Contents

Introduction...........................................................................................................................................1
Creative accounting defined..................................................................................................................2
Cases where creative accounting was evidenced...................................................................................3
The impacts of creative accounting.......................................................................................................7
Measures to mitigate the use of creative accounting..............................................................................9
References...........................................................................................................................................10

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Introduction
The current state of accounting practices allows individuals a given level of choice of policies
and professional judgement in determining the methods of treatment of transactions in
regards to measurement, criteria for recognition and even definition of accounting entity. This
liberty has created involves deliberate non-disclosure of information and manipulating of
figures which makes an institution look profitable than it actually is.
Global corporate collapse has become one of the major issues arising as a result of over
utilization of the practice of creative accounting. This is carried out with the intention to
indicate company performance aligned with the companies objectives. There has been a lot of
criticism to the accounting profession suggesting that it relies on methods which provide
misleading information to the users. This practices have greatly contributed to the downfall of
big organizations.
Financial accounting is aimed at generating reports that show a true and fair state of affairs of
a business entity to enable stakeholders and other users of financial information to make
appropriate decisions. This has greatly affected the stability of the financial system creative
accounting practices are in an increase world over. Periods of crisis are the biggest test for
companies that are tempted to resort to indigenous methods in order to improve the
presentation of financial statements.
There is a growing trend aimed at performing certain activities so as to manipulate the figures
and performance reports to distort the true. Consequences and negative effects always come
quickly first on the investors who are misled about the true overall situation of the society as
well as companies that actually carry out the economic activities.

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Creative accounting defined.
Creative accounting is defined as accounting manipulation to take advantage of the gaps in
the accounting rules and measurements and disclosure practices.
Creative accounting is the practice of influencing financial indicators using accounting
knowledge without explicitly violating accounting policies, rules, and the law. Creative
accounting is practiced to show the financial position as the company management would
like it to be; stakeholders are informed of what the management wants them to
perceive(Susmus, T.; Demirhan, D. Creative Accounting: A Brief History and Conceptual
Framework)
Creative accounting is also defined as the manipulation of financial numbers or transfer of
figures. These are aimed at getting a favourable financial impression. Creative accounting is
an exercise that management uses to prepare and report the company’s economic transactions
to reflect the wishes and interest of the company rather than to reflect the true and actual
financial position. This is always done by taking advantage of the loopholes to manipulate
public financial reports to meet the stakeholders expectations.
“It would be wrong to believe that regulation and normalisation render objectively the
accounting portrait of the company. They revel explicitly only the manner in which this
portrait was painted. On the other hand, they leave to account preparatory room for
manoeuver, while essential ad irreducible, that they can use according to considerations
deriving from financial or communication policy for the company” (colasse, quote by
raybaud- Turillo and teller, 1996)
While there might be disagreements regarding the definition of creative accounting, most
researchers agree that it distinguishes in two aspects. The first aspect is concerned with the
use of the professional accountant’s imagination to translate these legal, economic and
financial innovations that do not exist at the time of their occurrence and normalised
accounting solutions. The second aspect reveals that resulting arrangements which emerge
from this financial engineering are initiated depending on their incidence upon the balance
sheet and results of the company.
The current legal and accounting system is considered to be a permissive one, allowing
companies a greater flexibility in the way they can treat various accounting issues and make
decisions regarding the accounting policies they deem most appropriate to be applied by
them. This flexibility is agreed by professional accountants, who have created also a good
framework in order to “speculate” the accounting legislation and to practice creative
accounting.
The primary purpose of financial reports is to present the financial data to their users for
better awareness and continuous updates on the financial status of the bank. However, the
current secretarial policy provides some choices regarding accounting practices and the
objective judgments required to define the measurement strategies, recognition criteria, and,
in some cases, the characterisation of the accounting bodies. Investigations in the previous
literature contribute toward identifying the present research problem. This work has provided
information about the shortcomings in financial reporting in the banking sector, whereas
numerous studies reported that creative accounting contributes to indicating the levels of

