Creative Accounting

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Chapter 13
Creative Accounting
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Creative Accounting
1. Introduction 2. Definition 3. Managerial
Motivation 4. Methods of Creative
Accounting 5. Example 6. Real-Life 7. Polly Peck
A Case Study 8. Creative Presentation 9. Controlli
ng Creative Accounting 10.Conclusion
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Introduction

• Hot topic from 1980s
• Judicious choice of accounting policies advantage
  preparers not users
• Simple and complex methods

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Definition

• Using the flexibility within accounting to
• manage the measurement and presentation
• of the accounts so that they serve the
• interests of preparers.

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Flexibility Within Accounting
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Managerial Motivation

• Managers may wish to
• Boost profits to benefit from
• Profit related pay
• Shares and share options
• Profit-smooth
• Manage gearing

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Methods of Creative Accounting I

• Managers can manipulate
• 1. Income
• 2. Stock
• 3. Depreciation
• 4. Interest payable
• 5. Goodwill
• 6. Brands

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Methods of Creative Accounting IIStock
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Methods of Creative Accounting IIIDepreciation

• Business Profit 10,000
• Fixed Assets 100,000
• Depreciation straight line 10 years
• If company adopts 20 year asset life will this
  affect profit?
• Yes
• Original
  policy New policy
• 
  
• Profit before depreciation 10,000 10,000
• Depreciation (10,000) (5,000)
• Profit after depreciation -
  5,000
• Profit increases by 5,000

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Example I
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Example 1 Notes

• Less conservative income recognition policy
  creates additional 10 sales.
• Closing stock can be valued, less prudently, at
  18.
• Depreciation is charged over 5 years. A few
  competitors use 10 years.
• 4. 10 of the interest payable is interest on
  borrowings to finance a new factory.

 
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Example ICreatively Transforming Creatos Profit
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Example I Notes

• (in 000)
• Boost sales by 10 and be less conservative.
• Closing stock at 18, this will reduce cost of
  sales, thus boosting gross profit.
• Double the life of fixed assets, we can halve the
  depreciation charge.
• Interest payable reduces by 10 because it was
  capitalised.
• 10 over 10 years
•  
• Hey presto! A loss of 5,000 into a profit of
  23,000.

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Real-Life
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Polly Peck A Case Study

• Polly Peck had spectacular growth
• 1989 results showed continued growth
• e.g., sales up 53, profit up 43
• Creative accounting contributed
• Brands capitalised
• Currency mismatching
• i.e., borrows Swiss francs (low interest paid)
  invests in Turkish dinar (high interest
  received).
• Profit increases by 12.5 net interest
• Capital losses of 45 million

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Creative Presentation

• Graphs may be used
• 1. Selectivity
• 2. Deliberately to exaggerate trends

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Controlling Creative Accounting

• Since 1990s regulators have striven to curb
  creative accounting
• Merchant banks develop creative compliance
  schemes
• Continual creative accounting arms race

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Conclusion

• Creative accounting alive and kicking
• Serves managerial not shareholder interests
• Numerous methods
• Regulators seek to curb creative accounting