Financial Accounting: Understanding and Practice By Robert Perks

1. Financial Accounting: Understanding and PracticeBy Robert Perks Chapter 8 Creative Accounting

2. Introduction This chapter: • examines what is meant by ‘creative accounting’ • explains a number of different practices that have been described as creative accounting • assesses a number of different ways in which the problem might be tackled.

3. Learning Objectives After studying this chapter you should be able to: • explain what is meant by creative accounting and understand that the term is sometimes applied to very different practices • explain why creative accounting practices have developed • give examples of a number of creative accounting practices

4. Learning Objectives • describe how existing accountancy arrangements are intended to restrict creative accounting • evaluate a variety of different approaches to dealing with creative accounting.

5. What is Creative Accounting? • The term ‘creative accounting’ is used in relation to a variety of different accounting practices. • It can be used to describe fraudulent and criminal activities. • However it might be viewed as an honest presentation that emphasises the favourable aspects of a company’s performance- a company may prefer to put a positive spin on their financial position and performance.

6. How Bad are the Various Techniques? • The following is not intended to be authoritative or definitive but gives an idea of the range of different activities that some might classify as being ‘creative accounting’, from 1 to 10: 1. There is nothing questionable about the financial statements, but information has been presented to emphasise the more favourable aspects of financial position and performance, and to de-emphasise the least favourable.

7. How Bad are the Various Techniques? 2.The emphasis on the favourable aspects are so strong as to suggest more of a propaganda exercise than a balanced report. 3. All financial statements are properly drawn up, but somehow the rules seem to flatter the company’s performance whereas a different selection of accounting policies and measurements would be less flattering.

8. How Bad are the Various Techniques? 4. All financial statements have been properly drawn up in accordance with the requirements of law and accounting standards. Where the official accounting requirements allow choice or flexibility, the company selects those options which flatter the financial statements. 5.There are departures from accounting standards, but these have been properly disclosed and explained, and the financial effects have been quantified.

9. How Bad are the Various Techniques? 6. There is just a suspicion that there are departures from accounting standards which have not been disclosed. Some of the figures seem to be a bit questionable. 7. Rules and definitions have been pushed to the limit, and perhaps a little beyond. Judgements have been exercised to come up with treatments that the auditors have been persuaded to accept, but other accountants may find such treatments unacceptable.

10. How Bad are the Various Techniques? 8. Transactions and arrangements seem to have been deliberately designed to take advantage of, or to avoid, particular rules or accounting treatments. 9. Clear breaches of accounting standards without proper disclosure of departures or reasons for them 10. Criminal activity, fraud and deception.

11. Moderate Evolutionary Changes • The main suggestions for moderate evolutionary changes include: • the production of clearer accounting standards that reduce or eliminate choices • the ‘benchmark’ argument • stronger legal backing for accounting standards

12. Moderate Evolutionary Changes • relying on international standards • more effective monitoring and enforcement • principles rather than rules • current cost accounting • cash flow accounting

13. Radical Proposals • Right wing vs Left wing • Right wing: • laissez faire • freedom of access to information. • Left wing: • Inland Revenue rules OK • a state auditing board

14. Chapter Summary • Many accounting and financial scandals arise because of illegal (sometimes criminal) activity. • It is often normal accounting and auditing routines and reports that uncover the problems.

15. Chapter Summary • Creative accounting also arises where the rules are not clear and so technically there is no wrong-doing. • There will continue to be problems with creative accounting as long as directors have substantial control over the ways in which financial reports are presented. • The problems of creative accounting can only be curbed, not cured; and the process may be slow, especially if reliance is placed on moderate, evolutionary changes.

16. Chapter Summary • There may be potential for restricting creative accounting by requiring companies to use HM Revenue and Customs’ taxation rules for measuring profit – as is (or was) the case in some European countries. • But the US–UK approach usually seems to win in any contest with European approaches. • Substantial improvement can come from fuller and more clear-cut disclosure requirements. The most effective curbs would come from the most significant shifts of power over the presentation of accounting information.

17. Chapter Summary • The most likely outcome is that we will continue with gentle reforms, become increasingly international, and largely preserve the status quo. • More effective changes come as statutory requirements for additional specific disclosures are increased; and from restricting the powers of directors over auditing and accounting. • If creative accounting flourishes, it is because it is in the interest of those who have the power to allow it. Perhaps it can be effectively restricted only if there is a radical shift away from the existing power structures of the accountancy profession, standard setters, directors and auditors.

18. Review of Key Points • The term ‘creative accounting’ is applied to a wide range of accounting practices • The exercise of judgement is inevitable in some areas of accounting, and it may be tempting to exercise it in a creative way, and to extend this to other areas • Some companies use questionable accounting practices to boost profits, to improve key ratios, to boost equity on the balance sheet, and to smooth out profits and losses from year to year

19. Review of Key Points • Problem areas have included exceptional and extraordinary items, provisions, goodwill, and off balance sheet finance • Accounting standards setters have reduced the scope for creative accounting, but there are some ‘fuzzy’ rules, and some areas of choice remain • Moderate evolutionary changes are steadily reducing the scope for creative accounting • Creative accounting is still a problem and more radical solutions may be considered

20. Group Activity 1 • Obtain the annual reports of about four companies, two being major, well-known companies, and two being much smaller. Compare the reports in terms of the public relations material and ‘spin’ which they put on the results. Can the reports be ranked on a scale indicating the extent of ‘spin’? Do some reports contain little or nothing more than the minimum required? Why do some companies provide a lot more information, comment and explanation than is strictly required?

21. Group Activity 2 • Try to find a company whose accounting practices have been criticized. (Look for critical comments in the Financial Times, Accountancy, or Accountancy Age after the company has published its annual report and accounts.) Obtain a copy of the annual report and accounts (telephone the company or look on their website if it is not one supplied by the Financial Times Annual Reports service on 020 8391 6000; www.ftannualreports.com). Do you think that the company has been unduly ‘creative’?

22. Group Activity 3 • A company has a duty to maximize reported profits. If it uses creative accounting techniques to do so, it does not matter, as long as those profits have credibility. Discuss.

23. Group Activity 4 • Examine a number of company accounts in detail. Express the taxation charge as a percentage of the profit before taxation, and compare the companies. Examine the cash flow statements of the companies. Do these comparisons reveal anything that causes you to question reported profit figures?

24. Group Activity 5 • Produce a list of recent accounting standards, and select a few for detailed examination. Read the stated objectives in the standards, and try also to read between the lines. Can you suggest what ‘creative accounting’ techniques (if any) they are designed to address?

25. Group Activity 6 • Should the rules for profit measurement be laid down by governments?

26. Financial Accounting in Context • Read the article “Auditors toast lucrative new rules”, Daily Telegraph, 28 June 2006 • Discuss and comment on the item. • In whose interests do improved accounting standards operate?