Creative accountingBackground and baselineFinancial statements are bound by laws and accounting standards. To break these is anoffence and enforced as such. Judges enforce the letter of the law and where there are loopholes, the law may be changed.For judges the spirit of the law does not exist. However finance is too complicated to havea set of water-tight rules. For example an ASB working committee was meant to resolve howgoodwill should be handled and in 1995 they came up with 5 alternatives which did not evencover all eventualities. There is advisory recommended practice (such as the Cadbury guidelines) to resolve largergaps. The Cadbury report intends to extend best-of-practice, for example recommending thatdirectors report on the effectiveness of the company's internal controls i.e. taking theresponsibility actively and personally. However even following the law, the standards and the recommended practice, and even withthe results audited by external companies, the scope for creative accounting remains large. Why creative accounting?An annual review provides information on the financial position of a company. It is asnapshot of the company situation, as well as a history of change. However the message thereview gives is often taken to be about the future position of the company. In particularinvestors and the capital market will base their decisions on results to date and theprognosis for the future. The shareholder and market reaction is related more and more tomanagers' actions and directors are increasingly judged on profit, growth and EPS and havelarge bonuses at stake. So companies (and directors) want to use the report to present themessage they want investors to see, and at times this needs creative accounting. There may be one-off events which so distort the figures that the underlying health of thecompany is obscured. Accounting techniques may be used to produce more meaningful figuresand avoid unjustified market pessimism. In such caes the changes may be clearly indicatedin the notes to the accounts.. However more often than not creative accounting is used to:hide a particularly bad year for the company;force an exceptionally good year or continue the pressure to always be the best;smooth out results to give an impression of stability or sustained improvement;hide large profits by monopolies under anti-trust threat;boost assets to avoid take-over. Distortion in one year often increases the need to distort the next year. Typically the badyear continues (Argenti 1983) and the company gets more tied into misleading figures, oftenseeming to devote more time to presentation of figures rather than management of thecompany. Examples of creative accounting

What sort of things can be done as creative accounting?Acquisitions can hide poorer results (Watts) or boost EPS. A large provision can be takento cover reorganisation costs. These do not affect profitability but are taken against theassets of the company. Off-balance sheet financing. Items of the financial reports are omitted. This could bedone via a partial subsidiary which the company controls. For example assets could be soldto this subsidiary. This produces a profit in the balance sheet, but nothing has changed.It is simple a shuffling of debt/credit between companies producing no overall increase inhealth or profitability. Good-will and brand names. While brand names are a powerful marketing tool, companies thathave included them in their assets have done so to increase the value of the assets whenthey would otherwise have seemed poor. A further problem is the valuation of a brand namewhich can be arbitrary and is not independently verifiable. Capitalising R&D. The Austrian company MTM capitalised its R&D expenditure. Instead ofwriting it off as cost, it was added to assets in "know how". The approach is similar tothe way brand names can be handled. Depreciation. The British Airport Authority depreciate runways over 99 years. This meansin effect they ignore depreciation of the runways. However they are at least open andconsistent. Moving operating costs to reduced assets. Akzo Nobel had to renew the pipes in a majorchemical complex. This was simply to replace old equipment. Akzo Nobel did not record thisas an operating cost, but classified it as "environmental activity" and wrote it off againstassets. Something clearly a cost, and affecting the year's results, has been moved from thecash stream of the company. Creativity versus complicityCreative accounting affects the value of assets and liabilities, and also the allocation ofchanges to assets/liabilities or profit/loss. Infamous cases are not creative accounting but fraud. However a typical feature of creativeaccountancy is that it is to a greater or lesser extent hidden and is often result ofsustained poor performance. Engaging in creative accounting is then a possible first steptowards pushing at the boundaries of the law. And the danger is that respectable executiveslose sight of where the boundaries are, and end up like directors committing fraud (compareGriffiths 1992). Creative Accounting is increasing (Jones 1992) and will remain with us. As a personal rule of thumb: where the accounting is open and documented it is there to handle special situations. Where it is hidden or disguised, it is a case of a company hiding its true position. And given that the annual and half-yearly reviews are the only financial statements the shareholders receive, hiding the true position of a company is simply misleading the owners of the company and should be regarded