Exploiting Accounting Loopholes in the United Kingdom

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Introduction

There are various basic accounting concepts defining the assumptions underlying the preparation of financial statements. The accounting process is well regulated in the United Kingdom (UK). However, these rules and regulations do not eliminate the need for judgments and estimations to be made by preparers of accounts. In most cases, the principles used in financial reporting provide companies with options about accounting processes. However, in some instances, companies have exploited loopholes in financial regulations. They do this to gain advantage or present figures in a misleading way that is favorable to them.

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The current paper is written against this background of financial regulations and the potential loopholes. The author explores the nature of these ambiguities about financial standards and regulations in the UK. Incidences of financial malpractices are common among institutions and bureaucratically controlled markets. According to Milne, Guthrie, and Parker (2008), the agencies that create the rules are the same ones that create loopholes that pose a threat to accounting ethics. Milne et al. (2008) opine that these ambiguities are avenues for fraud among institutions. They encourage unethical innovations among auditors. As regulation processes evolve, defaulters exploit the uncertainties to adapt to changes. The resulting “creative accounting” is not in itself illegal. However, it is misleading to shareholders, potential investors, and other stakeholders who are consumers of the resulting financial reports.

Financial Regulations in the UK

According to Dean (2009), the UK has some of the most efficient regulatory agencies in the developed world. Generally Accepted Accounting Practice (GAAP) is one of the major organizations charged with the responsibility of formulating rules and regulations to check the operations of accounting firms in the country. The regulatory body is also part of the statutory terms used in the UK’s tax act.

The GAAP has formulated the Standard Accounting Practices (SAP), which are used when presenting financial statements (Lapsley, Miller & Panozzo 2010, p. 320).

Accounting standards are derived from different sources. They can also emerge from various accounting issues. It is the duty of the Accounting Standards Board (ASB) to issue new regulations. The new rules are referred to as the Financial Reporting Standards (FRS). The ASB and the FRS ensure that the reports presented through Statements of Standard Accounting Practice (SSAP) are correct. Erroneous and misleading presentations are discouraged. Every year, loopholes are noted in the regulatory frameworks. The ASB must set new standards to address these issues (Peecher, Ira & Trotman 2013).

The ASB is involved in the formulation of new policies. After discussion papers are presented, the proposals are put in the public domain for comments. After the comments, Financial Reporting Exposure Draft (FRED) is formed. The draft is returned to members of the public for further scrutiny and comments. The issues raised by the public are taken into consideration when creating a new document. The new accounting standards are then initiated. Some accounting issues demand an immediate course of action. As such, the Urgent Issues Task Force (UITF) meets regularly to amend or rescind some of the new regulations. The task force is composed of senior members of industrial and accounting firms in the country. After the amendments, the abstracts become binding with immediate effect (Lapsley et al. 2010).

The laws regulating accounting standards evolve in tandem with changes in the financial reporting field. Some of the recent changes involve new legislation requiring all listed companies to adhere to some of the European laws. Such laws include those related to International Financial Reporting Standards (IFRSs). Institutions that are not listed in the public domain have the option of using IFRS or GAAP in reporting their SSAP. In 2013, the new GAAP was used to revise the FRS. The resulting regulations are expected to take effect from 1st January 2015 (Peecher et al. 2013).

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Due to this fluid nature of accounting regulations in the UK, the profession remains under the threat of creative accounting practices. Creative accounting is a phenomenon that involves deviating from the goals of SAPs. Individuals and firms engaging in this practice exploit loopholes found in the accounting standards to maintain or improve the financial image of an institution. As already indicated, this undertaking is not considered to be illegal. However, the ambiguities exploited need to be addressed to curb the unethical practice (Lapsley et al. 2010).

