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Chapter 13. Creative Accounting. Creative Accounting. Common and serious problem for accounting Highlighted by recent frauds: Enron, WorldCom, etc
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Chapter 13 Creative Accounting
Creative Accounting • Common and serious problem for accounting • Highlighted by recent frauds: Enron, WorldCom, etc • ‘Use and abuse of accounting techniques and principles to create financial statements that do not give true and fair view’ emphasises intentional aspect • both techniques and principles manipulated • correct context of ‘true and fair’ [or ‘fair presentation’] • both active and passive aspects Financial Information Analysis
Accounting manipulation • A plc & B plc have following balance sheets and both are seeking loan of 50: A plcB plc Assets 100 200 Bank Loan nil 100 Capital 100 100 • A plc more favourably viewed as ‘low-geared’ • Temptation exists for B plc to hide existing loan and corresponding asset • This would be ‘creative accounting’ Financial Information Analysis
Earnings Management • Earnings management culture • Analysts’ expectations drive profits agenda • Short-term focus on share price • Various techniques: • ‘big bath’ accounting; • ‘cookie jar’ reserves; • aggressive revenue recognition • May impact long-term viability Financial Information Analysis
Creative accounting practices • Off-balance sheet financing • IAS 39 counters many aspects • Exploiting complexities of financial instruments • Derivatives, hedging etc • Fair values • Subjective nature • Increased volatility • Cash flow manipulation • Revenue Recognition • Aggressive practices relating to revenue • IAS 18 Financial Information Analysis
Regulatory responses • Variety of new elements: • FSA; UKLA; ASB; IASB • Legislation • FRRP: • power to require revision of ‘defective’ accounts • can require directors to be made personally liable • increasingly pro-active • FRRP has had considerable success in ‘persuading’ companies to conform Financial Information Analysis
Role of Ethics • Creative accounting persists • Cannot be resolved by regulation alone • Ultimately an ethical/moral issue • Accounting bodies proactive in this area • considerable corpus of ethical guidelines • self-regulation sufficient? • Cultural change in attitude required Financial Information Analysis
Whistleblowing • Regulators seeking to protect those who alert authorities to fraud, malpractice, etc • Public Interest Disclosure Act (1999) • Seeks to protect those who disclose • Identifies corporate culture as critical • Limited success to date • Role of accountants and auditors Financial Information Analysis
Summary • Creative accounting a significant and continuing problem for accounting • Some progress made in eradicating more common abuses • Role of FRRP important • Ethical challenges • Could/should creative accounting be eradicated entirely? Financial Information Analysis