What is Creative Accounting?
Creative accounting or aggressive accounting is a method used to manipulate financial figures. It does not violate the letter of the law or accounting standards but it is very much against their spirit.
Moreover, creative accounting certainly does not provide the true and fair view of an enterprise that accounts are meant to project.
Areas of Creative Accounting
Creative accounting tricks are generally applied in the following areas:
- Off-balance sheet financing
- Over-optimistic revenue recognition
- Use of exaggerated non-recurring items
By adopting these tricks, it is possible to inflate or deflate profit figures depending on the nature of the enterprise’s need.
That is to say, if operating efficiency needs to be boosted, then profits are inflated. Likewise, if secret reserves need to be created, then profits are deflated. Sometimes, enterprises may also reduce reported profits in good years to smoothen the results.
Assets and liabilities may also be manipulated to remain within limits (e.g., debt covenants) or to hide problems.
For example, working capital efficiency can be managed by valuing stock at market value rather than cost price (not recording the deviation), knowing full well that stock should be valued at the lower of the two.
The reporting of deviation (if done) is undertaken most often in the notes to take shelter under the loose ends of law (freedom of interpretation).
Effect of Changes in Accounting Standards
An important observation relating to creative accounting is that these techniques alter the figures in the financial statements but make themselves evident elsewhere (most often in the notes to the accounts).
Unless the information user thoroughly examines the financial statements along with the notes to the accounts and other additional details, it is not possible to detect the hidden information.
Accounting standards are meant to block specific ways of manipulating figures through creative accounting. However, when accounting standards change, the techniques that will or won’t work also change.
The above situation quickly gives rise to a paradox: namely, whenever well-intentioned changes in accounting standards are introduced, this opens up new opportunities for creative accounting. One of the best examples of this is the fair value concept.
It should be noted that every rule has an exception or contains a loophole that is used by knowledgeable accountants to their advantage through creative accounting.
Creative Accounting and Window Dressing
Window dressing and creative accounting are often used as synonyms, but the meaning of these terms is not the same. In the context of accounting, window dressing is a broader term than creative accounting that can be applied to other areas.
In the US, window dressing is often used to describe the manipulation of investment portfolio performance numbers. Additionally, compared to creative accounting, window dressing is more likely to involve illegal and fraudulent practices.
Evidently, there is a subtle yet significant difference between creative accounting and window dressing. It may not be incorrect to conclude that creative accounting is often a means to an end where window dressing is an end in itself.
Justification with the Provisions of Law
An accounts manager who engages in creative accounting can defend their actions in the following way:
- Proper verification of the stock revealed the difference.
- Defend building repairs as renewal amounting to an increase in the value of the building.
- Investments to be shown at the current market price can be defended as a policy matter.
- Based on higher profits, a 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.
While all of these changes are justifiable within the provisions of the law, the justification runs counter to the spirit of the law.
- Manipulating financial numbers through creative accounting is within the letter of the law, but it runs against the spirit of the law.
- The main tricks used in creative accounting are off-balance sheet financing, over-optimistic revenue recognition, and the use of exaggerated non-recurring items.
- As accounting standards change over time, so too do creative accounting techniques.
- If creative accounting is used to manipulate financial numbers, window dressing can also be applied to other areas as it is a broader term.
- In the context of accounting, window dressing is more likely than creative accounting to involve illegal and fraudulent practices.
- Creative accounting may be a means to an end, whereas window dressing is often pursued as an end in itself.
Source: NGFL Wales Business Studies A Level Resources Spec. Issue 2nd Sep. 2008