Navigating Financial Integrity

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From Historical Precedents to Contemporary Challenges and the Role of Effective Corporate Governance

By CPA Peter Kibet Kitur

Creative accounting has become perpetual in nature. They range from the ancient Mesopotamia, to the South Sea Bubble of 1720, to the famous Enron of 2001, down to Parmalat, Tesco, Toshiba, Kenya’s Uchumi and Nakumatt supermarkets. The series of accounting scandals that have occurred have called for a greater concern by the accounting profession and governments resulting in enactment of laws, regulations, policies, procedures, and accounting standards. They have also shown that there is a need to look beyond corporate governance in the fight against financial deception. 

Creative Accounting can be defined as using the flexibility within accounting to manage the measurement and presentation of the accounts so that they serve the interests of preparers and other interested individuals. It can also be defined as exploiting loopholes in the existing regulatory system, to serve preparers’ not users’ interests. As per Oxford Dictionary of English “The exploitation of loopholes in financial regulation in order to gain advantage or present figures in a misleadingly favorable light.”  According to Chartered Institute of Management Accounting (2000) “A form of accounting which, while complying with all regulations, nevertheless gives a biased impression (generally favorable) of the company’s performance.”, 

The term came to popularity as a result of a book published by Ian Griffiths in 1986, “Creative Accounting “(Griffiths, 1986), written in the UK. Since then, there have been many other explorations of creative accounting.

Other terms in the same family with creative accounting include fraud and fraudulent financial reporting. However, the difference between creative accounting and fraud is that creative accounting is working within the regulatory framework.

Fraud covers the use of deception to obtain an unjust or illegal financial advantage and intentional misrepresentations affecting the financial statements by one or more individuals among management, employees, or third pares. Fraud may involve: manipulation of accounting records or other documents, misappropriation of assets or suppression or omission of the effects of transactions from records or documents, recording of transactions without substance or deliberate misapplication of accounting polies as well as willful misrepresentation of transactions. 

Fraudulent financial reporting is the Intentional misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an administrative, civil or criminal proceeding” or an intentional material misstatement of financial statements or financial disclosures or the perpetration of an illegal act that has a material direct effect on the financial statements or financial disclosures. 

Other terms include:

Aggressive accounting near similar term with creative accounting where accounting rules and regulations to deliver a particular result, but working within the regulatory system. 

Earnings management involves using the flexibility within accounting to deliver a predetermined profit. 

Impression management represents an attempt by the management of the firm to give to users the impression of the firm which managers want and is usually associated with presentational issues such as accounting narratives and graphs. 

Profit smoothing This involves the use of accounting techniques to ensure a steady profit that is the natural peaks and troughs of accounting profit are eliminated.

Examples of companies affected by creative accounting

HIH

It was Australian second largest insurance company before its Collapsed in 2001. Creative accounting issues included under-provision for future expected claims, reinsurance which did not transfer risk (e.g., side letters) and losses transferred to goodwill account. Its executives were prosecuted while auditor, Anderson’s criticized for lack of independence. Failure of audit committee was also mentioned. HIH collapse led to enactment of Corporate Law Economic Reform Program Act 2004.

Zhenzhou Baiwen 

Company dealing with household appliances and was the fifth largest company in China in 1997. In 2002, it ran into serious problems. Creative Accounting Issues included fraudulent sales, misused raised capital, capitalized expenses, deferral of expenses, inflated assets and related party provisions. Zhengzhou auditing company fined while failures of governance were mentioned with blame be placed on board of directors, supervisory board and local government. the collapse resulted into revised corporate governance guidelines and changes to Law in China. 

Parmalat

In 2003, Parmalat defaulted on $150 million bond. Creative Accounting Issues included fictitious sales, double billing, fabrication of operating subsidiaries’ sales, failure in recording debts, recording debt as equity, overstating assets and forging a € 3.95 billion Bank of America cheque. Governance Issues mentioned included the fact that one family dominate Board, non-independent non-executive directors, Audit committee lacked independence.  It was mentioned that external auditors failed in their monitoring role. Parmalat collapsed resulted in the changes to audit regulations and changes in 8th Directive of Italy.

Uchumi Supermarkets

Mismanagement, poor expansion strategies/blind expansion, management disputes, poor financial decisions, liquidity issues, poor corporate structures, huge losses, tax compliance issues, poor customer target, and theft of products and cash by owners, employees, suppliers, and the management are some reasons for the collapse of Kenya’s retail giants. At one time, it was estimated that revenues were manipulated by a tune Kshs. 3 billion.

Effective corporate governance 

Effective corporate governance is essential for mitigating the risks of creative accounting and fraud within a company. This involves implementing strong internal controls, including a control environment, risk assessment, and management, as well as monitoring and control activities. The division of responsibilities between the chief executive and chairman is crucial to prevent the concentration of power, as exemplified by the case of Asil Nadir. Additionally, the establishment of an independent audit committee, free from personal connections with executive directors, is vital for effective oversight of auditors. Furthermore, a robust board of directors, with independent non-executive members, is necessary to strengthen overall governance. By focusing on these key areas, companies can enhance transparency, accountability, and ultimately reduce the likelihood of financial malpractice.

The pervasive nature of creative accounting throughout history, from ancient times to recent corporate scandals, underscores its enduring presence in financial practices. Numerous examples of companies, such as HIH, Zhenzhou Baiwen, Parmalat, and Uchumi Supermarkets, have succumbed to the repercussions of creative accounting, leading to regulatory changes in response. Effective corporate governance emerges as a critical solution to mitigate the risks associated with creative accounting and fraud. Strengthening internal controls, separating the roles of chairman and CEO, establishing independent audit committees, and having a robust board of directors with independent members are essential components for fostering transparency and accountability in financial reporting. As we confront the challenges posed by creative accounting, it is clear that a vigilant and comprehensive approach to governance is indispensable for maintaining the integrity of financial systems.

CPA Peter Kibet Kitur is a Tax consultant with Bon and Drew Associates, serves in public sector, is the ICPAK Central Rift Region’s Branch Chairman and a member of ICPAK’s Devolution subcommittee.

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