Perhaps you want to buy a business or make an investment. Maybe you’re already in business and another business wants you to supply them with stock. In these types of situations your money could be at risk and you’ll want to make a few checks.
The most recent annual accounts can tell you a lot about the financial health of a business. The Profit and Loss Account will show you the sales and profit while the balance sheet shows what the business owns and what it owes. Often the accounts will show you all you need to know, but can you really take the figures at their face value?
Thankfully, the answer, in many cases, will be yes, but what if the people running the other business have been a little creative and presented the figures in the way they want you to see them? What if the creative accountant has been at work?
Creative accounting involves the manipulation of figures or arrangement of affairs at the period end to make the accounts look better than would otherwise be the case. Some of the techniques may be perfectly legal but, unless you understand them, you could be misled.
Here are some examples of creative accounting techniques.
- If sales are invoiced to customers before the end of the period but they are not actually despatched until after the end of the period, there is a boost to sales and profit in the first period.
- If the business provides maintenance contracts (e.g. to service central heating systems), the amount payable on the contract will normally be charged to the customer before the work is carried out. If the amount charged to customers is included in the accounts for period one but the cost of carrying out the work is included in the accounts for period two, the accounts for period one will show a profit as there is income without associated costs, whereas the accounts for period two will show a loss as there are costs without the associated income. You will get a very distorted view if you only see the accounts for period one.
- Although property may be included in the balance sheet at the amount that the business actually paid for the property, it’s perfectly legitimate to revalue that property so that the amount included in the balance sheet is the value to the business at the balance sheet date. An over-optimistic revaluation can make the business appear to be in a healthier state than is really the case.
- If the business has made a loan to another person, the amount of the loan will appear in the balance sheet as an amount owing to the business. The bank balance will also have been reduced by the amount of the loan. If the loan was to someone connected with the business and there is some doubt that it will ever be repaid, there could be some attempt to hide the transaction from a reader of the accounts. A temporary arrangement could be set up so that the loan is repaid just before the end of the period and a new loan for the same amount is made just after the end of the period.
If you are relying on someone else’s accounts, an understanding of creative accounting could save you from making an unwise investment or warn you against trading with an unreliable business.
You can find out more about creative accounting in our book How to Understand Accounts where you’ll see explanations and examples of the creative accounting terms ‘off balance sheet financing’, ‘window dressing’ and ‘revenue recognition’.
Written by a chartered accountant, How to Understand Accounts explains accounts in detail in a clear, straightforward way so you don’t have to be an accountant to understand.