Creative Accounting-Meaning, Scope and Case Study

Creative accounting is the transformation of financial accounting figures from what they actually are to what those who prepare them want, by taking advantage of existing rules or by ignoring some or all of them - By Rajesh Gajra & Srikanth Srinivas

Creative accounting is the application of variability in the accounting principles, practices and procedures to modify the books of accounts so that the organization objectives are fulfilled. The term as generally understood refers to systematic misrepresentation of the true income and assets by corporations. It’s the operation on financial data, usually within the purview of the law and accounting standards but not providing a “true and fair” value. It is characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations desired by the organizations. It is also known as aggressive and sometimes innovative accounting.

Creative accounting has a wide scope, specifically in terms of manipulation of accounts. Under creative accounting a company can inflate its sales as well as its profits, so as to smoothen out the financial results. Companies can also inflate their EPS to bring out a rosy picture of the company in the eyes of existing and prospective shareholders. Under creative accounting manipulation is also done with regard to assets and liabilities value and capital of the organization, thus leading to an effective financial position. It is also possible to adjust the profits from one year to the other leading to a more impressible management of the financial performance of the company. There is also the scope of movement of sales between subsidiary and parent company leading to a depiction of higher than actual sales growth.

Methods of Creative Accounting

The various methods of creative accounting can be considered to fall in four broad categories:(1) Sometimes the accounting rules allow a company to choose between different accounting methods. A company can therefore choose the accounting policy that gives their preferred image.(2) Certain entries in the accounts involve an unavoidable degree of estimation, judgment, and prediction. In some cases, such as the estimation of an asset's useful life made in order to calculate depreciation, estimates are normally made inside the business and the creative accountant has the opportunity to err on the side of caution or optimism in making the estimate. (3) Artificial transactions can be entered into both to manipulate balance sheet amounts and to move profits between accounting periods. This is achieved by entering into two or more related transactions with an obliging third party, normally a bank. For example, supposing an arrangement is made to sell an asset to a bank then lease that asset back for the rest of its useful life. The sale price under such a 'sale and leaseback' can be pitched above or below the current value of the asset, because the difference can be compensated for by increased or reduced rentals.

(4) Genuine transactions can also be timed so as to give the desired impression in the accounts. As an example, suppose a business has an investment of Rs 1 million at historic cost which can easily be sold for Rs 3 million, being the current value. The managers of the business are free to choose in which year they sell the investment and so increase the profit in the accounts.

Reasons for Creative Accounting

It is the higher authorities who are the main culprits behind using Creative Accounting. The reasons for the directors of listed companies to seek to manipulate the accounts are as follows:(1) 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. (2) A variant on income smoothing is to manipulate profit to tie in to forecasts. (3) Company directors may keep an income-boosting accounting policy change in hand to distract attention from unwelcome news. (4) 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.(5) 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.

Methods to curb Creative Accounting

Accounting regulators who wish to curb creative accounting have to tackle each of theseapproaches in a different way:(1) Scope for choice of accounting methods can be reduced by reducing the number of permitted accounting methods or by specifying circumstances in which each method should be used. Requiring consistency of use of methods also helps here, since a company choosing a method which produces the desired picture in one year will then be forced to use the same method in future circumstances where the result may be less favorable.(2) Abuse of judgment can be curbed in two ways. One is to draft rules that minimize theuse of judgment. Auditors also have a part to play in identifying dishonest estimates. The other is to prescribe 'consistency' so that if a company chooses an accounting policy that suits it in one year it must continue to apply it in subsequent years when it may not suit so well.(3) Artificial transactions can be tackled by invoking the concept of 'substance over form', whereby the economic substance rather than the legal form of transactions determines their accounting substance. Thus linked transactions would be accounted for as one whole.

(4) The timing of genuine transactions is clearly a matter for the discretion of management.However, the scope to use this can be limited by requiring regular revaluations of items in the accounts so that gains or losses on value changes are identified in the accounts each year as they occur, rather than only appearing in total in the year that a disposal occurs.

Case study: Creative accounting practices by Xerox

Management at Xerox Corporation when faced with strategic mistakes and a tough economic environment, including Japanese competition resorted to creative accounting practices to meet financial targets and Wall Street expectations.

On April 11, 2002, the Securities and Exchange Commission filed a complaint against Xerox. The complaint alleged Xerox deceived the public between 1997 and 2000 by employing several "accounting maneuvers," the most significant of which was a change in when Xerox recorded revenue from copy machine leases —recognizing a 'sale' in the period a lease contract was signed, instead of recognizing revenue ratably over the entire length of the contract. The issue was when the revenue was recognized, not the validity of the revenue. Xerox's restatement only changed what year the revenue was stated.

