Creative accounting

Creative accounting . This term is used to describe the process by which accountants and advisers use their knowledge of accounting standards to make up the figures reflected in company accounting, while still complying with accounting principles. In this way, depending on whether criteria or other aspects of accounting are applied, the results may vary and be more favorable for organizations.

Enron, Worldcom among others, are some cases of creative accounting (euphemism for fraud with numbers) that have appeared in recent times, have had a great impact on the North American economy, to the point that the markets have lost confidence in the generally accepted accounting principles , in auditors, advisers and even investment analysts; Those who recommend the purchase of this or that stock earn good commissions and leave thousands of investors in the lurch.

Summary

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  • 1 Basic functions
  • 2 Reasons for its use
  • 3 Accounting record
  • 4 Most common transactions
  • 5 Techniques and Methods
  • 6 Keys to detect practice
    • 1 Ways to decrease or moderate practice
  • 7 See also
  • 8 Source

Basic functions

  • Provide information on significant changes in equity.
  • Study the causes that have caused these variations in order to determine an adequate planning of the actions to follow.

It is essential that the accountant is aware of progress, both in relation to the theoretical part and its conceptualization, and in relation to practical elements and investigative processes.

It is therefore of paramount importance to understand that general accounting plays an effective and decisive role in society and should not pursue independent objectives. General accounting, in addition to its historical function, has become important in its forecasting function as a tool for controlling the economy and administration. The demand for new areas is clear and solid, and the profession must necessarily direct its efforts to fulfill the aspirations and aspirations of society.

Control and information will be the basic elements for the success of large organizations. General accounting is part of an information network, so accountants need to broaden their skills and perspectives in order to cope with change when it occurs.

The Committee on Terminology of the American Institute of Public Accountants (AICPA) of the United States, proposed in 1941 that general accounting be defined as the art of recording, classifying and summarizing in a significant way and in monetary terms, transactions and events or events that are, at least in part, financial, as well as interpreting their results.

Reasons for its use

In recent times and as a consequence of the financial crisis that has affected large international companies, creative accounting has become particularly relevant, calling into question the data presented, as well as the credibility of auditors and advisers.

Discussions on the reasons that have led some companies to put creative accounting into practice have focused mainly on the impact they can have on the decisions of investors in the Stock Market since they have used “accounting tricks” to deceive to investors.

Among the reasons that the directors of the companies that list their shares have, to try to manipulate the accounts through the use of creative accounting include the following:

  1. Firms generally prefer to reflect a stable trend in profit growth, rather than showing volatile profits with series of dramatic ups and downs.
  2. It can help maintain or “increase” the stock price, both by reducing the apparent levels of indebtedness, and thereby making the company appear to be exposed to less risk, and by creating the appearance of an increasing profit trend.
  3. If managers are engaged in internal operations with their company’s shares, they can use creative accounting to delay the arrival of information on the market, taking advantage of the opportunity to benefit from their privileged information.

Ethically, the first of the three reasons stated, are open to honest debate. The other two ethically unacceptable reasons, especially the last one.

Accounting record

Sometimes, companies must make their accounting records objectively, but the accounting legislation has certain gaps or ambiguities that arise when accounting for certain aspects. In addition, there are many accounting points from which you can choose or many others that require making provisions about the future, and may be optimistic or pessimistic. This is not to mention the desire of many companies to manipulate the data. Therefore, accounting, as it is currently regulated, does not reflect or report on reality, but “only follows the rules”, leading to transformed annual accounts in companies. This is due to the predominance of a legalistic vision when preparing company accounts, that is, it is prepared by applying the rules, regardless of what the reality is. Currently, virtually all companies “make up the accounts” and rare is the company that has not used it in the last five years. The reasons for using this creative accounting are varied and extensive. There is a need to present an increase in results, such as in Banks, where despite economic crises, profits always increase compared to previous years. Another series of reasons to use in creative accounting, applicable to all types of companies, arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: Virtually all companies “make up the accounts” and rare is the company that has not used it in the last five years. The reasons for using this creative accounting are varied and extensive. There is a need to present an increase in results, such as in Banks, where despite economic crises, profits always increase compared to previous years. Another series of reasons to use in creative accounting, applicable to all types of companies, arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: Virtually all companies “make up the accounts” and rare is the company that has not used it in the last five years. The reasons for using this creative accounting are varied and extensive. There is a need to present an increase in results, such as in Banks, where despite economic crises, profits always increase compared to previous years. Another series of reasons to use in creative accounting, applicable to all types of companies, arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: There is a need to present an increase in results, such as in Banks, where despite economic crises, profits always increase compared to previous years. Another series of reasons to use in creative accounting, applicable to all types of companies, arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: There is a need to present an increase in results, such as in Banks, where despite economic crises, profits always increase compared to previous years. Another series of reasons to use in creative accounting, applicable to all types of companies, arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: It arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example: It arises because these are subject to different types of contractual rights and obligations, based on the amounts reflected in the financial statements; for example:

