Creative accounting is an accounting practice that has gained popularity among global firms. The practice will follow the internationally set rules and standards but slightly deviate from their spirit and norm for the firms’ benefits. Creative accounting will therefore seek to overstate or understate the firm’s value whenever the move seems to be beneficial. The practice also seeks to differ from the international set standards on the revenue recognition technique. The new practice opposes the historical cost valuation of assets and instead it advocates for the assets to be valued at their market price in order to capture the true value. This paper seeks to fully analyze the creative accounting practice.
How the practice was adopted
Creative accounting encourages the external users of the financial reports to increase their trust and faith in the firm’s management. The practice therefore uses similar accounting practices and guidelines, but may sometimes be manipulated to suit the targeted agenda. The firm’s management mostly acknowledges that some manipulations may deter the true and fair view, but it consistently insists that such undertakings are aimed at ensuring growth and development. According to the management, the creative accounting mission is to realize full growth potential within the industry. The reports may therefore be altered to enable the firm to easily access a loan or external funding which might necessitate it to expand its operations. In addition, the practice can be adopted to lower the firm’s recurring obligations such as loan repayments and tax liability. The corporate world, having greatly suffered from the previous economic recessions, prefers market valuation of assets and liabilities given that economic environment keeps on changing from time to time.
Due to poor performance in the current accounting practice, firms adopted the new creative accounting techniques. The current accounting practice is accused of having a very broad principles definitions which many firms have interpreted differently thus distorting consistency in the practice. Firms are unable to maintain proper accounting standards so they end up manipulating their books of accounts to reflect the true values of their assets and liabilities. The creative accounting practice, therefore, advocates for a true value reflected in the books of accounts. Many firms tend to overstate their assets values to induce the potential investors who may choose to join them. On the other hand, they understate their liabilities in order to reduce their leverage position. The creative accounting practice, therefore, emerged to inflate profit figures in order to overstate the firm’s value and therefore attract potential investors (Shah, 1998, p.9). The major difference between the current international accounting practice and creative accounting is that the latter emphasizes the true and fair reflection while the other one does not. Moreover, the new system employs some accounting tricks which usually include off-balance-sheet financing to overstate and exaggerate revenue recognition and the non-recurring items.
Creative accounting also keeps on changing from time to time as it seeks to advance with the new price development. Firms claim that the current principles’ diversities discourage the development and progress of many firms throughout the world. Although the major aim of accounting standards development was to ensure consistency, the different interpretation between firms makes it hard. The new practice tends to use the aggressive and innovative techniques in order to counter and manipulate the accounting systems (Mulford & Comiskey, 2002, p.39). The practice encourages the firm to use the market advantage in order to ensure competitiveness and survival. They therefore tend to overstate profits during the economic crisis period in order to convince the financial statement users of their good performance in the market. Although the move positively impacts the company’s present and future as the investors retain their invested amount, more loss can end up being experienced. Creative accounting therefore deviates from the firm’s co-objective which is usually the maximization of the shareholders’ wealth and interest. The adoption therefore cares much of the company’s welfare than that of the stakeholders.
The managers and other senior officials in a firm manipulate the financial reports to positively influence the contractual obligations that the firm may currently have with the external investors. As a matter of fact, the managers depend on creative accounting to hide the actual performance of the firm. Their main objective is therefore forcefully manipulated in order to avoid actual consequences that performance reductions entail. The earnings and revenues of the firm are therefore altered using some unique and aggressive accounting technique. The managers also exploit the loopholes in the current financial standards in order to capture the desired projections which eventually maintain the firm’s economic condition. The main factors that influence creative accounting include market expectations, personal realizations and the firm status. However, whenever the firm fails to achieve its market expectations, the aggressive earnings management becomes applicable (Duncan, 2002, p.1). Falsified figures will be used to reverse the downward performance in a company. Management may also use creative accounting to exaggerate their practical roles in the firm. In addition, the firm manipulates the reports so as to retain the top performance status even during worse economic periods.
