Understanding balance sheet creative accounting
Creative accounting occurs when companies take advantage of loopholes to show that they are more profitable or financially stable than they actually are. In some cases, companies are not yet breaking the law, but are most likely engaging in unethical behaviour. Creative accounting can lead to suspicion, audits by the government, mistrust by third parties and, in the case of fraud, even the dissolution of a company.
Accounting practices in many countries have improved over the years after the Enron and Worldcom scandals, but there are still plenty of ways that companies can manipulate their financial results to overstate assets or understate liabilities.
Why do companies use Creative Accounting?
There are many reasons why companies use creative accounting to manipulate their balance sheets. Most of the times they want to create the appearance to shareholders, investors, bankers, customers, suppliers and other third parties that companies’ financial standing is sound. Other times, management may be seeking to increase profitability due to pressures from the board or to receive unearned bonuses. Also, financially-sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms.
Below are just some of the most common and simple examples of Balance Sheet Creative Accounting:
Overvaluing Assets
Accounts Receivable is often overvalued by not making a reasonable provision for bad debts. This also inflates earnings. In such a case the Provision for Bad Debts will prove to be inadequate in the future, but accounts receivable and earnings will receive a temporary boost in the short term. Investors and other interested individuals can sometimes detect when the Provisions for Bad Debts are inadequate by comparing accounts receivable to net income and revenue. When the balance sheet item is growing at a faster pace than the income statement item, then investors and others may want to look into whether or not the provision for bad debts is adequate by further investigating the matter.
Inventory represents the value of goods that were purchased or manufactured but not yet sold. When these goods are sold, the value is transferred to the income statement as cost of goods sold. As a result, overstating inventory value will lead to understating cost of goods sold, and therefore an artificially higher net income, assuming actual inventory and sales levels remain constant.
Undervaluing Liabilities
By not recording liabilities and or creditors as of the balance sheet date, liabilities are understated and the net worth of the company is overstated.
Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee or the date payable. For example, warranty obligations or anticipated litigation loss may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating their materiality.
Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income or shareholders' equity. Investors can sometimes find evidence of such problems by carefully reading a company's footnotes, which may contain information about these obligations.
Nondisclosure of Material Information
On the other hand, it has been proved in the past that certain material information or events that would influence an investment decision were not disclosed in the Financial Statements.
Conclusion
A recent study on creative accounting revealed that the practice of creative accounting in whatever form, is an attempt to gain advantage of a form. The study shows that the current generally accepted accounting principles create a gap that can permit the practice of creative accounting.
However, the study also revealed that the new International Financial Reporting Standard (IFRS) will go a long way to reduce the practice, since it covers more areas than the former practice. It was also revealed that one of the best ways to prevent the practice of creative accounting is to enforce both preventive as well as strong enough punitive measures on those that engage in the practice. It was recommended that effective rules and regulation of accounting practice should be put in places within the organisation to forestall the incidence of creative accounting. Moreover punitive measure should be taken against those executives and others found culpable in the act of creative accounting.
In the next issue of the Financial Mirror we will deal with more sophisticated Creative Accounting Schemes and examples.
