Creative accounting is a euphemism referring to accounting practices that may follow the letter of the rules of standard accounting practices but deviate from the spirit of those rules. The Concept of Creative Accounting: Definition of Creative Accounting, Motivation for Creative Accounting, the existence of Creative Accounting, and Ethical Perspective of Creative Accounting! 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 desire by the authors.
Learn, Explain Creative Accounting: Definition, Motivation, and Ethical Considerations!
The terms “innovative” or “aggressive” are also sometimes used. Other synonyms include Cooking the books and Enronomics. Creative accounting is a euphemism referring to accounting practices that may follow the letter of the rules of standard accounting practices but deviate from the spirit of those rules – by Wikipedia.
Definition of Creative Accounting:
Creative accounts an accounting practice that falls outside the regulation and gives benefits to certain people. It can describe as a practice with a clear aim to interrupt the financial reporting process which affects reported income to make it looked normal; and, provides no true economic advantages to relevant parties like shareholders. Concisely, it is the transformation of financial accounting figures from what they are to what users desire by taking advantage of the accounting policies which permit by the accounting standard.
Creative accounts a practice that potentially undertakes as a result of some individual care more on their interest and indirectly causes issues to arise in the ethical dimension of creative accounting. From the information perspective, agency theory gives a clear picture of the creative accounting scenario. Whereby managers misuse their privileged position in manipulating financial reporting in their interest which providing superior information content to the shareholder. Lack of personal skill or unwillingness to carry out detailed analysis making individual shareholders do not have a clear view of the effect of accounting manipulation gives a high possibility of the incidence of creative accounting.
The motivation for Creative Accounting:
Several motivations have to identify in stimulating the behavior of creative accounting in the organization. Firstly, the significant motivator for creative accounting is to report a decrease in business income to lower the tax paid. Second, to enable the company’s performance to appear better in the future; the company will maximize the reported loss to make a bad loss that year. This is calls ‘big bath’ accounting to smooth the income. Thirdly, to provide a positive view on expectations, securities valuation, and reduction on risk for analysts in anticipated capital market transactions; and, maintain the firm’s performance in analyst’s expectations.
Other motivations are to manipulate profit to match the reported income to profit forecasts; and, to distract attention from negative news by boosting company profit figures through the change in accounting policies. Manager’s motivations in managing earning aim to report a stable growth in profit not only to reduce the perception of variability toward an organization’s earnings but also are about income measurement. To make the company faces less risk and gain more benefit in the aspect of raising funds; takeover bids as well as prevent the takeover by other companies.
It is needed to maintain or promote the share price and create a good profit growth. To gain benefit from inside knowledge, the director of the company engages creative accounting to postpone the release of information to the market. Last but not least, many types of contractual rights, obligations, and constraints based on the amount reported in the accounts also motivate the company to apply creative accounts. What are the Role and Duties of the Management Accountant?
The existence of Creative Accounting:
Theoretically, the manager’s motivation in there is acceptable. However, certain companies apply a particular technique of creative accounting to some extent; for example, applied in the non-discretionary component of the bad debts provision. Other evidence is Classificatory smoothing by using the extraordinary items; such as pensions cost, dividends from unconsolidated subsidiaries, extraordinary charges and credits; and, research and development costs in manipulating the figure of income in financial statements.
The behaviors can identify by having a thoughtful analysis of a financial statement or observe by the reasonably well-inform user of the financial statement. But, how clearness the users of statement observe creative accounting is questionable. Anyway, the value of the information contained in the financial statement is concerned even though financial statements give adequate information that enables users to adjust for them as certain investors rely on reported earning numbers in an income statement.
Ethical Perspective of Creative Accounting:
There are some ethical issues concerning the exercise of creative accounting. Loopholes in accounting standards provide managers some spaces in the sense of manipulating the timing in income reporting. Accounting is a tool to supervise contracts between managers and financial groups, identify the possibility of accounting manipulation; and, how properly it reflected in pricing and contracting decisions. Ethics of bias in choosing accounting policy which implies in they can see through accounting regulators and management level.
Managers tend to misapply accounting principles to give a better appearance in the financial statement to investors. Conflict of interest, client requests to alter account, and tax evasion are the most frequent ethical issues. Accountants’ attitudes toward creative accounting depend on whether it has arisen from the misuse of accounting principle and manipulation of transactions. Accountants more critical in the misuse of accounting principles as the accountant’s duty is rule-based; and, it falls within their expertise. Failure to act ethically may damage the reputation as an accountant unless he or she reports the abuse to the appropriate party. Slotting is not an acceptable accounting treatment in company practices.
There is some action can take by accounting regulators to restrain creative accounting:
- Decrease allowable accounting method or fixed method used in the different conditions so that the scope for choosing the accounting method can narrowly down. Companies should also be consistent in using the method chosen by them.
- Some rules should establish to reduce the abuse of justice. For instance, International Accounting Standards presently have almost removed the “extraordinary item” from operating profit. Also, companies should be consistent in applying accounting policy to restrain the abuse of justice.
- Implementation of “Substance over form” can decrease artificial transaction and this can make linked transactions become one as the whole.
- To restrict the use of timing of the genuine transaction, item in the account should regularly evaluate. Also, the increases or decreases in value should state in the account each year the revaluation occurs. International Accounting Standards also tends to value items at fair value rather than historical cost.
- Besides alteration in accounting regulations, ethical standards and governance codes must be properly executed to avoid individuals from performing creative accounts.
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”.