Reasons for Creative Accounting
Creative accounting is an accounting practice where those preparing the accounts follow the required rules and regulations but do not achieve what those rules and regulations intend to accomplish (Jones, 2011). It utilizes the loopholes in the general accounting standards to portray a better image of the institution by applying particular methods that make the financial statements look better. Creative accounting is legal though the loopholes exploited are filled to discourage the use of this practice.
There’re numerous reasons why accountants will alter the different items in an institution’s main statements. One of them is to increase the institution’s net worth. This is meant to make the company look attractive to potential and current investors and ensure that they keep investing their funds there.
Employing creative accounting can lead to an increase in a company’s stock value in the short-run where management is having problems achieving this goal. Managers of a company are responsible to the shareholders of the company and therefore they have to ensure that they portray good figures in the financial statements in order to keep their jobs (C.Pefianco & Mercado, 2005).
Some entries in the financial statements need to be estimated, for example, an asset’s useful life in determining depreciation. In such situations, preparers of financial statements can be creative while making the estimate. Companies prefer to report a steady trend of growth in profit and therefore they will use creative accounting to even out the profit curve.
Mechanisms used in Creative Accounting
Timing genuine transactions with the aim of giving the desired impression in the accounts (Kutz, 2003): For instance, a business with an investment whose initial cost and expenses totaled to 1,000,000 can choose to sell the investment when its market value is 3,000,000 so as to increase the profit in the accounts.
For the purpose of revenue recognition before a sale is completed; companies can use this technique in the pursuit of increasing their earning through recognizing a sales transaction before product delivery, at a time during which the can still opt out of the deal resulting to a situation of lower than recognized revenue (Warren et al., 2008).
Reversal of actual expenses; the accountant can reverse already recorded amounts relating to various already incurred and paid expenses. The reversal moves the expenses to different accounting periods, different to those in which they had been incurred. This resulted in an overstatement of the company’s income during the actual period that the expenses were incurred (Kwok, 2005).
The accounting process includes dealing with numerous issues where one has to decide which among the competing approaches to presentation of financial statements to use to resolve the issues (Yadav, 2013). This flexibility in the accounting requirements has provided opportunities for creative accounting.
Sometimes the accounting rules allow a company the choice among different accounting methods. The depreciation method used has usually has an impact on the profit or loss during the useful economic life of an asset. If a company uses the reducing balance method as outlined in IAS 16, depreciation expense for the year is relatively lower compared to when the same company uses the straight-line method which is also outlined in IAS 16. Thus, a different method of depreciation has a different impact on the outcome of the profit for that period (Langendijk et al., 2003).
Revaluation of tangible assets as outlined in IAS 16 usually results in an increase in asset value. The depreciation expense resulting from the revalued asset also increases and reduces the accounting profit for that income period and the subsequent (Hightower, 2008). The change in value of asset revalued leads to an increase in the company’s equity. This technique can be used to improve a company’s gearing ratio.
IAS 2 regarding inventory also provides sufficient opportunities for creative accounting. This standard allows for estimation of inventory in special cases. The over estimation of stocks gives an illusion that a company has more assets than it actually has; this has an impact on the financial statement of the year and of the subsequent years.
The decrease or increase of provision for liabilities and charges as outlined in IAS 37 is an effective tool for leveling outcome. For instance, a company may establish provisions in those years where they want to reduce the profit figure. They can also reassume a provision in the income year they want to understate the profit. The alternative is also effective when the company wants to overstate its profits to impress investors.
Under constructive contracts, IAS 11 provides an option of choosing between the two methods of accounting for the contracts. If a company chooses to use completed contracts, the result will be recognized after completion of the contract and only impact the profit or loss in the income period when the construction is completed. However, if the company opts for the method where percentage of completion is used, the results will be staggered over time throughout the process of the contract thereby affecting the profit in those years.
Use of IAS Globally
The harmonization of accounting standards has made remarkable progress within a relatively short period. Use of standardized reporting standards has helped reduce the cost of information processing and auditing to capital market participants (Carmona & Trombetta, 2008). Countries where foreign trade is an important driver of the economy can be expected to adopt IFRS and this move is expected to increase their share of foreign capital and trade in their economy. Preparers, users and auditors of financial reports are expected to familiarize themselves one common set of international accounting standards as compared to the various local accounting standards.
Companies listed in the different financial markets globally are required to consolidate their accounts using regulations stated in the IAS. However, domestic laws implementing accounting derivatives will continue to apply to broader accounting issues such as the requirement to produce audited accounts.
Adoption of IAS is unlikely to be of interest or consequence in countries with among the poorest human development measures. Such countries experience infant mortality and adult illiteracy and the adherence of the accounting standards is not a priority.
The stage has now been reached where IFRS is becoming the primary generally accepted accounting principles (GAAP) for many of the world’s larger audit engagements, and increasingly, becoming business as usual for the network firms. IFRS considerations are now beginning to be embedded in the firms’ policies and methodologies (Mirza et al., 2011).
Introduction of the IAS has provided companies with new techniques of managing financial risk. The new accountancy rules look at the ways in which hedging global financial risks occurred under the old system and how it is adopted in the new rules (Hyman, 2006). IAS 32 sets out the requirements for the presentation of financial instruments and disclosure of information about them so as to enhance the market’s understanding of the instruments to a company’s financial position, performance and cash flow. IAS 39 on the other hand outlines the principles for recognizing and measuring financial instruments (Gupta, 2008).
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