Creative Accounting

Introduction
In the accounting world, the general rule is that accounts should give a true and fair
view. Under local and international law, a professionally qualified accountant has a
responsibility to comply, a corporation has a legal responsibility to comply, auditors have a
legal responsibility to give some sort of opinion on compliance; yet frequently this all goes
out of the window. Occasionally accountants and businesses are motivated to produce
accounts that do not show a true and fair view. Not only this, but auditors rely on sampling
and somehow fail to spot there is a problem.

Definition:

Creative accounting, also called aggressive accounting, is the manipulation of

financial numbers, usually within the letter of the law and accounting standards, but very
much against their spirit and certainly not providing the “true and fair” view of a company
that accounts are supposed to. Creative accounting often fools auditors and regulators, e.g.
Enron, WorldCom, and the recent Madoff case.

Aim and Scope

A typical aim of creative accounting will be to inflate profit figures. A typical creative
accounting incident involves both human effort and a bias towards some objective. Most
typically the objective is increased profits, inflated asset values, understated liabilities, and
overstated shareholder value. The motivation of management and accountants typically being
bonuses, promotion, salary rises, etc. Some companies may also reduce reported profits in
good years to smooth results. Assets and liabilities may also be manipulated, either to remain
within limits such as debt covenants, or to hide problems. Typical creative accounting tricks
include off balance sheet financing, over-optimistic revenue recognition and the use of
exaggerated non-recurring items.

Takeovers and acquisitions also create opportunities for creative accounting. In the
year of the takeover, the new management and accountant have a bias to show a dismal
picture — low profits, deflated asset values, inflated provisions, and perhaps an impacted
stock value (as a result of the poor results if they are made public). Then in the years
proceedings the takeover, the assets can be re-inflated, provisions released, all contributing to
increased profits and a perception that the new management is doing a great job.

The above technique may also be used before a management buy-out. This helps the
new buyers negotiate a lower purchase price, and increases their return after the buy-out. The
most effective examples of creative accounting are the ones that tell a portion of the truth, but
downplay any elements that could alter the perception that the company wishes to convey to
others. For example, a company may play up the fact that it recently experienced significantly
increased sales during the last quarter. At the same time, little is said about the fact that
expenses increased in proportion to that jump in sales, effectively offsetting that extra sales
volume. If those who hear about the increase in sales do not probe a little deeper, the
perception is likely to be that the company is now financially stronger, when in fact the
business has achieved little to no growth at all.

Creative accounting may help maintain or boost the share price both by reducing the
apparent levels of borrowing, so making the company appear subject to less risk, and by
creating the appearance of a good profit trend. This helps the company to raise capital from
new share issues, offer their own shares in takeover bids, and resist takeover by other
companies. If the directors engage in 'insider dealing' in their company's shares they can use
creative accounting to delay the release of information for the market, thereby enhancing
their opportunity to benefit from inside knowledge.

Traces of Creative Accounting

There are few signs of Potential Creative Accounting Practices :-
1. Overly Aggressive Performance Targets: The company ups the ante by continually setting
revenue and earnings growth targets that are far ahead of its competitors'.
2. Overly Aggressive Management: The company's corporate leaders are known to be hard-
driving types who have a flair for self-promotion.
3. Big Upward Change in Accounts Receivable: This could be a sign a company is trying to
pad revenue; look for more explanation.
4. Big Downward Change in Reserve Account: It could be the product of overly optimistic
assumptions about things like collection of unpaid debts.
5. Big Upward Change in Inventory Account: A favorite accounting gimmick is to overvalue
inventory or create nonexistent inventory.
6. Changes in Accounting Policies: Companies should provide detailed explanations for any
changes in accounting treatments.
7. Frequent One-Time Charges: These could be a sign the company is trying to disguise some
recurring charges as nonrecurring items.
8. Frequent Related-Party Transactions: These could be a sign of potential conflicts of
interest if they involve loans or other transactions with corporate officers.
9. Premature Revenue Recognition: Booking sales before goods are actually sold, or by
immediately booking all the proceeds of a long-term contract.

WorldCom Case Study

At its peak in 1999 the telecommunications giant, WorldCom, was valued at $180
billion. In 2002 the company was forced to file for bankruptcy due to the discovery of an $11
billion accounting fraud. To this date, WorldCom remains the largest bankruptcy ever
recorded.
Background:
It was founded in 1983 by Bernard Ebbers.Up until 2000, WorldCom was the
second largest long-distance telephone company, and the largest mover of internet
traffic in the United States. In no more than 15 years, WorldCom had evolved
aggressively into one of the leading players of the telecommunications industry. At its
height, WorldCom employed over 80 000 people and Bernard Ebbers laid claim to a
personal fortune of just over $1.4 billion.