Prior to 1997, Xerox had recognized revenue from equipment (copy machine) rentals, or leases, as required by US generally accepted accounting principles (US GAAP). US GAAP (specifically FAS 13) prohibits companies from recognizing the entire proceeds of the sale of equipment unless certain criteria are met, such as transfer of ownership. If none of the criteria are met, the 'sale' is considered a lease, and only the rental payments owed to the company in the current period can be treated as revenue in the current period.

The SEC charged that the change in how Xerox applied accounting principles not only violated GAAP, but was intentionally designed to fool Wall Street into believing the new management team was working wonders, exceeding Wall Street's expectations nearly every quarter from 1997 through 1999. The SEC further charged that the accounting irregularities increased fiscal year 1997 pretax earnings by $405 million, 1998 pretax earnings by $655 million, and 1999 pretax earnings by $511 million (in each quarter of each year, earnings were inflated just enough to exceed the Wall Street's First Call Consensus EPS).

The SEC also alleged that Xerox's senior management was aware of, either by directing or approving, the accounting actions that were taken for the purpose of what management called "closing the gap" to meet revenue and profit goals. When Xerox's auditors, KPMG, questioned the legitimacy of the company's accounting practices, senior management requested that a new partner be assigned to its account. In order to keep the relationship with Xerox that had lasted nearly 40 years, and to protect the $82 million in audit and non-audit fees KPMG would collect from Xerox between 1997 and 2000, KPMG complied with management's request.

Of course, fool's gold becomes tarnished quickly, and the deception employed by Xerox's management soon came to light. The "accounting tricks" employed by Xerox were a double-edged sword: by accelerating future revenues into present periods, it became increasingly difficult for management to meet investors' expectations in future periods, especially as the economy began to worsen in 1999 and later years.

In response to the SEC's complaint, Xerox Corporation agreed to pay a $10 million penalty and to restate its financial results for the years 1997 through 2000. On June 5, 2003, six Xerox senior executives accused of securities fraud, including its former chief executive officer, Paul A. Allaire and G. Richard Thoman, and its former chief financial officer, Barry D. Romeril, agreed to pay $22 million in penalties, disgorgement, and interest.

On January 29, 2003, the SEC filed a complaint against Xerox's auditors, KPMG, alleging four partners in the "Big Five" accounting firm, Michael A. Conway, 59, Joseph T. Boyle, 59, Anthony P. Dolanski, 56, and Ronald A. Safran, 49, permitted Xerox to "cook the books" to fill a $3 billion "gap" in revenue and $1.4 billion "gap" in pre-tax earnings. As noted in the complaint: "There was no watchdog at Xerox. KPMG's bark sounded no warning to investors; its bite was toothless."

Case Analysis

The Xerox scandal to a certain extent was indirectly the result of lack of innovation on the part of the Xerox team. In the digital age, Xerox developed many technologies but then failed to take advantage of them. While other companies were continuously innovating, Xerox failed to capitalize on new technologies and thus gradually lost market share. Slowly the company reached a point where the management began resorting to unfair accounting practices, sometimes also referred to as creative accounting, to show a rosy picture of the financials of the company.

Ethics and values should be demonstrated by the top management in order to set up a positive work culture for the organization. One of the major factors impeding Xerox’s feasibility to change was its organizational culture. Xerox’s culture had declined to the point that the directors were culturally disinclined to question management, as the director’s personal gains were at stake.

Xerox’s story also demonstrates the desperate need for moral values in a business. Xerox’s recent success story is due to Mulcahy’s creation of an organizational culture built on a foundation of ethics and accountability, precisely the kind of culture that Xerox lacked under Allaire. Indeed, Xerox was guilty of a considerable number of accounting tricks that involvedmanipulating reports. It improperly recognized revenues with an intention to increase short-term results, by overstating the value of future payments from leasing agreements. It also failed to write off its mounting bad debts, another example of attempting to paint a rosier picture of the company’s finances through fraudulent means in order to increase investor confidence.

Thus it is clear from the case that creative accounting offers a formidable challenge to the accounting profession and the business world as a whole. Even though it is legally acceptable, it is no way ethical on any account. Thus companies should avoid using Creative Accounting, also on account of the fact that sooner or later it leads an organization into such a spiral from which it can never recover.