judgment in respect of assumptions about the future, the timing of some transactions, the use of artificial transactions and finally the reclassification and presentation of financial numbers. Taking each of the six areas in turn:
1. Regulatory flexibility. Accounting regulation often permits a choice of policy, for example, in respect of asset valuation (International Accounting Standards permit a choice between carrying non-current assets at either revalued amounts or depreciated historical cost).
2. Dearth of regulation. Some areas are simply not fully regulated. For example, there are (as yet) very few mandatory requirements in respect of accounting for stock options.
3. Management has considerable scope for estimation in discretionary areas. Mc Nichols and Wilson (1988), for example, examine the discretionary and nondiscretionary elements of the bad debts provision. 11 Techniques of Creative Accounting (Contd.)
4. Genuine transactions can also be timed so as to give the desired impression in the accounts. As an example, suppose a business has an investment at historic cost which can easily be sold for a higher sales price, being the current value.
5. Artificial transactions can be entered into both to manipulate balance sheet amounts and to move profits between accounting periods. This is achieved by entering into two or more related transactions with an obliging third party, normally a bank.
6. Reclassification and presentation of financial numbers are relatively under- explored in the literature.
12 Existence of Creative Accounting
Proving the existence of creative accounting is far more different and complicated than discussing it. However, over these years, numerous research studies which examined creative accounting have come to the conclusion that supports its existence Even though managers’ motivation for creative accounting may be established and accepted at least in theory, establishing empirically that it takes place is a separate problem.
• 1. Auditor report qualifications Creative accounting behavior identified by Amat and others • 2. Changes in accounting policy (2003) has 3 possible signs of • 3. Special authorizations to apply non- creative accounting: standard policy
Analysis of financial statements is an important step in this study to identify all creative accounting behaviors. The observation also show that the analyst’ reports in Spain fail to include the existence of audit report qualifications and special authorizations of creative accounting practices. This research result shows that some elements of creative accounting practices are usual. 13 The Ethical Perspective
Companies desire to show the report with the profit grow steadily. This report is done by having stipulation for liabilities and opposing assets value during good years so that the reported profit can be improved in bad years. The purpose of this method is to evaluate the sources generate in following years and prevent unachievable expectations. However, the investors have the right to be informed on the violation of trading provisions and the effects of income smoothing in profit trend
Revsine (1991) considers the main function of accounting is to supervise the contracts between managers and groups who provide the finance so that the market mechanisms function efficiently and able to pinpoint the possibilities in creative accounting. The text about the ethics of bias in the accounting policy regarding on creative accounting is evaluate at both ‘macro’ level of accounting regulator and ‘micro’ level in the management of individual.
14 The Ethical Perspective (Contd.)
Ruland (1984) differentiated the deontological view and teleological view which deontological view is where the moral rules apply actual actions whereas teleological view is action should be evaluated on the moral worth of outcome. However, Revsine (1991) tends to perceive deontological view in public sector and teleological view in private sector. Ruland (1984) also talk about difference between ‘positive’ responsibility and ‘negative’ responsibility. ‘Positive’ responsibility is the responsibility to exhibit unbiased account while ‘negative’ responsibility is the managers’ responsibility for the state of affairs which they fail to avoid. Ruland thinks that ‘duty to refrain’ that involves preventing the bias inherent in creative accounting is more critical because of the three issues which are relentlessness, certainty of outcome and responsibility.
Merchant and Rockness discovered that motivation of management impact the accountants’ attitudes to creative accounting. This motivation was to advance the company. Accountants and managers who protest the creative accounting might face the risk of ruining their reputation. Schilit (1997) reports case where the accountant’s employer, food wholesaler who capitalizes the slotting expense and amortize it for ten years. The accountant noticed that the employer was against the accounting treatment. Therefore, he notified the auditors to force the company expense but amortize the slotting. The company unable to pursue the auditors approves the capitalization of slotting costs. Later, the accountant was set off for thereason contrast with the employer judgment.
15 Example 1
It is common for loan agreements to include a restriction on the total amount that a company is entitled to borrow computed as a multiple of the total share capital and reserves. Where a company has borrowings that are near this limit there is an incentive to: choose accounting methods that increase reported profit and consequently the reserves. (Sweeney (1994) reports that companies nearing violation of debt covenants are two to three times more likely to make income increasing accounting policy changes than other companies); arrange finance in a way that will not be reflected as a liability on the balance sheet.
