Creative accounting is the use of the scope of freedom of persons who prepare financial statements, which results from the lack of appropriate patterns, standards, rules and procedures that are the basis for making decisions regarding the information creation process presented in the financial statements of enterprises, namely recognition, valuation, disclosure and information presentation.
Phenomenons in creative accounting
Creative accounting can cover four groups of phenomenons:
- creativity, which is understood as a creative element used to create financial statements. This is especially taken into account when deciding on the choice of the method of counting that will allow the report to be as reliable as possible,
- application of such techniques so that the measurement performed would be in accordance with the interest of the information producer and avoid the effects of regulation, which are in force in accounting,
- including in the financial statements such items that were not previously regulated, which entails changes in applied measurement practices,
- activities that are related to fraud, e.g. not including certain items in the reports, presenting data that is inconsistent with the actual state of affairs.
The first group of the above issues is related to the natural measurement feature, the last one concerns illegal phenomenons, i.e. the accounting scammer, so only the second and third groups are directly related to creative accounting.
The goals of creative accounting
The basic goals of creative accounting are:
- reducing losses or increasing profit,
- manipulation of indicators that are used during financial analysis,
- convincing others of their credibility, e.g. business partners, lenders, lenders,
- concealing financial risk,
- controlling the achievements of managers in order to be able to get a bonus for results,
- avoiding negative effects that may result from direct or indirect control by shareholders,
- enabling to obtain capital that would otherwise be unavailable.
Creative and aggressive and fraudulent accounting
In colloquial language, with reference to creative accounting, more and more often one can meet the terms "aggressive" and "faked", used interchangeably and treated as synonyms or as synonymous. It is a mistaken procedure, because all three terms are used in different aspects of accounting and serve to achieve different goals.
Creative accounting allows a certain freedom of choice in the area of record keeping and includes activities that remain within the law. Using, therefore, accounting tools and unlimited legal regulations of freedom, it is possible to present the financial and property situation of the company in financial reports in various ways, consistent with the concept of a reliable and true picture. This is a negative aspect of creative accounting, classifying it already for aggressive accounting.
In contrast to creative accounting, which uses the possibilities of unlimited freedoms, presents a reliable and real picture of the individual, aggressive accounting is a deliberate manipulation of financial data and misleading information recipients.
Most often, the practice of aggressive accounting is devoted to people holding managerial positions, which, in order to improve their results, embellish or distort the presented picture of the financial situation of the company. They direct accounting to artificially inflating profits, concealing financial risks and avoiding restrictions when borrowing, as well as manipulating financial indicators used in analyzes for market needs, potential investors or lenders.
Creative accounting uses the right to choose an accounting policy under applicable law, in accordance with the concept of a fair and clear picture, in order to present the image of the company in line with the assumptions set for itself by the managers.
Aggressive accounting uses the right to choose an accounting policy, the freedom of which is not limited in any way, in a way that leads to the manipulation of financial data and intended to mislead the recipients of information contained in the distorted financial statements.
Fraud accounting, on the other hand, means intentional accounting fraud, i.e. illegal activity, involving manipulation of financial data, aimed at achieving certain benefits.
Examples of Creative accounting
- Revenue Recognition: This technique is used to report larger revenues than those that actually exist. Companies can choose to recognize revenue earlier than it should be, or to recognize more revenue than what was actually earned. For example, a company that sells its services on a subscription basis may recognize revenue for the entire subscription up front instead of over the course of the subscription period.
- LIFO/FIFO Manipulation: Companies can choose to use either the last-in-first-out (LIFO) or first-in-first-out (FIFO) inventory method to value the inventory on their balance sheet. By manipulating which method they use, a company can make their inventory appear to be worth more or less than it actually is. For example, a company may choose to use the FIFO method when the market price of their inventory is high, and the LIFO method when the market price is low, in order to report higher or lower profits than what is actually earned.
- Asset Valuation Manipulation: Companies can manipulate the valuation of their assets on their balance sheet in order to make the assets appear to be worth more or less than they actually are. For example, a company may use an inflated estimate of the value of its real estate assets in order to report higher profits than what was actually earned.
- Off-Balance Sheet Accounting: Companies can use off-balance sheet accounting to hide liabilities from investors and creditors. For example, a company may enter into a contract with another company to provide services in exchange for payments over a period of time, but instead of recording the payments as a liability on their balance sheet, they may record the payments as a deferred expense. This allows the company to avoid reporting the liability on their balance sheet.
Advantages of Creative accounting
Creative accounting offers a variety of advantages to businesses. These include:
- Increased flexibility in reporting financial information, allowing companies to present their financial information in a more favorable light.
- Greater control over the presentation of financial information, allowing companies to customize their own financial statements to better reflect their financial performance.
- The ability to more effectively manage taxes and other liabilities, allowing companies to reduce their tax liability and improve their overall profitability.
- The ability to more accurately forecast future performance, allowing companies to make better decisions about investments and other financial decisions.
- The ability to more easily compare the financial performance of different companies, enabling businesses to make better decisions about potential investments.
Limitations of Creative accounting
Creative accounting, although it can be used to manipulate financial statements in order to present a more favourable picture of a company's financial health, has several limitations. These include:
- The risk of being accused of fraud: Creative accounting can be seen as an unethical practice, since it involves manipulating data for the purpose of misleading stakeholders and investors. This can lead to serious legal consequences, including criminal charges and financial penalties.
- Difficulty in detecting creative accounting: Creative accounting is often very difficult to detect and identify, as it involves complex techniques that are hard to trace and identify.
- Loss of credibility: Companies that have been found to have engaged in creative accounting can suffer a significant loss of credibility in the marketplace, as investors and stakeholders view such practices as unethical and untrustworthy.
- Difficulty in maintaining consistency: Creative accounting can often lead to inconsistencies in financial statements, as data is manipulated to present a favourable picture.
- Loss of trust: Creative accounting can lead to a loss of trust from investors and stakeholders, as it is seen as a way of avoiding responsibility and accountability for financial performance.
In addition to Creative accounting, there are several other approaches which are used in order to manipulate financial statements. These approaches include:
- Off-Balance Sheet Financing: This is a process where a company moves certain assets and liabilities off its balance sheet, thereby reducing the amount of assets and liabilities reported in the financial statements. This is done in order to reduce the amount of debt that a company has to report, which can give the impression of improved financial health.
- Revenue Recognition: This is a process where a company recognizes the revenue it has earned from the sales of its products or services, but delays the recognition of the associated expenses until a later date. This allows the company to report higher profits than it actually earned and can give the impression of improved financial performance.
- Inflated Assets: This is a process where a company artificially inflates the value of its assets by recording them at values higher than the actual market value. This is done in order to increase the amount of reported assets on the balance sheet, which can give the impression of improved financial health.
- Classification of Transactions: This is a process where a company classifies certain transactions as something other than what they actually are in order to manipulate the reported financial statements. This is done in order to reduce the amount of expenses reported or to increase the amount of reported profits, which can give the impression of improved financial performance.
Overall, Creative accounting is a process used to manipulate financial statements in order to give the impression of improved financial performance. Other approaches used to achieve this goal include off-balance sheet financing, revenue recognition, inflated assets, and classification of transactions.
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- Amat, O., Blake, J., & Dowds, J. (1999). The ethics of creative accounting. Economics Working Paper, 349, 715-736.