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Creative Accounting: Definition, Methods and Prevention

After reading this article you will learn about:- 1. Definitions of Creative Accounting 2. Methods of Creative Accounting 3. Prevention.

Definitions of Creative Accounting:

The term ‘creative accounting’ can be defined in a number of ways. Initially we will offer this definition; ‘a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business’.

They are characterised by excessive complication and the use of novel ways of characterizing income, assets or liabilities. This results in financial reports that are not at all dull, but have all the complication of a novel by James Joyce, hence the appellation “creative.” Sometimes the words “innovative” or “aggressive” are used.

Creative accounting, which generally involves the preparation of financial statements with the intention of misleading readers of those statements, is prima facie a form of lying.

It examines and rejects the arguments for considering creative accounting, in spite of its deceptive intent, as not being a form of lying. It then examines the ethical issues raised by creative accounting, in the light of the literature on the ethics of lying.

This literature includes the evaluation of various excuses and justifications for lying, and these are examined here in relation to creative accounting. It is concluded that even in circumstances in which creative accounting would arguably serve a worthy purpose, that purpose would be at least as well served by honest communication.

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 “true and fair” view of a company that accounts are supposed to:

(a) A typical aim of creative accounting will be to inflate profit figures. Some companies may also reduce reported profits in good years to smooth results. Assets and liabilities may also be manipulated, either to remain within limits such as debt covenants, or to hide problems.

(b) Typical creative accounting tricks include off balance sheet financing, over-optimistic revenue recognition and the use of exaggerated non-recurring items.

(c) Window Dressing has similar meaning when applied to accounts, but is a broader term that can be applied to other areas. In the US it is often used to describe the manipulation of investment portfolio performance numbers. In the context of accounts, “window dressing” is more likely than “creative accounting” to imply illegal or fraudulent practices, but it need to do so.

(d) The techniques of creative accounting change over time. As accounting standards change, the techniques that will work change. Many changes in accounting standards are meant to block particular ways of manipulating accounts, which means those intent on creative accounting need to find new ways of doing things. At the same time, other, well intentioned, changes in accounting standards open up new opportunities for creative accounting and in the use of fair value is a good example of this.

(e) Many creative accounting techniques change the main numbers shown in the financial statements, but make themselves evident elsewhere, most often in the notes to the accounts. The market has been surprised before by bad news hidden in the notes, so a diligent approach can give you an edge.

Methods of Creative Accounting:

(1) Although not technically wrong, many annual and quarterly reports and presentations dive heavily into theoretical scenarios where one time “charges” to earnings are excluded. What this means is for example, a law suit settlement amount would be taken out of the reported profit in one big chunk, even if its paid out little by little over time.

This practice is called reserving. Often, when explaining the quarterly results, a CEO might say “Well if we didn’t take this charge for the law suit, we would have made this much money”. Very often, the hypothetical situations proposed get even more complicated. The main “creative” aspect to this is when a “one time” “exceptional” charge really is something that is very common to the business.

(2) Banks are able to lend out most of the money they receive in deposit. The banks can also can lend money they borrow from other banks. However, to protect against bad loans, banks must keep aside a stash of money called a “reserve”. The bank, within general guidelines, gets to set the size of this reserve to what it feels is prudent compared to how risky its outstanding loans are. However, when the bank wants to make it look like it made more money this quarter than last, one way to do that is to take money from the reserve and call it profit with the excuse that the loans are safer now than before and that amount was no longer needed.

(3) One of the main genres of “creative accounting” is known as slush fund accounting, whereby some earnings from this quarter are hidden away just in case the profit from next quarter is not enough for the management to make their bonuses. This happened most famously at Freddie Mac. As of 2004 there is a large investigation underway to see if retroactive insurance policies from insurers such as General Re of Berkshire Hathaway were used for slush fund accounting. The question is if these insurance policies truly transferred some risk or were merely a slush fund.

Prevention of Creative Accounting:

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.

To prevent creative accounting, the experts opine that 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. The investors should diversify their investment portfolio to circumvent the problems related to the creative accounting by few unscrupulous companies.

The company has to adhere strictly to the ethical values it has set itself with the long-run and the short-run of the life of the company. The accounting and accounting practices have to be consistent and show to the investors that it is following the ethical practices in all its financial dealing as well as reporting.

How Enron Played the Game of Creative Accounting:

According to Mulford, the expert in the field, 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, Mulford wrote the book 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.”

About the author

Salman Qureshi

Salman Qureshi is an Accountant by profession & he loves to write on Commerce & Management Sciences Subject to assist Students. Hope you guys will like his effort.