  • It is quite common that, in the case of loan contracts, a restriction is included on the total amount that a company can obtain, calculated as a multiple of total capital and reserves.
  • Some companies, such as public utilities and urban cleaning services, for example, are subject to the authority of a public regulatory body that sets the maximum rates they can charge. If these companies reflect high profits, the supervising entity will respond by maintaining or freezing the rates. Therefore, these companies are interested in choosing accounting methods that tend to reduce the accounting profit.
  • A management model with compensation linked to companies’ profits or share prices will, in the case that they are linked to share prices, managers are motivated to present accounts that impress the stock market. If the premium is tied to profit, managers will try to adjust the profit figure so that their income is maximized.
  • When a subsidiary, section or division of the company is subject to a profit sharing agreement, this may affect the preference for different accounting methods.

Most common transactions

Analysts and researchers have compiled the most common transactions that can be found recorded in the company’s books managed with the criteria of creative accounting.

Some of these transactions are:

  • Increase or reduction of expenses: The accounting regulations provide a margin of maneuver in relation to the quantification in a certain period of certain expenses or income, such as amortizations, depreciation or the activation of certain expenses, such as research and development expenses.
  • Income increase or decrease: In some cases, the recognition of income may be delayed, by virtue of principles such as prudence or the correlation of income and expenses.
  • Increase or decrease in assets: Inventories can be valued according to various methods (FIFO, LIFO Weighted Average, among others) so that the total amount may differ with the corresponding effects on cost of sales and profit. These modifications will affect the relationship between current assets and short-term liabilities, directly influencing the liquidity index.
  • Increase or reduction of reversals: Changes in income or expenses, as stated above, affect profits or losses and therefore reserves. In this way, the ratio of debt to equity is altered with the corresponding effects on indicators such as debt or financial leverage.
  • Increase or reduction of debts: In relation to certain items, accounting regulations allow the choice between various possibilities. For example, in Europe for pension funds there is the possibility of regularizing the existing debt in a period that varies, for most companies between 7 and 15 years. Therefore, if a company is interested in increasing its profit, for example, it will delay as much as it is allowed the total regularization of the existing debt for pension plans. This practice also modifies the analysis of financial indebtedness indices, financial independence or liquidity.
  • Reclassification of assets or liabilities: In other cases, there may be a certain margin when determining whether a concept is included in one item or another. By way of example, the case of certain elements that can be accounted for in fixed assets or in inventory can be cited. This possibility may affect the relationships between the various items and, therefore, the indices that allow evaluating aspects such as liquidity, inventory turnover, working capital, among others.
  • Information included in the report, in the management report and in the audit report: There are sections or bodies in the reports and in the management report in which more or less information can be included. This may lead to changes in the opinion that follows from them. Regarding the audit report, in some cases the qualifications or opinions can be expressed in such a way that a certain interpretation of them is sought.
  • Presentation of information: Another possibility for creative accounting is provided by the criteria used for the presentation of information, which according to the makeup used can form an opinion contrary to reality or according to the interests of the company.

Techniques and Methods

There are various techniques for the application of creative accounting, it is the same situation that occurs if you want to pay few taxes within the law. Therefore, a company that wishes to modify its results will search the accounting regulations for those parts that are not regulated, have an alternative treatment or are subjects in which one can be optimistic or pessimistic when making future forecasts. Makeups are also performed when valuing inventories and how to reflect provisions; in the way of accounting for debts, exchange differences, off-balance sheet operations, obligations or contingencies.

Other companies opt for creative accounting in consolidation processes; in the reclassification of assets and liabilities and when evaluating profits and losses, including expenses charged to reserves or in estimating income and expenses, among others.

Lastly, the makeup of the figures is also used when preparing the reports of the annual reports of the companies, the management reports and the audit reports. In those countries in which scandals have occurred due to the practice of creative accounting, they have exposed the most widely used techniques of creative accounting.

