3. Critical Evaluation
Word Count excluding appendix and references: 1,
The spectacular breakdown of Polly Peck impressively demonstrated the role of creative accounting in the 1980s. Although many companies were not doing well, creative accountants could easily deceive shareholders by manipulating figures.
The Companies Act requires financial statements ‘to give a true and fair’ (i.e., factual and unbiased) ‘view’1. This enables user groups to properly assess a company’s financial position. If, however, accountants are free to arbitrarily manipulate figures, this becomes impossible. Therefore efforts had to be made to confine the extent of creative accounting.
By defining creative accounting (section 2), a critical evaluation of measures (section 3) and the conclusion (section 4), this essay will show that the measures introduced by the ASB are powerful to contain present creative accounting. However, they will not prevent future creative accounting.
2.1 Creative Accounting
Naser1 defines creative accounting as ‘the process of manipulating accounting figures by taking advantage of the loopholes in accounting rules (…)’. This definition, however, lacks an important point: loopholes are not everything. The basic idea of creative accounting is to comply with the letter of the law and the standards – thus presenting itself as ‘perfectly legal’2 – instead of their spirit.
Creative Accounting, therefore, shall be defined as the whole of accounting methods which optically improve a company’s financial position, with these methods complying with the letter, but not the spirit of the law and the standards.
2.2 The ASB
The Accounting Standards Board (ASB) is the standard-setting body of generally accepted accounting principles in the UK. Although the ASB’s standards are no statutory requirements, ‘an accounting standard (…) becomes (…) a source of law in itself in the widest sense of that term’3.
3. Critical Evaluation
The ASB has introduced many measures against creative accounting (Viz. appendix). I will concentrate on standards which fight schemes that affect the primary financial statements, i.e. the balance sheet and the profit and loss (p&l) account.
3.1. Off-balance sheet finance
The ICAEW1 defines this as ‘the funding or refinancing of a company’s operations in such a way that (…) some or all of the finance may not be shown on the balance sheet’2. Off-balance sheet finance aims to reduce the gearing ratio, defined as
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The higher a company’s net borrowings, the higher the gearing ratio. Gearing therefore assesses the company’s indebtedness. Due to the risk a high gearing implies, banks will not approve additional funding for high-geared companies. Therefore, off-balance sheet finance schemes try to pretend a lower gearing.
3.1.1 Quasi-subsidiaries and ‘lease and saleback’ schemes
The Companies Act and SSAP 21 contained loopholes in its definitions of a subsidiary. Companies therefore created quasi-subsidiaries, i.e. ‘conducted business through another entity while keeping out of the formal definition of the Companies Act’3: the mother company places assets into the quasi-subsidiary, thereby legally, but not commercially disposing of them.
‘Lease and saleback’ transactions use the same loophole. Companies either lease assets or sell them together with a repurchase option. Again the assets are legally disposed of. Finally, removing assets and their liabilities from the balance sheet pretends a lower gearing. FRRP4 Press Notice 445 provides an illustrative example.
- Quote paper
- Marcus Matthias Keupp (Author), 2001, Can the ASB really reduce creative accounting?, Munich, GRIN Verlag, https://www.grin.com/document/7763