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financial reporting(Hameedi, K.S.; Al-Fatlawi, Q.A.; Ali, M.N.; Almagtome, A.H. Financial
Performance Reporting, IFRS Implementation, and Accounting Information: Evidence from
Iraqi Banking Sector. J. Asian Financ. Econ. Bus. 2021, 8, 1083–1094)
Management may use different types of creative accounting techniques to manipulate the
result represented in the financial statements which complying with all applied accounting
standards and other regulations. There are various methods used for creative accounting
which can fall into four categories: Different accounting policies, abuse of judgment,
artificial transactions (substance over form), and the timing of genuine transactions. The
techniques that management used for creative accounting are: Window dressing, off balance
sheet finance, 98 changes in accounting policies, profit smoothing, capitalizing expenses,
contingent liabilities, changes in depreciation policy, etc. (Ismael, 2017). There are also many
other techniques that has been used by different firms all over the world.

Cases where creative accounting was evidenced.

While creative accounting has been greatly adopted worldwide, it has far reaching
implications if not managed or utilised well. There are several big companies that have
collapsed as a result excessive use of creative accounting techniques as highlight below.
2002 is one of the years that put the accounting profession in a lot of limelight when it saw
great American coporate collapses like worldcom, Enron, Tyco and many others. This led to
the questioning of accounting firms, their practices and audit methodologies. Enron was
highlighted because its collapse was followed bt the bankruptcy of worldcom compay. Plus a
series of similar scandals in the Netherlands and the UK.
The Enron phenomena.

Enron was formed in 1985, following a merger between Houston Natural Gas Co. and
Omaha-based InterNorth Inc. Deregulation of the energy markets allowed companies to place
bets on future prices, and Enron was poised to take advantage. In 1990, the CEO created the
Enron Finance Corp. To head it, he appointed Jeffrey Skilling, whose work as a McKinsey
consultant had impressed Lay. Skilling was at the time one of the youngest partners at
McKinsey. Skilling joined Enron at an auspicious time.

One of Skilling's early contributions was to move Enron from a traditional historical cost
accounting method to a mark to market (MTM) accounting method, for which the company
got official SEC approval in 1992. MTM is a measure of the fair value of accounts that can
change over time, such as assets and liabilities. MTM aims to provide a realistic appraisal of
an institution's or company's current financial situation. It is a legitimate and widely-used
practice. However, it can be manipulated, since MTM is not based on "actual" cost but on
"fair value," which is harder to pin down. Some believe MTM was the beginning of the end
for Enron, as it essentially started logging estimated profits as actual ones.

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By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey
Skilling had a way of hiding the financial losses of the trading business and other operations
of the company it was called MTM accounting. This is a technique used where you measure
the value of a security based on its current market value, instead of its book value. This can
work well when trading securities, but it can be disastrous for actual businesses.

In Enron's case, the company would build an asset, such as a power plant, and immediately
claim the projected profit on its books, even though it hadn't made one dime from it. If the
revenue from the power plant was less than the projected amount, instead of taking the loss,
the company would then transfer the asset to an off-the-books corporation, where the loss
would go unreported. This type of accounting enabled Enron to write off unprofitable
activities without hurting its bottom line.

The MTM practice led to schemes that were designed to hide the losses and make the
company appear to be more profitable than it really was. To cope with the mounting
liabilities, Andrew Fastow, a rising star who was promoted to CFO in 1998, came up with a
deliberate plan to make the company appear to be in sound financial shape, despite the fact
that many of its subsidiaries were losing money.

Fastow and others at Enron orchestrated a scheme to use off-balance-sheet special purpose
vehicles (SPVs), also known as special purposes entities (SPEs) to hide its mountains of debt
and toxic assets from investors and creditors. The primary aim of these SPVs was to hide
accounting realities, rather than operating results. Enron would transfer some of its rapidly
rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the
stock to hedge an asset listed on Enron's balance sheet. In turn, Enron would guarantee the
SPV's value to reduce apparent counterparty risk.

Although their aim was to hide accounting realities, the SPVs weren't illegal, as such. But
they were different from standard debt securitization in several significant – and potentially
disastrous – ways. One major difference was that the SPVs were capitalized entirely with
Enron stock. This directly compromised the ability of the SPVs to hedge if Enron's share
prices fell. Just as dangerous was the second significant difference, Enron's failure to disclose
conflicts of interest. Enron disclosed the SPVs' existence to the investing public, although it's
certainly likely that few people understood them, but it failed to adequately disclose the non-
arm's length deals between the company and the SPVs.