Key Events:
By 2000 WorldCom was facing a consumer price war, the rise of mobile telephone usage
and a vast over-capacity of bandwidth coverage. Consumer demand for the provision of
internet services offered over broadband networks was dwindling and the long-distance
sector was characterized by falling rates and the rise of local competition.WorldCom had
made a fatal error: the company had neglected the importance of the mobile communications
market.

Ghost Profits

In June 2002 the WorldCom group admitted to overstating profits by

nearly $4 billion though the use illusory accounting practices. In order to improve the
appearance of the company’s financial situation, Scott Sullivan authorized the improper
recording of expenses as capital investments. Operating expenses are immediately deducted
from revenue, whilst capital investments are subject to depreciation over a number of years.
This incorrect spreading of operating costs resulted in the overstatement of WorldCom’s
profits.

Manipulation of Reserves:
Companies often set aside reserves in order to cover foreseeable estimated costs and
losses.WorldCom allegedly inflated the value of its reserves so as to create a hefty ‘slush
fund’ that could be used to boost profits. The manipulation of reserves resulted in a profit
irregularity ofroughly $3.3 billion At the time of WorldCom’s disastrous announcement in
June 2002,Bernard Ebbers had more than $400 million in personal loans outstanding from the
company. Arthur Anderson, the same auditors of Enron, claimed that Scott Sullivan withheld
information during crucial audits. Arthur Anderson was replaced by KPMG in June 2002.
Subsequent investigation has brought the total losses resulting due fraudulent behaviour by
WorldCom executives to $11 billion.

Consequences:
Shortly after WorldCom’s announcement the SEC filed a civil lawsuit against the
company, charging it with fraud. In July 2002 WorldCom filed for bankruptcy. The company
was forced to sell off most of its peripheral business units and cut 17 000 jobs. In 2003
WorldCom was forced to pay a $500 million penalty to the SEC. Scott Sullivan and David
Myers were charged with securities fraud and conspiracy. In 2004, Sullivan agreed to plead
guilty to three counts of securities fraud and turned prosecution star witness in an attempt
toimplicate the extent of Bernard Ebbers’ knowledge and involvement in the scandal. In 2005
Sullivan was sentenced to 5 years in prison. Other former WorldCom employees who agreed
to cooperate with investigators were sentenced in August 2005.

Both, David Myers and Buford Yates were sentenced to 1 year in prison. Betty Vinson
was sentenced to 5 months in prison. Troy Normand was given 3 years probation. Bernard
Ebbers was found guilty on nine counts of fraud. In July 2005 he was sentenced to 25 years
in prison. The former WorldCom chief executive agreed to forfeit up to $40 million. Many of
his assets are still to be transferred in to an account set up for WorldCom shareholders. These
funds are to be used in settlement of a class action lawsuit. After the scandal WorldCom
changed its name to MCI Telecommunications Corporation.

Analysis:
At any time, WorldCom could have began to change their business practices and
attempted to right their wrongs, but that may not have resulted any differently than it did
when prior transactions were discovered by Cynthia Cooper. A plan to correct fraudulent
practices, whether done with intentional harm or as survival techniques, should include
restitution to those who were inadvertently negatively affected. Based on the final bankruptcy
report by Thornburgh (2004), the organization faced potential claims of enormous magnitude,
some of which may be substantiated and others not. The best practice for correcting such
activity is to never have strayed so far from common ethical practices in the beginning. Hind
sight is 20/20 but it is foreseeable that long before the thought of filing bankruptcy, when the
vision of decision making was merely a bit cloudy, a good framework for ethical decision
making would have changed the course of the organization, although maybe not the fate of
Bernie Ebbers. Current news of the restructured WorldCom organization is that they are a
washed-up has-been, with their once, CEO in prison serving a twenty-five year sentence at
the age of sixtythree. WorldCom was hibernating from the media after the 2002 scandal but
they still remained active. Some internet surfing led to Verizon while additional searching led
to MCI connections. The most profitable of searches led to an article by Molly Ivans (2003)
that detailed WorldCom’s involvement with contracting to develop technologies in Iraq in
2003 and their upheld contracts with the government as the primary contractors. The contract
for building a wireless phone network in Iraq was given to them without requiring them to
bid on it, which angered competitors such as AT&T and Sprint. There is a possibility that old
habits of unethical practices continued for WorldCom and as it is commonly said, “Old habits
are hard to break”.
References and Bibliography

1. http://www.creativeaccounting.net/
2. http://moneyterms.co.uk/creative-accounting/
3. http://www.irmsa.org.za/library/WorldCom.pdf- case study
4. http://www.sampledisplay11.com/