Creative Accounting

'Creative Accounting ' means 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.
Accounting methods used to conceal firm's true state the use of accounting methods to hide
aspects of a company's financial dealings in order to make the company appear more or less
successful than it is in reality. The term 'creative accounting' can be defined in a number of
ways. Initially we will offer this definition: 'a process whereby accountants use their
knowledge of accounting rules to manipulate the figures reported in the accounts of a
business'.
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.
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.
Advocates of this approach argue that it is a measure against the 'short-termism' of judging an
investment on the basis of the yields achieved in the immediate following years. It also avoids
raising expectations so high in good years that the company is unable to deliver what is required
subsequently. Against this is argued that: if the trading conditions of a business are in fact volatile
then investors have a right to know this; income smoothing may conceal long-term changes in
the profit trend.
(2) A variant on income smoothing is to manipulate profit to tie in to forecasts. Fox (1997)
reports on how accounting policies at Microsoft are designed, within the normal accounting

rules, to match reported earnings to profit forecasts. When Microsoft sell software a large part
of the profit is deferred to future years to cover potential upgrade and customer support costs.
This perfectly respectable, and highly conservative, accounting policy means that future
earnings are easy to predict.
(3) Company directors may keep an income-boosting accounting policy change in hand to
distract attention from unwelcome news. Collingwood (1991) reports on how a change in
accounting method boosted K-Mart's quarterly profit figure by some $160 million, by a happy
coincidence distracting attention from the company slipping back from being the largest
retailer in the USA to the number two slot.
(4) 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.
(5) 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.
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.
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 covenants, 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.
Accounting scandals, or corporate accounting scandals, are political and business
scandals which arise with the disclosure of misdeeds by trusted executives of large public
corporations. Such misdeeds typically involve complex methods for misusing or misdirecting
funds, overstating revenues, understating expenses, overstating the value of corporate assets or
underreporting the existence of liabilities, sometimes with the cooperation of officials in other
corporations or affiliates.

In public companies, this type of "creative accounting" can amount to fraud and investigations
are typically launched by government oversight agencies, such as the Securities and Exchange
Commission (SEC) in the United States.
Scandals are often only the 'tip of the iceberg'. They represent the visible catastrophic failures.
Note that much abuse can be completely legal or quasi legal.
For example, in the domain of privatization and takeovers:
It is fairly easy for a top executive to reduce the price of his/her company's stock due
to information asymmetry. The executive can accelerate accounting of expected expenses,
delay accounting of expected revenue, engage in off balance sheet transactions to make the
company's profitability appear temporarily poorer, or simply promote and report severely
conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings
news will be likely to (at least temporarily) reduce share price. (This is again due to information
asymmetries since it is more common for top executives to do everything they can to window
dress their company's earnings forecasts). There are typically very few legal risks to being 'too
conservative' in one's accounting and earnings estimates.
A reduced share price makes a company an easier takeover target. When the company gets
bought out (or taken private) at a dramatically lower price the takeover artist gains a
windfall from the former top executive's actions to surreptitiously reduce share price. This can
represent tens of billions of dollars (questionably) transferred from previous shareholders to the
takeover artist. The former top executive is then rewarded with a golden handshake for
presiding over the firesale that can sometimes be in the hundreds of millions of dollars for one
or two years of work. (This is nevertheless an excellent bargain for the takeover artist, who will
tend to benefit from developing a reputation of being very generous to parting top executives).
Similar issues occur when a publicly held asset or non-profit organization
undergoes privatization. Top executives often reap tremendous monetary benefits when a
government owned or non-profit entity is sold to private hands. Just as in the example above,
they can facilitate this process by making the entity appear to be in financial crisis this
reduces the sale price (to the profit of the purchaser), and makes non-profits and governments
more likely to sell. It can also contribute to a public perception that private entities are more
efficiently run reinforcing the political will to sell off public assets. Again, due to asymmetric
information, policy makers and the general public see a government owned firm that was a
financial 'disaster' miraculously turned around by the private sector (and typically resold)
within a few years.

All accounting scandals are not caused by top executives. Oftentimes managers and employees
are pressured or willingly alter financial statements for the personal benefit of the individuals
over the company. Managerial opportunism plays a large role in these scandals. For example
managers who would be compensated more for short term results would report inaccurate
information since short term benefits outweigh the long-term ones such as pension. [1]

Satyam Computer Services

2009[42] PricewaterhouseCoopers

India Falsified accounts

CONCLUSION
Creative accounting offers a formidable challenge to the accounting profession. The problem is
an international one, with accounting policy choice being a particular problem in the AngloAmerican tradition and transaction manipulation a particular problem in the continental
European tradition.
There is a wide variety of motivations for managers to engage in creative accounting. The
justification for creative accounting put forward in the 'positive accounting theory' tradition is:
In conflict with mainstream thinking on ethics. Particularly relevant to the USA, where there is
a well-developed stock market and a focus on detailed accounting regulation rather than broad
principles, and is considerably less relevant in other countries.
Accountants who accept the ethical challenge that creative accounting raises need to be aware
of the scope for both abuse of accounting policy choice and manipulation of transactions. New
Zealand offers an example of a country where a well-designed framework of accounting
regulation has curbed creative accounting. However, our interviews raised some concerns as to
whether this situation will last.
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.
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 covenants, 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.

Solution of Creative Accounting/Techniques to resolve the Accounting Scandals:

A) Investigate Motives for Unethical Practices
B) Administer Effective & Ethical Controls
A) Motives for Unethical Behavior:
1) Situational Pressure:
If an employee is having high pressure due to the nature of job, the chances of getting
indulge into the unethical practices are high. And if its low, an employee would tend to
remain loyal towards the organization.
2) Opportunities:
Opportunities availability in terms of financial gain to the person and not to the
organization. If high personal gain is there, it can attract an individual to involve in
unethical practices. So, there should be a proper observation and any activity should
generate a gain to the organization itself.
3) Personal Characteristics (Integrity):
An employees integrity and honesty for an organization matters a lot. If an employee is
morally sound and having a high integrity as well as determination, it would prevent
him/her to do any unethical activity.
High

High

Situational Pressure

Opportunities

Low

Low

High

Personal Characteristics (Integrity)

Low

Ethical

Unethi

B) Administer Effective Ethical & Internal Controls:

Effective ethical control:

An Ethical control needs to be maintained by an organization. It can be done by structuring a
Code of Conduct. It gives a clear idea about what is expected from an employee and in which
way he/she needs to behave. There should be some punishment for deviation of norms of code
of conduct within an organization. While preparing norms of Code of Conduct, the following
aspect needs to be incorporated in it;
-

Integrity

Objectivity

Independence

Due Care

Effective Internal Control System:

Control
Environment:

Risk
Assessment:

Influence Control
Awareness of
Management and
Employees

Identify,
Analyze, and
Manage Risks
Relevant to

Information and
Communication:
Quality of Info
Impacts Reliability of
Financial

Monitoring:
Entities
Activities

Control
Activities:
Transaction
Authorization
Segregation
of Duties
Supervision

Ensure reliability of accounts &

Safeguard assets of the
records
firm
Outcome of Ethical and Internal
Control:

Promote efficiency in firms

operation

Effective Internal
Control

Effective Ethical
Control

Opportunity

Situational
Pressure

Personal Integrity