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Enron believed that its stock price would keep appreciating, a belief similar to that embodied
by Long-Term Capital Management, a large hedge fund, before its collapse in 1998.
Eventually, Enron's stock declined. The values of the SPVs also fell, forcing Enron's
guarantees to take effect.

In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting
firm Arthur Andersen LLP and partner David B. Duncan, who oversaw Enron's accounts. As
one of the five largest accounting firms in the United States at the time, Andersen had a
reputation for high standards and quality risk management.

However, despite Enron's poor accounting practices, Arthur Andersen offered its stamp of
approval, signing off on the corporate reports for years, which was enough for investors and
regulators alike. This game couldn't go on forever, however, and by April 2001, many
analysts started to question Enron's earnings and their transparency.

Arthur Andersen was one of the first casualties of Enron's prolific demise. In June 2002, the
firm was found guilty of obstructing justice for shredding Enron's financial documents to
conceal them from the SEC. The conviction was overturned later, on appeal, however, the
firm was deeply disgraced by the scandal, and dwindled into a holding company. A group of
former partners bought the name in 2014, creating a firm named Andersen Global.

Several of Enron's executives were charged with a slew of charges, including conspiracy,
insider trading, and securities fraud. Enron's founder and former CEO Kenneth Lay was
convicted of six counts of fraud and conspiracy and four counts of bank fraud. Prior to
sentencing, though, he died of a heart attack in Colorado.

Enron's former star CFO Andrew Fastow plead guilty to two counts of wire fraud and
securities fraud for facilitating Enron's corrupt business practices. He ultimately cut a deal for
cooperating with federal authorities and served a four-year sentence, which ended in 2011.
Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest sentence of
anyone involved in the Enron scandal. In 2006, Skilling was convicted of conspiracy, fraud,
and insider trading.

Apart from the Enron scandal, there were several creative accounting scandals of which some
have been summarised below.
WorldCom was an American telecommunications company based out of Ashburn, Virginia.
In 2002, it was discovered that Worldcom had inflated its assets by almost $11billion, making
it by far the largest accounting scandal ever. The company had underreported line costs by

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capitalising instead of expensing them and has inflated its revenues by making false entries.
The scandal first came to light when the company’s internal audit department found almost
$3.8billion in fraud accounts. The Company’s CEO Bernie Ebbers, was sentenced to 25 years
in prison for fraud, conspiracy and filing false documents. The scandal resulted into over
30,000 job losses and over $180billion in losses by investors.
Tyco international was an American blue-chip security systems company based out of
Princeton, New Jersey. In 2002, it was discovered that CEO, Dennis Kozlowski and CFO,
Mark Swartz had stolen over $150million from the company and has inflated the company’s
earnings by over $500million. Kozlowski and Swartz had siphoned off money using
unapproved loans and stock sales. The scandal was discovered when SEC and office of
district attorney of Manhattan carried out investigations related to certain questionable
accounting practices by the company. These were both sentenced to 8-25 years in prison and
forced them to pay $2.92 billion to investors.

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The impacts of creative accounting.
This section highlights at the effects of creative accounting practices as observed in the
various accounting scandals experienced overtime.
Impact of Creative Accounting on Financial Statements Accounting creativity is euphemism
and contributes the biggest percentage to the unfair reporting of firms operations. The
creativity in those practices is motivated by greed and intended to deceive the public,
potential investors and shareholders and increases the rate of enterprise failures at a
decreasing rate. Creative accounting promotes and sustains company’s image, and to select
information so that the data offered should maintain the interest that they have in mind. The
fact is that the managers under financial pressure are looking for solutions without thinking of
ethical issue at hand. The presence of options based on freedom of choice and appreciation
enables management enterprise, according to its interests, to reverse reasons or translate
legal, economic and financial innovations for problems that cannot be yet solved by
regulations, which leads to creative accounting and subjectivism resulting in the shaping of
results and financial statement contents (Marlina & Corina, 2012).

Some of the effects are short term while others stretch over a long period of time. The effects
of creative accounting may stretch far beyond the immediate confines of the company.
Creative accounting usually goes unnoticed until it either develops into a fraud or there is a
corporate collapse or some other form of accounting scandal.

