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ACKNOWLEDGEMENTSA CKNOWLEDG
CERTIFI take this opportunity to express my deep sense of gratitude to all those who have contributed significantly by sharing their knowledge and experience in the completion of this project work. I am greatly obliged to, for providing me with the right kind of opportunity and facilities to complete this venture.
I am highly thankful to Dr. P.P. Ghosh my internal faculty guide under whose able guidance this project work was carried out. I thank him for his continuous support and mentoring during the tenure of the project. I also thank my college authorities and specially my Vice Principal Fr. Dominic Savio for giving me the opportunity to work on this project and for there constant support and encouragement. I would also like to thank my dear friend Vinay Sharma for his cooperation, advice and encouragement during the long and arduous task of carrying out the project and preparing this report.
I also extend my acknowledgement to my beloved Parents and all my Friends for their continuous encouragement at every moment. Last but not the least; I thank each and every individual who has rendered his/her assistance in the successful completion of this project.
Introduction
Creative accounting is also known as earning management and referring to accounting practices that follows the letter of rules of standard accounting practices but certainly deviate from the spirit of those rules. Creative accounting practices are different from fraudulent practices and thus are not illegal but immoral in terms of misguiding investors. The practices, which are followed in manipulating the books, are duly authorized by accounting system and thus can not be considered as violation of any rule or regulations. It is characterized by excessive compliance and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations of desired results. Earning Management or Creative accounting is result of judgments which is used by managers in financial reporting and in maintaining books to manipulate reports for either misleading investors or stakeholders or to influence economy to give positive response towards financial performance of the company. The usual practice followed under earning management is to increase or decrease earnings artificially through choices available in accounting system. Creative accounting is root cause of number of accounting scandals and many proposals for accounting reform are focusing on removing such practices. Financial statement is the result of the financial accounting process that accumulates, analyzes records, classifies, summarizes, verifies, reports, and interprets the financial data of a business firm, which reflect the financial position, performance and change in financial position of an enterprise (Elliott, 2005). However, in recent years, creative accounting is becoming increasing popular running through companies, which lead to considerable allegation about the practice of creative accounting. Companies are able to manipulate the financial statements through various types of creative accounting techniques. It attracts more and more attention in the whole financial market and its presence distorts the true and fair view of the financial position of companies, and may cause serious corporate failure.
The fact that these companies used creative accounting only became known because these companies had become insolvent or bankrupt and proceedings were going through the legal system. It can be argued that creative accounting is normally exposed if something in a company has gone wrong such as if the business is facing bankruptcy.
If such high profile companies engaged in creative accounting then the question that should be asked is why do companies or accountants use creative accounting? Some of the reasons why creative accounting is used are as follows: Creative accounting is used to overstate profits so that a business can appear to be more profitable than it actually is. Businesses can inflate profits by deliberately excluding expenses or understating expenses, overstating their revenues, or treating certain expenses as assets.To preserve or to create an impression to the users of accounting information or the outside world that they are a solvent business with a remote probability of financial distress.To achieve market expectations or budgetary targets. Usually failure to meet market expectations or budgetary targets is usually followed by a decline or collapse of the share price of the reporting entity. Companies then use creative accounting to avoid market anger being meted out to them.Some managers use creative accounting to ensure they meet targets that will allow them to receive performance bonuses. Managers may use window dressing such as to report more sales than they actually achieved or they can capitalise expenses to increase or meet profit and efficiency targets. Managers can also use creative accounting to conceal under-performing operations from users of accounting information.Businesses also use creative accounting to mislead their bank managers and lenders so that they are able obtain loans. Enron used creative accounting to mislead the markets about the companys poor financial state and proximity to bankruptcy to maintain the value of the share price and to maintain its relationship with financial stakeholders such as lenders, bankers, capital providers, and counter parties. Businesses involved in raising equity can also use creative accounting to underpin the share issue by inflating the financial performance.
WINDOW DRESSING
Window dressing is presenting company accounts in a manner which enhances the financial position of the company. It is a form of creative accounting involving the manipulation of figures to flatter the financial position of the business. It is also defined as: A form of accounting, which while complying with all the regulations, nevertheless, gives a biased impression of the companys performance. Though it is not illegal, it is considered by many financial pundits as unethical.
