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CREATIVE ACCOUNTING

by Ed Soriano

Although there are always steps being taken to eliminate it, creative accounting is probably here to stay. Consequently, it is important that we are aware of the possibility when we are analyzing companies' accounts.  Whilst there has always been some elements of 'window dressing' in the accounts, these were primarily companies trying to 'smooth out' their profits. However, in the 1980's, things started to get out of hand. Companies were:   

  • taking their debt off the balance sheet
  • improving post acquisition profits with the use of acquisition provisions which increased the amount of goodwill written off to reserves and reduced the rationalization costs charged to  profit and loss account
  • manipulating earnings per share by classifying exceptional items as extraordinary
  • showing profits on disposal of subsidiaries by calculating the profit from the net asset value, not by what they have originally paid for the subsidiary.  

Creative accounting is largely a child of the 1980's. It probably started when companies got difficulties during the recessions in the early 80's.  There was pressure to produce better profits when profits of any description were hard to find. The companies discovered that the rules only told you what you cannot do, not what you can. If you cannot earn profits you can always CREATE  them.  


In that recession, creative accounting bought companies time; the last recession went on too long and many companies reporting 'creative profits' were forced into liquidation. In fact, this is probably the recession where many large, apparently profitable companies have gone bust. By the end of the 80's, it was difficult to believe that accounts were supposed to be true and fair. The ability to read and understand the notes to financial statements became an integral part of financial analysis. You usually start with the notes if you wanted to understand what was really happening in the company.
Since its inception in the 1990, the Accounting Standards Board has reduced the amount of large-scale  creative accounting. It has :

  • standardized the format for the cash flow statement and made it much more user friendly.
  • reduced the scope for 'off balance sheet' funding with FRS 2 and virtually eliminated it with FRS 5.
  • introduced a more detailed profit and loss account. This now enables us to see how much profit has come from acquisitions and how much will be disappearing next year as it was generated by business sold or discontinued during the year. From June 1998, following the implementation of FRS 9, the shares of associates and joint ventures' profit are shown in the profit and loss account.
  • revised the definitions for operating profit, the profit on sale of fixed assets and subsidiaries and earnings per share.
  • encouraged  the use of multiple earnings per share calculations and tightened the definition of extraordinary items to make the standard earnings per share figures more comparable.
  • eliminated the scope for creativity  in acquisition accounting with the introduction of FRS 6 (Acquisition and Mergers.)

Most of the opportunities for large-scale creative accounting have gone or will disappear. However, there are still some scope for manipulating the numbers and we must be aware of this before embarking on an analysis.


Large to small private companies manipulate their numbers in different ways. Large companies tend to want to improve their profits often at the expense of the balance sheet  (but to the enhancement of many of the ratios). Small private companies tend to be more concerned with improving their net worth often enhancing their profit at the same time. They have different concerns and different objectives. Companies want to show nice steady profit growth, as this reduces the company's apparent risk profile. Private company's shareholders are usually the directors, so the shareholders tend not to be the problem. The main problem is usually the bank. To keep the bank happy, they need to show a reasonable profit but more importantly, they need to have lots of assets. The banks would not lend to them on the strength of their good name!


With the recent accounting scandals that have rocked and shocked Corporate America, the accounting profession in general has been significantly affected. The Code of Professional Ethics has been sidelined just to influence the figures thereby showing a healthy financial report which in reality is but a deceiving report. With the forthcoming Regional Conference to be held in Dubai on December 5 & 6, the PICPA Committee on Professional Development hopes that the speakers of the conference would extensively enlighten the participants of the conference on the substance and significance of the Code of Professional Ethics especially at this time when the profession is shrouded with doubts and uncertainty.


  


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