Creative Accounting

Aggressive accounting, income smoothing, earnings management, innovative and creative accounting are the financial reporting gimmicks used to moderate company’s financial reports to encourage investors to buy the company’s stocks to increase the firm’s market value (Mulford and Comiskey, 2002)

Creative accounting refers to accounting practices that may or may not follow the letter of the rules of accounting standard practices but certainly deviate from those rules and regulations. It may be characterized by excessive complication and using innovative ways of characterizing income, assets and liabilities. 

DEFINITIONS OF CREATIVE ACCOUNTING

Creative Accounting refers to the use of accounting knowledge to influence the reported figures, while remaining within the jurisdiction of accounting rules and laws, so that instead of showing the actual performance or position of the company, they reflect what the management wants to tell the stakeholders.

Creative accounting is the transformation of financial accounting figures from what they actually are to what preparer desires by taking advantage of the existing rules and or  ignoring some or all of them [Kamal Naser, 1992].

Is any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may in fact, in the long-term, be detrimental. (Merchant and Rockness, 1994)

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.

Creative accounting is a process whereby accountants use knowledge of accounting rules to manipulate figures reported in the accounts of a business. 

REASONS FOR CREATIVE ACCOUNTING

Discussions of creative accounting have focused mainly on the impact on decision of investors in the stock market. Reasons for the directors of listed companies to seek to manipulate the
accounts are as follows.

1.   Income smoothing. Companies generally prefer to report a steady trend of growth in profit rather than to show volatile profits with a series of dramatic rises and falls. This is achieved by making unnecessarily high provisions for liabilities and against asset values in good years so that these provisions can be reduced, thereby improving reported profits, in bad years

2.   Creative accounting may help maintain or boost the share price both by reducing the apparent levels of borrowing, so making the company appear subject to less risk, and by creating the appearance of a good profit trend. This helps the company to raise capital from new share issues, offer their own shares in takeover bids, and resist takeover by other companies.

3.  If the directors engage in 'insider dealing' in their company's shares they can use creative accounting to delay the release of information for the market, thereby enhancing their opportunity to benefit from inside knowledge.

4.   Winning investor's confidence. The main purpose of creative accounting is of course winning the confidence of the investors. This will ensure that the face value of the company is not lost even if it is going through a rough phase. The bad performance of the company is somehow balanced and overcome in the book of records with few creative entries. This small adjustment in the books can help the company to hide those temporary lows and thus ensure investors stay interested.

5.  Consistent growth. Every business wants to portray consistent growth instead of depicting volatility in terms of profits. This is the main reason why creative accounting is being used as profit boosting tool in most of the business. By working the accounts in a legitimate method, the business could showcase a rosy picture although the story might not be as appealing as it is on the outside.

TECHNIQUES OF CREATIVE ACCOUNTING

The potential for creative accounting is found in six principal areas: regulatory flexibility, a dearth of regulation, a scope for managerial judgement in respect of assumptions about the future, the timing of some transactions, the use of artificial transactions and finally the reclassification and presentation of financial numbers.

1. Regulatory flexibility. Accounting regulation often permits a choice of policy, for example, in respect of asset valuation (International Accounting Standards permit a choice between carrying non-current assets at either revalued amounts or depreciated historical cost). Business entities may, quite validly, change their accounting policies. As Schipper (1989) points out, such changes may be relatively easy to identify in the year of change, but are much less readily discernible thereafter.
2. Dearth of regulation. Some areas are simply not fully regulated. For example, there are (as yet) very few mandatory requirements in respect of accounting for stock options. In the majority of countries, like Spain for example, accounting regulation in some areas is limited: for example the recognition and measurement of pension liabilities and certain aspects of accounting for financial instruments
3. Management has considerable scope for estimation in discretionary areas. McNichols and Wilson (1988), for example, examine the discretionary and non discretionary elements of the bad debts provision.
4. Genuine transactions can also be timed so as to give the desired impression in the accounts. As an example, suppose a business has an investment at historic cost which can easily be sold for a higher sales price, being the current value. The managers of the business are free to choose in which year they sell the investment and so increase the profit in the accounts.
5. Artificial transactions can be entered into both to manipulate balance sheet amounts and to move profits between accounting periods. This is achieved by entering into two or more related transactions with an obliging third party, normally a bank. For example, supposing an arrangement is made to sell an asset to a bank then lease that asset back for the rest of its useful life. The sale price under such a 'sale and leaseback' can be pitched above or below the current value of the asset, because the difference can be compensated for by increased or reduced rentals.
6. Reclassification and presentation of financial numbers are relatively under-explored in the literature. However, the study by Gramlich et al. (2001) suggests that firms may engage in balance sheet manipulation to reclassify liabilities in order to smooth reported liquidity and leverage ratios. A special type of creative accounting relates to the presentation of financial numbers, based on cognitive reference points.