An accounting rule change can plunge a company into difficulties with loan agreements. Thus in the USA, when the FASB introduced a rule requiring that income from extended warranties must be allocated over the life of the warranty rather than being recognised at the time of sale, consumer electronics retailers were badly hit: The biggest problem could be with the banks that keeps a close eye on debt to equity ratios.. so stores that borrowed heavily to build inventory and finance expansion could end up in technical violation of bank lending agreements pegged to certain ratios. (Therrien 1991:42)
16 Example 2
Some companies, such as public utilities like electricity and telephone companies, are subject to the authority of a government regulator who prescribes the maximum amounts they can charge. If such companies report high profits then the regulator is likely to respond by curbing prices. These companies, therefore, have an interest in choosing accounting methods that tend to reduce their reported profits.
17 Example 3
A directors' bonus scheme may be linked to profits or to the company share price. where the link is to the share price then clearly the directors will be motivated to present accounts that will impress the stock market. Where a bonus is based on reported profit the scheme often stipulates that the bonus is a percentage of profit above a minimum level, and is paid up to a maximum level.
Thus: • 1 If the profit figure is between the two levels then directors will choose accounting methods that lift profit towards the maximum. • 2 If the profit is below the minimum level directors will choose accounting methods that maximise provisions made so that in future years these provisions can be written back to boost profit. • 3 Similarly if the profit is above the maximum level directors wifl seek to bring the figure down to that level so that the profit can be boosted in later years.
The timing of the announcement of gains and losses can have a major impact on bonuses. In January 1991 Westinghouse announced unaudited record earnings of $1 billion and related hefty bonuses; in February 1991 bad debt write-offs of $975 million were announced, putting the legitimacy of bonuses in question (Schroeder and Spiro 1992). 18 Example 4
Where a part or division of a business is subject to a profit-sharing arrangement then this may affect the preferred accounting methods. In the UK, for example, we know of a local council that had a contract with a company for the company to manage the council's leisure centre. The contract provided for profits to be shared equally between the two parties. At the end of one year; not surprisingly the company's accountants said the centre had made a loss and the council's accountants said it had made a profit. The problem was solved by an agreement for the company to pay a fixed amount of money each year instead of a profit share. In the USA film companies have been notorious for claiming massive expenses against successful films so that writers, producers, and actors on 'net profit' deals receive little or no remuneration (Grover 199 la).
19 Example 5
Taxation may also be a factor in creative accounting in those circumstances where taxable income is measured by relation to the accounting figures.
Example 6
When a new manager takes over responsibility for a unit there is a motivation to make provisions that ensure that any losses appear as the responsibility of the previous manager. Dahi (1996) reports on a survey of US bank managers that found provisions for loan losses tended to be higher in the year of change in manager
20 Accounting Scandals – Across Time
i. Ancient and • 1.Cruciform monument, Mesopotamia second millennium BC • 2.Medieval merchants, Italy, fourteenth century medieval • 3.Cely Family, England , late fifteenth century
ii. Seventeenth and • 4. Africa and India company of Scotland, Scotland, 1695 eighteenth centuries • 5. South Sea Bubble, England, 1720
iii. Nineteenth • 6. Railway scandals 1840s-1860s , England Century • 7. City of Glasgow bank, Scotland, 1878
iv. Twentieth century: • 8. P&O , New Zealand, 1917-36 • 9. Royal Mail Steam Packet Company , UK, 1931 Before Second World • 10. Kreuger & Toll, Inc., US, 1932 War • 11.McKesson & Robbins, US, 1937 21 Accounting Scandals – Across Time (Contd.)
• 12. Reid Murray, Australia, 1963 • 13. H.G. Palmer, Australia, 1965 v. Twentieth • 14. Associated Electrical Industries takeover by General Electric Company, UK, 1967 century: • 15. Minisec, Australia, 1971 • 16. Equity Funding Corporation of America, US, 1973 • 17. Cambridge Credit, Australia, 1974 1945-1980s • 18. Renouf and Judge Corporations, New Zealand, 1980s
22 Major Accounting Cases Covered
INDIA NETHERLANDS ITALY SPAIN Satyam Fokker Parmalat Afinsa and Forum Royal Ahold Filatelico RSV Banesto Caja Rural de Jaen Gescatera Promotura Social De Viviendas JAPAN SWEDEN UK US Fuji Sash ABB Mirror Group Adelphia Riccar Fermenta Polly Peck Communications Kanebo Prosolvia Bank of Credit and Bear Stearns Sanyo Special Steel Skandia Commerce International Bre-X Minerals Livedoor California Micro Devices Sawako Enron Morimoto-gumi HealthSouth Yamaichi Securities Lehman Brothers Nikko Cordial Yaohan Madoff Securities Japan International Tyco International WorldCom 23 ENRON SCANDAL
ENRON SCANDAL
24 ENRON
Highly Successful company
Off-balance sheet financing, fictitious income, misreported cash flow
Seventh biggest company in US, Bankruptcy Sarbanes Oxley Act
25 Some Themes
• Charismatic persuaders and conmen 1.Overstrong • e.g. In UK, Robert Maxwell and Asil Nadir personalities In US, Bernie Ebbers at WorldCom In Spain, Mario Conde at Banesto
