Creative Accounting


The prevalence of creative accounting in the corporate world is as a result of deficiencies in the legal systems for banking and accounting, inadequacies in the autonomy of governmental regulation and supervision bodies, practical difficulties in enforcing legal and ethical rules due to the slow functioning of the judicial system and the personal greed of top management and owners. However, it has been argued that recent developments in international accounting standards have dramatically reduced the incidence of creative accounting in recent time.

Creative accounting is when managers of an organisation intentionally misstate their financial information to favoura bly represent the entity¶s financial performance. Managers of nonprofits organisations may have incentives to manipulate their reported program-spending ratios because donors use them in determining contribution decisions.

Definitions of creative accounti ng vary, and include the following: µIs the deliberate dampening of fluctuations about ³some level of earnings considered to be normal for the firm´¶. (Barnea et al. 1976) µIs any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may infact, in the long term, be detrimental¶. (Merchant and Rockness, 1994) µInvolves the repetitive selection of accounting measurement or reporting rules in a particular pattern, the effect of wh ich is to report a stream of income with a smaller variation from trend than would otherwise have appeared¶. (Copeland, 1968) 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 ³true and fair´ view of a company accounts.

6AC001 Advanced Financial Reporting

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1999) A bit of a difficult definition. summarise what it is. over -optimistic revenue recognition and the use of exaggerated non -recurring items. Tax avoidance is legal but may travel a crooked road. Blake. & Dowds. Creative accounting can be associated with tax avoidance as opposed to tax evasion. (Ian Griffiths (1986) Sidgwick and Jackson). certainly in the UK. As we will wee. The problem with Griffiths¶ definition. therefore. My definition. whereas tax evasion is simply illegal. Assets and liabilities may also be manipulated either to remain within limits such as debt agreements. Creative Accounting is a term that many people. Some companies may also reduce reported profits in good years to smooth results. but it. feel free to use. or to hide problems. The term ³window dressing´ has similar meaning when applied to accounts. In the context of accounts. Ratio manipulation. but which can prove difficult to define. from all walks of life. is that Creative accounting is the legal use of accounting principles and rules in such a way as to create a deceptive view of a financial statement. creative accounting includes profit manipulations. One of the first books. but it also includes such matters as Off Balance Sheet financing. the title was Creative Accounting: How to make your profits what you want them to be. This point is emphasised by the following extract from the Dearing Committee Rep ort: 6AC001 Advanced Financial Reporting Page 2 . but is a broader term that may be applied to other areas . Creative accounting is ³a process whereby accountants use their knowledge of accounting rules to manipulate the figures in the account of a business´ (Amat. had a title that gave a good clue as to the defi nition of creative accounting. if that is what it is. shareholder control avoidance. to be written on this subject. Typical creative accounting tricks include off balance sheet financing.Creative Accounting A typical aim of creative accounting will be to inflate profit figures. is that suggesting that it is merely a profit manipulation technique does not take it far enough. ³window dressing´ is more likely to imply illegal or fraudulent practices.

and any other interested party. McBarnet and Whelan provide a good list of what it has come to include: Creative accounting can: ¢ ¢ ¢ ¢ ¢ ¢ Boost reported profits/minimise reported losses Manipulate key ratios used in market analysis Conceal financial risk Circumvent borrowing restrictions Escape shareholder control Enhance management performance (and performance related management pay) Gain access to finance. then there is plenty of scope of planning and manipulation the accounting information. absolutely confused as to what is and what is not real and true in connection with a published set of accounting statements. Such manipulation might leave the shareholder. We should also be able t o see that if creative accounting is practiced by any organisation. 6AC001 Advanced Financial Reporting Page 3 . the Government. We can see from McBarnet and Whelan¶s list why Griffiths¶ title does not go far enough. the public. that would otherwise be impossible to raise.Creative Accounting µThere is little evidence that companies are engaging in flagrant breaches of accounting standards « However « there is strong pressure on auditors from time to time to accept interpretations of accounting standards which conform to the interests of the preparers rather than with the spirit of the standard µ (Dearing Committee (1988) The making of accounting standards) Creative accounting includes Creative accounting is more than just a profit changing technique.