How the practice works
The practice allows the accountants to manipulate the accounting reports in order to achieve desirable results. It has a different revenue recognition mechanism that aims at overstating the firm’s assets and alternatively understating liabilities. The off-balance sheet financial records are also altered in order to window dress the overall firm’s value. The practice similarly exaggerates the non-recurring items to inflate the current financial capabilities of a firm (Barreveld, 2002, p.135). Whenever the management feels that bonus ought to be paid to the investor, they inflate profits since as a rule such payments should only be effected at certain levels of profits. And in order to ensure less tax liability is charged to the firm, less profit will be reported. Because the financial institutions mainly check on the firm’s perceived risk, firms mainly minimize their bad debts, overstate incomes and assets and understate their liabilities in order to lower their risk standards. This manipulation therefore assists the firm to qualify for a loan at a considerably lower rate. The creative accounting has different reporting technique which intends to sway the potential investor’s decision on whether or not to purchase the company’s shares. As the majority of investors look forward to investing in a low price share and a firm with some growth potential, firms lower their profits to take the market advantage. In this case, the firm mainly understates income and assets while it overstates liabilities, stock levels, cost and expenses (Beneish, 2001, p.3). Additionally, the firm will delay income recognition in order to ensure that some revenues are not reflected in the books of account.
Adverse impacts of the practice to the users of the financial reports
Creative accounting is a risky practice that can adversely affect the intended purpose of the financial statements. The practice encourages some unfair and illegal practices which may end up ruining the report users. For instance, the overstatements of the profits will negatively lure the potential investors to incorrectly invest their amounts in uneconomical areas. Since the economic viability of many firms is usually measured from the financial reports, potential misrepresentation will significantly influence the report’s objective and focus (Abdel-Khalik, 1998p.148). The government also loses huge sums of money through fraudulent tax evasion of the firms. The firm presents considerably lower profits which the tax authority bases in determining the liability.
Failure to reflect true and fair values discourages accountability among the management team. As senior officials and fund managers, they should be ready to accept the outcomes of the company at all times. The manipulation has also adversely affected the financial institutions which lend out funds to unqualified companies. The distorted financial reflections also give a wrong image to a firm (Riahi-Belkaoui, 2004, p.54). The general public might therefore retain the high reputation of an economic declining entity; however, the real problem comes in when the firm shows a profitable image while it still continues to have some financial suffering in its internal operations. The share price valuations may also be a problem when the financial statements are wrongly defined and the capital market authority may therefore produce unfair share price value which may significantly mislead the potential investors.
My personal reflection on creative accounting
According to my personal view, creative accounting is an illegal practice that should not be encouraged among the firms. This is because the practice not only violates the set rules and principles in accounting, but it leads to huge loss of money in the governments. The practice also misleads the general public who solely depend on the reports to make some viable and economical decisions. The practice also employs unsuitable revenue recognition techniques which are aimed at benefiting the firm’s objectives. The firm may therefore understate its incomes and make some intentional delays when it wants to lower its tax liability. In such a scenario the firm usually uses some aggressive accounting tactics which seek to reduce its profit levels. To falsify the current debt position, the firm may seek to inappropriately estimate its liabilities and other financial obligation. By so doing the financial institution will wrongly calculate to risk level which they eventually use when determining the interest rates on the loan advanced. Loans advanced to a risky venture usually bear high-interest charges while those with low-risk levels are charged reduced interests.
Firms therefore tend to manipulate the financial statements to reflect a low-risk status. Some firms report some excessive provisions in their books of accounts, an undertaking that assists them lower the taxable amounts. Creative accounting equally allows for some minor breaches in the financial reporting which consequently aggregate to a material breach (Reynolds, 2005, p.1). The cunning and tactful accounting manipulations that the practice upholds can therefore greatly hamper the main objective in financial reporting. From my understanding, the financial statements ought to give a true and fair reflection of the financial position in a firm and any misrepresentation can greatly hamper the measures consequently undertaken in order to correct a downturn. In case of such a scenario, the management may not take some adequate measures which may assist the firm to grow and develop economically. The practice therefore not only misleads the external users, but it equally negatively influences the internal operations of a firm. I therefore agree that creative accounting has a negative impact on the management and also the external financial report users.
The practice can encourage the greedy and ambitious corporate leaders to further their selfish interests. Such leaders may therefore end up endangering the firm’s resources through undertaking risky and unproductive ventures which may adversely affect the future of the firm. Such fund managers may also illegally avoid tax liability payment which may have an adverse repercussion to the firm (Epstein, Nach & Bragg, 2009p.864). Legal action may be taken for the firm which fails to accurately furnish its tax liability in due time. As a result an extra expenditure may be incurred to pay fines and penalties charged due to contract breaches.
The corporate firms that use the creative accounting mainly discourage external auditing since they might discover some of the fraudulent manipulations in the books of accounts. The financial institutions and other external users of the financial reports therefore greatly question the reliability of such reports. It is advisable that, whenever an investor detects complexity in the financial reporting, he or she should beware since the firm might have implemented the creative accounting tactics. Creative accounting is mainly targeted to take advantage of the unsophisticated users of the financial statements who are many in the market (Baralexis, 2004, p.5).
