‘Many investors now believe that companies can manipulate their accounts more or less at will, with the aim of producing profits that increase steadily over time. Provisions are bumped up in good years and later released, or the value of an acquisition is slashed; there are plenty of tricks.’ In your opinion is it possible to eliminate creative accounting?
I do not think that creative accounting practice can be eliminated completely. However, I do feel that there are many precautionary measures that can be taken in order to discourage directors from engaging in this practice. In this essay, I will discuss the reasons for creative accounting and show some real world examples of where it has been used and its effects. Creative accounting can be defined as accounting practice that follows the required regulations, but deviates from what those standards intend to accomplish. It is often aggressive accounting or involves questionable accounting techniques. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company and to hide its true financial state. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviours. Creative accounting may include selling assets with a low cost basis, shipping unusually large quantities of product near the end of the year, and failure to write down inventories that have declined in value. Reasons for creative accounting practice:
In Nasar’s book ‘Creative financial accounting’, a survey was conducted to determine the main reasons behind the use of creative accounting. The results showed that the main reasons management partake in creative accounting was to meet limits on borrowing and gearing ratios. Other reasons included the desire to control dividends and reduce tax, and due to pressure from the big institutional investors. Nasar feels that the results of the survey may be attributed to agency theory, in order to minimise agency costs, managers are willing to enter into contracts which limit their borrowing levels or limit gearing ratios. Watts and Zimmerman’s positive accounting theory believes that management is influenced by the size hypothesis, the debt/equity hypothesis and the bonus plan hypothesis. The size hypothesis states that large firms may want lower profits to avoid any political costs. The debt/equity hypothesis indicates that firms with high debt/equity ratios may want to increase profits to meet loan requirements. With regard to the bonus hypothesis, management may have the incentive to increase their profits when managerial bonuses are based on accounting earnings. The Big Bath theory may provide another reason for the use of creative accounting. This involves new management’s desire to get rid of everything bad and to start fresh. This theory is more common in tougher times, when earnings are particularly weak and the financial period is already a bust. For example, Ryanair took the attitude that if they were going to miss; they were going to miss big. They added additional charges to a certain period, allowing for fewer charges in later periods, showing improvement. The object of this is to hold previous management responsible for any previous mishaps, allowing new management take the credit for future profits.
Examples of creative accounting:
The most famous example of a company using creative accounting techniques is Enron. The Enron case, as everybody knows, ended in the collapse of the seventh biggest company in the US and is probably the most extreme example of creative accounting. Using a creative accounting technique was really quite easy for Enron, as nobody was exactly sure as to what they do. Enron was able to keep any bad financial news hidden from the public and was able to invent profits from nowhere. They had a Sell and Buyback scheme, allowing them to bring future profits...
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