Current £ Operating profit Equity capital Long term debt Total capital employed 40.000 200. it used to be the case that the asset would not appear on the Balance Sheet. and neither would the finance that helped supply it. Example: leasing and gearing DW ltd acquires one extra machine for the production of its main product.33% 1: 1 11.000 300.000 200. they are applying the form in the hope that the substance will disappear from view.000 100.00% 0.5: 1 13.000 200.000 but it will improve the operating profit by 10% per year. outright theft and misrepresentation « The point here is that accountants are taking the accounting rules as they stand are in breach of the principle of substan ce over form.000 100.Creative Accounting Why is creative accounting a problem for discussion? Why are we talking about something that isn¶t illegal: surely we would be better off looking at something that is illegal and that concerns us all: fraud.66% 6AC001 Advanced Financial Reporting Page 4 .000 Gearing ratio ROCE 0. Therefore.000 400.000 Buy £ 44.000 300. The problem here is that when a company leases an asset.000 200. The machinery costs £100.5: 1 14. Here are the current position and the positions whether the organisation buys or leases the machinery: assuming that leasing takes and keeps the asset and the attendant financing off the Balance Sheet yet buying keeps the asset and the borrowing on the balance sheet.000 Lease £ 44. The Chief Executive of DW ltd is aware that the gearing ratio and the return on capital employed ratio will change as a result of whether the organisation buys or leases (operating lease) this machinery.

the impact of choosing between finance and an operating lease will equally effect the ratios of an organisation. the gearing ratio and the ROCE ratio are both radically different to the position when the business buys the asset in question. If the lease remains off the Balance Sheet. 1999) The situation we have then is that accountants have a genuine array of techniques they can employ in the creative accounting field. Similarly. yet they are primarily responsible for the accounting statements ¢ The law that needs to be applied is the criminal law and that might be too heavy handed a weapon (McBarnet & Whelan.Creative Accounting The value of the relevant key ratios varies significantly depending on the approach taken to financing the machinery. Note: See the appendix for further examples of creative accounting. The key problems with creative accounting stem from the inadequate enforcement of the law ¢ ¢ The independence of auditors vi s a vis the strength of directors Directors are not accountable to the accountancy pro fession. 1999) This example helps to show us the sort of outcome being creative can comprise on the results of a business. but inadequate enforcement of the rules and the legislation provides little or no deterrent from being so creative. 6AC001 Advanced Financial Reporting Page 5 . (McBarnet & Whelan.

Creative accounting can conceal shortcomings in corporate performance: the leasing example above can be construed to demonstrate this point. Management of fraud are usually prepared in advance. investors can through careful analysis. identification of false accounting statements to find a strategy. 6AC001 Advanced Financial Reporting Page 6 . usually involving direct embezzlement of public funds or theft of property. the final result in losses for investors. False accounting statements to investors falsely convey the company's information will lead to investor decision -making errors. Management of fraud generally refers to senior management personnel to obtain illegal benefits to achieve the purpose of deliberately glossing over the accounting statements. The downside of creative accounting include The potentially adverse impact of creative accounting on ¢ ¢ ¢ Investors Creditors Employees Note: The theoretical framework proposed for the understanding of creative accounting practices. and afterwards strongly try to hide those who cheat the higher levels of management. in the world market. Corporate accounting statements are on the market for corporate investors an important source of information. µEnterprise Management fraud¶ and corporate failure of two aspects of the business. General internal control system can be used to prevent and detect. The primary cause of false accounting statements. diagram and caption see the appendix.Creative Accounting Disadvantages of creative accounting It is not all-good news for those who would be creative. there are still more false accounting statements. leading to serious inaccuracies in the accounting statements. However. within the short term even more difficult to identify.

tax ev asion. Business leaders sometimes instructed the accounting personnel in the accounting fraud. in order to maximize their own rewards. so when enterprises realize the number of its financial statements has violated or will violate the conditions laid down. The blood of the enterprise funds.Creative Accounting Enterprise management moti vation for fraud Here are five categories: 1. As in the enterprise and its creditors signed a loan contract. management by false ways in which accounting numbers favour. the enterprise will be managed on the surplus in order to reduce the possibility of violation of debt contracts. the situation is even more so. creditors in making investment. management and reporting of tax saving on the need for a better trade -off between performance. To evade taxes. To ensure that jobs and earn rewards . credit decision-making. in financial accounting and tax accounting highly unified country. Therefore. is a more effective incentive. 6AC001 Advanced Financial Reporting Page 7 . the creditor in order to protect their own interests. often provides a lot of constraints such as not allowed to release the excess dividends. as the authorities and not consistent between the interests of shareholders. may gloss over its accounting statements to mislead investors. companies must resort to some kind of incentive mechanism to make the regulatory authorities in order to maximize shareholder value hard work. according to corporate profits figures to determine the management compensation contracts. Because corporate defaults are p aying a high price. Business loans or additional capital in order to achieve the purpose. To raise funds. For example. In business. liquidity ratio. quick ratio shall not be below a specific level. in order to reduce cash expenditures. shareholders and regulatory authorities is a contract between the contractual relationships. This is the most obvious one of accounting fraud motivation in financial accounting and tax accounting separation of the country. Of course. However. 3. 2.

