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INTRODUCTION Creative Accounting is normally portrayed maligned and negative act.

As soon as these words Creative Accounting are mentioned, the image that emerges in ones mind is that of manipulation, dishonesty and deception. Creative accounting is a tool which is much like a weapon. If used correctly, it can be of great benefit to the user; but if it is mishandled or goes into the hands of the wrong person, it can cause much harm. Creative Accounting has helped more companies to get out of a crisis than land them into a crisis. The weapon is almost always innocent; the fault whenever it emerges lies with the user. WHAT IS CREATIVE ACCOUNTING? Creative Accounting (CA) is the practice of producing financial accounts that suit a particular purpose but do not really show the true and fair view. CA also called aggressive accounting which is manipulation of a company's financial earnings either directly or through indirect accounting methods. This is more likely to occur when a company habitually is unable to meet investor expectations or in periods of volatile earnings. Earnings management is often considered materially misleading and thus a fraudulent activity. Even though the changes may follow all of the accounting standards and laws, they may go against what the standards and laws were originally trying to establish. Sometimes the accountant may wish to show favorable profits such as to get a bonus at other times losses for example to pay less tax. Sometimes the accountant may wish to show a healthy balance sheet such as to get a bank loan, at other times an unhealthy balance sheet for example before a management buy-out to get a bargain.

EXAMPLES OF CREATIVE ACCOUNTING

EXAMPLE 1 Off- balance sheet financing Off- balance sheet financing does not reveal certain financial information. It is effective because off- balance sheet financing is not likely to be detected by independent users of company accounts. It is not a new practice but it has grown rapidly in recent years. This could be done via a partial subsidiary which the company controls. For example assets could be sold to this subsidiary. This produces a profit in the balance sheet, but nothing has changed. It is simple a shuffling of debt/credit between companies producing no overall increase in health or profitability. In using this method, companies are able to show better debt ratio, borrow more money and still maintain the appropriate debt ratio required by lenders and put on a good face for investors. However, as off- balance sheet financing is a short term solution to a long term problem, inevitability the loan still has to be repaid and the company still has to obtain enough fund to pay off the hidden loan ( in the subsidiary ) to the ultimate lender, which in most cases, is outside the group. EXAMPLE 2 Revenue Recognition Postponing or accelerating income recognition is a great profit smoothing tool particularly for companies whose earnings are lumpy spreading over two or more accounting periods. For example, leasing firms may front load rental payments by charging installation fees or claiming up-front part of the eventual residual value of the asset leased. Another example that this method is applied when companies increase their earnings by recognizing a sale prior to the completion of that sale, before the product is delivered to the customer or at a time when the customer still has the option to terminate the deal resulting is a lower revenue being observed.

EXAMPLE 3 Smoothing Expenses Expense can be capitalized, allocated to inventory, paid directly from reserves or more blatantly under-provided. Capitalisation of interest can be justified by deciding that the cost of borrowing money is part of the overall cost of an asset. Though interest is normally taken from profits, many companies argue that the interest charge is a cost of capital. Consequently, the interest charges which are not included in the statement of financial performance, resurfaces as an increase to the fix assets in the statement of financial position. Other expensing adjustments which may involve a capitalization option are: Research and Development the latter element may be capitalized Overhead involved in the costs of production may be allocated to stock so that work-in-progress and finished goods include a proportion of overheads and developmental cost. Taking expenses to reserves is likely to occur during periods of acquisition which involve restructuring and rationalisation. EXAMPLE 4 Improper accounting Improper accounting for expenses as long term investments making the company looks more profitable. The executives may take ordinary operating expenses, such as wages paid to workers for maintaining telecom systems, and treat them as capital expense accounts. This allows the firm to spread their expenses out over several years rather than accounting for them all at once. The results are inflated earnings because costs associated with long-term investments are spread out and subtracted from earnings over the life of the asset whereas operating expenses are deducted from earnings immediately. In doing this the company artificially lowered their expenses and may increase their profits. Therefore the value of the firm is also artificially inflated.