It redistributes income statement credits and charges among different time periods. The prime objective is to moderate income variability over the years by shifting income from good years to bad years. An example is reducing a Discretionary Cost (e.g., advertising expense, research and development expense) in the current year to improve current period earnings. In the next year, the discretionary cost will be increased.
E.g. Computer software with useful life of 3 years. As revenue expenditure it is treated as negative item on P&L account. As capitalizing expenditure, it is treated as an asset in balance sheet, with yearly depreciation in the P&L.
- Increasing expected life of asset reduces depreciation provision in P&L account, hence, increasing net profits. Also, net book value in balance sheet will be higher for a longer period, thereby, increasing firms asset value.
- Change in method of stock valuation policy (LIFO, FIFO or AVCO) can lead to increase in value of closing stock, boosting up the profits. For example, in a rising price scenario, usage of FIFO method helps in increasing closing stock inventory valuation, thereby reducing the COGS, and hence inflating the earnings. Similarly, in a falling price scenario, LIFO valuation method for inventory is more favourable.
- If intangible assets like goodwill are not depreciated the firm can maintain value of its assets giving a misleading view.
Sales show up in the P&L account when the order is received and not at the point of transfer of ownership rights as mentioned in the notes to accounts of the Co. under the heading of Revenue Realisation.Encouraging customers to place orders earlier than planned increases the sales revenue figure in P&L account. This brings
- Extraordinary items are revenues or costs that occur, but not as a result of normal business activity. These events are unusual and unlikely to be repeated They should be highlighted in accounts, and inserted after the calculation of Profit before Interest and Taxation. To include these in normal revenues will again exaggerate business profits.
1. Tata Motors transferred 24% stake in Tata Automotive Components (TACO), a company with revenue of $675 in FY07, to Tata Capital, a group company, and booked a profit of Rs 110 crore in Q1 FY09. Management declined to disclose the valuation methodology. Tata Motors also changed its methodology for calculating provisions for doubtful receivables, which resulted in higher reported Ebitda to the extent of Rs 50.7 crore (10% of Ebitda).
2. TCS, the software major, increased its depreciation policy on computers from two years to four years. As a result, Q1 FY09 PBT was higher by an estimated Rs 50 crore (4% of net profit in 1QFY09). TCS followed cash-flow hedge accounting and till FY08, it used to recognise hedging gains on effective hedges in its revenue line, thus boosting the reported revenue growth and Ebit margin. In FY08, TCS had Rs 421crore from hedging gains, of which, Rs 137 crore was included in the revenue line. However, from Q1 FY09, TCS is expected to report all forex losses/gains below the Ebit line in other income. Thus, the losses it had on its hedge position will no longer be booked in the operating line.
3. Jet Airways, changed its depreciation policy from WDV to SLM, and thereby wrote back Rs 920 crore into its P&L, which helped the company to report profits during the quarter. It also helped Jet to report a higher net worth, which will help in keeping reported gearing low..
4. Dr Reddys adjusted mark to market losses (Q1 FY08) on outstanding $250 million of hedges in the balance sheet, while P&L reflects forex gains realised.
5. Reliance Communications adjusted short-term quarterly fluctuations in foreign exchange rates related to liabilities and borrowings to the carrying cost of fixed assets. The company adjusted Rs 109 crore of realised and Rs 955 crore of unrealised forex losses in the above manner. In addition, the company has not recognised Rs 399 crore of translation losses on FCCBs, since the FCCBs can potentially get converted, although the FCCBs are out of money. Adjusted for all the above, the company would have virtually no profits in Q1 FY09.
- balance sheet financing does not reveal certain financial information. It is effective because off- balance sheet financing is not likely to be detected by independent users of company accounts. It is not a new practice but it has grown rapidly in recent years. This could be done via a partial subsidiary which the company controls. For example assets could be sold to 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 in health or profitability. In using this method, companies are able to show better debt ratio, borrow more money and still maintain the appropriate debt ratio required by lenders and put on a good face for investors. However, as off- balance sheet financing is a short term solution to a long term problem, inevitability the loan still has to be repaid and the company still has to obtain enough fund to pay off the hidden loan ( in the subsidiary ) to the ultimate lender, which in most cases, is outside the group.