of course. but a more formal list of who should report creativity in accounting statements is ¢ ¢ ¢ Business organisations. particularly evident in the performance of the industry. or other corporate bodies A qualified audit report in the statements themselves A note in the accounting statements discusses a depar ture from accounting standards or other requirements ¢ An article in a newspaper. This is possibl e. often using false financial statements to achieve their goals. they will be too much public and government concern. 5. 1999) 6AC001 Advanced Financial Reporting Page 8 . How do we know when a company has been creative with its accounts? When should someone blow the whistle on the company that is using creative accounting? It might happen by accident: someone may be idly reading through a set of accounting statements and be the first person to spot something that falls foul of the creative accounting rules. the use of false finan cial statements continue to prop up share prices to make their own to reap huge profits. Government departments may be taken to impose high taxes or other restrictions on the enterprise. This is in large enterprises and people's livelihood. the burden of expenditure. To avoid the huge cost. the oil company profits soared. and the oil companies have adopted varying degrees of fraud in order to reduce profits. Political costs refer to enterprises for political reasons. When the strong profitability of the enterprises. the government may be taken in order to avoid the very income tax. in order to achieve greater control over.Creative Accounting 4. Business leaders to manipulate the stock volatility. or for sale. Since then. world oil prices rose. The expected stock price volatility may be done intentionally to make a temporary drop in stock prices in order to manipulator able to buy cheap shares. since 2003. To manipulate the company's stock price . journal or magazine (McBarnet & Whelan. For example. while the medium and small investors suffered huge losses.

is related with the ³agency theory´ (Amat et al. This reality justifies the proposition that the financial managers confront with miscellaneous pressure to overes timate the financial state of their companies.K. higher stock prices. 36).Creative Accounting Audit partner A. The ³true and fair view´ concept which is unique to U. to manipulate profit to tie into fo recasts and to distract attention from the news. had this to say on U. accounting is an illustration of the belief that auditors are capable of evaluating the overall picture of financial performance provided by a set of financial statements (McGee.) Creative accounting represents undesirable practices because such practices prevent people seeing the true and fair financial state of a company.. The creative accounting practices sometimes occur due to the pressure coming from the top management (Leib. The companies prefer to use creative accounting practices to report a steady trend of growth in profit rather than to show volatile profits with a series of dramatic rises and fall. March 1992.** Interview. p. particularly in the private sector. managers are able to manipulate income between years so as to maximise their earnings. p. ethical conduct and the correct 6AC001 Advanced Financial Reporting Page 9 ..K. 1999. a senior member of the Institute of Chartered Accountants in England and Wales. On the other hand. and incentive earnings (Person. shareholders also benefit from the managers¶ manipulation of reported earnings to smooth income since this may decrease the apparent volatility of earnings and increase the value of t heir shares. which will not be welcome (Amat et al. 1991). these practices are all realised to overestimate the financial situation of firms and economies. p. It is also argued that both managers and shareholders benefit from the accounting standards that provide managers with latitude in timing the reporting of income. This is actually where. accounting standards are amongst the weakest in the developed world. a firm can confront with a better earning picture. 2002. more valuable stock options. 9).´ (*¶ Hughes & Lubbock (1989). On one hand. 1999. accounting standards:*¶ I think that U. One may not always expect objectivity. p. 7±8). This regulatory system placed a significant reliance on the auditors¶ exercise of professional judgement in areas where there were no specific pronouncements. As a result of creative accounting practices. Therefore. the ethical framework of the creative accounting. 2002.K. and there is significant scope for subjectivity and creativity. 88).

