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Creative Accounting and How to Spot it

Word loophole printed and defined in a English dictionary

Creative accounting can be summed up in one word: manipulation. Manipulation of financial statements in order to portray a given image about a company which may not be an accurate reflection of the financial position of the company. Accounting is a science and an art and creative accounting consists of accounting practices that follow required laws and regulations but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in laws and this can have multiple benefits to owners and even employees but ultimately may impact on shareholders.  Creative accounting practices are legal but the loopholes they exploit are often reformed.

 

Key Drivers of Creativity

Numerous studies have demonstrated that senior level accountants negotiate audit findings with auditors, creating the opportunity for reported accounting information in audit work-papers to be manipulated to support negotiations. Managerial accountants create budgetary slack as a defense mechanism and there may be both positive and negative consequences. Take earnings management, for instance. Timing a transaction so it falls within a certain period may lead to fraudulent earnings management. It is common industry knowledge that accountants manage earnings to meet expectations and it is also evidenced that finance executives are willing to sacrifice real economic value for short-term accounting earnings through means of legitimate, yet unethical business decisions. Some public companies use the latitude allowed within GAAP to manage the disclosure of information to their advantage and some financial accountants even fraudulently report earnings. With increasing complexity of trading practices and financial dealings, new accounting standards are issued to mitigate these activities. One consequence of this is increased alternatives that a company can use to achieve its goals, hide its real operational results and its real financial position or show it in a false way through manipulating financial statements. An external auditor needs to know all the different creative accounting practices, so that it will be easy for them to discover these practices and to conduct a qualified and efficient audit, giving a view on how accurate the financial statements actually are. In this way the expectation gap is minimized, and contributes to increasing trust in financial statements and audit services.

 

Spotting Creative Accounting

Accounting practices in Asia, and globally, are continually improving but there are still plenty of ways that companies can manipulate their financial results. One common technique is for the balance sheet being used to ‘store earnings’ for future periods. The result can be a misleading picture of earnings power. Warning signs of this can be seen in restated earnings that can significantly affect the stock price. Overvaluing assets is also common. Accounts receivable play a key role in detecting premature or fabricated revenues, but they can also be used to inflate earnings on their own through the provision of dubious accounts. Current and potential investors can detect when the reserves for dubious accounts are inadequate by comparing accounts receivable to net income and revenue. When the balance sheet item is growing at a faster pace than the income statement item, then investors may want to examine whether or not the provision for dubious accounts is adequate. Inventory represents the value of goods that were manufactured but not yet sold. When these goods are sold, the value is transferred over to the income statement as cost of goods sold. As a result, overstating inventory value will lead to an understated cost of goods sold, and therefore an artificially higher net income, assuming actual inventory and sales levels remain constant. A notable example of manipulated inventory was a manufacturing company in China which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some one billion RMB from six banks by using the inventory as collateral. Meanwhile, the company reported 10 million RMB in net income for the period, when it really lost 35 million RMB. Investors can spot overvalued inventory by looking for signals in trends such as; inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets and falling cost of sales as a percentage of sales. Any unusual variations in these figures can be warning signs of potential inventory accounting fraud. The bottom line is that companies can manipulate their balance sheets in many different ways and investors can detect these practices by simply reading the financial statements with skeptical but wise eyes.

 

Creative Accounting in South East Asia

Recent corporate scandals caused by accounting malpractices and creative accounting in Hong Kong and China have been exposed. One high profile case in Hong Kong involved a computer services company whose accounting practices were characterised by fraud and manipulation to the tune of RMB 4 billion. The company was accused of exaggerating financials as well as delaying recognition of debts in order to appear more profitable. A wave of accounting manipulations among corporate organisations in China has been on the rise, affecting investors’ confidence. Another Hong Kong company was spotted using accounting practices characterised by underrating the expenses while exaggerating the revenues in order to portray the company in good standing. This was also accompanied with numerous off – the – balance sheet transactions which added weight to the manipulation leading to the resignation of their independent auditor and causing the share price to plummet.

 

The differences in accounting standards between Asia, the USA and Europe may play a significant role in mitigating the levels of accounting manipulation practiced. While the Chinese accounting systems mainly place emphasis on the cost model of evaluation European and North America allow for the use of revaluations which are prone to manipulation by creative accountants. In the wake of large-scale financial crises in the US there were widespread calls for countries to align their accounting practices along the International Accounting Standards and to take a common approach towards the eradication of the creative accounting.

 

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