Some of the immediate consequences of creative accounting is that the company itself may
collapse, taken over by another firm or drop in share prices where investors lose money. Both
the innocent and the guilty always suffer from the effects. The guilty are always punished by
the innocent may never get compensated for their financial loss. Individual like Jeffrey
Skilling, Bernard Ebbers and Bernard Madoff in the USA were sent to prison while others
were fined as a result of having been found guilty in the accounting scandals that took place
in the USA.

It can lead to imprisonment of the directors, mangers or employees of the company who are
accused of orchestrating creative accounting upon being found guilty of accounting
malpractice.in the USA, Jeffrey Skilling of the Enron scandal was sentenced to 25years while
Bernard Ebbers of worldcom was also sentenced to 25years.

Creative accounting gone bad can easily lead to the loss of jobs. This can be witnessed from
the several employees who lost jobs in the USA after the big companies had collapsed as a
result of excessive use of accounting techniques. This can be witnessed in the major
accounting scandals in the USA that have led to loss of jobs of over 20000 people.

Auditors are another group of people that are affected whenever creative accounting scandals
emerge. Auditors are supposed to be independent of the companies they audit, and to exercise
professional care and scepticism. It is, therefore, inevitable that after major cases of financial
irregularities or financial collapse, auditors are often censured. Most of the times, the auditing
firms are always fined or settlement is made out of court. For example In Germany, KPMG
were the auditors of Flowtex and gave a set of fictitious accounts an unqualified report.
Having failed to spot such a widespread fraud, the auditor paid the banks an out-of-court
settlement of DM 100 million although without admitting any wrongdoing.

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There are also wider economic impacts of accounting scandals. These easily distort the
operation of the stock markets for example in japan, the accounting scandal at Livedoor led to
a wide spread sale of Livedoor’s shares and also caused panic to the Tokyo stock exchange.
There was a massive drop of share prices of the Enron Company on the stock market in the
USA upon the discovery of the accounting scandal that had been caused in Enron.

Upon the discovery of accounting scandals, there is always a lot of extensive media interest,
follow-up stories, investigations and many other things which greatly exposes the company to
the public leading to massive reputational damage. At times this reputational damage is
unrecoverable.

Creative accounting scandals have led to emergence of increased regulations and laws that
guide and govern how reporting is done in public entities. The most famous regulation
introduced was the Sarbane-Oxley Act in the USA after the Enron and WorldCom accounting
scandals. There were also different boards introduced such as the Public companies
accounting oversight board.

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Measures to mitigate the use of creative accounting.
Companies risk having the adverse effects of creative accounting such as collapse,
reputational image distortion, fine and penalties, insolvency, loss of jobs and many others. In
order to avert these risks, they have to adopt mechanisms and practices as summarised below.

Companies should develop a system of segregation of duties where employee’s tasks and
activities are made clear and independent of each other. This will reduce the risk of having
one person carry out different tasks that can be easily manipulated hence leading to
manipulation of figures without detection.

Management should cultivate and ethical work environment and this should be emphasized
and developed right from the top. The use of creative accounting normally stems from a
business culture where management does not emphasize or demonstrate ethical behaviour.

Institution of constant audits both by internal and external auditors. These may not
necessarily prevent unauthorised extensive accounting but with extensive experience, it is
easy to identify or detect traces of creative accounting (international journal of business and
management, February 2013)

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References.
1. Raybaud Turillo B., Teller R., 1996. Comptabilite creative, Economica, Paris
2. Susmuş, T., & Demirhan, D. (2013). Creative accounting: a brief history and conceptual
framework. Uluslararası Hakemli Sosyal Bilimler E-Dergisi, 38(2), 3-9
3. Ismael, A. Y. A. (2017). The impact of creative accounting techniques on the reliability of
financial reporting with particular reference to Saudi auditors and academics. International
Journal of Economics and Financial Issues, 7(2), 283-291
4. Marilena, Zuca & Corina, Ioanas, 2012, Embellishment of financial statements through
creative accounting policies and options, Procedia - Social and Behavioral Sciences, vol 62,
pp 347 – 351.

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