well-intentioned. a motivation. to do it. other. 2003.Creative Accounting information from accounting records (McKernan and Dunn. Many (but not all) creative accounting techniques change the main numbers shown in the financial statements. identifying the prospect of accoun ting manipulation and reflecting this appropriately in pricing and contracting decisions. p. market mechanisms will operate efficiently. The techniques of creative accounting change over time according to the accounting standards. In some cases. The literature on the ethics of bias in accounting policy choice is reviewed at the 'macro' level of the accounting regulator. This literature can similarly be applie d to the bias in accounting policy choice at the 'micro' level of the management of individual companies that is implicit in creative accounting. 442) due to distortion and spoilage of the accounting knowledge. so a diligent approach can give you an edge Of course. At the same time. most often in the notes to the accounts. Many changes in accounting standards are meant to block particular ways of manipulating accounts. Revsine (1991) considers the problem in relation to both managers and shareholders and argues that each can draw benefits from 'loose' accounting standards that provide managers with latitu de in timing the reporting of income. the reasons could be weak or very weak: ¢ Shareholders may resist blowing the whistle because the accounting policy adopted may be good for the dividend ¢ Auditors may resist blowing the whistle because they may lo se the audit account if they do 6AC001 Advanced Financial Reporting Page 10 . changes in accounting standards open up new opportunities for creative accounting (the use of fair value is a good example of this). there has to be a reason. He thinks that the prime role of accounting is as a mechanism for monitoring contracts between managers and other groups providing finance. but make themselves evident elsewhere. In other cases. which can be counted among the reasons of creative accounting . which means that intent on creative accounting need to find new ways of doing things. for someone to want to blow the whistle. The market has been surprised before by bad news hidden in the notes. such reasons could be strong.

IASs will become the standard for all European listed companies from 2005. 2003). Scope for choice of accounting methods can be reduced by reducing the number of permitted accounting methods or by specifying circumstances in which each method should be used. 6AC001 Advanced Financial Reporting Page 11 . recent developments in International Accounting Standards (IASs). Accounting regulato rs who wish to curb creative accounting have to tackle each of these approaches in a different way: 1. where applicable. Griffiths (1995) New Creative Accounting MacMillan p vii Are there solutions? It seems clear that in general creative accounting is seen as a deceitful and undesirable practice. T his is not to say that creative accounting is not frowned upon and that action is not being taken at least to limit the effects of creative accounting. The latest developments in International Accounting Standards are pursuing the objective of reduction in accounting choice. which produces the desired picture in one year. However. (IASB. There seems little doubt that there is always room for the accounting profession to leave room for manipulative actions in accounting statements.Creative Accounting Conclusions If an accountant wants to use creative accounting. identifying. In this section we analyse some measures that can help to reduce the scope for creative accounting practices. those who are charges with the responsibility of preparing a set of accounts still have an extensive range of techniques available to them which can be used to massage the figures which are presented to the watchi ng world. he will. as Griffiths says in the second of his two books on creative accounting: While many of the more flagrant abuses « have been outlawed. will then be forced to use the same method in future circumstances where the result may be les s favourable. since a company choosing a method. Requiring consistency of use of methods also helps here.

Artificial transactions can be tackled by invoking the concept of 'substance over form'. the present rules of the International Accounting Standards have nearly abolished the category of 'extraordinary item'. 3. whereby the economic substance rather than the legal form of transactions determines their accounting substance. However. Regulation without thorough enforcement techniques is likely to be ineffective in preventing individuals from employing misleading reporting practices. Auditors also have a part to play in identifying dishonest estimates. It is interesting to observe that the International Accounting Standards Bo ard is tending to move towards valuation at fair value rather than based upon historical cost in several recent accounting standards and discussion papers. Both legitimate and illegitimate creative accountings are in practice frequently. Again. the scope to use this can be limited by requiring regular revaluations of items in t he accounts so that gains or losses on value changes are identified in the accounts each year as they occur. for example. (Baralexis. At one time. The timing of genuine transactions is clearly a matter for the discretion of management. company accountants tended to use the 'extraordinary item' part of the profit and loss account for items they wished to avoid including in operating profit. The other is to prescribe 'consistency' so that if a company chooses an accounting policy that suits it in one year it must continue to apply it in subsequent years when it may not suit so well. Abuse of judgement can be curbed in two ways.Creative Accounting 2. 2004) 6AC001 Advanced Financial Reporting Page 12 . ethical standards and governance codes must be properly enforced in the corporate world. apart from changes in accounting regulation. The challenge of enforcing International Accounting Standards within a range of differing accounting cultural contexts is likely to be especially problematic. Nevertheless. rather than only appearing in total in the year that a disposal occurs. Thus linked transactions would be accounted for as one whole. 4. (Profit overstatement) and (profit understatement) of Appendix 3 cons titute violation of the law and of GAAP. One is to draft rules that minimise the use of judgement.

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