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.
- taking their debt off the balance
- 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
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
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
- 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
- eliminated the scope for creativity
in acquisition accounting with the introduction of FRS 6 (Acquisition and
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