HOW TO PREVENT CREATIVE ACCOUNTING

Following are to steps that can help to prevent creative accounting:

1.  Make sure your company is run under one bookkeeping system and one accounting system: Large companies often unintentionally promote creativity or error if every clerk, bookkeeper, or office manager is left to run their system as they see fit. In the case of a governmental audit, this can be difficult or devastating for a company to find themselves unable to make a good case that the accounting books are solid. One way to avoid this is to adopt a new and more efficient accounting program. Hire a head accountant to train everyone and to check that everyone follows the new practices to the letter.
2. Hire an internal auditor. Although this may sound unintuitive to audit yourself, it is preferable to check up on your own business transactions before the federal or state governments decide to audit you. It can also help your company to reduce waste, change to a more efficient system and reorganize. Many professional auditors work in this capacity. Also, many Certified Public Accountants (CPA) work in this capacity in the months after taxes are traditionally submitted.
3. Make sure your accountants, clerks and bookkeepers take a certain amount of ethics courses each year. While CPAs are required to take these credits, you should consider enrolling anyone who is involved with your finances from a clerk to the Chief Financial Officer (CFO). In the case of the largest scandals, such as Enron, the downfall was considered due to creative accounting. CFOs and other managers hid the debt of the company to inflate the stock price. These cases are now taught in ethics courses, so they can be analyzed, and, ideally, never repeated.
4. Create an internal checklist. These are the checks and balances that will make a company's books honest and scrupulous in the eyes of the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC) or any other outside agency. An internal checklist should start with monthly reports that follow the accounting system. It should include regular internal audits. It should also create a way in which whistle blowers on creative accounting will not lose their job.

ADVANTAGES OF CREATIVE ACCOUNTING

To the Managers:

 a). Helps to enhance management performance.

 b). Forms the basis of personal incentives of the Manager.

 c). To show incompetency of the management of the past.

 d). To meet internal targets set up by higher management.

e). Boost reported profits or minimize reported loss. 

To the Company:

a). Helps to gain access to Finance.

 b). Forms the base of Tax Management.

c). Helps in Management Buyouts.

d). Helps to conceal Financial Risk.

e). Avoid borrowing restrictions. 

To the Stakeholders:

a). Higher returns on their Investments

b). Consistency in Earnings.

To the Workers:

 a). Ensures Job Surety.

 b). Enhances Income.

c). Increase in Bonus and Incentives. 

DISADVANTAGES OF CREATIVE ACCOUNTING

1. Creative accounting Practical experiences shows that most of the time the creative accounting practices are not being handled judiciously and such techniques are mostly undertaken with unscrupulous intensions in order to misrepresent and mislead the society.
2. The Managers of the company are the one responsible for the misuse and abuse of Creative Accounting since in order to fulfill their selfish motives they defy the ethical consideration which are an essential part of Creative accounting. 
3. It is totally unethical and out of the limits of accounting standards  
4. it some time lead to uncontrollable situations which may impose a threat to the very existence of the company
5. Creative accounting can lead to suspicion audits by the government and in the case of fraud, it  to dissolution of a company.