FINANCIAL STATEMENT

ANALYSIS

ASSIGNMENT I

Submitted By:
Saket Jhanwar
09BS0002013
Creative Accounting has been defined as any action on part of the management
which affects the reported income and which provides no true economic advantage
to the organization and may, infact, in the long term detrimental. It involves
manipulation of figures to flatter the financial position of the business. Discuss the
concept with specific reference to the motives and practices followed at

 Enron

 Satyam
 Creative accounting, also called aggressive accounting, is the manipulation of financial
numbers, usually within the letter of the law and accounting standards, but very much
against their spirit and certainly not providing the “true and fair” view of a company that
accounts are supposed to.
A typical aim of creative accounting will be to inflate profit figures. Some companies may
also reduce reported profits in good years to smooth results. Assets and liabilities may
also be manipulated, either to remain within limits such as debt covenants, or to hide
problems.
Typical creative accounting tricks include off balance sheet financing, over-
optimistic revenue recognition and the use of exaggerated non-recurring items.
"Creative accounting" is at the root of a number of accounting scandals

ENRON SCANDLE

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of

the Enron Corporation, an American energy company based in Houston, Texas, and the
dissolution of Arthur Andersen, which was one of the five
largest audit and accountancy partnerships in the world. In addition to being the largest
bankruptcy reorganization in American history at that time, Enron undoubtedly is the
biggest audit failure.
When Jeffrey Skilling the former president of the company was hired, he developed a
staff of executives that, through the use of accounting loopholes, special purpose entities,
and poor financial reporting, were able to hide billions in debt from failed deals and
projects. Chief Financial Officer Andrew Fastow and other executives were able to
mislead Enron's board of directors and audit committee of high-risk accounting issues as
well as pressure Andersen to ignore the issues.
1. Enron earned profits by providing services such as wholesale trading and risk
management in addition to developing electric power plants, natural gas pipelines,
storage, and processing facilities. When taking on the risk of buying and selling products,
merchants are allowed to report the selling price as revenues and the products' costs
as cost of goods sold. In contrast, an "agent" provides a service to the customer, but does
not take on the same risks as merchants for buying and selling. Service providers, when
classified as agents, are able to report trading and brokerage fees as revenue, although
not for the full value of the transaction. Enron instead elected to report the entire value of
each of its trades as revenue.
2. Enron’s use of distorted, "hyper-inflated" revenues was more important to it in creating
the impression of innovation, high growth, and spectacular business performance than
 the masking of debt. Between 1996 to 2000, Enron's revenues increased by more than
750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000. For just the first nine
months of 2001, Enron reported $138.7 billion in revenues, which placed the company at
the sixth position on the Fortune Global 500.

3. Mark-to-market accounting requires that once a long-term contract was signed, income
was estimated as the present value of net future cash flows. Often, the viability of these
contracts and their related costs were difficult to judge. Due to the large discrepancies of
attempting to match profits and cash, investors were typically given false or misleading
reports. While using the method, income from projects could be recorded, this increased
financial earnings. However, in future years, the profits could not be included, so new and
additional income had to be included from more projects to develop additional growth to
appease investors. For one contract, in July 2000, Enron and Blockbuster Video signed a
20-year agreement to introduce on-demand entertainment to various U.S. cities by year-
end. After several pilot projects, Enron recognized estimated profits of more than $110
million from the deal, even though analysts questioned the technical viability and market
demand of the service. When the network failed to work, Blockbuster pulled out of the
contract. Enron continued to recognize future profits, even though the deal resulted in a
loss.

4. Enron used special purpose entities—limited partnerships or companies created to fulfill

a temporary or specific purpose—to fund or manage risks associated with specific assets.
The company elected to disclose minimal details on its use of special purpose entities.   In
total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.
Enron's balance sheet understated its liabilities and overstated its equity, and its earnings
were overstated. Enron disclosed to its shareholders that it had hedged downside risk in
its own illiquid investments using special purpose entities. However, the investors were
oblivious to the fact that the special purpose entities were actually using the company's
own stock and financial guarantees to finance these hedges.

5. Andersen's auditors were pressured by Enron's management to defer recognizing the

charges from the special purpose entities as their credit risks became clear. Since the
entities would never return a profit, accounting guidelines required that Enron should take
a write-off, where the value of the entity was removed from the balance sheet at a loss.
To pressure Andersen into meeting Enron's earnings expectations, Enron would
occasionally allow accounting firms Ernst & Young or PricewaterhouseCoopers to
complete accounting tasks to create the illusion of hiring a new firm to replace Andersen.
 SATYAM SCANDAL
On 7 January 2009, company Chairman Ramalinga Raju resigned after notifying board
members and the Securities and Exchange Board of India (SEBI) that Satyam's accounts
had been falsified
Raju confessed that Satyam's balance sheet of 30 September 2008 contained:

 inflated figures for cash and bank balances of Rs 5,040 crore (US$ 1.07
billion) as against Rs 5,361 crore (US$ 1.14 billion) crore reflected in the books.
 an accrued interest of Rs. 376 crore (US$ 80.09 million) which was non-existent.
 an understated liability of Rs. 1,230 crore (US$ 261.99 million) on account of
funds was arranged by himself.
 an overstated debtors' position of Rs. 490 crore (US$ 104.37 million) (as
against Rs. 2,651 crore (US$ 564.66 million) in the books).

Raju claimed in the same letter that neither he nor the managing director had benefited
financially from the inflated revenues. He claimed that none of the board members had
any knowledge of the situation in which the company was placed.The gap in the balance
sheet has arisen purely on account of inflated profits over a period of last several  years
(limited only to Satyam standalone, books of subsidiaries reflecting true performance).
What started as a marginal gap between actual operating profit and the one reflected in
the books of accounts continued to grow over the years. It has attained unmanageable
proportions as the size of the company operations grew significantly (annualized revenue
run rate of Rs 11,276 crore in the September quarter, 2008 and official reserves   of Rs
8.392 crore). The differential in the real profits and the one reflected in the books was
further accentuated by the fact that the company had to carry additional resources and
assets to justify higher level of operations – thereby significantly increasing the costs.

Based on the above cases it is observed that the most common creative accounting
practices include improper revenue recognition and misreporting expenses .Hence, to
prevent creative accounting, accountants and managers should divide the duties of an
internal control checklist. Furthermore, an independent audit committee should always
have someone with a strong accounting background and audit experience who deals
directly with outside auditors. Focus on cash flow rather than income numbers.