Feeling creative?

After previous recessions, many businesses used creative accounting to
improve their stated financial position. Today, companies may be tempted to do
the same, believing that it will help them to obtain credit from suppliers,
reassure customers, attract investors or support the share price. Yet after a
string of scandals, “creative accounting” is a highly pejorative term that few
companies want linked to their corporate brand. Moreover, it may not even be
useful in the short or long-term.

Few examples of creative accounting are actually criminal, like Enron.
Generally, companies follow the relevant accounting rules, but deviate from them
in principle and spirit. In part, this reflects the limitations of accounting
standards. UK GAAP minimised creative accounting, but listed companies must
comply with international accounting standards, which introduced grey areas that
may be exploited.

The Enron effect
Enron led to a tightening of revenue recognition rules under US GAAP, with
specific guidance for software and telecoms companies where bundling can result
in aggressive practices. For example, a telecoms customer may sign a two year
contract that includes free calls and a free handset.

The company may decide to book a proportion of revenues up front rather than
across the term of the contract and attribute income to the sale of the “free”
handset. In 2007, Dell was forced to restate its accounts for the previous four
years partly because of the auditor’s concerns over aggressive revenue
recognition. By comparison, Cisco is cautious in reporting revenues, so
investors tend to hold it in high regard. The IAS on revenue recognition will be
revised by 2012.

Arguably, we did not learn the full lesson of Enron and there was a
subsequent failure in the IAS regarding non-consolidation of entities, as
evidenced by the off balance sheet investment vehicles employed by banks and
financial institutions in the past decade.

Still in use
Depreciation can be used to inflate profits simply by increasing the useful life
of an asset and spreading the charge over a longer period of time, but some
cases have attracted criticism. For example, BAA depreciates its premises over
20 to 100 years; it is likely the high capital cost of building new terminals
would completely wipe out the company’s profits otherwise.

Yet under Ferrovial’s ownership the depreciation on London Heathrow Terminals
One and Two has been accelerated, as it became clear the depreciation period
would outlast the terminals’ useful life and demolition. The relevant IAS allows
companies to review and extend depreciation periods if adequate reason is given
and the company’s auditors are willing to sign it off, as was the case with BAA.

Fair value is another accounting treatment that can be used creatively. It
has not received the same criticism as revenue recognition or non-consolidation.
The IAS on fair value is less prescriptive so its application can vary from
company to company. Some banks and financial institutions are booking a
contribution to profits by fair valuing their own borrowings. For example, one
major bank used fair value to book gains on its own borrowings of more than
£1.5m in 2008. However, in the long term this debt is likely to be redeemed at
its original level, at which point the institution will have to book a
corresponding loss.

Accounting for pensions also receives less media attention, but is
increasingly important as more schemes are in deficit. It is a complex area,
filled with jargon that is poorly understood beyond specialists in the field.
Under IAS 19, an organisation’s full pension deficit may be shown on the balance
sheet, offering stakeholders an accurate picture of the company’s liabilities.
Alternatively, the company can adopt the “corridor” method, where actuarial
losses on the pension scheme can be recognised over time, lessening the immedia
te impact.

Companies can also benefit from a one-off boost to profits by changing the
way they value their inventories. Under IAS, if stock is in the right location
then it is deemed to be more valuable. Therefore, transport costs may be added
to the value of stock rather than treated as an expense. However, the company
will then need to use the same valuation method going forward and will report
lower margins when it sells the stock to customers in the future. Yet this may
not be visible to analysts or investors, particularly if the stock is sold on
over a long period of time. As with many other grey areas in IAS, there is
discussion about restricting this provision in future.

The drawbacks
There are three main disadvantages to creative accounting. First, rating
agencies and company analysts are recovering from two major market shocks in the
past decade ­ the dotcom bubble and the credit crunch. They have been stung by
criticism for not scrutinising corporate results. From now, on the underlying
figures will be examined even more closely. If creative accounting techniques
are used, the inherent weaknesses in the company’s position will be highlighted,
not camouflaged.

Second, many of the most popular tricks have been used over a long period of
time and rating agencies, analysts and investors are well-versed in spotting
them. Contrary to the objective, employing such techniques may have a negative
impact on the company’s reputation. Market sentiment is likely to favour those
that are more conservative in their reporting.

Finally, if a company uses creative accounting to recognise profits earlier
than would otherwise be the case, the time will come to balance the books. The
company may need to book corresponding losses just as the economy recovers.

Pat Eckersall is training consultant at CTG, a division of the ILX Group

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