2. Managerial • Cover up bad performance • Personal benefits Motivations • Meet listing requirements
26 Some Themes (Contd.)
3. Failure of •At “Zhenzou Baiwen” failure of supervisory, board, Internal Control independent directors and state controlled shareholders •At “Parmalat” no independent directors, supervisory board and Frequent audit committee failed Examples:
4. Failure of •In all seven Chinese cases negligent or complicit auditors •At “Parmalat” auditors failed may have let company post a External Auditors letter to Bank •surprising failure of auditor to spot a non-existent subsidiary Frequent •In Spain at Forum auditors did spot some irregularities, but features: failed to question sales and repurchase agreements.
27 Aftermath
•Loss of share price Short term, •Company taken over or goes into liquidation •Directors jailed or fined generally •Auditors fined
•Regulations especially: Longer Term •i. changes in law •ii. new Codes of Corporate Governance
Continual revisions
Gradual increase in laws, regulations and political interference 28 Suggestions
29 Suggestions
Accounting regulators who wish to curb creative accounting have to tackle each of these approaches in a different way:
1. Auditor can play an important role in prevention and detection of creative accounting practices. If company’s auditor is well establish entity and has good track record then its auditing process may be trusted. But that auditor should not be the only auditor of the company, there should be more than one auditor and that also should be rotated periodically. So that familiarity between company and auditor does not lead to decrease in objectivity.
2. Proper system should be introduce to educate investors about the financial terms and its probable impact on financial position through providing booklet of methods adopted by the proposed company for various items in different situations and expected changes in special circumstances.
3. Existence of artificial entities should be carefully checked by its actual presence and actual business transacted through it.
4. Companies which are allowed to enter into Indian market via mergers and acquisition or any other mode should be clearly examined; their financial statements should be checked through two or more independent auditors under the supervision of government for preventing fraudulent activities to come into Indian market. 30 Suggestions (Contd.)
5. Close examination of those transactions which are changed in special circumstances and reason behind it. And transactions with related parties should also be examined thoroughly.
6. Laws and regulations laid down by government should be strictly followed by imposing heavy penalties in case of non application of such rules.
7. Introduction of gifts and rewards for employees for their participation in management and motivate them to disclose any manipulations going on in the company records by anyone can also work in eliminating or reduction in creative accounting practices.
8. Indian law has a major problem of slow trail and delay in investigation which reduced the materiality not the case and hence motivates others to follow the same practices. Through fast trial and quick investigation can reduce the number of accounting fraudulent practices. 31 Conclusion
32 Conclusion
A company has to meet many expectations from external parties. It has to face expectations of higher return from its stakeholders, the employees and customers expects long term survival of the company for their own interest and suppliers want assurance of their payments. Moreover, companies want to show steady income to keep their share prices stable and to impress the investors. All these urges the company to seek to Creative accounting practices. But owing to the dynamic and complicated nature of the business transactions and the liberty available in the accounting standards and the procedures, it is difficult to handle the issue of creative accounting. It is basically the responsibility of the users of the creative accounting whether to use it properly and with good intentions or to misuse it. It is really very unfortunate that its misuse or abuse cannot be stopped completely. But efforts could be made to encourage judicious use of Creative Accounting so that the solutions neither mislead nor misrepresents the results of the business and give fair solutions to the problems faced by the management of the business.
33 Corporate Governance Revisited
34 Accounting and Reporting in Changing Environment
Global Pinnacle Challenges, Risks and Sustenance Countr y
Frequency Monthly and many more one-offs Entity Division Reporting to Stakeholders, Gov. Group and Management
Frameworks Conceptual, Institutional, Regulatory, Legal
Functions Measure > Recognise > Record > Report
Critical documents Risk Register and Financial Reporting Procedure 35 Dimensions of Corporate Governance
Risk and Performance Management
Disclosure and Transparency Legal and Regulatory Boundaries
Corporate
Governance
Independence and Value Orientation
Business Practices and Ethics 36 Corporate Governance – Revisited Factors that Influence
Ownership structure – Co-existence of multiple categories *
Composition of Board of Directors and its Sub Committees
Independent Directors – Positions in too many corporate houses
Financial Structure – External debt vs. equity *
Socio-economic environment *
Effective Audit Committee • Risk Management * • Value - Maximise creation and minimise destruction *
