Creative Accounting — How much of it is right?
Imagine someone with multiple burner phones. Now, owning multiple burners may not be illegal but owning many and constantly switching them could be a red flag for criminal activity where someone wants to actively avoid detection. Now let us consider someone who makes bulk purchases in cash. It is legal to do so but it is highly suspicious and a well-known way of transaction for fencing of stolen goods. The perception of creative accounting is no different.
Investopedia defined creative accounting as, “Accounting practices that follow required laws and regulations, but exploit loopholes to present misleading results.”
That is quite an interesting concept. I have always been fascinated by the idea of loopholes. Being an avid reader and a fan of thrillers, murder mysteries and courtroom dramas, I am well-versed with loopholes in laws and how many ingenious individuals attempt to take advantage of them. Some of them even succeed!
But then, if we look at creative accounting, is it all bad? Is it pure evil and the doers devil-worshipers? As I was reading through various articles written on creative accounting, one common theme that was mentioned is that there are a lot of ways in which companies try to take advantage of the laws and they try to hide the fact that they are doing it. This ultimately leads to their downfall. When something smells fishy, it almost always means something must be rotten.
Over the years, we have seen many companies trying to cook the book and then getting caught. There is really no escape. Companies may be tempted to do this for various reasons, be it the famous Enron scandal in the USA or something closer to home like the Satyam scam, where the companies wanted to hide millions in debt and inflate profit. Or maybe how Cox & Kings Ltd. created 15 fake travel agent companies and sold tickets to them only on paper to hide the poor financials of Cox & Kings and its subsidiaries. Whenever companies have tried to hide something, they have gotten caught.
But as I was reading through The Accounting Game, by Darrell Mullis and Judith Orloff, they had some other clever ideas.
You’ve probably heard the statement, “They are using creative accounting.” You may think this means someone is doing something shady or illegal — but there are legitimate and legal forms of “creative accounting.”
I was very surprised and wanted to delve into the nuances. Darrell Mullis and Judith Orloff have discussed a few of those legal forms of creative accounting.
1. The cash method of accounting
The cash method of accounting is when businesses track their income only by cash transactions. The income is recorded only when the business actually receives the cash and not when they carry out the service. Similarly, the expenses are recorded only when they are paid for in cash even though they may have been incurred earlier. So, when doing this, some of the items that are an integral part of accrual accounting can be omitted. For example, accounts payable, accounts receivable, bad debts etc.
If we look at most businesses, they need cash to function. Without cash, a business will not survive even for a day. A business may be highly profitable but have no cash in hand — such a business is destined for doom. On the other hand, thousands of businesses function with great ease when they are at a loss, but they have excellent cash flow. When we use accrual accounting, the picture is much clearer because everything is accounted for. It is definitely more accurate and generally speaking, it shows more profit on books and hence is great to take to the banks or investors.
So why would a company choose to go with cash accounting? TAXES! Between the two, cash accounting will show a lower profit as we have considered only cash transactions. But here the question arises, ‘Can every business opt for cash accounting and save on taxes??’
The short answer is No. The long answer is it depends on the type of business. Generally speaking, corporate entities (Public and Private Limited Companies) are mandated to follow the accrual method of accounting. Non-corporate entities have the flexibility to choose but only if they are in the service sector. If the industry handles inventories, then they must use the accrual method.
2. FIFO and LIFO
FIFO and LIFO concepts are used for inventory management. Any kind of non-service type industry will have involvement with some kind of inventory that they maintain, be it raw materials or finished goods.
What any industry does is buy raw materials, add value to them and then convert them to finished goods to sell. It would be very reasonable to believe that they might not have a single supplier of raw materials or that the price of the materials may fluctuate depending on various factors like availability, market demand, natural disasters etc. How will a company show the consumption of these raw materials of various costs in their books? FIFO and LIFO come into play here.
FIFO or First-In-First-Out is a concept where whatever is purchased first is sold first. As a child, have you used those stack-able pencils where there are small sections with individual lead bits? Something like this.
Any bit that goes in first through the bottom, comes out first from the front. FIFO principle is similar. It assumes that the oldest inventory purchased is used first and as such the prices are reflected in the Cost of Goods Sold in the Income statement.
LIFO or Last-In-First-Out is a concept where whatever is purchased last is sold first. Imagine that you sell tennis balls, and you have a small barrel where you store them. Whenever new products arrive, you dump it on top of the existing tennis balls. Also, since all the balls are identical, a customer in your shop will pick up a new ball from the top and buy it. This kind of inventory management is what LIFO is all about.
A question that must be arising in your mind is what about I say in my books that I am selling my older inventory first (FIFO) but in real practice, I do otherwise? Well, the fun fact is that it does not matter. LIFO and FIFO are just concepts that you use in your accounting. In real practice you can sell however you want, the first ones, the last ones, heck, even mix it up! If in the books, you follow a single way of valuation, everything is alright.
But how is FIFO/LIFO linked with creative accounting? Again, companies can sometimes use this to save taxes in the present. The way companies save on tax money is by showing less profits for that financial period. If the prices are rising, then it makes sense to use LIFO which results in higher COGS and lower ending inventory and lower profit. Which directly means lower taxes for that financial period. Using the same logic when the prices are falling, it would make sense to use FIFO.
But this does not mean that companies can switch between the two at will. As a thumb rule, companies follow the FIFO method as it is much simpler and easier to maintain. Different countries have different regulations as to how one can switch between the two. In some countries, companies are also allowed to switch from one method to the other on their own for the first time. But to switch it back, they need explicit permission from their respective tax authorities, and it is not easy to get that. Also, companies need to mention in their balance statement what kind of inventory valuation method has been used. Transparency is extremely important.
Loopholes will always exist in any system we build. We are humans after all. And if there are loopholes, other humans will try to take advantage of the situation for their gain. To be ethical and transparent needs integrity. Companies may get a little “creative” with their accounts but as long as they are ethical, they are acceptable. And hey, it also keeps them out of paying heavy fines when caught, or worse still jail time.
