CREATIVE

ACCOUNTING
BY
K. VENKATA RAMANA
LECTURER, MBA DEPT.,GIACR
RAYAGADA
CREATIVE ACCOUNTING
Creative Accounting is a process in which a company
firstly estimates its target financial position, and then
works backwards in order to achieve these desired
figures. This process, also referred to as cooking the
books is sometimes used as a means of manipulating
the true incomes and losses of Companies.

The term as generally understood refers to systematic
misrepresentation of the true income and assets of
corporations or other organizations. "Creative
accounting" is at the root of a number of accounting
scandals. The idea of Creative Accounting, cosmetic
accounting or profiteering is not a new concept to the
Accounting world. Manipulation of accounts done in one
year often requires the same kind of tailoring to be
made the next year too and thus the process is constant.
The practice often throws financial reporting out of
control eventually results in frauds of very large
magnitude.
What is Creative Accounting?
* Creative accounting, also called aggressive accounting or
innovative accounting, is the manipulation of financial numbers,
usually within the letter of the law and accounting standards, but
very much against their spirit and certainly not providing the "true
and fair" view of a company that accounts are supposed to. A
typical aim of creative accounting could be to inflate profit figures.
Some companies may also reduce reported profits in good years to
smooth results. Assets and liabilities may also be manipulated,
either to remain within limits such as debt covenants, or to hide
problems.

* A different definition from the perspective of an accountant would
be The accounting process consists of dealing with many matters
of judgment and of resolving conflicts between competing
approaches to the presentation of the results of financial events and
transactions... this flexibility provides opportunities for manipulation,
deceit and misrepresentation. These activities - practiced by the less
scrupulous elements of the accounting profession - have come to be
known as creative accounting
Why Creative Accounting?
A quarterly or an annual review provides information
on the financial position of a company. It is a
snapshot of the company situation, as well as a
history of change. However, the message the review
gives is often taken to be about the future position of
the company. In particular, investors and the capital
market tend to base their decisions on results to date
and the prognosis for the future. The shareholder
and market reaction is related more and more to
managers' actions and directors are increasingly
judged on profit, growth and EPS and have large
bonuses at stake. So companies (and directors) are
tempted to use the financial reports to present the
message they want investors to see, and may resort
to creative accounting
Situations where Creative Accounting may
be resorted to:
* Acquisitions, to hide poor results or boost EPS;
* Off-balance sheet financing;
* Valuations particularly of intangible assets such
as Goodwill and brand names;
* Capitalizing R&D or Revenue Expenses;
* Depreciation;
* Revenue recognition;
* Asset sales;
* Failure to write down inventories that have
declined in value;
* Reflecting higher margins.
Accounting fraud or corporate accounting fraud are
business scandals which arise with the disclosure of
misdeeds by trusted executives of large public
corporations. Such misdeeds typically involve complex
methods for misusing or misdirecting funds, overstating
revenues, understating expenses, overstating the value
of corporate assets or underreporting the existence of
liabilities, sometimes with the cooperation of officials in
other corporations or affiliates.

The phenomenon of corporate fraudulent financial
reporting has battered investors confidence in financial
reporting, the accounting profession and global financial
markets. It has not only caused severe damage to
corporations and banks but also harmed small investors
who have lost considerable amounts of money. And,
with the increasing complexity of financial structures and
the intensity of business competition, fraud has become
more tempting to commit and harder to detect. Fraud
thus continues to be a prominent issue and has become
increasingly important in the eyes of the regulators.
The biggest reported fraud of Corporate India i.e.
Satyam Fraud is an example of how creative accounting
could be used for corporate fraud. A copy of the
confession letter of by Shri Ramlinga Raju, the ex-
Chairman of Satyam, addressed to the members of the
Board of Directors of Satyam is annexed. Shri Raju
confessed among other things that the company had
been fudging figures to show better results. Some other
instances of creative accounting used to perpetrate
Corporate Fraud noticed during investigation are given
below:

Changes in Depreciation Policy: Changes in the
depreciation policy on the software programmes by a
media company to report higher profits, create reserves
and use the same reserves for payment of bonus was
noticed. After the payment of bonus, the policy was
reversed and production costs charged to P&L account.
Revenue Recognition: In one company, non-existent
revenue was being recognized based on the fake
Invoices raised by the company to report higher profits.

Capitalizing R&D or Revenue Expenses: In one case
investigated, revenue expenditure was treated as R&D
expenditure and capitalized to report better profit. After
objective of reporting a rosy picture was achieved, the
amount was reversed and charged to Profit & Loss
account.

Valuation: In one case, the company whose shares
were to be acquired was valued using the method
(Discounting the Future Cash Flows) most suited to the
acquirer. This investment was written off after a couple
of years while the company from whom shares were
acquired made huge profits.
Types of Creative Accounting:

The incidents of creative accounts are fairly common. These
Accounting methods can broadly be categorized in the following
four ways:-

Sometimes the accounting rules may allow a company to choose
between different accounting methods. In many countries, for
example, a company is allowed to choose between a policy of
writing off development expenditure as it occurs and amortizing it
over the life of the related project. A company can therefore choose
the accounting policy that gives their preferred image.

1. Certain entries in the accounts involve an unavoidable degree of
estimation, judgment, and prediction. In some cases, such as the
estimation of an asset's useful life made in order to calculate
depreciation, these estimates are normally made inside the business
and the creative accountant has the opportunity to err on the side
of caution or optimism in making the estimate


2. Artificial transactions can be entered into both to
manipulate balance sheet amounts and to move profits
between accounting periods. This is achieved by
entering into two or more related transactions with an
obliging third party.

3. Genuine transactions can also be timed so as to give the
desired impression in the accounts. As an example,
suppose a business has an investment of Rs. 100 Crore
at historic cost which can easily be sold for Rs. 500
Crore, being the current value. The managers of the
business are free to choose in which year they sell the
investment and so increase the profit in the accounts.

4. Engaging in creative accounting is a possible first step
towards pushing at the boundaries of the law. The
danger is that respectable executives lose sight of where
the boundaries are, and end up committing fraud.
How to Tackle the Issue:
The statutory auditors have an important role
to play in checking and restraining creative
accounting. The auditors are appointed by
the actual owners the shareholders, and
should ensure they protect the interests of all
stakeholders. The audit due diligence hence
assumes great significance. The laid down
standards and other guidelines have to be
followed not just in letter but in spirit also.
The role of auditors and their liability would
need to be enhanced to check the propriety
of financial transactions of a company.
Challenges before the Investigator:
Access to Audit Documents: The investigator has to
receive and examine audit documents for the relevant
period from the statutory auditors of the company. In
many cases, the auditors do not keep the documents or
do not keep the required documents like groupings to
the balance sheet, profit and loss account etc. This
problem is compounded when the company is not
available to provide the documents.

Independence of Auditors: The Statutory Auditors are
appointed by the shareholders in the AGM and are
required to discharge their function independently. How
diligently the audit has been performed by the auditors
and whether they had sought independent
confirmations, wherever required, or went with the
management certificates and whether they had complete
access to the data and records is an important issue.

* Interpreting the changes to accounting policies: The
investigator needs to interpret the changes brought out
in various policies being followed for preparation of
Annual statements permitted by law. This is a
challenging job, since the people behind such creative
accounting normally make all efforts to project the same
as in the interests of company and hence correct.

* Disciplining the Erring Auditors: The statutory auditors
who have failed in their duties or have ignored the
warning signals need to be brought to book. The current
punishment prescribed u/s 227/233 is not sufficient as
deterrence. The complaints filed in the ICAI take an
unusually long time to be decided and defeat the
purpose of deterrence.