Creative accounting refers to accounting practices that seem to follow the letter of the applicable accounting standards but deviate from the spirit of those standards. It is 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. In other words, Creative accounting is the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing rules and/or ignoring some or all of them. The motivation to indulge in these practices is anticipation of rewards which may include higher share prices, improved credit rating resulting in lower borrowing costs, higher incentive compensation for executive management etc. Some of the creative accounting schemes perpetrated by companies include improper revenue and expense recognition, faulty accounting in connection with business combinations, and wrongful use of off- balance-sheet arrangements. . Listed companies engage in creative accounting practices include the usual smooth earnings, balance-sheet financing, abuse of mergers and acquisitions accounting, any changes to accrual method of manipulating the consolidated financial statements, asset replacement and so on. These fraudulent schemes can be devastating to users like shareholders, lenders, employees, board of directors and other stakeholders. The conflicts of interest among different interest groups represent the real causes of creative accounting. The managers are interested in paying fewer taxes and dividends, the shareholders in gaining higher dividends, the employees in obtaining better salary and higher profit share, the authorities in collecting more taxes. It can be easily seen that the interests are tremendous divergent and creative accounting is deepening it. But creative accounting puts one group or two to advantageous position at the expense of others. Sometimes for investors taking a company’s financial statements at Face value can be ‘a recipe for disaster’.
Reasons for creative accounting
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. It is argued 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. But, if the trading conditions of a business are in fact volatile then investors have a right to know this and it may conceal long-term changes in the profit trend. 2) A variant on income smoothing is to manipulate profit to tie in to forecasts. This perfectly respectable, and highly conservative, accounting policy means that future earnings are easy to predict. E.g. 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. It allows them to match reported earnings to profit forecasts. 3) Company directors may keep an income-boosting accounting policy change in hand to distract attention from unwelcome news. E.g. 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...
Please join StudyMode to read the full document