What is meant by Creative Accounting?
Creative accounting or Aggressive accounting is a method adapted to manipulate the financial numbers, usually, within the letters of the law and accounting standards, but very much against their spirit and certainly not providing the true and fair view of an enterprise that accounts are supposed to project.
Areas of Creative Accounting
The creative accounting tricks are done generally in the following areas:
- Off balance sheet financing
- Over optimistic revenue recognition
- Use of exaggerated non-recurring items
By adopting these tricks, profit figures are inflated or deflated (depending on the type of need). That is if operating efficiency should be boosted, then profits are inflated. If secret reserves are to be created, then profits are deflated. Sometimes, the enterprises may also reduce reported profits in good years to smoothen the results.
Assets and liabilities may also be manipulated, either to remain within limits such as debt covenants or to hide problems. For example, working capital efficiency is managed by valuing the stock at market value which is higher than the cost (not recording the deviation at the main place) knowing fully well stock should be valued at cost or market price whichever is lower. The reporting of deviation (if done) is done most often in the notes to take shelter under the loose ends of law (freedom of interpretation).
Effect of Changes in Accounting Standards
One of the major observations relating to creative accounting is that 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. Unless, the user of information thoroughly examines the financial statements along with notes to the accounts and other additional details, the hidden information cannot be detected.
In fact, accounting standards are meant to block particular ways of manipulating accounting through creative accounting. As accounting standards change over time, the techniques of creative accounting also change overtime. In the sense, when the accounting standards change, the techniques that will work also change.
The paradox is that the well-intentioned changes in accounting standards open up new opportunities for creative accounting. One of the best examples for this is the fair value concept. It should be noted that every rule has an exception or contains a loophole that is used by the intellectuals of the accounting profession to their advantage by practicing the method of creative accounting.
Creative Accounting and Window Dressing
Many a times, widow dressing and creative accounting are used as synonyms. But it is not so. When applied to accounts, window dressing is a broader term that can be applied to other areas. In the US, window dressing 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 and fraudulent practices. Despite this explanation, one can see a thin layer of difference between the two. Hence, it may not be incorrect to conclude that creative accounting is often a means where window dressing is an end.
Justification with the Provisions of Law
The accounts manager can defend his action in the following way:
- Proper verification of the stock revealed the difference.
- Defend repairs as renewal amounting to enhancement in the value of building.
- Investments to be shown at current market price can be defended as a policy matter.
- Based on the increased profits, revised value of goodwill can easily be defended.
- Treating bad debts as good debts can be defended by quoting the positive aspects of the frantic efforts made to collect the debts.
Though all these changes are justifiable within the provisions of law, the justification is not within the spirit of law.
- Manipulating financial numbers, within the letter of law but against tho spirit is considered as creative accounting.
- The tricks used are: Off balance sheet financing, over-optimistic revenue recognition and use of exaggerated non-recurring items.
- Moro often, as accounting standards change over time, creative accounting techniques also change.
- If creative accounting is used to manipulate financial numbers, window dressing can be applied to other areas also as it is a wider term.
- In the context of accounting, window dressing is more likely than creative accounting.
- Creative accounting may be a means, where as window dressing may be an end.
Source: NGFL Wales Business Studies A Level Resources Spec. Issue 2nd Sep. 2008