Creative Accounting

Assignment
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.

Introduction

Creative accounting is when managers of an organisation intentionally misstate their

financial information to favourably 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 accounting vary, and include the following:

‘Is the deliberate dampening of fluctuations about “some level of earnings
considered to be normal for the firm”’. (Barnea et al. 1976)
‘Is 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)
‘Involves the repetitive selection of accounting measurement or reporting rules in a
particular pattern, the effect of which 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 “true and fair” view of a
company accounts.

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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
agreements, or to hide problems.

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

The term “window dressing” has similar meaning when applied to accounts, but is a
broader term that may be applied to other areas. In the context of accounts, “window
dressing” is more likely to imply illegal or fraudulent practices.

Creative Accounting is a term that many people, from all walks of life, feel free to
use; but which can prove difficult to define. One of the first books, certainly in the
UK, to be written on this subject, had a title that gave a good clue as to the definition
of creative accounting, the title was Creative Accounting: How to make your profits
what you want them to be. (Ian Griffiths (1986) Sidgwick and Jackson).
 
The problem with Griffiths’ definition, if that is what it is, is that suggesting that it is
merely a profit manipulation technique does not take it far enough. As we will wee,
creative accounting includes profit manipulations; but it also includes such matters
as Off Balance Sheet financing, Ratio manipulation, shareholder control avoidance.
My definition, therefore, 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 is “a process whereby accountants use their knowledge of

accounting rules to manipulate the figures in the account of a business”
[ CITATION Ama99 \l 2057 ]
 
A bit of a difficult definition; but it, summarise what it is. Creative accounting can be
associated with tax avoidance as opposed to tax evasion. Tax avoidance is legal but
may travel a crooked road; whereas tax evasion is simply illegal. This point is
emphasised by the following extract from the Dearing Committee Report:

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‘There 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 ‘
(Dearing Committee (1988) The making of accounting standards)

Creative accounting includes

 
Creative accounting is more than just a profit changing technique. 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, that would otherwise be impossible to raise.

We can see from McBarnet and Whelan’s list why Griffiths’ title does not go far
enough. We should also be able to see that if creative accounting is practiced by
any organisation, then there is plenty of scope of planning and manipulation the
accounting information. Such manipulation might leave the shareholder, the public,
the Government, and any other interested party, absolutely confused as to what is
and what is not real and true in connection with a published set of accounting
statements.
 

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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, 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 substance over form. Therefore,
they are applying the form in the hope that the substance will disappear from view.
The problem here is that when a company leases an asset, 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. 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 machinery costs £100,000 but it will improve the operating profit by 10% per
year. 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.
  Current Buy Lease
  £ £ £
Operating profit 40,000 44,000 44,000
Equity capital 200,000 200,000 200,000
Long term debt 100,000 200,000 100,000
Total capital employed 300,000 400,000 300,000
       
Gearing ratio 0.5: 1 1: 1 0.5: 1
ROCE 13.33% 11.00% 14.66%
 
The value of the relevant key ratios varies significantly depending on the approach
taken to financing the machinery. Similarly, the impact of choosing between finance
and an operating lease will equally effect the ratios of an organisation.

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 [ CITATION McB99 \l 2057 ]

This example helps to show us the sort of outcome being creative can comprise on
the results of a business. If the lease remains off the Balance Sheet, the gearing
ratio and the ROCE ratio are both radically different to the position when the
business buys the asset in question.

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 vis a vis the strength of directors
 Directors are not accountable to the accountancy profession, 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
 [ CITATION McB99 \l 2057 ]

The situation we have then is that accountants have a genuine array of techniques
they can employ in the creative accounting field; but inadequate enforcement of the
rules and the legislation provides little or no deterrent from being so creative.
 

Disadvantages of creative accounting

 
It is not all-good news for those who would be creative. The downside of creative
accounting include

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The potentially adverse impact of creative accounting on

 
 Investors
 Creditors
 Employees

Note: The theoretical framework proposed for the understanding of creative

accounting practices, diagram and caption see the appendix.