The following is a summary of these techniques:

  • Sometimes the existing regulations allow you to choose between different accounting methods for recording accounting transactions. For example, in some European countries, a company can choose between a policy of consolidating development costs at the same time they are incurred or amortizing them over the life of the project in question. The company may choose the accounting policy that projects the preferred image.
  • Some accounting records involve a large number of estimates, opinions, and predictions. In certain cases, such as estimating the useful life of fixed assets to calculate their depreciation, it is normal for these estimates to be made internally in the company and the creative accountant has the opportunity or possibility of being more or less cautious or optimistic in the estimate.
  • You can record artificial transactions, both to manipulate the amounts in the balance sheets, and to shift profits between accounting years. This is accomplished by recording two or more transactions related to a third party, usually a bank. It is assumed that the sale of an asset to a bank is arranged and then it is contracted on a lease basisfor the rest of its useful life (operation known as lease-back). The sale price of this operation can be above or below the current value of the asset, because the difference can be offset by higher or lower leasing installments.
  • In some cases, the accounting criteria may change from one year to the next. The principle of uniformity or consistency establishes that the accounting criteria for accounting from one year to another cannot be modified, except in exceptional cases that were identified and justified in the accounting report or report.
  • “Clog the channels” of finished product or raw material. In other words, persuade the client to accept the product even if they do not need it and store it. In this way, even if the sale is made on credit and the seller agrees to finance redundant inventories, profits are inflated. A variant of this practice is to rent warehouses to store the product purchased by companies that are fictitious subsidiaries.
  • Sell ​​assets and not report them as extraordinary income but take them to operating income. With this practice, in addition, the impression is given that the administrative cost of the company is reduced with what seems to increase its efficiency.
  • Increase profits with capital gains registered by the workers’ pension funds of companies, administered by them.
  • Inventing subsidiaries (“entities with specific purposes”) to hide debt and generate unrealistic profits.
  • Make exchanges of raw materials or finished products of similar characteristics with competing companies, immediately bringing profits to the product of what has been sold and amortizing what has been acquired in much longer terms.

It is obvious that all this disorder has revealed flaws in the regulatory and supervisory fields that supposedly prevent bad practices and has caused all kinds of recommendations by government agencies to further bureaucratize it, instead of making it more agile and efficient. .

Keys to detect practice

There are several ways to easily detect this type of makeup, as long as they are legal. For this, it will be necessary to have the annual accounts of four or five years; observe if there are extraordinary results and those of previous exercises to know if they have been made up; Analyze the audit report, in order to see if there are changes in accounting criteria or qualifications and if the auditor has reported it, as well as its influence on the final result.

In the same way, it will be necessary to review the depreciation periods of fixed assets and compare it with other companies in the sector to discover if they depreciate in the same periods and if they adopt aggressive or conservative policies. It is also necessary to read the Annual Reports issued by senior management and see the valuation standards used, verify the movements of reserves; whether there have been special treatments or authorizations and the provisions that exist.

Analyzing the key moments in the company, such as an exit from the Stock Market, the possibility of being sold, the change of auditor or in the top management, can also be decisive when it comes to detecting this kind of makeup. These types of practices are considered legitimate, but it is a fraud of law, as the law is used to deceive users. It is legitimate since the standards are used to prepare the accounting, but the data is manipulated in order to achieve the desired results.

Some companies use different types of accounting according to the economic periods in which they are. That is, if the economy is in a boom and bust phase, companies tend to be conservative and more concerned with auditing. As the situation begins to worsen, less conservative accounting is chosen and when low-quality profits are reached, the company is inclined to vary some accounting criteria.

Ways to decrease or moderate practice

There are many proposals to decrease the practice of creative accounting, among these proposals are the following:

  • The range of choice of accounting methods can be narrowed by decreasing the permitted accounting principles or specifying circumstances in which each will apply. Demanding consistency in the use of them also helps since a company that chooses a method so that it achieves the desired image that year, must use the same method in future circumstances where the result may be less favorable or perhaps the least desired.
  • The abuse of the possibility that managers use their opinions can be controlled in two ways. One is by designing standards that minimize the use of opinions, and the other would be one in which auditors play a role in identifying dishonest estimates.
  • Artificial transactions can be treated by invoking the concept that the substance is above the form, where the economic substance and not the legal form of the transactions, which determines their accounting. Therefore linked transactions will be accounted for as a set.
  • The timing of extraordinary transactions is a matter reserved for management, however, the extent of their use can be limited by requiring regular evaluations of account items so that gains or losses from changes in value are identified in the accounts each year, at the time they occur, rather than appearing only at the end of the year the asset in question is disposed of.

It has been seen that creative accounting is perceived as a characteristic of the accounting approach, very flexible and with room for different opinions, rather than in the continental European way, traditionally much more rigid, with very detailed rules.

 

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