Enron has made everyone from politicians to comedians aware of the potentially disastrous results of creative accounting practices. And though the jury is still out on what exactly caused the sudden collapse of the seventh largest company in the country, investors are now scrutinizing financial statements, and companies are scrambling to squash investor doubts by improving disclosure.

As well, professionals in the field are expressing strong opinions on the debacle. A recent poll conducted by BusinessWeek and Financial Executives International -- a professional association whose members include CFOs, controllers, and treasurers -- revealed that nearly half of those surveyed believe Enron is not an isolated situation. It is merely the most extreme example of problematic financial reporting, suggest some (1).

While we know what companies have to lose when managers play this game -- such as a good reputation and investor confidence -- we may not understand what managers have to gain in exchange for the risk.

Table: Classification of Creative Accounting Practices Recognizing Premature or Ficticious Revenue Aggressive Capitalization and Extended Amortization Policies Misreported Assets and Liabilities Getting Creative with the Income Statement Problems with Cash-flow Reporting Source: The Financial Numbers Game, John Wiley & Sons © 2002

According to The Financial Numbers Game, creative accounting practices -- a term the authors chose to encompass any and all steps used to play the financial numbers game (see table) -- may be employed in exchange for a variety of expected rewards. These rewards may include a favorable effect on share prices, lower corporate borrowing costs due to an improved credit rating, incentive compensation plans for corporate officers and key employees, and/or political gains.

Charles Mulford, co-author of The Financial Numbers Game, says "the accounting model isn't broken, financial reporting just needs some tweaks." In the meantime, investors must educate themselves about how to detect creative accounting, and professionals such as accountants and managers need to know how to prevent it from happening in their firms.

Detection
There are various ways to detect creative accounting -- all of which are outlined in the book -- but Mulford provides a simple rule to apply when examining financial statements.

Investors should be able to answer two questions when reading a statement: one, how the company makes money, and two, how they are accounting for it. You should be able to verbalize your answers, says Mulford, in simple English. Complicated statements should make one cautious.

Protection
To protect themselves against fraud, Mulford says "diversification for investors is key. But first and foremost, don't forget why you are investing in the first place -- to make money. You won't be able to find a perfect fraud in financial statements, which is why you have to diversify."

Prevention
Those companies most at risk for fraudulent financial reporting tend to be those that have one or more of the following attributes: weak internal control; no audit committee; a family relationship among directors and/or officers; assets and revenue less than $100 million; and/or a board of directors dominated by individuals with significant equity ownership and little experience serving as directors of other companies. (2)

Hence, to prevent creative accounting, Mulford says 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.

How Enron played the game
According to Mulford, the most common creative accounting practices include improper revenue recognition and misreporting expenses. However, Enron's game, explains Mulford, involved special-purpose entities.

"Enron conducted much of its business in these entities that they controlled. They transacted with themselves. That kind of self-dealing allowed them to report profits when they weren't traditionally making a profit."

Though the book was written before and published shortly after Enron's dealings became public, the authors included a special note in the preface regarding the company's accounting practices, noting that Enron's "investors and creditors had not fully discounted the risk associated with the firm's trading activities, its off-balance sheet liabilities, and its related-party transactions." The authors add they believe careful attention to steps outlined in The Financial Numbers Game "would have provided an early alert to the possibility of developing problems."

The Financial Numbers Game: Detecting Creative Accounting Practices is available for purchase at the John Wiley & Sons Web site.