Creative Accounting Flashcards
What is creative accounting (IMPORTANT)
-> the exploitation of loopholes in financial regulation in order to gain advantage or present figured in a misleadingly favourable light by pushing the boundaries from the intended interpretation of the accounting standards
Cookie jar= where they seek to move some profits into next year which will have the effect of changing the balance sheet
Investors get involved in creative accounting if..
-> they want to increase profits (to ensure dividends are paid)
-> they want to reduce profits (if political climate is hostile)
-> in extreme conditions governments can get involved with creative accounting (to increase tax revenue)
Terminology
-earnings management
-massaging the numbers
-cooking the books
-window dressing
-> accounting scandals
Intention to deceive (IMPORTANT)
-creative accounting involves intention to deceive
-accounting error is often judgement related or estimate that turns out to be wrong, but the judgement was made in good faith, on the basis of information available at the time
Problem = how can you tell the difference between a mistake and a deliberate intention to deceive
Indicators of the intention to deceive (IMPORTANT)
- Breaking the companies own accounting policies
- Changing accounting policies abruptly, for no good reason
- Managers benefiting from bonuses and other incentives
- Not using all available information when making judgements
- Misleadingly the auditors as to the logic or evidence behind an accounting policy
Methods of creative accounting (how to manipulate the bottom line)
(IMPORTANT)
How managers can take advantage of loopholes in the legislation:
1. Deconsolidate loss making subsidiaries
-> exploiting loose definitions of a subsidiary and associate has a huge impact.
2. Sale and leaseback
-> selling off the asset before the end of financial year and using the money to fund the business and maintain the liquidity position, but then leasing back the asset for a longer term
3. Changing accounting policies re stock valuation
-> this might be done to increase or decrease the profits depending on what management are trying to portray
4. Revenue recognition
-> how business records revenue dependent on performance (underperformance leads to sped up revenue recognition)
5. Capitalisation of expenses (balance sheet)
6. Creation of provisions
-> cookie jar accounting, using provisions to smooth or reduce profits
7. Ignore write downs of fixed assets
8. Changing the accounting policy for depreciation for no good reason
9. Revalue fixed assets upwards
10. Ignoring bad debt provisions
11. Exaggerated research and development claims
12. Foreign currency translation, the difference between average rate and year end exchange rate
People that should stop creative accounting (IMPORTANT)
- Auditors = need stronger powers in company law and restrict them to audit only so greater independence enforced by the accounting bodies
- Managers acting ethically = need to see stronger independent review, lower bonuses and more investigation of law
- Independent internal auditors keeping watch = need more internal audit rules
- Accountants preparing the figures using conceptual framework
- Regulators (FRC) = more powers to regulators and more harsh penalties in cases of fraud, stronger corporate governance rules
- ICAEW helping determine accounting policies and conceptual framework = apply more strict rules, better enforcement of ethics code
Effectiveness of accounting regulation is determined by (IMPORTANT)
-the number of regulators & their level of skill and knowledge
-the nature of the accounting rule book, its strictness and detail
-the budget allocated to regulation (many million needed)
-the budget is determined by the priority & importance placed on regulation by politicians and regulators
How effective is uk financial reporting (IMPORTANT)
-overall quality and reliability of financial reporting in annual reports is difficult to measure
-bound to be errors, exaggerations, and hidden figures
-financial reporting council (FRC) is a regulatory body set up by the government to oversea the quality annual reports and corporate governance
-they monitor the conduct of all professionals, especially accountants and accounting firms involved
-believe that high quality reporting and governance will stimulate more investment
Sources of evidence on the quality of financial reporting
- Number of qualified audit opinions in a year
- Number of material misstatements and restatement figures in a year
- Number of serious fraud office (SFO) investigations, in so far as they involve accounting
- Results of HMRC investigations, in so far they involve accounting
- Number of finance directors resigning or leaving, often for accounting related disputes
- Number of companies adopting fair value
CASE STUDY- what did worldcom do wrong
Inappropriate capitalisation of expenses
-capitalised excessive amounts of operating expenses. Costs that, under correct accounting standards, would normally be expensed during the period, were being held on the balance sheet.
-massively overstating profits but achieving the goal of maintaining an inflated share price
-falsely portraying the excellent results to the stock market, its investors, board of directors, employees
-in 2001 company overstated its profits by $3.8 billion
CASE STUDY - Tesco 2014 scandal What did they do wrong
- Revenue recognition
-> they included the sales made under the loyalty club card scheme as a cash sale but then made an adjustment in its half year and final year results. Competitors did not do this. - Depreciation
-> tescos reported profits are inflated with a lower depreciation charge compared to others - Property profit allocation
-> included property gains from its developing of property within its operating profit - Capitalised interest expense
-> tescos way higher than competitors
Explain method of creative accounting that WorldCom used in order to improve their bottom line (IMPORTANT)
->Worldcom used excessive and inappropriate capitalisation of expenses.
->Costs that would normally be expenses to the income statement were being held on the balance sheet
->This lead to inflated profits and share prices
What impact might Covid have on use of creative accounting (IMPORTANT)
- Increase incentive to boost otherwise failing profitability
- Pressure on management to drive a business through a pandemic might increase incentive
- Alternatively, the temptation might be to try hide underlying profitability issues and pass them off as due to the pandemic
Times of recession (IMPORTANT)
-> sales and profits will fall as costs and expenses increasing, squeeze on profitability which negatively impacts share price
