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.
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 accounting can be used to manage earnings and to keep debt off the balance sheet.Creative accounting and earnings management are euphemisms referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules. They are characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes used.
The term as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations. "Creative accounting" is at the root of a number of accounting scandals, and many proposals for accounting reform – usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added.
Newspaper and television journalists have hypothesized that the stock market downturn of 2002 was precipitated by reports of accounting irregularities at Enron, Worldcom, and other firms in the United States.
One commonly accepted incentive for the systemic over-reporting of corporate income which came to light in 2002 was the granting of stock options as part of executive compensation packages. Since stock prices reflect earning reports, stock options could be most profitably exercised when income is exaggerated, and the stock can be sold at an inflated profit
Characteristics of the creative accounting concept
Although today there is enough material on this issue, in accounting practices this
phenomenon appears very often and it surprises me how far are some owners able and willing
to go due vision of money2.
If there were the perfect environment, the perfectly unblemished people or even better no
"creative" entrepreneurs, there might operate only two types of accounting - management and
financial one. Management accounting at its core deals with the cost structure dividing cost in
terms of species and or purpose, calculations, the activities of individual departments and thus
can generalize its internal usage based on internal accounting.
In contrast financial accounting represents the company externally, provides the information
to external stakeholders. In describing the basic elements of accounting is clear that
somewhere in between creative accounting just being born. Accounting is a language and
could be easily read by those who understands it. The necessary economic information could
be easily found but also when the rules are used “the right way” they could be unprecedented.
Creativity in the accounting therefore comes at a time when the true background, figures and
results should reach the public. This transforms the actual financial statements to those which
the owners would like to achieve as positive and favourable results of the company. At this
moment there start internal processes in which the owners choose the way they will follow.
For such a decision the experts on accounting and tax issues (auditors or tax advisors) are
usually present.3Even though they have thousands of compelling arguments why not to use
creativity in accounting in the most cases do nothing else than to retreat from their view
although is supported by arguments based on the accuracy of the law. It is the shareholders
and directors who are responsible for the accuracy of accounts. The paradox however remains
the fact that the experts must to find out the accounting and tax levers to fix situation when
the enterprise gets into trouble trough its creativity
The reasons of creative accounting
The reasons for creative accounting could be several. To defend the owners of companies the
creativity by itself can sometimes come from the very person who maintains the accounts and
this is time to question whether that creativity is deliberate or caused by lack of financial
knowledge. At this point necessary steps have to be taken by the owners.
Such a questions, however, does not have to be ask when the owners of creative accounting
are also the owners of enterprise. There is always a conscious thing. Most of the owners are
warned in advance of the possible dangers and risks that result from their decisions.4
Another element that comes into contact with the financial statements is management. If it is a
large company managers are usually valuated according to company earnings. We should
imagine enterprise which owners are also part of management and therefore there is no
separation and all decisions do not go through the management, but directly from
shareholders. Then we can analyze the reasons for creative accounting.
always "only" two reasons; the overestimation or underestimation of the individual
components of financial statements and it corresponds accordingly to what is needed to get. If
the company (not the new established company) needs to gain a greater amount of the loan, it
is clear that they must have their assets in the desired positive values. In the specific example
below shows what all such an artificial overestimation can cause. The same procedure should
be used by even a moment the company needs to attract investors. Converse steps will be
proceeding with applying for grants or tax optimization of course.
Whatever the reason is the creative accounting will always be reflected in financial indicators
and ultimately the of company solvency, because not everything that looks like profit is
really a profit. The truth is that even at the moment of artificial overestimation of financial
ratios the company could fall into insolvency, bankruptcy, insolvency, etc. That is the essence
of the creative accounting that eventually affects everything and the situation grow to the
stage where is difficult to save anything
Advantages and disadvantages
Although the present text refers rather to the disadvantage of creative accounting and
identifies with not to use it, I'd like to add also the knowledge from my accounting practices
that there are not always so catastrophic scenarios. There are situations where creative
accounting and its impact are not let to go too far and are used in the short term and rather
make the "gear" stone than some kind of permanent condition.
Yes, there are also company owners who fully recognize the risks and impacts of fictional
accounts, so they use creativity sparingly and then rearranged the facts so that their financial
statements comply with its primary mission and the faithfully reflects the economic reality of
company at the end.5
4. How to avoid creative accounting
Large restriction on creative accounting could be seen at so-called harmonization of financial
reporting and by application of mandatory IFRS (International Financial Reporting Standards)
IAS, which are international guidelines for accounting and also preparation and presentation
of financial statements published by the International Accounting Standards Board (IASB
International Accounting Standards Board)