Numbers are power, especially in business. They explain profits, loss, and how the company could grow. And what if most of the times these numbers lied? Creative accounting has come to the attention of researchers and continues to remain a hot topic due to major financial scandals where companies have used creative accounting techniques for various reasons.
Creative accounting is often seen as a manipulation of figures to show what management, the preparers of financial statements want them to show. Creative accounting is the boundary between the alternative approaches allowed by legislation and fraudulent financial reporting. Businesses take advantage of weak control and therefore, they can easily hide handling of financial statements.
On the other hand, the application of creative accounting may be desirable and tolerated under certain circumstances and it can save the business from failure. Hence, creative accounting seems to be something of a danger in Sri Lanka as corporate pressure mounts the need for an improved financial performance record. Although seeming harmless, actually, creative accounting distorts all financial information which erodes their confidence in all financial statements presented. Creative accounting is manipulating financial records by using loopholes in accounting rules to report an unrealistically more favourable financial position than in fact exists. Though this approach is technically legal, it is usually considered unethical since it intentionally misleadingly informs stakeholders. Financial statements should be transparent tools that reflect the reality of companies’ performances. When creative accounting tactics are applied, they cloud the truth and make companies appear healthier or more profitable.
Common techniques
In Sri Lanka, the most common technique of creative accounting is income smoothing. Companies manipulate their revenues and expenses to make the earnings appear smoother in a time series. A business may delay its revenue recognition until later periods or accelerate its expenses into the current period to make earnings less volatile.
This technique will give an illusion of stable growth to investors who want stability. Off-balance-sheet financing is another popular method of camouflaging debt. A Special Purpose Vehicle (SPV) is a separate legal entity created by an organization. The SPV is a distinct company with its own assets and liabilities. Companies create SPVs for keeping liabilities off the balance sheet. This reflects a less risky balance sheet. Though this may be technically justified, it is actually a deliberate attempt to hide financial obligations.
Asset revaluation is another method adopted very commonly in industries such as real estate and hospitality. Companies revalue properties and other fixed assets to inflate their worth on financial statements. At such difficult times of economic slowdown, these revaluations make the balance sheet look more robust even though the real market value of the assets could be substantially lower. Also, capitalizing expenses rather than recording them immediately as costs is another subtle way of inflating profits. Instead of recording the full cost of an asset as an expense, a company could spread it over several years to improve short-term profitability.
Manipulating revenue timing also takes place. Most companies bring in future sales revenues as current income in their books of accounts to give an artificial boost to earnings. While the trick provides a short-term boost to the profit and loss account, the implications on liability going forward become overwhelming in due time. In Sri Lanka, it has sounded an alarm for some industries based on forward contracts and large-scale orders.
Real-life repercussions
The real world repercussions of the practice of creative accounting are great. In fact, in many institutions of banking in Sri Lanka, there exist accusations of their underestimating non-performing loans and presenting a healthier profitability picture instead of disclosing this to the authorities. But upon such revelation regarding the true picture of the company’s financial statements, it may undermine confidence in banking as a system. Investors, depositors, and regulatory bodies lose confidence in the sector.
There are instances wherein some hotel chains in the hospitality industry have during downturns reappraised their assets to recover for losses. On paper, though this is done within the perimeter of local accounting standards, real questions arise here about the proper financial health status of such organizations.
Long-term effects on market stability: Investors, creditors, and employees make decisions based on the financial statements. Poor investment decisions are the outcome if such reports are tampered with and may eventually incur losses in the financial area. Trust is the foundation of a healthy financial system, and creative accounting undermines that. When such errors are detected by stakeholders, not only does the credibility of that company suffer, but the whole market does.
Addressing the problem
To deal with creative accounting, a full-fledged response is needed. Firstly, there must be enhanced supervision and monitoring from regulatory authorities, such as the Security Exchange Committee. Conducting regular audits and imposing harsher punishments for financial reports that are misleading would discourage malpractices. Auditors are vital; they need to remain impartial and unbiased. Rotation of audit firms and the prohibition on giving non-audit services are bound to prevent a conflict of interest. Corporate governance must also be improved. Boards of directors must question financial decisions rigorously and ensure transparency in reporting.
Role of investor education
The investors, too, must be educated. Well-informed stakeholders are far more able to catch the red flags that have crept into financial statements.
Workshops, publications on diverse subjects, and financial education programs will guide individuals towards more sensible decisions. The capacity to dissect cash flow statements or even decipher revenue recognition policies will better help one understand significant insights into an enterprise’s actual performance.
A road to transparency
Although all this may sound difficult, transparency and ethical accounting are, in fact, achievable goals. Those companies that practise integrity assure their stakeholders by commanding trust. Long-term, this will drive more investment, make companies more financially secure, and help boost economic growth. Sri Lanka can then have an enabling business environment when honesty and transparency become standard practice.
The company’s financial statements serve as an information base for internal and external users. Their main task is to give a true and faithful picture of the company’s financial situation, its performance and changes. Managers are responsible for publishing this information, and they are most often motivated to misrepresent data according to their ideas. They strive to improve the image of a company in the eyes of the public.
In the end, creative accounting in Sri Lanka is a contrast between short-term gains and long-term sustainability. While it may provide some temporary financial benefits, the damage to credibility and trust goes much farther.
The commitment to ethical financial reporting is the only insurance to a stable, trustworthy, and prosperous business landscape. Numbers tell stories, and those stories should be based on truth, not fiction. Transparency is not just good ethics; it is good business.
