CREATIVE ACCOUNTING AND IMPLICATIONS THEREON

[The Conceptual Framework]

Creative Accounting [an introduction]

Creative accounting essentially refers to the
simple techniques [in the nature of accounting
jugglery] often adopted by companies to make
their financials look healthier than they actually
are. Most of these actions are usually aimed at
increasing revenues and reducing expenses
[applying clever, though legal accounting
practices one way or the other] although in
certain cases it could also be the other way
round. In a nutshell, companies across the
globe indulge in creative accounting essentially
with the purpose of keeping their income
statement pretty by hiding the warts deep
inside the balance sheet.

When it comes to manipulating

the earnings figure, companies
do not have to cook the books.
The Accounting Standards set
by professional bodies provide
enough room for what is called
creative accounting.

Its not cheating, mind you. Accounting rules,

the world over, have many grey areas and hence,
companies enjoy some freedom or flexibility in
deciding
what
constitutes
revenues
and
expenses. Such flexibility is certainly welcome
considering different business situations and
commercial consideration, but companies often
take advantage of this flexibility to keep their
income statement in good shape.
The
Accounting Standards offer too many variable
methods or choices in accounting for identical
transactions.
Moreover, nonadherence to
standards, norms and rules does not attract that
strict a penalty in most countries across the
globe India being no exception.

An assortment of techniques is used to

doctor the financials.
Although an
exhaustive list can never be provided for
the same, it may be commented that the
important among those are as under:

Changing the basis of accounting

Altering the timing expenditure [sometimes even revenues]
Doctoring the cost estimates
Accounting for capital and revenue transactions

Changing the Basis of Accounting

It is a globally accepted fact that the
accounting rules across the globe recognize
that there may be more than one accepted
accounting basis for dealing with identical
business transactions and naturally two
different bases would culminate into two
different earnings figure. In fact choosing a
different accounting method is a common
technique for managing the bottom line. This
technique can have the maximum and the most
permanent impact on earnings.

However, if the method of accounting is

undergoing a change as compared to the
immediately preceding previous year, the
same needs to be disclosed, explained
and
quantified
in
the
financial
statements. It may be noted that such
disclosures are warranted only in the
year of change and not in the subsequent
years.
Therefore, such clauses get
buried in the past financial statements
and are conveniently forgotten.

Stock Valuation Policy

The Accounting Standard No 2 [AS 2] on

Valuation of Inventories provides different
options for inventory valuation, namely, cost
may be computed either under the FIFO or
Weighted Average method and companies are
allowed to shift from a method which
incorporates fixed production overheads to a
method which excludes it while valuing
inventories.
These
flexibilities
in
the
Accounting Standard provides enough room for
Indian companies to tamper with the inventory
figure, which has a direct bearing on operating
profit, net profit and the balance sheet
reflection of the financial position as well.

Depreciation Policy
In India, the applicable depreciation
rates are those given in the
Companies Act in respect of single,
double and triple shift working of
companies. It may be noted that
only minimum wages are mentioned
in such regulations and hence,
higher rates are not precluded.

Altering the Timing of the Expenditure

[sometimes even revenues]

Another
method
of
earnings
manipulation involves altering the
timing of the expenditure and
sometimes
even
revenues
as
illustrated
in
the
following
examples.

Treatment of Fixed Assets

In the Indian Income Tax Act, there

is a provision which states that if a
new fixed asset is used for less
than six months in a financial year
[even one or two days], full six
months
depreciation
may
be
claimed on that asset. Thus, fixed
assets could be capitalized a little
sooner than later in order to gain
from tax credits.

Issue of Materials
In so many manufacturing companies
based in India, a standard practice
followed is that whenever raw materials
or consumables are issued from main
stores to the shop floor, the same is
treated as consumption irrespective of
the fact whether it has been actually
consumed or not. Thus, companies may
expedite the issue of materials since
such issues would naturally be deducted
from the current income line.

Doctoring the Cost Estimates

Another effective technique for manipulation is fiddling
with the estimates of cost. As per the conservatism
principle, all foreseeable future losses estimated with
reasonable accuracy needs to be provided in the
books of accounts, unlike foreseeable gains which are
only disclosed in the financial statements.
It is
evident that the process of estimation is inherent in
drawing up financial statements and is influenced by
an element of judgment by the company management,
provided the statutory auditors are in agreement with
the same.
As an opportunity is provided to
incorporate estimated figures in the financials, the
floodgates are open as the concerned companies take
advantage of such flexibilities sometimes with the
malafide intention to fudge the financial numbers. The
following example would clarify the concept.

Estimating Future Losses in Current Assets Items

Management estimates what portions of their

receivables are irrecoverable or what portion of
their inventory is obsolete.
They tend to
maximize write offs in good years and minimize
such write offs in bad years. When things go
well, there is a tendency on the part of the
management to try and provide more than what
would normally be required.
These extras
which reduce the profits, are kept in a
corporate barrel.
In bad years, the
management can draw from the barrel for
writing back the extras to supplement and
boost reported earnings.

Another area of concern is valuation of

work in process inventories.
The
valuation of such items largely depend
on the state of completion of the same,
which is also estimated by the company
management.
Management and Statutory Auditors may
sometimes form different judgments on
the level of cost estimates but can
generally reach on agreement based on
the range of acceptable estimates.

Accounting for Capital and Revenue Transactions

The fourth method of bottom line

manipulation is through fiddling with
segregation
of
costs
into
capital
expenditure, revenue expenditure and
deferred revenue expenses [which are
amortized in the books of accounts].
Obviously,
any
misclassification
of
revenue expenses into capital expenses
or deferred revenue amounts to carry
forward of revenue expenditure which in
turn would boost the earnings figure. A
reverse treatment would deflate the
reported earnings as well.

Identifying the Root Causes

Flexibilities in the Accounting Rules and
Standards
The Accountability Parameters are not
well Defined
The nonexistence of Strict Penal Clause
Lack of Adequate Protection for Auditors

Suggesting Control Devices/Mechanisms

Strengthening Statutory Audit

Stressing on cost Audit
The Directors
Statement

Responsibility

Both in the UK and the US, company

management are required to indicate the
directors responsibilities in their report
of the Board of Directors.
The
Companies
Amendment
Bill
[India]
introduces a similar concept known as
the
Directors
Responsibility
Statement. Nowadays, such disclosure
is an integral component of annual
reports of Indian companies.

Directors Responsibility Statement A Sample

In the preparation of the annual

accounts, the applicable accounting
standards have been adhered to.
We have selected such accounting
policies and applied them consistently
and made judgments and estimates that
are reasonable and prudent so as to give
a true and fair view of the state of affairs
and profits of the company.

We have taken sufficient care for the

maintenance of adequate accounting
records
in
accordance
with
the
provisions of the Companies Act and for
safeguarding the assets of the company.
Adequate care has also been taken in
preventing and detecting frauds and
other irregularities.
The financial statement have been
prepared on historical cost and on going
concern basis.

Advising the Investors

Read the
carefully

fine

print,

Trust the cash flows