FAM assignement Creative Accounting

FAM assignement Creative Accounting - Transcript

Creative Accounting
Subject Financial Accounting for Management

Creative Accounting
Introduction
Creative accounting also called aggressive 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 In other words Creative accounting is the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing rules and or ignoring some or all of them A typical aim of creative accounting will 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 Typical creative accounting tricks include off balance sheet financing over optimistic revenue recognition and the use of exaggerated non recurring items The term window dressing has similar meaning when applied to accounts but is a broader term that can be applied to other areas In the US it is often used to describe the manipulation of investment portfolio performance numbers In the context of accounts window dressing is more likely than creative accounting to imply illegal or fraudulent practices but it need to do so The techniques of creative accounting change over time As accounting standards change the techniques that will work change Many changes in accounting standards are meant to block particular ways of manipulating accounts which means those intent on creative accounting need to find new ways of doing things At the same time other well intentioned changes in accounting standards open up new opportunities for creative accounting the use of fair value is a good example of this Many but not all creative accounting techniques change the main numbers shown in the financial statements but make themselves evident elsewhere most often in the notes to the

accounts The market has been surprised before by bad news hidden in the notes so a diligent approach can give you an edge

Techniques of creative accounting
Six main areas are considered the source of inspiration for the creative accounting 1 2 3 4 5 6 Flexibility in regulation Lack of regulation Scope for management that assumed some targets for the future Timing of some transactions Use of artificial transactions Reclassification and presentation of financials

It was proved that even in highly regulated countries such as USA the accounting environment afford a great deal of flexibility In order to be understood we proceeded to the detail of these 1 Flexibility in regulation Generally the regulation particularly the accounting regulation permits flexibility in choosing a policy to follow the International Accounting Standards let the financial management to choose between valuation of the non current assets at depreciated historical value or at revaluated value The management may decide the change of the policies and these shifts are difficult to be identified a few years later 2 Lack of regulation in some areas in every domain In most countries accounting regulation is limited in some areas for example in Romania there is few mandatory requirements for transactions with futures and stock options or for the recognition and measurement of pension liabilities 3 Management can use their discretionary position in order to obtain the financial position and stability they assumed for example the managers decide the increase or reduce of the provisions for bad debts 4 The timing of some transactions offers to the management the opportunity to increase the revenues when the operating profit is not satisfactory and to create the desired impression in the accounts The existing stocks in company s patrimony that have a significant higher value compared to the historical value may be sold only when the operating profit is not satisfactory 5 The artificial transactions are often used in order to manipulate the balance sheet amounts or to move the profits between accounting periods These transactions are realized by entering in a controlled transaction with two or three parties one of them most of the times a bank Such arrangements consists in selling of an asset at a higher lower rate than in an uncontrolled transaction and then leasing it back for the rest of it useful period compensating through the rentals the price difference 6 Reclassification and presentation of financials are relatively less analysed in accounting literature However in reality the companies often proceed to make up the amounts in orderto obtain good level of profitability liquidity or leverage ratios Most of the times the numbers are smoothly modified in order to improve the investors perception The idea behind this

behaviour is that humans may perceive a profit of say 301 million as abnormally larger than a profit of 298 million Their study and others have indicated that some minor massaging of figures does take place in order to reach significant reference points Techniques that define creative accounting are not new but experience has shown that most of the times may prove extremely expensive In order to attract investors and to appear profitable to the shareholders employees creditors suppliers and other categories the companies can decide to misstate the financials this practise often lead to drastic consequences The manipulation of the conduct to a mismatch of the financial position and of the results with the fair presentation zone which implies that the profit will not represent the long term capacity of the firm to generate earnings

Reasons of creative accounting
1 Income smoothing Companies generally prefer to report a steady trend of growth in profit rather than to show volatile profits with a series of dramatic rises and falls This is achieved by making unnecessarily high provisions for liabilities and against asset values in good years so that these provisions can be reduced thereby improving reported profits in bad years 2 Company directors may keep an income boosting accounting policy change in hand to distract attention from unwelcome news 3 Creative accounting may help maintain or boost the share price both by reducing the apparent levels of borrowing so making the company appear subject to less risk and by creating the appearance of a good profit trend This helps the company to raise capital from new share issues offer their own shares in takeover bids and resist takeover by other companies 4 If the directors engage in insider dealing in their company s shares they can use creative accounting to delay the release of information for the market thereby enhancing their opportunity to benefit from inside knowledge

Consequences of creative accounting
1 The confusion created among the stock exchange investors because the figures shown by financial statements are often inflated and the difficulty of investors to distinguish between the fair and unfair statements 2 The prospectuses of the listed companies do not always offer a detailed picture the financial positions and performance 3 The techniques used by creative accounting can impress the investors only over short time periods while the financial position goes worse this cannot be hide anymore and these methods are helpless 4 The long time effect of such practise is the distrust of the investors conducted by the collapse of companies that take advantage of these techniques

Case Satyam Accounting Scandal
Company Year Location Audit Firm Notes Satyam Computer Services 2009 India PricewaterhouseCoopers Falsified accounts

The Satyam Computer Services scandal was publicly announced on 7 January 2009 when Chairman Ramalinga Raju confessed that Satyam s accounts had been falsified

Details
On 7 January 2009 company Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India SEBI that Satyam s accounts had been falsified 1 2 3 Raju confessed that Satyam s balance sheet of 30 September 2008 contained inflated figures for cash and bank balances of 5 040 crore US 1 09 billion as against 5 361 crore US 1 16 billion crore reflected in the books an accrued interest of 376 crore US 81 59 million which was non existent an understated liability of 1 230 crore US 266 91 million on account of funds was arranged by himself an overstated debtors position of 490 crore US 106 33 million as against 2 651 crore US 575 27 million in the books

Aftermaths
On 11 January 2009 the government nominated noted banker Deepak Parekh former NASSCOM chief Kiran Karnik and former SEBI member C Achuthan to Satyam s board Merrill Lynch now a part of Bank of America and State Farm Insurance terminated its engagement with the company Satyam s shares fell to 11 50 rupees on 10 January 2009 their lowest level since March 1998 compared to a high of 544 rupees in 2008 Chartered accountants regulator ICAI issued show cause notice to Satyam s auditor PricewaterhouseCoopers PwC on the accounts fudging The Crime Investigation Department CID team picked up Vadlamani Srinivas Satyam s then CFO for questioning

On 22 January 2009 CID told in court that the actual number of employees is only 40 000 and not 53 000 as reported earlier and that Mr Raju had been allegedly withdrawing INR 20 crore rupees every month for paying these 13 000 non existent employees

Root Cause
Prof Sapovadia in his study shows that in spite of there being a strong corporate governance framework and strong legislation in India top management sometimes violates governance norms either to favour family members or because of jealousy among siblings He finds that there is a lack of regulatory supervision and inefficiency in prosecuting violators He investigates in detail the recent governance failure at India s 4th largest IT firm Satyam Computers Services Limited and considers possible reasons underlying such large failures of oversight

PricewaterhouseCoopers Reply
On 14 January 2009 Price Waterhouse the Indian division of PricewaterhouseCoopers announced that its reliance on potentially false information provided by the management of Satyam may have rendered its audit reports inaccurate and unreliable 19

References
http moneyterms co uk creative accounting http www investorwords com tips 22 9 signs of potential creative accountingpractices html http www recercat net bitstream 2072 495 1 349 pdf http steconomice uoradea ro anale volume 2008 v3 finances banks accountancy 172 pdf http en wikipedia org wiki Accounting scandals http en wikipedia org wiki Satyam accounting scandal