Loopholes and Ambiguities in UK’s Accounting Standards

Cash and Accrual Loopholes

Various weak points are exploited by unscrupulous firms as far as financial reporting and accounting regulations are involved. A good example of this is the cash and accrual loophole. In this context, the management of internal revenue utilizes the idea of cash accounting. For instance, expenses and revenues are only valid if they are paid in or out. However, the scenario changes about accrual accounting. In such cases, expenditures and revenues are confirmed only after the incurred costs have been approved. The revenue gained in the current year, but which is received in the incoming period, is documented in tax statements for the following trading session. Conversely, expenses accrued in the current financial period, but which are paid the following year, will affect the tax statements for the preceding session. The tax statement will decrease due to forwarded expenses (Dean 2009).

Entities might exploit this loophole by manipulating their expenses and revenues. They do this to avoid paying the stipulated taxes. The boundary between these standards leads to conflicts in the cash accounting process. The International Regulatory Standards were put in place to avert such scenarios. However, the provisions made in IRS have not fully addressed the issue. The reason is that many accounting institutions are still acquainting themselves with the new regulatory guidelines provided by GAAP in the UK (Lehman 2010).

Boundaries Regulating the Production of Financial Statements

Financial statements are very useful to various end-users. For example, potential investors use this information to decide whether or not to put their money in the firm. The credibility of the financial statements must be protected to ensure that the entity announces valid results. There are various boundaries and principles put in place to ensure that this happens. An entity is expected by law to produce and announce results based on the legitimacy of demand for information. If there are no justifications for that information at that particular time, then the organization has no reason to release the same to the public (Greig 2006).

The boundaries controlling the release of information are determined by the scope of a particular regulation. In this context, aspects of direct and indirect control are put into consideration when preparing financial statements. For instance, an entity has direct control over its activities and resources if no other agents are involved. However, the organization may have indirect control over assets under special circumstances. Indirect control is exhibited when a separate entity has direct control over an asset on behalf of another firm. Lehman (2010) thinks that based on this understanding, the company is said to have indirect control over its subsidiary. The reason is simply that this company has a direct relationship with the entity. The resulting boundaries determine the mechanisms used in producing and reporting financial results based on the direct and indirect control dimensions.

The direct and indirect approaches are useful in providing valid information under the FRS requirements. Direct control defines the margins of the announcing company, which prepares a single financial statement. Financial reporting from this perspective will encompass gains, losses, assets, and liabilities (Lehman 2010). Conversely, direct and indirect control allows for the announcement of reports from a consolidated approach. In light of this, the financial statements will involve gains, losses, assets, and liabilities that are both directly and indirectly regulated by the company.

Many entities define the term “control” to suit their objectives. They aim to exploit the vague provisions of these rules. Such scholars as Lapsley et al. (2010) argue that firms use this excuse to evade their responsibility of correctly presenting financial results. The UK ASB demarcates the boundaries that determine the level and nature of control.

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According to Lapsley et al. (2010), the term control has two connotations. First, the entity must have the capacity to deploy the economic resources involved in financial reporting. Secondly, the organization must be ready to face the consequences of the deployment. The effects may include both benefits and losses (Milne et al. 2008).

The deployment of economic control should be contrasted with agency relationships. In such cases, regulatory powers are held by different parties. As such, organizations are expected to fully understand the extent of their control before presenting the financial statements to the public (Milne et al. 2008). However, despite these boundaries, organizations still identify loopholes and take advantage of them.

Techniques of Creative Accounting

Overview

The possibilities of creative accounting are cited in many principles. Such analysts as Milne et al. (2008) observe that even in highly regulated accounting markets (including the UK), opportunities for ‘flexibilities’ abound. For instance, ‘regulatory flexibility’ allows accounting institutions to choose the policy they deem appropriate for their operations. In essence, the firms are given the freedom to regulate their accounting processes. A good example is a policy involving asset valuation. In this case, the IFRS and GAAP provide firms with the option of initiating a non-current asset based on either revalued amount or depreciated past expenditure. According to Peecher et al. (2013), such scenarios are relatively easy to track in the current year of operations. However, discerning such practices become problematic in the following year.