Creative accounting can conceal shortcomings in corporate performance: the leasing

example above can be construed to demonstrate this point. Corporate accounting
statements are on the market for corporate investors an important source of
information. However, in the world market, there are still more false accounting
statements. False accounting statements to investors falsely convey the company's
information will lead to investor decision-making errors, the final result in losses for
investors. The primary cause of false accounting statements, ‘Enterprise
Management fraud’ and corporate failure of two aspects of the business, investors
can through careful analysis, identification of false accounting statements to find a
strategy.

General internal control system can be used to prevent and detect, usually involving
direct embezzlement of public funds or theft of property. Management of fraud
generally refers to senior management personnel to obtain illegal benefits to achieve
the purpose of deliberately glossing over the accounting statements, leading to
serious inaccuracies in the accounting statements. Management of fraud are usually
prepared in advance, and afterwards strongly try to hide those who cheat the higher
levels of management, within the short term even more difficult to identify.
Enterprise management motivation for fraud
Here are five categories:
1. To ensure that jobs and earn rewards. In business, shareholders and
regulatory authorities is a contract between the contractual relationships.
However, as the authorities and not consistent between the interests of

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shareholders, companies must resort to some kind of incentive mechanism

to make the regulatory authorities in order to maximize shareholder value
hard work. For example, according to corporate profits figures to determine
the management compensation contracts, is a more effective incentive.
Therefore, in order to maximize their own rewards, management by false
ways in which accounting numbers favour.

2. To raise funds. The blood of the enterprise funds. Business loans or

additional capital in order to achieve the purpose, may gloss over its
accounting statements to mislead investors, creditors in making investment,
credit decision-making. As in the enterprise and its creditors signed a loan
contract, the creditor in order to protect their own interests, often provides a
lot of constraints such as not allowed to release the excess dividends,
liquidity ratio, quick ratio shall not be below a specific level. Because
corporate defaults are paying a high price, so when enterprises realize the
number of its financial statements has violated or will violate the conditions
laid down, the enterprise will be managed on the surplus in order to reduce
the possibility of violation of debt contracts.

3. To evade taxes. This is the most obvious one of accounting fraud

motivation in financial accounting and tax accounting separation of the
country, the situation is even more so. Business leaders sometimes
instructed the accounting personnel in the accounting fraud, tax evasion, in
order to reduce cash expenditures. Of course, in financial accounting and
tax accounting highly unified country, management and reporting of tax
saving on the need for a better trade-off between performance.

4. To avoid the huge cost. Political costs refer to enterprises for political
reasons, the burden of expenditure. When the strong profitability of the
enterprises, they will be too much public and government concern.
Government departments may be taken to impose high taxes or other
restrictions on the enterprise. This is in large enterprises and people's
livelihood, particularly evident in the performance of the industry. For

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example, since 2003, world oil prices rose, the oil company profits soared,
the government may be taken in order to avoid the very income tax, and the
oil companies have adopted varying degrees of fraud in order to reduce
profits.

5. To manipulate the company's stock price. Business leaders to

manipulate the stock volatility, often using false financial statements to
achieve their goals. 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, in order to achieve greater control over, or for
sale. Since then, the use of false financial statements continue to prop up
share prices to make their own to reap huge profits, while the medium and
small investors suffered huge losses.

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. This is possible, of course, but a more formal list of
who should report creativity in accounting statements is
 Business organisations, or other corporate bodies
 A qualified audit report in the statements themselves
 A note in the accounting statements discusses a departure from accounting
standards or other requirements
 An article in a newspaper, journal or magazine
[ CITATION McB99 \l 2057 ] 

Audit partner A, a senior member of the Institute of Chartered Accountants in

England and Wales, had this to say on U.K. accounting standards:*’
I think that U.K. accounting standards are amongst the weakest in the developed
world, and there is significant scope for subjectivity and creativity.

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This regulatory system placed a significant reliance on the auditors’ exercise of

professional judgement in areas where there were no specific pronouncements. The
“true and fair view” concept which is unique to U.K. 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, 1991).”
(*’ Hughes & Lubbock (1989).** Interview, March 1992.)

