Creative Accounting Definition, Importance and Methods

Financial statements or accounts provide information that is used by interested parties to assess the performance of managers and to make economic decisions. Users may assume that the financial information presented in the financial statements or accompanying documents is reliable and fit for its purpose.

Accounting laws and regulation attempt to ensure that reliable, consistent and timely information is produced and disseminated to the intended users. That is the principal reason for having a broadly consistent and coherent set of accounting standards throughout the globe.

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’.

They are characterised by excessive complication and the use of novel ways of characterizing income, assets or liabilities. This results in financial reports that are not at all dull, but have all the complication of a novel by James Joyce, hence the appellation “creative.” Sometimes the words “innovative” or “aggressive” are used.

Creative accounting, which generally involves the preparation of financial statements with the intention of misleading readers of those statements, is prima facie a form of lying.

It examines and rejects the arguments for considering creative accounting, in spite of its deceptive intent, as not being a form of lying. It then examines the ethical issues raised by creative accounting, in the light of the literature on the ethics of lying.

The Importance of applying creative accounting are:       

• Obtaining personal gain
• Competition
• Attracting investors
• Increasing or maintaining the level of capital or gearing ration
• Avoid breaching loan covenants
• Buying time for not settling debts
• Beating analysts’ forecasts about future company performance
• And others

Methods:

Wrong Estimation of Inventory in Stores

Some companies’ management does this type of practice to overstate the inventories’ valuation. They do this to show that their cost of goods sold is understood and thus tries to show the increased profits their company will earn this year.

Failures to Make Proper Contingent Liabilities

It is a very technical method of creative accounting. The contingent liabilities are not shown properly in the notes to accounts; thus, it will give the impression that the company is not having any liability and thus is free from that.

Booking Less Expense

To show lower expenses, the company sometimes makes client payments by cash or an outdated cheque. It helps the management book the lower expenses per year, and their books of accounts will depict the fewer expenses figure, which may attract some investors.

Willfully Attempting to Manipulate Depreciation Figures and Methods

Many companies use this technique to make a good impression on their investors. The depreciation calculation method is sometimes changed by simply giving a disclaimer. No estimation increases the lifespan of the assets. The management attempts to set an arbitrary life span, usually more than expected. It thus can have a less depreciation calculated on the above and corresponding to that increases the salvage value of the assets company’s assets. Although depreciation is cashless, the calculation of the same greatly impacts the company’s finances.

Lowering Personal Liabilities of the Company

A company does not usually tend to show its liability, so it is also a great creative accounting technique.

Manipulating Revenues and Sales Figures

It is a very basic thing most companies are doing. Sometimes they lower the sales revenue in their books to get rid of taxes, and sometimes they increase the sales figure with some arbitrary transaction to show the company’s revenue to encourage their investors.

Advantages

• Creative accounting helps the company set the required parameters, which is practically impossible.
• The company can show a smooth and good growing graph of the company. The management adopts this technique to show steady profits and good revenue to attract investors.
• The company that makes losses can benefit from this creative accounting. Investors can be hopeful by seeing the future gains in the companies’ budgeted accounts, and often the company can cope with the situation.
• By adopting this method, the company can conceal the financial risk they may tend to suffer.

Disadvantages

• The company will always be at a high risk of losing its investors because in case the investors get to understand the manipulations, it will not be good for the company. The investor’s interest might get hampered.
• Although creative accounting is an ethical practice, sometimes it may be treated as illegal. When the values of the books of accounts are unethically or illogically misrepresented, it can call for some qualifications.
• The biggest disadvantage is that if an expert does the manipulation, it is fine, but if not, so the literate financial director or CEO decides to make a change, it will be a problem. Therefore, this may add to the cost of hiring a financial expert.
• In the long run, if it is disclosed that the company does a creative accounting practice, then the expectation from the company by their clients will also be at risk; thus, the company may lose its business.