EXAMPLE 2
Revenue Recognition
particularly for companies whose earnings are lumpy spreading over two or more accounting periods. For example, leasing firms may front load rental payments by charging installation fees or claiming up-front part of the eventual residual value of the asset leased.
recognizing a sale prior to the completion of that sale, before the product is delivered to the customer or at a time when the customer still has the option to terminate the deal resulting is a lower revenue being observed.
EXAMPLE 3
Smoothing Expenses inventory, paid directly from reserves or more blatantly under-provided. Capitalisation of interest can be justified by deciding that the cost of borrowing money is part of the overall cost of an asset. Though interest is normally taken from profits, many companies argue that the interest charge is a cost of capital. Consequently, the interest charges which are not included in the statement of financial performance, resurfaces as an increase to the fix assets in the statement of financial position. expensing adjustments which may involve a capitalization option are: the latter element may be capitalized
that work-in-progress and finished goods include a proportion of overheads and developmental cost.
EXAMPLE 4
Improper accounting mproper accounting for expenses as long term investments making the company looks more profitable. The executives may take ordinary operating expenses, such as wages paid to workers for maintaining telecom systems, and treat them as capital expense accounts. This allows the firm to spread their expenses out over several years rather than accounting for them all at once. -term investments are spread out and subtracted from earnings over the life of the asset whereas operating expenses are deducted from earnings immediately. In doing this the company artificially lowered their expenses and may increase their profits. Therefore the value of the firm is also artificially inflated.
The motivation to use Creative Accounting Various research studies have examined the issue of managerial motivation to use creative accounting. The following have been identified as significant factors: 1. Tax avoidance
especially when taxable income is measured through accounting numbers. If income can be understated or expenses overstated, then it may be possible to avoid tax.
period. Ideally, this would show a steady upward trajectory without nasty surprise for these shareholders, and so would help to avoid volatility in share price, and would make it easier to raise further capital via share issues.
and customers want long term survival of the company for their interests. Suppliers want assurance about the payment and long term relationships with the company. Company also wants to meat analysts forecasts and dividend payout pattern.
keep the share prices stable. Advocates of this approach favor it on account of measure against the 'short-termism' of evaluating an investment on the basis of the immediate yields. It also avoids raising expectations too high to be met by the management.
6. Personal gain uses are linked to profitability, there is a clear motivation for manager to ensure that profit hit the necessary threshold to trigger a bonus payment.
7. Following the pack ve accounting practices, they may feel obliged to do the same.
Besides, various opinions about the motivation to use creative accounting for example from Healy and Whalen [1999] summarize the major motivations to manage earnings which include
Public offerings, Regulation, Executive compensation, and financial liabilities. Schipper [1989] provides a conceptual framework for analyzing earnings management from an informational perspective.
Beneish [2001] added insider trading in this list of motives. Managers aware of misstatement of profits can benefit by trading the securities. Stolowy and Breton [2000] suggest three broad objectives for earnings management: minimization of political costs; minimization of the cost of
capital and maximization of managers wealth. Deangelo [1988] refers to earnings management in buyout cases. Teoh, Welch and Wong [1998] find that firms manage earnings prior to seasoned equity offers and IPOs.Burgstahler and Eames [1998] conclude that firms manage earnings to meet financial analysts forecasts.