37 Corporate Governance – Revisited Factors that Influence (Contd.)
Multiplicity of Tools * • Statutes, Rules, Regulations, Regulators
Discipline in Capital and Bond Market
• Demand / compulsive * Systemic problems related to • Monitoring costs investor friendly information • Dissemination – Accounting *, Financial * and Operational *
* To be directly or indirectly impacted more by IFRS / IND AS 38 Issues and Controversies
Questionable ethics *
Behaviour and attitude at the top
True independence of the Board
Doctrine of Indoor Management – Lifting the corporate veil *
Aggressive earnings management *
Gaps and Ineffectiveness in accounting and reporting *
Faulty executive compensation practices *
Outdated rule based accounting disregarding substance *
People are important than process *
Senior management not responsible for control *
Lack of engagement on the part of shareholders
* To be directly or indirectly impacted more by IFRS / IND AS 39 Attributes and Facets of Good CG
Depends on the culture in which the corporate operates *
Honesty, integrity and transparency beyond regulation *
DNA and value system of the Group – Ethical code of conduct
Top management in a state for readiness to • Face challenge * • Deal with fear factor • Responsive to dynamic environment Good CG is philosophy and matter of attitude *
Non compromising, adaptable, and scalable *
Trustworthy for all stakeholders *
Sustainability *
Oriented towards ‘Tripple P Bottom Line’
* To be directly or indirectly impacted more by IFRS / IND AS
Protect Existing + Enable Growth = More Results for Stake Holders 40 Key Questions to be Answered For The Audit Committee and Board of Directors
41 Key Questions to be Answered for AC and BoD
Revenue • Industry specific changes - Retail, Vehicle, Telecom, Constn. etc. • Approaches to revisit measurement and recognition Recognition and • IT enablement of the process Accounting • Articulation of disclosure for policy and measurement
• Fair valuation on first adoption • Componentisation of assets Fixed Assets – • Annual review of useful life and residual value Institutionalised • Annual tests for impairment and accounting of outcomes • Instances of leases under ‘Take or Pay Arrangement’ (IFRIC 4) Process • Tax implications for all the above – Current and Deferred
Assets and • Covenant compliances for Loans and consequent changes • Split Pref. Shares and Combined Instruments into Debt , Equity and Liabilities – Current Interest • Restricted Cash & Cash Equivalents & Non Current
42 Key Questions to be Answered for AC and BoD … 2
Business • Effects on transactions planned for future • Impacts of changes due to fair valuations of assets and liabilities Combinations • Future exit strategies
Investments in • Changes in number of entities under ‘Equity Accounting’ method • Modifications required in Joint Venture agreements Associates and Joint • Alignment of policies and procedures for measurement and accounting Ventures
• Deferred Tax – Balance Sheet based approach • Overall impact on Current IncomeTaxes Taxes • Effect on Indirect Taxes due to changes in Revenue accounting
• Reassessment and categorise into Remote, Possible, or Probable Contingent Liabilities • Provision requirement for probable cases • Transparent disclosures after detailed review
43 Key Questions to be Answered for AC and BoD … 3
•Changes in Formats and Classifications
•Functional vs. natural grouping of expenses
•Volatility in Income Statement
•EBITDA not a defined measurement
•Additional – ‘Comprehensive Income’ and ‘Changes in Equity’ Financial •Capital Management Policy – Objective, Debt and Equity
Statement •Assessed adjusting events post Balance Sheet date
Presentation •Sensitivity Analyses – Currency Exchange Rate and Interest
•Financial Risk Management •Credit to Customers •Currency Exchange Rate Exposures •Liquidity – Maturity Profile of Loans, Creditors, Derivatives •Commodity procurement •Communication strategy and presentation to Analysts
44 Additional Notes and Disclosures for More Transparency
Financial Risk Management - Objectives and Policies covering • Credit Risk on Customers • Currency Exchange Exposures • Liquidity Risk - Maturity Profile for Loans, Creditors, Derivatives, Lease • Commodity Price Risk Restricted Cash
Capital Management Policy - Objective, Debt, Equity
Tax Reconciliation and Analyses • Reconciliation at Effective Rate • Component-wise Analysis of Deferred Tax Sensitivity Analyses • Interest Rate on Loan Portfolios with ‘Reset Clauses’ or ‘Floating Rate’ Exchange Variations on Financial Assets and Liabilities
Analyses of Contingent Liabilities - Probable, Possible and Remote
Analysts to exercise caution while using and comparing such disclosures 45