Question

Where appropriate please support your claims with data. How would we determine whether a company has used “creative accounting” in their financial statements?

Answer 1

Financial statements can show the fall in company's operations. Creative accounting is manipulating accounts to show a false image of their company.  In the example of Satyam scandal, fall in maket capitalisation was because of false accounts and income tax returns.

We can determine whether a company has used “creative accounting” in their financial statements by the following:

Auditors

Auditors analyse the financial statements of a company. If there are continuous change in auditors before the time period of 5 years is a dangerous sign. For example, Pricewaterhouse has resigned as an auditor of Vakrangee Ltd. because of lack of availability of proper financial books of jewellery business.

Financial statements include Income Statement, Balance Sheet and Cash flows. Manipulation can be detected in these accounts as follows:

• Income Statement - Revenue is the main account of income statement. Creating accounting can make the Income Statement look good by recording the revenue before taking delivery of goods, showing future expenses to the current accounting period etc.
  
• Balance Sheet - Provision for doubtful accounts - Investors only look at the net income and EPS for valuation. Provision of doubtful debts should be checked by comparing accounts receivable with revenue and net income.
  Inventory - Inventory are the goods that are manufactured but not sold. It can be determined whether inventory is overvalued or not by analysing if the inventory is increasing fast than the sales or it is increasing fast than the total assets.
  
• Cash flows - Managers can also try to manipulate cash flows by making them look good. Operating cash flow can be manipulated by misusing of non-operating cash. If the company adds income from other than normal business to the cash flow, then it gives impression that the receipts are from the standard operations whereas it is actually not. Companies can show the receipt of cash flows early and delay the showing of payment of cash flows to next period.
  

Determining whether a company has used “creative accounting” in their financial statements can be done by reading the financial statements properly and precisely.