Question

Topic: creative accounting

a) What is the problem?

b) How to solve the problem/issue/case?

Answer 1

Creative accounting consists of accounting practices that 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.

(a) Creative accounting tricks vary in nature and consistently evolve as regulations to police them change. Here are some examples of common techniques:

• Overestimating revenues: One of the most common techniques used by public companies looking to artificially boost their income is to prematurely recognize revenue. Revenue recognition is an accounting method that enables companies to recognize sales before they deliver a product or perform a service. It is open to exploitation.
• Lowering depreciation charges: Compaies often spread out the cost of assets, rather than expensing them in one hit. Methods to reduce annual charges on these items can include extending the useful life estimate of the asset or increasing its assumed salvage value.
• Delaying expenses: Deferring the recording of current period expenses, such as payments to suppliers and rent, to a subsequent period makes current period earnings look better.
• Masking contingent liabilities: Failure to record potential liabilities that are likely to occur and underestimating how much they are likely to cost can boost net income or shareholders' equity.
• Undervaluing pension liabilities: Pension obligations can easily be manipulated because the liabilities occur in the future and company-generated estimates need to be used to account for them.
• Inventory manipulation: Inventory represents the value of goods that were manufactured but not yet sold. Overstating the value of inventory will lead to an understatement of cost of goods sold, and therefore an artificially higher net income, assuming actual inventory and sales levels remain constant.   

(b)To prevent creative accounting, the experts opine that accountants and managers should divide the duties of an internal control checklist. Furthermore, an independent audit committee should always have someone with a strong accounting background and audit experience who deals directly with outside auditors. The investors should diversify their investment portfolio to circumvent the problems related to the creative accounting by few unscrupulous companies.

The company has to adhere strictly to the ethical values it has set itself with the long-run and the short-run of the life of the company. The accounting and accounting practices have to be consistent and show to the investors that it is following the ethical practices in all its financial dealing as well as reporting.

PRACTICAL PROBLEM:

1) Laribee Wire Manufacturing Co. offers a good example of inventory manipulation. The copper-wire maker was in trouble in the late 1980s as sales to the troubled construction industry faltered and a big acquisition left it with massive debt. Laribee recorded phantom inventory and carried other inventory at bloated values to convince banks to lend it $130 million. The company reported $3 million in net income for the period, when it really lost $6.5 million.

2) The WorldCom scandal is another high profile example of creative accounting leading to fraud. To hide its falling profitability, the company inflated net income and cash flow by recording expenses as investments. By capitalizing expenses, it exaggerated profits by around $3 billion in 2001 and $797 million in Q1 2002, reporting a profit of $1.4 billion instead of a net loss.