WHAT ARE THE MOTIVES TO DO CREATIVE ACCOUNTING? The motivation to use Creative Accounting Various research studies have examined the issue of managerial motivation to use creative accounting. The following have been identified as significant factors: 1. Tax avoidance The creative accounting may also be a result of desire for some tax benefit especially when taxable income is measured through accounting numbers. If income can be understated or expenses overstated, then it may be possible to avoid tax. 2. Increasing shareholders confidence Creative accounting is used to ensure an appropriate level of profit over a long period. Ideally, this would show a steady upward trajectory without nasty surprise for these shareholders, and so would help to avoid volatility in share price, and would make it easier to raise further capital via share issues. 3. To meet internal targets. The managers want to cook the books for meeting internal targets set by higher management with respect to sales, profitability and share prices. 4. Meet external expectations. Company has to face many expectations from its stakeholders. The Employees and customers want long term survival of the company for their interests. Suppliers want assurance about the payment and long term relationships with the company. Company also wants to meat analysts forecasts and dividend payout pattern. 5. Provide income smoothing. Companies want to show steady income stream to impress the investors and to keep the share prices stable. Advocates of this approach favor it on account of

measure against the 'short-termism' of evaluating an investment on the basis of the immediate yields. It also avoids raising expectations too high to be met by the management.

6. Personal gain Where managerial bonuses are linked to profitability, there is a clear motivation for manager to ensure that profit hit the necessary threshold to trigger a bonus payment.

7. Following the pack If managers perceive that every other entity is their sector is adopting creative accounting practices, they may feel obliged to do the same. Besides, various opinions about the motivation to use creative accounting for example from Healy and Whalen [1999] summarize the major motivations to manage earnings which include Public offerings, Regulation, Executive compensation, and financial liabilities. Schipper [1989] provides a conceptual framework for analyzing earnings management from an informational perspective. Beneish [2001] added insider trading in this list of motives. Managers aware of misstatement of profits can benefit by trading the securities. Stolowy and Breton [2000] suggest three broad objectives for earnings management: minimization of political costs; minimization of the cost of capital and maximization of managers wealth. Deangelo [1988] refers to earnings management in buyout cases. Teoh, Welch and Wong [1998] find that firms manage earnings prior to seasoned equity offers and IPOs.Burgstahler and Eames [1998] conclude that firms manage earnings to meet financial analysts forecasts. Rewards of the managing Profits (Earnings Management) & Financial Position:

Category Share-Price Effect

The Objectives & Benefits Companies Trying To Achieve Higher Share Price Reduce Share Price Volatility Increase Firm Value Lower Cost of Equity Capital Increased Value of Stock Options Improve Credit Rating Lower Borrowing Costs Relaxed or Less Stringent Financial Covenants Increased Bonuses based on Profits/ Share Price Decreased Regulations Avoidance of Higher Taxes

Borrowing Cost Effects

Management Performance Evaluation Effects Political Cost Effects

DO YOU THINK CREATIVE ACCOUNTING IS GOOD? Creative accounting was an essential innovative tool in the early nineteenth century for creating method for accounting that was previously non existent. There is an ongoing argument if Creative Accounting (CA) is "Good" or "bad". This argument claims that CA can be used in two different contexts which are Good Creative Accounting and Bad Creative Accounting. Justifications for "Good" CA can be seeing when it is used to convey information. It is done with the intention NOT to defraud users. For example, income smoothing is done to signal future prospects of the company or to reduce the volatility with view to stabilize the share price movement. Other companies especially those involve in volatile markets like the big oil companies may seek to flatten spiky result that would otherwise spook investors. CA is also used to be more informative. Managers can also use CA to make financial reports to be more informative for users. This can arise if certain accounting choices or estimates are perceived to be credible signals of a firm's financial performance. For example, estimates of net cash receivables will be viewed as credible forecast of cash allocations.

Other than that, it can be viewed in a positive light as when large corporation with monopolistic position need to smooth income pattern so to avoid the attention of authorities or lobby group with a political agenda.

