Chapter 3 • Financial statements and their interpretation
needs that decision makers currently try to satisfy. Rather, it developed to provide
a historic financial record of the business’s transactions. On the one hand, this was
a record of where funds had come from – shareholders, lenders and so forth – and how
much each had contributed. On the other hand, there was a record of how these funds
had been deployed. Therefore, when shareholders subscribed for shares of £1 million
and the business used the cash to buy a building, this appeared on the balance sheet
as share capital £1 million and freehold land £1 million. The fact that five years later
the land might have a market value of £10 million is not relevant, because the balance
sheet simply records the transaction. For one reason or another, accountants have
never really sat down with a clean sheet of paper and tried to design a system that
would be more useful to decision makers. From time to time they have grafted on
additional features, such as the income statement, but these features were always
underpinned by the same approach that had been taken with the balance sheet.
Despite the deficiencies of financial statements, they remain a major, if not the only,
source of information for many decision makers. Provided that accounting informa-
tion is used with care, it should be helpful, despite its limitations.
There is no reason of principle why a particular business should not prepare finan-
cial statements for its internal purposes in such a way as to correct for the distorting
factors. Undoubtedly some businesses do this, but probably most do not.3.5 Creative accounting
In the previous section we considered the problems that the accounting conventions
raise for those trying to interpret financial statements. In addition, there can be other
concerns about financial statements. There is evidence that the directors of some com-
panies have used particular accounting policies or structured particular transactions
in a way that portrays a picture of financial health that is in line with what they would
like users to see rather than what is a true and fair view of financial position and
performance. This practice is referred to as creative accountingand it poses a major
problem for accounting rule makers and for society generally.
There seem to be various reasons for the existence of creative accounting, including:
l getting around restrictions (for example, to report sufficient profit to be able to pay
a dividend);
l avoiding government action (for example, the taxation of excessive profits);
l hiding poor management decisions;
l achieving sales revenue or profit targets, thereby ensuring that performance
bonuses are paid to the directors;
l attracting new share capital or loan capital by showing a healthy financial position;
and
l satisfying the demands of major investors concerning levels of return.Creative accounting methods
There are several approaches that unscrupulous directors have adopted with the aim
of manipulating the financial statements. Some of these methods concern the over-
statement of revenue. This often involves the early recognition of sales revenue or the
reporting of sales transactions that have no real substance.‘