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CREATIVE ACCOUNTING AND IMPLICATIONS THEREON

[The Conceptual Framework]

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Creative Accounting [an introduction]

Creative accounting essentially refers to the

simple techniques [in the nature of accounting

jugglery] often adopted by companies to maketheir financials look healthier than they actually

are. Most of these actions are usually aimed at

increasing revenues and reducing expenses

[applying clever, though legal accountingpractices one way or the other] although in

certain cases it could also be the other way

round. In a nutshell, companies across the

globe indulge in creative accounting essentially

with the purpose of keeping their income

statement pretty by hiding the warts deep

inside the balance sheet.

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When it comes to manipulatingthe earnings figure, companies

do not have to cook the books.

The Accounting Standards setby professional bodies provide

enough room for what is called

creative accounting.

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Its not cheating, mind you. Accounting rules,

the world over, have many grey areas and

hence, companies enjoy some freedom orflexibility in deciding what constitutes revenues

and expenses. Such flexibility is certainly

welcome considering different business

situations and commercial consideration, but

companies often take advantage of thisflexibility to keep their income statement in

good shape. The Accounting Standards offer

too many variable methods or choices in

accounting for identical transactions.Moreover, nonadherence to standards, norms

and rules does not attract that strict a penalty

in most countries across the globe India being

no exception.

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An assortment of techniques is used to

doctor the financials. Although anexhaustive list can never be provided for

the same, it may be commented that the

important among those are as under:

Changing the basis of accounting

Altering the timing expenditure [sometimes even revenues]

Doctoring the cost estimates

Accounting for capital and revenue transactions

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Changing the Basis of Accounting

It is a globally accepted fact that theaccounting rules across the globe recognize

that there may be more than one accepted

accounting basis for dealing with identical

business transactions and naturally two

different bases would culminate into twodifferent earnings figure. In fact choosing a

different accounting method is a common

technique for managing the bottom line. This

technique can have the maximum and the mostpermanent impact on earnings.

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However, if the method of accounting is

undergoing a change as compared to theimmediately preceding previous year,

the same needs to be disclosed,

explained and quantified in the financial

statements. It may be noted that suchdisclosures are warranted only in the

year of change and not in the

subsequent years. Therefore, such

clauses get buried in the past financialstatements and are conveniently

forgotten.

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Stock Valuation Policy

The Accounting Standard No 2 [AS 2] on

Valuation of Inventories provides different

options for inventory valuation, namely, costmay be computed either under the FIFO or

Weighted Average method and companies are

allowed to shift from a method which

incorporates fixed production overheads to amethod which excludes it while valuing

inventories. These flexibilities in the

Accounting Standard provides enough room for

Indian companies to tamper with the inventory

figure, which has a direct bearing on operatingprofit, net profit and the balance sheet

reflection of the financial position as well.

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Depreciation Policy

In India, the applicable depreciation

rates are those given in the

Companies Act in respect of single,

double and triple shift working ofcompanies. It may be noted that

only minimum wages are mentioned

in such regulations and hence,higher rates are not precluded.

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Altering the Timing of the Expenditure

[sometimes even revenues]

Another method of earnings

manipulation involves altering the

timing of the expenditure and

sometimes even revenues as

illustrated in the following

examples.

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Treatment of Fixed Assets

In the Indian Income Tax Act, thereis a provision which states that if a

new fixed asset is used for less

than six months in a financial year

[even one or two days], full six

months depreciation may be

claimed on that asset. Thus, fixed

assets could be capitalized a littlesooner than later in order to gain

from tax credits.

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Issue of Materials

In so many manufacturing companies

based in India, a standard practicefollowed is that whenever raw materials

or consumables are issued from main

stores to the shop floor, the same is

treated as consumption irrespective of

the fact whether it has been actually

consumed or not. Thus, companies may

expedite the issue of materials sincesuch issues would naturally be deducted

from the current income line.

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Doctoring the Cost Estimates

Another effective technique for manipulation is

fiddling with the estimates of cost. As per the

conservatism principle, all foreseeable future losses

estimated with reasonable accuracy needs to be

provided in the books of accounts, unlike foreseeable

gains which are only disclosed in the financial

statements. It is evident that the process of

estimation is inherent in drawing up financial

statements and is influenced by an element of

judgment by the company management, provided the

statutory auditors are in agreement with the same. As

an opportunity is provided to incorporate estimated

figures in the financials, the floodgates are open as

the concerned companies take advantage of such

flexibilities sometimes with the malafide intention to

fudge the financial numbers. The following example

would clarify the concept.

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Estimating Future Losses in Current Assets Items

Management estimates what portions of their

receivables are irrecoverable or what portion oftheir inventory is obsolete. They tend to

maximize write offs in good years and minimize

such write offs in bad years. When things go

well, there is a tendency on the part of the

management to try and provide more than what

would normally be required. These extras

which reduce the profits, are kept in a

corporate barrel. In bad years, the

management can draw from the barrel forwriting back the extras to supplement and

boost reported earnings.

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Another area of concern is valuation of

work in process inventories. The

valuation of such items largely depend

on the state of completion of the same,

which is also estimated by the company

management.

Management and Statutory Auditors may

sometimes form different judgments on

the level of cost estimates but cangenerally reach on agreement based on

the range of acceptable estimates.

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Accounting for Capital and Revenue Transactions

The fourth method of bottom line

manipulation is through fiddling withsegregation of costs into capitalexpenditure, revenue expenditure anddeferred revenue expenses [which are

amortized in the books of accounts].Obviously, any misclassification ofrevenue expenses into capital expensesor deferred revenue amounts to carryforward of revenue expenditure which inturn would boost the earnings figure. Areverse treatment would deflate thereported earnings as well.

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Identifying the Root Causes

Flexibilities in the Accounting Rules andStandardsThe Accountability Parameters are notwell DefinedThe nonexistence of Strict Penal ClauseLack of Adequate Protection for Auditors

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Suggesting Control Devices/Mechanisms

Strengthening Statutory Audit

Stressing on cost Audit

The Directors Responsibility

Statement

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Both in the UK and the US, company

management are required to indicate thedirectors responsibilities in their report

of the Board of Directors. The

Companies Amendment Bill [India]

introduces a similar concept known as

the Directors Responsibility

Statement. Nowadays, such disclosure

is an integral component of annualreports of Indian companies.

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Directors Responsibility Statement A Sample

In the preparation of the annualaccounts, the applicable accountingstandards have been adhered to.

We have selected such accountingpolicies and applied them consistentlyand made judgments and estimates thatare reasonable and prudent so as to give

a true and fair view of the state of affairsand profits of the company.

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We have taken sufficient care for the

maintenance of adequate accounting

records in accordance with theprovisions of the Companies Act and for

safeguarding the assets of the company.

Adequate care has also been taken in

preventing and detecting frauds andother irregularities.

The financial statement have beenprepared on historical cost and on going

concern basis.

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Advising the Investors

Read the fine print,carefullyTrust the cash flows