Creative accounting represents undesirable practices because such practices

prevent people seeing the true and fair financial state of a company. 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, to
manipulate profit to tie into forecasts and to distract attention from the news, which
will not be welcome (Amat et al., 1999, p. 7–8). This is actually where, the ethical
framework of the creative accounting, particularly in the private sector, is related with
the “agency theory” (Amat et al., 1999, p. 9).
The creative accounting practices sometimes occur due to the pressure coming from
the top management (Leib, 2002, p. 36). This reality justifies the proposition that the
financial managers confront with miscellaneous pressure to overestimate the
financial state of their companies. 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. On one hand, managers are able to
manipulate income between years so as to maximise their earnings. On the other
hand, 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 their shares. As a result of creative accounting
practices, a firm can confront with a better earning picture, higher stock prices, more
valuable stock options, and incentive earnings (Person, 2002, p. 88). Therefore,
these practices are all realised to overestimate the financial situation of firms and
economies. One may not always expect objectivity, ethical conduct and the correct
information from accounting records (McKernan and Dunn, 2003, p. 442) due to
distortion and spoilage of the accounting knowledge, which can be counted among
the reasons of creative accounting.

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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 latitude in timing the reporting of income. He thinks that the
prime role of accounting is as a mechanism for monitoring contracts between
managers and other groups providing finance; market mechanisms will operate
efficiently, identifying the prospect of accounting manipulation and reflecting this
appropriately in pricing and contracting decisions. 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 applied to the bias in accounting policy
choice at the 'micro' level of the management of individual companies that is implicit
in creative accounting.

The techniques of creative accounting change over time according to the accounting
standards. Many changes in accounting standards are meant to block particular
ways of manipulating accounts, which means that 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 (the use
of fair value is a good example of this). Many (but not all) 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

Of course, for someone to want to blow the whistle, there has to be a reason, a
motivation, to do it. In some cases, such reasons could be strong. In other cases,
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 lose the audit
account if they do
Conclusions
 
If an accountant wants to use creative accounting, he will. There seems little doubt
that there is always room for the accounting profession to leave room for

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manipulative actions in accounting statements. This 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. However, as Griffiths says in the second of his two
books on creative accounting:
 
While many of the more flagrant abuses … have been outlawed, 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 watching world.
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. In this section we analyse some measures that can help to
reduce the scope for creative accounting practices, identifying, where applicable,
recent developments in International Accounting Standards (IASs). IASs will become
the standard for all
European listed companies from 2005.
Accounting regulators who wish to curb creative accounting have to tackle each of
these approaches in a different way:

1. 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. Requiring consistency of use of methods
also helps here, since a company choosing a method, which produces the
desired picture in one year, will then be forced to use the same method in
future circumstances where the result may be less favourable. The latest
developments in International Accounting Standards are pursuing the
objective of reduction in accounting choice. (IASB, 2003).

2. Abuse of judgement can be curbed in two ways. One is to draft rules that
minimise the use of judgement. At one time, for example, 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. Again, the

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present rules of the International Accounting Standards have nearly abolished

the category of 'extraordinary item'. Auditors also have a part to play in
identifying dishonest estimates. 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.

3. Artificial transactions can be tackled by invoking the concept of 'substance

over form', whereby the economic substance rather than the legal form of
transactions determines their accounting substance. Thus linked transactions
would be accounted for as one whole.

4. The timing of genuine transactions is clearly a matter for the discretion of

management. However, the scope to use this can be limited by requiring
regular revaluations of items in the accounts so that gains or losses on value
changes are identified in the accounts each year as they occur, rather than
only appearing in total in the year that a disposal occurs. It is interesting to
observe that the International Accounting Standards Board is tending to move
towards valuation at fair value rather than based upon historical cost in
several recent accounting standards and discussion papers. Nevertheless,
apart from changes in accounting regulation, ethical standards and
governance codes must be properly enforced in the corporate world.
Regulation without thorough enforcement techniques is likely to be ineffective
in preventing individuals from employing misleading reporting practices. The
challenge of enforcing International Accounting Standards within a range of
differing accounting cultural contexts is likely to be especially problematic.

Both legitimate and illegitimate creative accountings are in practice frequently. (Profit
overstatement) and (profit understatement) of Appendix 3 constitute violation of the
law and of GAAP. [ CITATION Bar04 \l 2057 ]

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