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Creative Accounting


Background and baseline
Financial statements are bound by laws and accounting
standards. To break these is an offence and enforced as
such. Judges enforce the letter of the law and where there
are loopholes, the law may be changed. For judges the
spirit of the law does not exist. However finance is too
complicated to have a set of water-tight rules. For example
an ASB working committee was meant to resolve how goodwill
should be handled and in 1995 they came up with 5
alternatives which did not even cover all eventualities.
There is advisory recommended practice (such as the Cadbury
guidelines) to resolve larger gaps. The Cadbury report
intends to extend best-of-practice, for example
recommending that directors report on the effectiveness of
the company's internal controls i.e. taking the
responsibility actively and personally. However even
following the law, the standards and the recommended
practice, and even with the results audited by external
companies, the scope for creative accounting remains large.
Why creative accounting? 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 will 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) want
to use the report to present the message they want
investors to see, and at times this needs creative
accounting. There may be one-off events which so distort
the figures that the underlying health of the company is
obscured. Accounting techniques may be used to produce more
meaningful figures and avoid unjustified market pessimism.
In such caes the changes may be clearly indicated in the
notes to the accounts.. However more often than not
creative accounting is used to: hide a particularly bad
year for the company; force an exceptionally good year or
continue the pressure to always be the best; smooth out
results to give an impression of stability or sustained
improvement; hide large profits by monopolies under
anti-trust threat; boost assets to avoid take-over.
Distortion in one year often increases the need to distort
the next year. Typically the bad year continues (Argenti
1983) and the company gets more tied into misleading
figures, often seeming to devote more time to presentation
of figures rather than management of the company. Examples
of creative accounting What sort of things can be done as
creative accounting? Acquisitions can hide poorer results
(Watts) or boost EPS. A large provision can be taken to
cover reorganisation costs. These do not affect
profitability but are taken against the assets of the
company. Off-balance sheet financing. Items of the
financial reports are omitted. 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.
Good-will and brand names. While brand names are a powerful
marketing tool, companies that have included them in their
assets have done so to increase the value of the assets
when they would otherwise have seemed poor. A further
problem is the valuation of a brand name which can be
arbitrary and is not independently verifiable. Capitalising
R&D. The Austrian company MTM capitalised its R&D
expenditure. Instead of writing it off as cost, it was
added to assets in "know how". The approach is similar to
the way brand names can be handled. Depreciation. The
British Airport Authority depreciate runways over 99 years.
This means in effect they ignore depreciation of the
runways. However they are at least open and consistent.
Moving operating costs to reduced assets. Akzo Nobel had to
renew the pipes in a major chemical complex. This was
simply to replace old equipment. Akzo Nobel did not record
this as an operating cost, but classified it as
"environmental activity" and wrote it off against assets.
Something clearly a cost, and affecting the year's results,
has been moved from the cash stream of the company.
Creativity versus complicity Creative accounting affects
the value of assets and liabilities, and also the
allocation of changes to assets/liabilities or profit/loss.
Infamous cases are not creative accounting but fraud.
However a typical feature of creative accountancy is that
it is to a greater or lesser extent hidden and is often
result of sustained poor performance. Engaging in creative
accounting is then a possible first step towards pushing at
the boundaries of the law. And the danger is that
respectable executives lose sight of where the boundaries
are, and end up like directors committing fraud (compare
Griffiths 1992). Creative Accounting is increasing (Jones
1992) and will remain with us. As a personal rule of
thumb: where the accounting is open and documented it is
there to handle special situations. Where it is hidden or
disguised, it is a case of a company hiding its true
position. And given that the annual and half-yearly
reviews are the only financial statements the shareholders
receive, hiding the true position of a company is simply
misleading the owners of the company and should be



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