1. Creative Accounting
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.
In the accounting world, the general rule is that accounts should give a true and fair view.
Under local and international law, a professionally qualified accountant has a responsibility to
comply, a corporation has a legal responsibility to comply, auditors have a legal responsibility to
give some sort of opinion on compliance; yet frequently this all goes out of the window.
Occasionally accountants and businesses are motivated to produce accounts that do not show a
true and fair view. Not only this, but auditors rely on sampling and somehow fail to spot there is
a problem.
Creative accounting is the practice of producing financial accounts that suit a particular purpose
but do not really show the true and fair view. Sometimes the accountant may wish to show
favorable profits (e.g. to get a bonus) at other times losses (e.g. to pay less tax). Sometimes the
accountant may wish to show a healthy balance sheet (e.g. to get a bank loan), at other times an
unhealthy balance sheet (e.g. before a management buy-out to get a bargain).
Creative accounting often fools auditors and regulators, e.g. Enron, WorldCom, and the recent
Madoff case.
Creative accounting is euphemisms referring to accounting practices that may follow the letter
of the rules of standard accounting practices, but certainly deviate from the spirit of those rules.
They are characterized by excessive complication and the use of novel ways of characterizing
income, assets, or liabilities and the intent to influence readers towards the interpretations desired
by the authors. The terms "innovative" or "aggressive" are also sometimes used.
The term as generally understood refers to systematic misrepresentation of the
true income and assets of corporations or other organizations. "Creative accounting" is at the root
of a number of accounting scandals, and many proposals for accounting reform - usually
centering on an updated analysis of capital and factors of production that would correctly reflect
how value is added.
Newspaper and television journalists have hypothesized that the stock market downturn of
2002 was precipitated by reports of accounting irregularities at Enron, Worldcom, and other
firms in the United States.
One commonly accepted incentive for the systemic over-reporting of corporate income which
came to light in 2002 was the granting of stock options as part of executive compensation
packages. Since stock prices reflect earning reports, stock options could be most profitably
exercised when income is exaggerated, and the stock can be sold at an inflated profit.
The most notable activist is Abraham Briloff (professor emeritus of CUNY Baruch) who for
years wrote a column for Barron's that constantly analyzed breaches of ethics and audit
professionalism among CPA firms. His most famous book is called Unaccountable Accounting.
2. The profession, in turn, was not kind to Dr. Briloffbut much of what he advocated has been
forced on the industry in the wake of the Enron scandal
Enron Fraud
Enron was a Houston-based natural gas pipeline company formed by merger in 1985.
By early 2001, Enron had morphed into the 7th largest U.S. Company, and the largest
U.S. buyer/seller of natural gas and electricity.
Enron was heavily involved in energy brokering, electronic energy trading, global
commodity and options trading, etc.
Enron, the 7th largest U.S. Company in 2001, filed for bankruptcy in December 2001.
Enron investors and retirees were left with worthless stock.
Enron was charged with securities fraud (fraudulent manipulation of publicly reported
financial results, lying to SEC,…)
On October 16, 2001, in the first major public sign of trouble, Enron announces a huge
third-quarter loss of $618 million.
On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry
into Enron’s accounting practices.
On December 2, 2001, Enron files for bankruptcy.
Findings
Enron used complex dubious energy trading schemes
Took advantage of a loophole in the market rules governing energy trading in California
Enron would schedule electric power transmission on a congested line from bus A to bus
B in the opposite direction to demand, thus enabling them to collect a “congestion
reduction” fee for seemingly relieving congestion on this line.
Enron would then schedule the routing of this energy all the way back to bus A so that no
energy was actually bought or sold by Enron in net terms. It was purely a routing scheme.
To reduce Enron’s tax payments;
To inflate Enron’s income and profits;
To inflate Enron’s stock price and credit rating;
To hide losses in off-balance-sheet subsidiaries;
To engineer off-balance-sheet schemes to funnel money to themselves, friends, and
family;
To fraudulently misrepresent Enron’s financial condition in public reports.
Accounting Frauds
3. Accrual accounting provides many opportunities for unscrupulous managers or employees to
commit fraud. Here are some of the more common accounting frauds.
Accounts Receivable
The accounts receivable number that shows up in the asset section of a balancer sheet is almost
always an estimate of what accounts are actually collectable. Why is the number an estimate?
Because even if management can identify the precise amount its customers or clients owe the
business, usually it is less than certain that this is the actual number that will ultimately be
collected.
Sometimes the valuation of accounts receivable goes beyond simply making a good faith
estimate of collectability. In some situations management may be tempted to commit outright
fraud. Because no cash is collected when sales are made “on account”, a corrupt management
can record fraudulent additional sales by simply creating fictitious customers and recording
fictitious sales.
Another time honored-means of inflating accounts receivable and sales revenue involves
“keeping the books open” at the end of the accounting period. In this case the customers and
sales are real, but January sales are recorded as December sales so the end of year financial
statements include inflated assets and revenue.
Part of the audit function is to test the existence and collectability of accounts receivable and this
can serve as a brake on such fraudulent practices. In the audit of large companies with millions
of dollars of receivables and hundreds of thousands of individual accounts, the audit process
relies on statistical sampling, which usually provides a reasonable, but not exact, estimate of
collectable accounts.
Accounts Payable
Management may have a motive to understate payables, as this understates expenses and
overstates net income. Usually the amount of payable understatement is not too great and such
understatement can easily be detected.
Deferred Revenue and Prepaid Expenses
A manager can overstate income and understate liabilities by treating deferred revenue as earned
revenue. Essentially, this shady practice seeks to recognize revenue before it is actually earned.
Such mischief often is not easy to detect, because it is not always clear when the earnings
process is fully complete.
A manager also can understate current year expenses by claiming they are prepaid expenses.
This amounts to a fraudulent claim that payments for a certain service benefit future accounting
periods when, in fact they do not. Recently a large telecommunications company incurred
significant cash expenses on maintenance of its utility lines. It fraudulently classified most of the
4. outlays as prepaid expense, rather than current period expense. Since prepaid expenses are
recorded as an asset rather than an expense, expenses were understated; hence, profits were
overstated.
Fixed Assets
Because GAAP allows so many different methods of depreciation and the useful life of assets is
subject to varying estimates, there is plenty of opportunity for management mischief.
Management can make a firm appear more profitable than it really is by understating
depreciation expense.
Depreciation expense can be understated by overstating the useful life of assets. Management
can also overstate its assets by keeping obsolete and no longer used assets on its balance sheet.
Maintaining obsolete assets on the balance sheet also overstates net income because losses on the
disposal of these assets are not recorded.
Inventory
Inventory offers a big opportunity for management to air brush their financial statements. If they
want gross profits and, hence, operating profits to appear higher, the value of ending inventory
simply needs to be overstated. There are many ways this can be done.
The ending inventory value can be fudged upward by overstating the amount of inventory on
hand. Unit costs assigned to ending inventory can be inflated as well. Or obsolete or damaged
inventory can be included in the ending inventory count.
Sometimes for income tax purposes, management may want to show lower gross and operating
profits. Ending inventory mis-measurement can be used for this purpose as well. In this situation,
management seeks to undercount and undervalue ending inventory.
5. Assignment
Submitted to:
Mr. Jamil
Submitted by:
IrfanGhafoor
Roll No 810-MBA-11
Title:
Accounting Frauds
Management Studies Department
GC University of Lahore
