Not fair, but creative accounting’s arrived

Investment decisions are based on an analysis of the financial statements and working results of the corporates. So long as the financial statements depict a “true and fair” picture, the investment decision is justified.

However, of late, there have been a lot of discussions about the financial statements depicting a less “true and fair” picture because of creative accounting techniques.

Much has been discussed about the Satyam accounting fraud magically producing non-existent bank deposits. It was pure creative accounting at work. Many such camouflaged accounting instances have gone undetected, to the investor’s peril. Satyam was not the first and will not be the last instance of unethical accounting practices being used. This leads to a question: What is this “creative accounting”? Is it legal and ethical?

Creative accounting is best described as “following the accounting standards but deviating from what those standards intend to accomplish,” falsely portraying a better image of the company through the financial statements, which are indicators of the way the business is progressing. Loopholes in accounting standards have led to some “creative” accounting practices, resulting in a less “true and fair” picture. Such “creativity” has caused the downfall of many companies and losses to investors and creditors. Is corporate governance on the wane?

Adoption of such techniques basically stems from the tendency of the corporates to maximise the benefits for themselves and the increased temptations among corporate managers to monetise their performance through hefty bonuses and incentives. Within the ambits of accounting standards, the creativity can be legal. Based on the purpose, the ethical nature is to be determined. It is a double-edged sword—it may be used or abused by corporates. If abused, it is the corporate that must be blamed and not the “creative accounting” technique itself.

What prompts the creativity? The competitive environment and the pressure to show good and improving financial results, declare a lower dividend, stabilise profit, and be on par with the best in the segment vis-à-vis the earnings benchmarks.

It could also be used to even out an exceptionally good year and a bad year and show a bad year as a normal year. Following are some of the techniques used in creative accounting:

Recognising revenue for a legitimate sale earlier than the acceptable accounting norm and accounting for fictitious revenue for a non-existent sale

Income in a bad year is made to look even worse by writing off as many costs as possible in the current period so that future performance looks better

Overprovisioning for accrued expenses when profits are high, with the twin goals of (a) reducing profits to a safe, maintainable level; and (b) stashing profits

Expenses capitalisation and extended amortisation resulting in inflated profits, manipulating the quantity or the value of the inventory. A classic example is expensing something that needs to be capitalised or vice versa. This will have a bearing on the profits or revenue, providing for the likely bad debts based on “judgements” suiting the demand.

The list of illustrative techniques also includes increased provisions to reduce profits or decreased provisions to increase profits, (corporates having credit sales are more comfortably placed to do this). Corporates tend to show cash inflows from financing or investing activities under operational activities to mask the negative flow under “operational activity”.

The creative accounting practices mislead and induce investors as well as creditors to continue their association with the company when, in fact, it is time to exit.

They can be discouraged through various preventive measures: increasing autonomy for internal auditors; establishing a better corporate governance environment; making reinforcement interventions to managers on the code of ethics; adopting forensic accounting as a preventive tool rather than a post-mortem mechanism; and adopting laws to minimise the leeway on judgements.

It is accepted that the practice of “creative accounting” in the corporate world has taken hold. Its elimination can only be desired, not ensured. However, efforts should be made to minimise the negative effects by giving importance to ethical considerations and decreasing the flexibility of the managers in deciding among different accounting methods.

(The writer is a former banker and currently teaches at the Manipal Academy of Banking, Financial Services, and Insurance, Bengaluru.)