Week 24 - (Part of other deck, carried on) Creative Accounting & its Impact on Accounting Ratios Flashcards
(27 cards)
What happens to current and next year’s profit if a company understates accruals or overstates prepayments?
Current year’s profit: Increases (+)
Next year’s profit: Decreases (−)
Due to the reversal of the manipulation (rebound effect).
What happens to current and next year’s profit if a company overstates accruals or understates prepayments?
Current year’s profit: Decreases (−)
Next year’s profit: Increases (+)
This is also due to the reversal in the following period (rebound effect).
What is the rebound effect in accrual/prepayment manipulation?
It’s the automatic reversal of the profit manipulation in the subsequent period, which offsets the original gain or loss in profit.
What is the capitalisation of costs in creative accounting?
It involves treating expenses as assets (e.g., R&D, brand development) to make the balance sheet look stronger and increase profit by reducing current expenses.
What type of costs are commonly misclassified as assets to inflate profit?
Research and Development (R&D)
Brand development
Other intangible costs that should normally be expensed
What is front-end revenue recognition?
It’s the practice of recognising future/deferred revenue (a liability) as current income, even though the service (e.g. updates/support) hasn’t been fully delivered.
Why is recognising all software revenue upfront misleading?
Because a portion of the revenue relates to future obligations (e.g. updates over 3 years), so recognising it early overstates current profit and violates revenue recognition principles.
What’s the accounting principle violated by front-end revenue recognition?
The matching principle — revenues should be matched to the period in which related services are provided.
What is Real Earnings Management?
A practice where actual business activities are adjusted (not just accounting entries) to meet financial reporting targets.
How can companies use real earnings management to decrease profits?
Accelerate R&D or advertising expenditure
Delay sales into the next period
Why would a company want to decrease profits using real earnings management?
To create a reserve for future periods, manage tax liabilities, or smooth earnings.
How can companies use real earnings management to increase profits?
Postpone R&D or advertising expenditure
Accelerate sales into the current period
What’s a key risk of real earnings management?
It may harm long-term performance by disrupting normal business operations and undermining strategic goals.
What is fraudulent accounting?
It involves clear violations of GAAP with the intent to mislead users of financial statements.
How does fraudulent accounting differ from creative accounting?
Fraudulent accounting breaks the rules (illegal), while creative accounting stretches the rules (usually within GAAP but ethically questionable).
Give an example of fraudulent revenue recognition.
Recording sales before they are realisable
Recording fictitious sales
Backdating sales invoices
How can inventory be fraudulently overstated?
By recording inventory that doesn’t exist (fictitious inventory).
What is an example of overstating assets in fraudulent accounting?
Recording fictitious assets that do not exist or inflating asset values without justification.
What does comparing reported profits and operating cash flows reveal?
It helps identify earnings quality. A large gap may suggest aggressive accounting or profit manipulation.
Why examine the tax charge in relation to reported profits?
A low tax rate may indicate use of tax havens, losses, or earnings manipulation.
Why check the notes for changes in accounting policies and estimates?
Because such changes can affect profits and may signal creative accounting or earnings management.
What is the importance of the audit report in health checks?
It provides an external opinion on whether the financial statements are fairly presented and free from material misstatement.
What are the 4 health checks on financial statements?
Compare reported profits and operating cash flows
Look at the tax charge in relation to reported profits
Check notes for changes in accounting policies and
estimates
Audit report
Which financial statement elements can be affected by creative accounting?
Assets, liabilities, equity, income, and expenses.