The Satyam Computer Services scandal was publicly announced on 7 January 2009 when Chairman Ramalinga Raju confessed that Satyam s accounts had been falsified
Details On 7 January 2009 company Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India SEBI that Satyam s accounts had been falsified 1 2 3 Raju confessed that Satyam s balance sheet of 30 September 2008 contained inflated figures for cash and bank balances of 5 040 crore US 1 09 billion as against 5 361 crore US 1 16 billion crore reflected in the books an accrued interest of 376 crore US 81 59 million which was non existent an understated liability of 1 230 crore US 266 91 million on account of funds was arranged by himself an overstated debtors position of 490 crore US 106 33 million as against 2 651 crore US 575 27 million in the books
Aftermaths On 11 January 2009 the government nominated noted banker Deepak Parekh former NASSCOM chief Kiran Karnik and former SEBI member C Achuthan to Satyam s board Merrill Lynch now a part of Bank of America and State Farm Insurance terminated its engagement with the company Satyam s shares fell to 11 50 rupees on 10 January 2009 their lowest level since March 1998 compared to a high of 544 rupees in 2008 Chartered accountants regulator ICAI issued show cause notice to Satyam s auditor PricewaterhouseCoopers PwC on the accounts fudging The Crime Investigation Department CID team picked up Vadlamani Srinivas Satyam s then CFO for questioning
On 22 January 2009 CID told in court that the actual number of employees is only 40 000 and not 53 000 as reported earlier and that Mr Raju had been allegedly withdrawing INR 20 crore rupees every month for paying these 13 000 non existent employees
Root Cause Prof Sapovadia in his study shows that in spite of there being a strong corporate governance framework and strong legislation in India top management sometimes violates governance norms either to favour family members or because of jealousy among siblings He finds that there is a lack of regulatory supervision and inefficiency in prosecuting violators He investigates in detail the recent governance failure at India s 4th largest IT firm Satyam Computers Services Limited and considers possible reasons underlying such large failures of oversight
PricewaterhouseCoopers Reply On 14 January 2009 Price Waterhouse the Indian division of PricewaterhouseCoopers announced that its reliance on potentially false information provided by the management of Satyam may have rendered its audit reports inaccurate and unreliable 19
2. Tyco: chief executive officer charged with tax evasion, waste of corporate assets. Massive charge of $6 billion to earnings after disposal of CIT unit.
3. WorldCom: $3.8 billion fraud. Loans to chief executive officer and became bankruptcy.
7. Qwest Communications: chief executive officer resigned. Profits restated assets cut by 50%, or $34 billion. The share price down.
8. Health South: $1.4 billion fraud. Make false entries created in income statements and balance sheets. $110 billion merger of AOL and TimeWarner cemented with inflated accounting of AOL revenues. Within 18 months, company value declined 75%, and massive write-downs of asset values were taken AOLs 2002 earnings were written down by $98.7 billion (a figure only slightly smaller than the European Unions budget for 2003); civil litigation ensued for damages to investors.
9. Bristol-Myers: restates $2.5 billion in sales and $900 million in profits after inflating distributors stock levels. They settles antitrust lawsuits for a cost of $670 million.
10.Vivendi-Universal in France: failure of strategy, loss to shareholders, and class action suits filed alleging misrepresentation of companys financial realities.
11.HIH insurance group in Australia: failed with debts of $3.1 billion after consistently understating claims liabilities. The chief executive officer, among other things, spent A$ 340,000 on gold watches in 1 year. The criminal and civil charges pending against several directors.
CONCLUSION
To sum up the discussion on creative accounting practices, it is an unfortunate situation that we cannot completely restrict or stop the misuse or abuse of creative accounting practices. The improper use of such creative accounting practices had fooled both auditors and regulators in the past and it continues to do the same. The complex and diverse nature of the business transactions and the latitude available in the accounting standards and policies make it difficult to handle the issue of creative 101 accounting. It is not that creative accounting solutions are always wrong. It is the intent and the magnitude of the disclosure which determines its true nature and justification. In the current economic climate, there is tremendous pressure--and personal incentive for managers--to report sales growth and meet investors' revenue expectations. As a result, more companies have issued misleading financial reports, according to the SEC, especially involving game playing around earnings. But it's shareholders who suffer from aggressive accounting strategies; they don't get a true sense of the financial health of the company, and when problems come to light, the shares they're holding can plummet in value. How can investors and their representatives on corporate boards spot trouble before it blows up in their faces? According to the authors, they should keep their eyes peeled for common abuses in six areas: revenue measurement and recognition, provisions and reserves for uncertain future costs, asset valuation, derivatives, related party transactions, and information used for benchmarking performance. This article examines the hazards of each accounting minefield, using examples like Metallgesellschaft, Xerox, MicroStrategy, and Lernout & Hauspie. It also provides a set of questions to ask to determine where a company's accounting practices might be overly aggressive. These questions are the first line of defense against creative accounting. The authors argue that members of corporate boards need to be financially literate