Chapter 3 • Financial statements and their interpretation
an additional $628 million of liabilities at the end of 2000. The business collapsed at the
end of 2001.
Finally, creative accounting may involve the overstatement of asset values. This
could be done by revaluing the assets, using figures that do not correspond to their fair
market values. It may also, as we have seen, involve the capitalising of costs that
should have been written off as expenses, as described earlier.
Parmalat SpA, a large Italian dairy-and-food business, provided an example of
overstatement of an asset. Parmalat announced in December 2003 that a bank balance
of a3.95 billion with the Cayman Islands branch of the Bank of America did not, in fact,
exist.Checking for creative accounting
When examining the financial statements of a business, a number of checks may be
carried out on them to help gain a feel for their reliability. These can include checks to
see whether:
l the reported profits are significantly higher than the operating cash flows for the
period, which may suggest that profits have been overstated;
l the corporation tax charge is low in relation to reported profits, which may suggest,
again, that profits are overstated, although there may be other, more innocent
explanations;
l the valuation methods used for assets held are based on historic cost or current
values, and, if the latter approach has been used, why and how the current values
were determined;
l there have been any changes in accounting policies over the period, particularly in
key areas such as revenue recognition, inventories valuation and depreciation;
l the accounting policies adopted are in line with those adopted by the rest of the
industry;
l the auditors’ report gives a ‘clean bill of health’ to the financial statements; and
l the ‘small print’, that is, the notes to the financial statements, is not being used to
hide significant events or changes.
Although such checks are useful, they are not guaranteed to identify creative
accounting practices, some of which may be very deeply seated and subtle.Is creative accounting a permanent problem?
A few years ago, around the turn of the millennium, there was a wave of creative
accounting scandals in both the USA and Europe, but this now appears to have sub-
sided. It seems that accounting scandals are becoming less frequent and that the qual-
ity of financial statements is improving. It is to be hoped that trust among users in the
integrity of financial statements will soon be restored. As a result of the actions taken
by various regulatory bodies and by accounting rule makers, creative accounting has
become a more risky and difficult process for those who attempt it. However, it will
never disappear completely and a further wave of creative accounting scandals may
occur in the future. The recent wave coincided with a period of strong economic
growth, and during good economic times, investors and auditors may become less
vigilant. Thus, the opportunity to manipulate the figures becomes easier. We must not,