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.

The profession, in turn, was not kind to Dr. Briloff but 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 Enrons 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 Enrons tax payments; To inflate Enrons income and profits; To inflate Enrons 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 Enrons financial condition in public reports.

Accounting Frauds

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

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.

Assignment
Submitted to: Mr. Jamil Submitted by: Irfan Ghafoor Roll No 810-MBA-11 Title: Accounting Frauds

Management Studies Department GC University of Lahore