Creative accounting


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Creative accounting

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Creative accounting

  2. 2. CREATIVE ACCOUNTING • Creative Accounting is a process in which a company firstly estimates its “target” financial position, and then works backwards in order to achieve these desired figures. This process, also referred to as “cooking the books” is sometimes used as a means of manipulating the true incomes and losses of Companies. • The term as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations. "Creative accounting" is at the root of a number of accounting scandals. The idea of Creative Accounting, cosmetic accounting or profiteering is not a new concept to the Accounting world. Manipulation of accounts done in one year often requires the same kind of tailoring to be made the next year too and thus the process is constant. The practice often throws financial reporting out of control eventually results in frauds of very large magnitude.
  3. 3. What is Creative Accounting? * Creative accounting, also called aggressive accounting or innovative accounting, is the manipulation of financial numbers, usually within the letter of the law and accounting standards, but very much against their spirit and certainly not providing the "true and fair" view of a company that accounts are supposed to. A typical aim of creative accounting could be to inflate profit figures. Some companies may also reduce reported profits in good years to smooth results. Assets and liabilities may also be manipulated, either to remain within limits such as debt covenants, or to hide problems. * A different definition from the perspective of an accountant would be “The accounting process consists of dealing with many matters of judgment and of resolving conflicts between competing approaches to the presentation of the results of financial events and transactions... this flexibility provides opportunities for manipulation, deceit and misrepresentation. These activities - practiced by the less scrupulous elements of the accounting profession - have come to be known as creative accounting”
  4. 4. Why Creative Accounting? A quarterly or an annual review provides information on the financial position of a company. It is a snapshot of the company situation, as well as a history of change. However, the message the review gives is often taken to be about the future position of the company. In particular, investors and the capital market tend to base their decisions on results to date and the prognosis for the future. 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) are tempted to use the financial reports to present the message they want investors to see, and may resort to creative accounting
  5. 5. Situations where Creative Accounting may be resorted to: * Acquisitions, to hide poor results or boost EPS; * Off-balance sheet financing; * Valuations – particularly of intangible assets such as Goodwill and brand names; * Capitalizing R&D or Revenue Expenses; * Depreciation; * Revenue recognition; * Asset sales; * Failure to write down inventories that have declined in value; * Reflecting higher margins.
  6. 6. Accounting fraud or corporate accounting fraud are business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations. Such misdeeds typically involve complex methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of corporate assets or underreporting the existence of liabilities, sometimes with the cooperation of officials in other corporations or affiliates. The phenomenon of corporate fraudulent financial reporting has battered investors’ confidence in financial reporting, the accounting profession and global financial markets. It has not only caused severe damage to corporations and banks but also harmed small investors who have lost considerable amounts of money. And, with the increasing complexity of financial structures and the intensity of business competition, fraud has become more tempting to commit and harder to detect. Fraud thus continues to be a prominent issue and has become increasingly important in the eyes of the regulators.
  7. 7. • The biggest reported fraud of Corporate India i.e. Satyam Fraud is an example of how creative accounting could be used for corporate fraud. A copy of the confession letter of by Shri Ramlinga Raju, the exChairman of Satyam, addressed to the members of the Board of Directors of Satyam is annexed. Shri Raju confessed among other things that the company had been fudging figures to show better results. Some other instances of creative accounting used to perpetrate Corporate Fraud noticed during investigation are given below: • Changes in Depreciation Policy: Changes in the depreciation policy on the software programmes by a media company to report higher profits, create reserves and use the same reserves for payment of bonus was noticed. After the payment of bonus, the policy was reversed and production costs charged to P&L account.
  8. 8. • Revenue Recognition: In one company, non-existent revenue was being recognized based on the fake Invoices raised by the company to report higher profits. • Capitalizing R&D or Revenue Expenses: In one case investigated, revenue expenditure was treated as R&D expenditure and capitalized to report better profit. After objective of reporting a rosy picture was achieved, the amount was reversed and charged to Profit & Loss account. • Valuation: In one case, the company whose shares were to be acquired was valued using the method (Discounting the Future Cash Flows) most suited to the acquirer. This investment was written off after a couple of years while the company from whom shares were acquired made huge profits.
  9. 9. Types of Creative Accounting: The incidents of creative accounts are fairly common. These Accounting methods can broadly be categorized in the following four ways:Sometimes the accounting rules may allow a company to choose between different accounting methods. In many countries, for example, a company is allowed to choose between a policy of writing off development expenditure as it occurs and amortizing it over the life of the related project. A company can therefore choose the accounting policy that gives their preferred image. 1. Certain entries in the accounts involve an unavoidable degree of estimation, judgment, and prediction. In some cases, such as the estimation of an asset's useful life made in order to calculate depreciation, these estimates are normally made inside the business and the creative accountant has the opportunity to err on the side of caution or optimism in making the estimate
  10. 10. 2. 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. 3. 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 of Rs. 100 Crore at historic cost which can easily be sold for Rs. 500 Crore, being the current value. The managers of the business are free to choose in which year they sell the investment and so increase the profit in the accounts. 4. Engaging in creative accounting is a possible first step towards pushing at the boundaries of the law. The danger is that respectable executives lose sight of where the boundaries are, and end up committing fraud.
  11. 11. How to Tackle the Issue: • The statutory auditors have an important role to play in checking and restraining creative accounting. The auditors are appointed by the actual owners – the shareholders, and should ensure they protect the interests of all stakeholders. The audit due diligence hence assumes great significance. The laid down standards and other guidelines have to be followed not just in letter but in spirit also. The role of auditors and their liability would need to be enhanced to check the propriety of financial transactions of a company.
  12. 12. Challenges before the Investigator: Access to Audit Documents: The investigator has to receive and examine audit documents for the relevant period from the statutory auditors of the company. In many cases, the auditors do not keep the documents or do not keep the required documents like groupings to the balance sheet, profit and loss account etc. This problem is compounded when the company is not available to provide the documents. Independence of Auditors: The Statutory Auditors are appointed by the shareholders in the AGM and are required to discharge their function independently. How diligently the audit has been performed by the auditors and whether they had sought independent confirmations, wherever required, or went with the management certificates and whether they had complete access to the data and records is an important issue.
  13. 13. * Interpreting the changes to accounting policies: The investigator needs to interpret the changes brought out in various policies being followed for preparation of Annual statements permitted by law. This is a challenging job, since the people behind such creative accounting normally make all efforts to project the same as in the interests of company and hence correct. * Disciplining the Erring Auditors: The statutory auditors who have failed in their duties or have ignored the warning signals need to be brought to book. The current punishment prescribed u/s 227/233 is not sufficient as deterrence. The complaints filed in the ICAI take an unusually long time to be decided and defeat the purpose of deterrence.