Creative Accounting

'Creative Accounting ' means Accounting practicesthat follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.Accounting methods used to conceal firm's true state the use of accounting methods to hide aspects of a company's financial dealings in order to make the company appear more or less successful than it is in reality. The term 'creative accounting' can be defined in a number of ways. Initially we will offer this definition: 'a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business'.A primary benefit of public accounting statements is that they allow investors to compare the financial health of competing companies. However, when firms indulge in creative accounting they often distort the value of the information that their financials provide. Creative accounting can be used to manage earnings and to keep debt off the balance sheet. REASONS FOR CREATIVE ACCOUNTINGDiscussions of creative accounting have focused mainly on the impact on decision of investors in the stock market. Reasons for the directors of listed companies to seek to manipulate the accounts are as follows:(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.

Advocates of this approach argue that it is a measure against the 'short-termism' of judging an investment on the basis of the yields achieved in the immediate following years. It also avoids raising expectations so high in good years that the company is unable to deliver what is required subsequently. Against this is argued that: if the trading conditions of a business are in fact volatile then investors have a right to know this; income smoothing may conceal long-term changes in the profit trend.

(2) A variant on income smoothing is to manipulate profit to tie in to forecasts. Fox (1997)reports on how accounting policies at Microsoft are designed, within the normal accountingrules, to match reported earnings to profit forecasts. When Microsoft sell software a large partof the profit is deferred to future years to cover potential upgrade and customer support costs.This perfectly respectable, and highly conservative, accounting policy means that futureearnings are easy to predict.

(3) Company directors may keep an income-boosting accounting policy change in hand to distract attention from unwelcome news. Collingwood (1991) reports on how a change inaccounting method boosted K-Mart's quarterly profit figure by some $160 million, by a happycoincidence distracting attention from the company slipping back from being the largestretailer in the USA to the number two slot.

(4) Creative accounting may help maintain or boost the share price both by reducing theapparent levels of borrowing, so making the company appear subject to less risk, and bycreating the appearance of a good profit trend. This helps the company to raise capital fromnew share issues, offer their own shares in takeover bids, and resist takeover by othercompanies.

(5) If the directors engage in 'insider dealing' in their company's shares they can usecreative accounting to delay the release of information for the market, thereby enhancing theiropportunity to benefit from inside knowledge.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.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.Accounting scandals, orcorporate accounting scandals, arepoliticalandbusiness scandalswhich arise with the disclosure of misdeeds by trustedexecutivesof large public corporations. Such misdeeds typically involve complex methods for misusing or misdirecting funds, overstatingrevenues, understating expenses, overstating the value of corporate assets or underreporting the existence ofliabilities, sometimes with the cooperation of officials in other corporations or affiliates.In public companies, this type of "creative accounting" can amount to fraud and investigations are typically launched by governmentoversight agencies, such as theSecurities and Exchange Commission(SEC) in the United States.Scandals are often only the 'tip of the iceberg'. They represent the visible catastrophic failures. Note that much abuse can be completely legal or quasi legal.For example, in the domain ofprivatizationandtakeovers:It is fairly easy for a top executive toreducethe price of his/her company's stock due toinformation asymmetry. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue, engage inoff balance sheettransactions to make the company's profitability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due toinformation asymmetriessince it is more common for top executives to do everything they can towindow dresstheir company's earnings forecasts). There are typically very few legal risks to being 'too conservative' in one's accounting and earnings estimates.A reduced share price makes a company an easiertakeovertarget. When the company gets bought out (or taken private) at a dramatically lower price the takeover artist gains a windfall from the former top executive's actions to surreptitiously reduce share price. This can represent tens of billions of dollars (questionably) transferred from previous shareholders to the takeover artist. The former top executive is then rewarded with agolden handshakefor presiding over thefiresalethat can sometimes be in the hundreds of millions of dollars for one or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will tend to benefit from developing areputationof being very generous to parting top executives).Similar issues occur when a publicly held asset or non-profit organization undergoesprivatization. Top executives often reap tremendous monetary benefits when a government owned or non-profit entity is sold to private hands. Just as in the example above, they can facilitate this process by making the entity appear to be in financial crisis this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. It can also contribute to a public perception that private entities are more efficiently run reinforcing the political will to sell off public assets. Again, due toasymmetric information, policy makers and the general public see a government owned firm that was a financial 'disaster' miraculously turned around by the private sector (and typically resold) within a few years.All accounting scandals are not caused by top executives. Oftentimes managers and employees are pressured or willingly alter financial statements for the personal benefit of the individuals over the company.Managerial opportunismplays a large role in these scandals. For example managers who would be compensated more for short term results would report inaccurate information since short term benefits outweigh the long-term ones such as pension.[1]Satyam Computer Services2009[42]PricewaterhouseCoopersIndiaFalsified accounts

CONCLUSIONCreative accounting offers a formidable challenge to the accounting profession. The problem is an international one, with accounting policy choice being a particular problem in the Anglo-American tradition and transaction manipulation a particular problem in the continental European tradition.

There is a wide variety of motivations for managers to engage in creative accounting. The justification for creative accounting put forward in the 'positive accounting theory' tradition is: In conflict with mainstream thinking on ethics. Particularly relevant to the USA, where there is a well-developed stock market and a focus on detailed accounting regulation rather than broad principles, and is considerably less relevant in other countries.

Accountants who accept the ethical challenge that creative accounting raises need to be aware of the scope for both abuse of accounting policy choice and manipulation of transactions. New Zealand offers an example of a country where a well-designed framework of accounting regulation has curbed creative accounting. However, our interviews raised some concerns as to whether this situation will last.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.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.

Solution of Creative Accounting/Techniques to resolve the Accounting Scandals:A) Investigate Motives for Unethical PracticesB) Administer Effective & Ethical ControlsA) Motives for Unethical Behavior:1) Situational Pressure:If an employee is having high pressure due to the nature of job, the chances of getting indulge into the unethical practices are high. And if its low, an employee would tend to remain loyal towards the organization.2) Opportunities:Opportunities availability in terms of financial gain to the person and not to the organization. If high personal gain is there, it can attract an individual to involve in unethical practices. So, there should be a proper observation and any activity should generate a gain to the organization itself.3) Personal Characteristics (Integrity):An employees integrity and honesty for an organization matters a lot. If an employee is morally sound and having a high integrity as well as determination, it would prevent him/her to do any unethical activity. High Situational Pressure Low

High Opportunities Low

High Personal Characteristics (Integrity) Low

Ethical

Unethical B) Administer Effective Ethical & Internal Controls:Effective ethical control:An Ethical control needs to be maintained by an organization. It can be done by structuring a Code of Conduct. It gives a clear idea about what is expected from an employee and in which way he/she needs to behave. There should be some punishment for deviation of norms of code of conduct within an organization. While preparing norms of Code of Conduct, the following aspect needs to be incorporated in it; Integrity Objectivity Independence Due CareEffective Internal Control System:

Control Activities:Transaction Authorization Segregation of Duties Supervision Accounting Records Access Control Independent VerificationMonitoring:Entities ActivitiesRisk Assessment:Identify, Analyze, and Manage Risks Relevant to Financial Reporting.Control Environment:Influence Control Awareness of Management and Employees

Information and Communication:Quality of Info Impacts Reliability of Financial Statements

Safeguard assets of the firmEnsure reliability of accounts & records Promote efficiency in firms operation Outcome of Ethical and Internal Control:

Effective Ethical Control

Effective Internal Control

Opportunity

Situational Personal IntegrityPressure