Question

Topic: creative accounting

a)Existing case

b)What the next action to prevent?

Answer 1

Q.1 Creative accounting

Answer :a)Existing case

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. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.

How Creative Accounting Works :

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 accountants will always find bizarre and novel ways to tweak figures to a company’s advantage. Their goal is to make a firm look as successful and profitable as possible and sometimes they will go about doing this by twisting the truth. If a gray area in accounting is found, it may be exploited, even if it results in misleading investors.

Getting caught can ruin a company's reputation overnight. However, some management teams are willing to run that risk, condoning the use of creative accounting because failure to meet short-term expectations of Wall Street or year-end financial targets can have a hugely adverse impact on share prices.

It is also worth remembering that more attractive figures may lead to higher bonuses for directors, help convince a lender to give a firm a loan and inflate the company’s valuation in the event of a sale.

Existing case :

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.

Then there is Enron Corp. In the 1990s, the energy, commodities, and services company engaged in all sorts of unethical accounting practices. It hid debt, understated losses and manipulated various financial figures to create an illusion of profitability, before filing for bankruptcy in 2001.

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.

b) What the next action to prevent?

Answer :  Creative accounting, which many be known by other terms such as earnings management, income smoothing or aggressive accounting, refers to accounting practices that portray a business’s financial situation as either better or worse than the actual circumstances. While legal in a technical sense -- the practices do not violate generally accepted accounting principles (GAAP) creative accounting proves ethically questionable. The fallout from the revelation of creative accounting practices, which some consider fraud, can damage a business’s reputation and provides a strong reason to prevent it in the first place.

Follwing action to be taken to prevent creative accounting :

1.Segregating Functions :

Segregating functions offers a simple method of control that helps prevent creative accounting. For example, the business can employ an internal bookkeeper to manage daily transactions, but use a CPA to review banking transactions and prepare a financial statement each month. A similar approach, applicable in larger organizations, calls for reviews of financial statements by members of different departments to make it more difficult for any one individual or small group to artificially change the numbers.

2.Create an Ethical Atmosphere :

Ethical lapses, such as the use of creative accounting practices, often stem from a business culture where management or executives do not emphasize or demonstrate ethical behavior. The failure to demonstrate ethical behaviors sends the unmistakable message that any ethics code set out by the business serves only as PR. Business owners, executives and managers that make ethical choices, such as honest discussions with customers when things go wrong, set a model of behavior that employees often prove willing to follow.

3.Formal Policies and Penalties :

Formal policies and penalties against creative accounting serve a three-fold purpose. On one level, they put new employees on explicit notice that a business does not condone such practices. Formal policies and penalties serve as a mechanism for correcting the behavior of employees that disregard the policy with some form of punishment short of firings. If an employee did not believe in the authenticity of the prohibition on creative accounting, for example, direct reprimands solidify the business’s position on the matter. Formal policies and penalties also provide grounds for letting an employee go, should he persist in creative accounting practices after receiving less severe punishments.

4.External Audits :

External audits do not entirely prevent unauthorized creative accounting, but external auditors with extensive experience often prove more capable of detecting creative accounting, according to a research study in the February 2013 issue of the International Journal of Business and Management. Even if auditors do not always spot creative accounting, external audits as a standard practice often serve as a psychological deterrent. The threat of detection reduces perceived opportunity, one of the triggers for fraudulent behavior.