Another scenario that involves flexibility is the reclassification and presentation of financial figures. Financial firms may come together in manipulative syndicates to alter balance sheets. A reclassification of liabilities attempts to ‘smoothen out’ the liquidity and leverage ratios before announcements are made. An example of this includes the presentation of figures about cognitive reference points. In this context, financial preparers may engage in minor ‘massaging’ of numbers to achieve a significant reference point (Greig 2006).

According to Dean (2009), variation of incomes involves the manipulation of profits to march with the forecast figures. Some policies are formed by the provisions of SAB rules. However, when entities sell their merchandise, a significant portion of their profits is transferred to the following years. The ‘unreported’ profits are used to cover company upgrades and customer expenditure. Some scholars argue that this approach is respectable (Dean 2009). However, others think that accounting policy makes it possible to predict future profits. As such, it is difficult to explain declines in case there are no profits forwarded to the next year (Lehman 2010).

Information asymmetry

Information asymmetry is a phenomenon where one party is richer in information than the other. In the accounting field, the presented statement may comprise what we do not know. The scenario may cause what Greig (2006, p. 665) refers to as an imbalance of power as far as transactions are concerned. The regulations entities are unable to control this aspect since the power of information is in the hands of those in control. In the worst scenario, the imbalance of information has caused the market failure and sometimes caused companies to go awry.

In addition, the information asymmetry has affected the use of “true” and “fair” elements in UK financial reporting. Formerly, there was no definite term to use when referring to true and fair. Accountants use the terms to misrepresent financial statements. In the present regulations, the terms are defined to mean the presentation of information, derived from acceptable accounting principles. In addition, the definition includes submitting accurate figures without any wilful biasness or manipulations. However, the power of information asymmetry is very disastrous if the information is not provided to the lower levels of entities (Milne et al. 2008).

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The information perspective is a major element used in creative accounting. Conflict is derived between complex corporate structures and underprivileged remote departments. Managers may opt to utilize their position and information asymmetry for their gain. They achieve this by controlling reporting disclosures. Due to this fact, regulators who lack enough knowledge on the same may not discern any misrepresentation in the financial statements (Milne et al. 2008).

Scholars argue that if there are no fraudulent activities involved in information asymmetric, the act is deemed legal and ethical. This provides loopholes for creative accounting and may jeopardize financial statements in different areas like market risk, internal trading, and indiscriminate lending (Milne et al. 2008).

Conclusion

In summary, the author of this paper has elaborated implications arising from the exploitation of loopholes in accounting regulation in the UK. It has emerged that the more rules are created the more innovation for creative accounting is formed. To secure correct financial statements, impromptu decisions are initiated, for instance, UTIF is responsible for urgent issues that are believed to compromise the accounting process.

The introduction of the IFRSs is directed to ensure that the accounting process is comparable across the board. However, the mechanism should be subjected to thorough scrutiny to ensure that no further loopholes are exploited due to creative accounting. To curb creative accounting especially in information asymmetry, all stakeholders need to have a knowledgeable background about accounting in general.

References

Dean, D 2009, ‘Auditing Santa’, Accounting, Auditing & Accountability Journal, vol. 22 no. 8, pp. 1311-1314.

Greig, K 2006, ‘Accounting standards in the UK’, European Accounting Review, vol. 15 no. 4, pp. 665-668.

Lapsley, I, Miller, P & Panozzo, F 2010, ‘Accounting for the city’, Accounting, Auditing & Accountability Journal, vol. 23 no. 3, pp. 305-324.

Lehman, G 2010, ‘Perspectives on accounting, commonalities and the public sphere’, Critical Perspectives on Accounting, vol. 21 no. 8, pp. 724-738.

Milne, M, Guthrie, J & Parker, L 2008, ‘Into the light and engagement: two decades of interdisciplinary perspectives on accounting, auditing and accountability research’, Accounting, Auditing & Accountability Journal, vol. 21 no. 2, pp. 117-128.

Peecher, M, Ira, S & Trotman, K 2013, ‘An accountability framework for financial statement auditors and related research questions’, Accounting, Organizations and Society, vol. 38 no. 8, pp. 596-620.

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