Some companies tend to participate in so-called “creative accounting,” which primarily serves the purpose of altering their financial reports to achieve some objective. The practice can be considered unethical, but it is not necessarily fraudulent or illegal, and there are significant distinctions between the two. Notably, creative accounting interferes with the results of ratio analysis, which is among the most important tools for financial statement examinations. This essay will investigate various aspects of the practice and discuss the external and internal limitations of the instrument.
Substance over Form
Substance over form is an important principle that reduces the opportunities for creative accounting by demanding that information is represented faithfully. According to Aggestam-Pontoppidan and Andernack (2015), the idea requires that records represent the substance of any economic event, which may differ from its legal description. Such an approach introduces additional clarity to the document, helping the reader to avoid misleading records that constitute a significant part of creative accounting. Examples of the application of the principle in various areas are listed below:
- It is sometimes possible to alter an organization’s structure in a manner that would qualify the company for deferred tax benefits. However, the structure would be suboptimal, and no substantial changes would take place. The substance over form principle dismisses such attempts and denies tax relief despite such efforts.
- Preference shares can be represented as equity in legal documentation, as they are issued by the entity. However, they represent an obligation to redeem them or to pay dividends, making them a liability. The principle forces a correction of the misrepresentation, promoting the faithful interpretation and displaying the situation more accurately.
- A company may own inventory but lease it to another party, such as a distributor, in an arrangement known as a consignment. It is possible to recognize the relationship as a sale, but the goods can often be returned if they are not resold successfully. As such, substance over form requires that profits be recorded only in case of a third-party sale.
Creative and Fraudulent Accounting
Creative accounting and outright fraud are often conflated, and considerable disagreement exists on whether there is any difference between the two practices. Many of the techniques utilized in the former method are not legal, and the results of both are financial statements that mislead the reader and make him or she believe data that are not true. According to O’Regan (2015), both approaches are intentional and intended not to provide a true and fair view. However, there is a fundamental difference between the two. It lies in the methods that constitute each of the practices and their acceptability.
The techniques employed in misleading accounting are not intended to exist regardless of the variety. However, fraudulent accounting is necessarily beyond the boundaries of the law, while the creative type is permissible, if inadvisable. It exploits the weaknesses that are enabled by the incomplete nature of the existing documents. As loopholes in the legislation are discovered and eliminated, practices that were formerly legal but belonged to the realm of creative accounting may become illegal and fraudulent. However, they have to be found out first, and so it is essential to watch for cases of lawful abuse to learn about current weaknesses and propose potential improvements.
Motivating Factors
Creative accounting is usually related to underperformance or other difficulties that the company cannot handle. Bowers (2018) cites reasons such as meeting analyst expectations, bonus plan incentives, default prevention, or cover-ups of illegal activities. In the modern economy, the outward perception of the company’s performance can be significantly damaging if it is seen as underperforming, and some executives will choose to lie to maintain growth.
This tendency is particularly relevant for companies that can gain directly from a good performance or those the existence of which is endangered. Employees who have committed financial crimes would also be likely to attempt to conceal their activities with further deception to avoid responsibility and retain their positions, possibly to commit new fraud.
There have been numerous notable examples in recent history, which have led to the introduction of new laws as a response. Bowers (2018) notes the cases of Waste Management, Inc., Enron Corp, WorldCom, and others. The first one concerned several top-level executives who embezzled money and grew more affluent at the expense of shareholders while falsifying reports to make the mismatches disappear. Enron Corp. was under a heavy debt load and concealed the fact, reporting fictitious profits to secure more loans. WorldCom inflated its income statements, leading to a massive penalty and bankruptcy once the fraud was discovered. Ultimately, the cases were caused by the decision of the management to conceal undesirable information instead of accepting it and addressing the issues.
Ratio Analysis Limitations
Ratio analysis is a powerful instrument that allows one to estimate a company’s performance based on a variety of metrics. It enables the determination of profitability, efficiency, growth compared to past periods, and other values that are central to financial inspections. However, ratio analysis is also subject to a variety of limitations, both internal and external. The tool is invaluable within these boundaries, but they have to be taken into account during an inspection.
Internal factors are related to the nature of the document inspected and the weaknesses of the procedure itself. According to Tulsian and Tulsian (2016), they include a focus on quantitative factors, the historical nature of the insight, and the limited usefulness of the results. Ratio analysis does not provide original ideas and may be based on outdated and irrelevant information. It cannot pinpoint the solutions for concerns or determine their origins, though it can indicate their manifestations.
External influences are pertinent matters that did or did not go into the formation of the statement. Tulsian and Tulsian (2016) indicate them to be price-level changes, personal bias, the reality behind the accounts, and their accuracy. The state of the market and the success of competition are not factored into the analysis, and various accountants would produce different views of the same situation. Furthermore, inaccurate or invalid data renders the evaluation worthless as it does not represent the actual situation.
Conclusion
Substance over form is a central principle that tries to eliminate fraudulent manipulations of the law. Such activities would fall under creative accounting unless they broke the rules. The practice is often motivated by the need to conceal underperformance, the danger of bankruptcy, or criminal activity, as indicated by numerous recent high-profile cases that have led to new legislation being passed. Misrepresentation of data should be taken into account during ratio analysis, as it can be a significant limitation for the procedure along with other factors.
Reference List
Aggestam-Pontoppidan, C & Andernack, I 2015, Interpretation and application of IPSAS, John Wiley & Sons, New York.
Bowers, SL 2018, Accounting and corporate finance for lawyers, Wolters Kluwer, New York.
O’Regan, P 2015, Financial information analysis: the role of accounting information in modern society, Routledge, New York.
Tulsian, PC & Tulsian, B 2016, Financial management for CA-IPC (group-I): a self-study textbook, S. Chand Publishing, New Delhi.