CREATIVE ACCOUNTING AND IMPLICATIONS THEREON

[The Conceptual Framework]

Creative Accounting [an introduction]

Creative accounting essentially refers to the simple techniques [in the nature of accounting jugglery] often adopted by companies to make their financials look healthier than they actually are. Most of these actions are usually aimed at increasing revenues and reducing expenses [applying clever, though legal accounting practices one way or the other] although in certain cases it could also be the other way round. In a nutshell, companies across the globe indulge in creative accounting essentially with the purpose of keeping their income statement pretty by hiding the warts deep inside the balance sheet.

When it comes to manipulating the earnings figure, companies do not have to cook the books. The Accounting Standards set by professional bodies provide enough room for what is called creative accounting.

Its not cheating, mind you. Accounting rules, the world over, have many grey areas and hence, companies enjoy some freedom or flexibility in deciding what constitutes revenues and expenses. Such flexibility is certainly welcome considering different business situations and commercial consideration, but companies often take advantage of this flexibility to keep their income statement in good shape. The Accounting Standards offer too many variable methods or choices in accounting for identical transactions. Moreover, nonadherence to standards, norms and rules does not attract that strict a penalty in most countries across the globe India being no exception.

An assortment of techniques is used to doctor the financials. Although an exhaustive list can never be provided for the same, it may be commented that the important among those are as under:
Changing the basis of accounting Altering the timing expenditure [sometimes even revenues] Doctoring the cost estimates Accounting for capital and revenue transactions

Changing the Basis of Accounting

It is a globally accepted fact that the accounting rules across the globe recognize that there may be more than one accepted accounting basis for dealing with identical business transactions and naturally two different bases would culminate into two different earnings figure. In fact choosing a different accounting method is a common technique for managing the bottom line. This technique can have the maximum and the most permanent impact on earnings.

However, if the method of accounting is undergoing a change as compared to the immediately preceding previous year, the same needs to be disclosed, explained and quantified in the financial statements. It may be noted that such disclosures are warranted only in the year of change and not in the subsequent years. Therefore, such clauses get buried in the past financial statements and are conveniently forgotten.

Stock Valuation Policy

The Accounting Standard No 2 [AS 2] on Valuation of Inventories provides different options for inventory valuation, namely, cost may be computed either under the FIFO or Weighted Average method and companies are allowed to shift from a method which incorporates fixed production overheads to a method which excludes it while valuing inventories. These flexibilities in the Accounting Standard provides enough room for Indian companies to tamper with the inventory figure, which has a direct bearing on operating profit, net profit and the balance sheet reflection of the financial position as well.

Depreciation Policy In India, the applicable depreciation rates are those given in the Companies Act in respect of single, double and triple shift working of companies. It may be noted that only minimum wages are mentioned in such regulations and hence, higher rates are not precluded.

Altering the Timing of the Expenditure [sometimes even revenues]

Another method of earnings manipulation involves altering the timing of the expenditure and sometimes even revenues as illustrated in the following examples.

Treatment of Fixed Assets

In the Indian Income Tax Act, there is a provision which states that if a new fixed asset is used for less than six months in a financial year [even one or two days], full six months depreciation may be claimed on that asset. Thus, fixed assets could be capitalized a little sooner than later in order to gain from tax credits.

Issue of Materials In so many manufacturing companies based in India, a standard practice followed is that whenever raw materials or consumables are issued from main stores to the shop floor, the same is treated as consumption irrespective of the fact whether it has been actually consumed or not. Thus, companies may expedite the issue of materials since such issues would naturally be deducted from the current income line.

Doctoring the Cost Estimates

Another effective technique for manipulation is fiddling with the estimates of cost. As per the conservatism principle, all foreseeable future losses estimated with reasonable accuracy needs to be provided in the books of accounts, unlike foreseeable gains which are only disclosed in the financial statements. It is evident that the process of estimation is inherent in drawing up financial statements and is influenced by an element of judgment by the company management, provided the statutory auditors are in agreement with the same. As an opportunity is provided to incorporate estimated figures in the financials, the floodgates are open as the concerned companies take advantage of such flexibilities sometimes with the malafide intention to fudge the financial numbers. The following example would clarify the concept.

Estimating Future Losses in Current Assets Items

Management estimates what portions of their receivables are irrecoverable or what portion of their inventory is obsolete. They tend to maximize write offs in good years and minimize such write offs in bad years. When things go well, there is a tendency on the part of the management to try and provide more than what would normally be required. These extras which reduce the profits, are kept in a corporate barrel. In bad years, the management can draw from the barrel for writing back the extras to supplement and boost reported earnings.

Another area of concern is valuation of work in process inventories. The valuation of such items largely depend on the state of completion of the same, which is also estimated by the company management. Management and Statutory Auditors may sometimes form different judgments on the level of cost estimates but can generally reach on agreement based on the range of acceptable estimates.

Accounting for Capital and Revenue Transactions

The fourth method of bottom line manipulation is through fiddling with segregation of costs into capital expenditure, revenue expenditure and deferred revenue expenses [which are amortized in the books of accounts]. Obviously, any misclassification of revenue expenses into capital expenses or deferred revenue amounts to carry forward of revenue expenditure which in turn would boost the earnings figure. A reverse treatment would deflate the reported earnings as well.

Identifying the Root Causes

Flexibilities in the Accounting Rules and Standards The Accountability Parameters are not well Defined The nonexistence of Strict Penal Clause

Lack of Adequate Protection for Auditors

Suggesting Control Devices/Mechanisms

Strengthening Statutory Audit Stressing on cost Audit The Directors Statement Responsibility

Both in the UK and the US, company management are required to indicate the directors responsibilities in their report of the Board of Directors. The Companies Amendment Bill [India] introduces a similar concept known as the Directors Responsibility Statement. Nowadays, such disclosure is an integral component of annual reports of Indian companies.

Directors Responsibility Statement A Sample

In the preparation of the annual accounts, the applicable accounting standards have been adhered to. We have selected such accounting policies and applied them consistently and made judgments and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs and profits of the company.

We have taken sufficient care for the maintenance of adequate accounting records in accordance with the provisions of the Companies Act and for safeguarding the assets of the company. Adequate care has also been taken in preventing and detecting frauds and other irregularities.
The financial statement have been prepared on historical cost and on going concern basis.

Advising the Investors

Read the carefully

fine

print,

Trust the cash flows