In the accounting world, the general rule is that accounts should give a true and fair view. Under local and international law, a professionally qualified accountant has a responsibility to comply, a corporation has a legal responsibility to comply, auditors have a legal responsibility to give some sort of opinion on compliance; yet frequently this all goes out of the window. Occasionally accountants and businesses are motivated to produce accounts that do not show a true and fair view. Not only this, but auditors rely on sampling and somehow fail to spot there is a problem. Definition:
Creative accounting, also called aggressive 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. Creative accounting often fools auditors and regulators, e.g. Enron, WorldCom, and the recent Madoff case. Aim and Scope
A typical aim of creative accounting will be to inflate profit figures. A typical creative accounting incident involves both human effort and a bias towards some objective. Most typically the objective is increased profits, inflated asset values, understated liabilities, and overstated shareholder value. The motivation of management and accountants typically being bonuses, promotion, salary rises, etc. 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. Typical creative accounting tricks include off balance sheet financing, over-optimistic revenue recognition and the use of exaggerated non-recurring items. Takeovers and acquisitions also create opportunities for creative accounting. In the year of the takeover, the new management and accountant have a bias to show a dismal picture — low profits, deflated asset values, inflated provisions, and perhaps an impacted stock value (as a result of the poor results if they are made public). Then in the years proceedings the takeover, the assets can be re-inflated, provisions released, all contributing to increased profits and a perception that the new management is doing a great job. The above technique may also be used before a management buy-out. This helps the new buyers negotiate a lower purchase price, and increases their return after the buy-out. The most effective examples of creative accounting are the ones that tell a portion of the truth, but downplay any elements that could alter the perception that the company wishes to convey to others. For example, a company may play up the fact that it recently experienced significantly increased sales during the last quarter. At the same time, little is said about the fact that expenses increased in proportion to that jump in sales, effectively offsetting that extra sales volume. If those who hear about the increase in sales do not probe a little deeper, the perception is likely to be that the company is now financially stronger, when in fact the business has achieved little to no growth at all. Creative accounting may help maintain or boost the share price both by reducing the apparent levels of borrowing, so making the company appear subject to less risk, and by creating the appearance of a good profit trend. This helps the company to raise capital from new share issues, offer their own shares in takeover bids, and resist takeover by other companies. If the directors engage in 'insider dealing' in their company's shares they can use creative accounting to delay the release of information for the market, thereby enhancing their opportunity to benefit from inside knowledge.
Traces of Creative Accounting
There are few signs of Potential Creative Accounting Practices :-...
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