Besides, some in a less comfortable position may seek to maintain debt finance and the financial support of creditors by choosing the most optimal accounting policies to attain attractive debt ratios and high profitability margins. In these instances, the benefits are not only the immediate company but also related shareholders and stakeholders. The Certified Management Accountants of Canada group is embracing the usually negative term of "creative accounting" as a positive concept. In a statement from the group's headquarters in Calgary, Alberta, David Fletcher, vice president of public affairs for CMA Canada, said the term traditionally suggested an accountant wasn't being true to the numbers. "Creativity is increasingly being identified as the single most important ingredient of success in today's business landscape," Fletcher wrote. "This is about people, not a criminal practice. The group said in a release while it isn't the norm for a professional association to "challenge the status quo ... and put a stop to a misused expression," it wanted its 47,000 members to not only embrace the term but apply it in dealing with increased competition, advances in technology and growing globalization. Justification for "Bad" CA can be seeing when it becomes negative when it is used by unscrupulous management to mislead and defraud users of accounts. It involves transactions that break accounting rules. As general conclusion is that: Good or bad depends on the intention of CA and the consequences of the actions. Ultimately, CA should be used if and only if, it is within the ramifications of the law and it achieves company's ultimate goal of increasing stock value.

CONSEQUENCES OF CREATIVE ACCOUNTING TO THE COMPANY 1. Enron: accounting/off balance sheet contrivances. Chief financial officer indicted. The company bankrupt with billions of equity value lost. 2. Tyco: chief executive officer charged with tax evasion, waste of corporate assets. Massive charge of $6 billion to earnings after disposal of CIT unit.

3. WorldCom: $3.8 billion fraud. Loans to chief executive officer and became bankruptcy. 4. Adelphia Communications: off balance sheet loans to senior officers. 5. Xerox: accounting overstates profits by $1.4 billion. 6. Global Crossing: filed for bankruptcy after fiddling accounts. 7. Qwest Communications: chief executive officer resigned. Profits restated assets cut by 50%, or $34 billion. The share price down. 8. Health South: $1.4 billion fraud. Make false entries created in income statements and balance sheets. $110 billion merger of AOL and TimeWarner cemented with inflated accounting of AOL revenues. Within 18 months, company value declined 75%, and massive write-downs of asset values were taken AOLs 2002 earnings were written down by $98.7 billion (a figure only slightly smaller than the European Unions budget for 2003); civil litigation ensued for damages to investors. 9. Bristol-Myers: restates $2.5 billion in sales and $900 million in profits after inflating distributors stock levels. They settles antitrust lawsuits for a cost of $670 million. 10.Vivendi-Universal in France: failure of strategy, loss to shareholders, and class action suits filed alleging misrepresentation of companys financial realities. 11.A hold in The Netherlands: chief executive officer fired and stock price collapsed after American subsidiary was found to have falsely reported earnings. 12.HIH insurance group in Australia: failed with debts of $3.1 billion after consistently understating claims liabilities. The chief executive officer, among other things, spent A$ 340,000 on gold watches in 1 year. The criminal and civil charges pending against several directors. 13.SK Global in South Korea: overstates 2001 earnings by $1.2 billion. The liquidity crisis caused for credit card companies. $10 billion pulled by investors from investment trusts.

CONCLUSION To sum up the discussion on creative accounting practices, it is an unfortunate situation that we cannot completely restrict or stop the misuse or abuse of creative accounting practices. The improper use of such creative accounting practices had fooled both auditors and regulators in the past and it continues to do the same. The complex and diverse nature of the business transactions and the latitude available in the accounting standards and policies make it difficult to handle the issue of creative 101 accounting. It is not that creative accounting solutions are always wrong. It is the intent and the magnitude of the disclosure which determines its true nature and justification.

Source: 1. The Financial Number Game by Charles W. Mulford& Eugene E. Comiskey, 2002 (John Wiley & Sons 2. Creative Accounting: A Tool to Help Companies in a Crisis or a Practice to Land Them into Crises by Dr. Syed Zulfiqar Ali Shah and Dr. Safdar Butt 3. From Creative Accounting Practices And Enron Phenomenon To The Current Financial Crisis By Dana Simona Gherai And Diana Elisabeta Balaciu

FACULTY OF ECONOMICS AND MUAMALAT MAB4013 ACCOUNTING FRAMEWORK FIRST SEMESTER 2011/2012

CREATIVE ACCOUNTING
PREPARED FOR: PN KASUMALINDA BINTI ALWI PREPARED BY:

NURIAH BINTI ZAKARIA HABIBAH BINTI MOHD SAFIYAH BINTI ARIFFIN NADZIRAH BINTI MOHD SAID MOHD FARHAN BIN ABDUL SAMAD

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