Creative Accounting

What is Creative Accounting?

Creative accounting consists of accounting practices that follow required laws and regulations,
but deviate from what those standards intend to accomplish. Creative accounting capitalizes
on loopholes in the accounting standards to falsely portray a better image of the company.
Although creative accounting practices are legal, the loopholes they exploit are often reformed
to prevent such behaviors.

How Creative Accounting Works

A primary benefit of public accounting statements is that they allow investors to compare
the financial health of competing companies. However, when firms indulge in creative
accounting, they often distort the value of the information that their financials provide.

Creative accountants will always find bizarre and novel ways to tweak figures to a company’s
advantage. Their goal is to make a firm look as successful and profitable as possible and
sometimes they will go about doing this by twisting the truth. If a gray area in accounting is
found, it may be exploited, even if it results in misleading investors.

Getting caught can ruin a company's reputation overnight. However, some management teams
are willing to run that risk, condoning the use of creative accounting because failure to meet
short-term expectations of Wall Street or year-end financial targets can have a hugely adverse
impact on share prices.

It is also worth remembering that more attractive figures may lead to higher bonuses for
directors, help convince a lender to give a firm a loan and inflate the company’s valuation in the
event of a sale.

Types of Creative Accounting

Creative accounting tricks vary in nature and consistently evolve as regulations to police them
change. Here are some examples of common techniques:

 Overestimating revenues: One of the most common techniques used by public

companies looking to artificially boost their income is to prematurely
recognize revenue. Revenue recognition is an accounting method that enables
companies to recognize sales before they deliver a product or perform a service. It is
open to exploitation.
 Lowering depreciation charges: Companies often spread out the cost of assets, rather
than expensing them in one hit. Methods to reduce annual charges on these items can
include extending the useful life estimate of the asset or increasing its assumed salvage
value.
  Delaying expenses: Deferring the recording of current period expenses, such as
payments to suppliers and rent, to a subsequent period makes current period earnings
look better.
 Masking contingent liabilities: Failure to record potential liabilities that are likely to
occur and underestimating how much they are likely to cost can boost net
income or shareholders' equity.
 Undervaluing pension liabilities: Pension obligations can easily be manipulated because
the liabilities occur in the future and company-generated estimates need to be used to
account for them. 
 Inventory manipulation: Inventory represents the value of goods that were
manufactured but not yet sold. Overstating the value of inventory will lead to an
understatement of cost of goods sold, and therefore an artificially higher net income,
assuming actual inventory and sales levels remain constant.

Real World Examples of Creative Accounting

Laribee Wire Manufacturing Co. offers a good example of inventory manipulation. The copper-
wire maker was in trouble in the late 1980s as sales to the troubled construction industry
faltered and a big acquisition left it with massive debt. Laribee recorded phantom inventory and
carried other inventory at bloated values to convince banks to lend it $130 million. The
company reported $3 million in net income for the period, when it really lost $6.5 million.

Then there is Enron Corp. In the 1990s, the energy, commodities, and services company
engaged in all sorts of unethical accounting practices. It hid debt, understated losses and
manipulated various financial figures to create an illusion of profitability, before filing for
bankruptcy in 2001.

The WorldCom scandal is another high profile example of creative accounting leading to fraud.
To hide its falling profitability, the company inflated net income and cash flow by recording
expenses as investments. By capitalizing expenses, it exaggerated profits by around $3 billion in
2001 and $797 million in Q1 2002, reporting a profit of $1.4 billion instead of a net loss.

Special Considerations
Analysts, asset managers, and financial journalists failed to see many of the above scandals
coming, proving that it is not always easy to spot questionable accounting practices. However,
that does not mean that investors should sit back and do nothing. Being skeptical and
reading financial statements a little more closely, rather than just focusing on what
management highlight, can go a long way to detecting suspicious activity.

A good starting point is to carefully read company footnotes, assess the reliability

of auditors and pay careful attention to any unusual variations in figures.

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