Some of the positive arguments of the international accounting standards
The standards encourage consistency in the accounting practice. Since similar firms will be required to have similar financial statement preparations, the comparability becomes easy. The standards also emphasize true and fair reflections in the financial statements which improve their reliability (Epstein, Nach & Bragg, 2009, p.135). Potential investors can therefore solely depend on the financial reports in decision making. The system also encourages external auditing checks which may assist the firm to identify the irregularities in the financial recording. Since similar principles are supposed to be followed, the government can use such auditors whenever they sense that the firm is trying to manipulate its statements. As a result no much loss will be incurred through tax avoidance.
Firms follow the accrual accounting which enhances management accountability within the firm. The reports also encourage transparency of the financial reports to the internal and external users (Ruppel, 2009, p.87). Accrual accounting also assists the firm in efficiently and effectively allocating its resources. Such allocations translate positively to the firm’s growth. Conversely, the practice has been criticized for having inadequate assets and liabilities disclosures. Accrual accounting is also accused of increasing the tax liability of a firm since the entity cannot defer any liabilities amounts. In addition the reliability of the accruals accounting is questionable. This is because its microeconomic base is usually considered to be weak. When it comes to revenue recognition techniques, the GAAP has a unified way of accounting. Considering the wide use of financial statements in the decision-making process, it is important to have a universally recognized mechanism to ensure consistency.
How the accounting standards have positively changed to counter creative accounting
Many governments throughout the world have opted to adopt business sector accounting, to improve on financial reporting. Different sectors therefore prepare their financial statement differently depending on the field the sector engages in. the new financial reporting aims at improving accountability in the public sector (Benito, et al, 2007, p.8). The practice is also aimed at enhancing financial awareness among the general public. It ensures the reliability of the reports in the decision-making by emphasizing efficiency. Some governments also adopt the dynamic accrual accounting in order to reflect the flexible and changing nature in the accounting practice (Vinnari & Nasi, 2008, p.6). More flexible revenue recognition techniques have been adopted in order to cater to the diverse market changes. Efforts have therefore been directed towards replacing the existing generally accepted accounting principles (GAAP) with a new accounting approach. The move is aimed at creating consistency in the preparations of financial statements regardless of the industry the business operates in. In addition the new approach will significantly seek to reduce the many standards involved in the GAAP. The revenue recognition principles of many contracts will still remain as outlined in the GAAP. This is because the new practice does not aim at replacing the principles, but instead it targets improving them in order to ensure efficiency and effectiveness of the financial statements.
The retail transactions together with the long-term contracts will not be affected by the new practice. According to the board, revenue should be recognized after the goods have been successfully delivered to the customer (Bragg, 2004, p.74). This move aims at ensuring that all the performance obligations are accounted for in the books of accounts. To cater for the deficiency caused by the cash-based revenue recognition, the board intends to use the collect ability of payment criteria in determining the amount which increases the contract net wealth. If even after the delivery of goods and services to the customer, there stands a high possibility of losing the amount, the amount should not be considered as revenue. This move will ensure, that bad debts are not accounted as revenues in the financial statements. The newly improved revenue recognition principles, therefore, tend to improve the overall reliability in the financial statements (Bragg, 2007, p.118).
In order to take care of the broad definitions in the GAAP principles the concerned bodies are making relevant adjustments which may be beneficial to the overall accounting practice (Clarke, Dean & Oliver, 2003, p.25). The principles have nevertheless resulted in inconsistencies since firms have differently interpreted the standards. Partial changes of the principles are underway as the board seeks to ensure efficiency and consistency in the financial statements preparations. Consequently, the board also aims at simplifying the standards in order to increase their usability. The new approach intends to reduce the many standards that are currently used by the firms thus making them more user-friendly. The regulating body therefore seeks to increase the reliability in the accounting practice. It also seeks to check the few firms which may seek to exploit the aggressive techniques in engaging in illegal undertakings. The body has also significantly advanced in materiality determination. According to the new rules and regulations the small contract breaches that are advocated by creative accounting can be aggregated to produce a material breach which a firm may be sued for. Such clear definitions are aimed at ensuring that firms are accountable for the loss they cause to the external report users. The body also emphasizes the importance of a firm using an external auditor. Strict rules and regulations have been put in place in order to guide the behavior of such auditors. The code of ethics is also deeply aligned to the personal discipline which is always regulated by regular checks on their practices (Bragg, 2006, p.11). According to the body the credibility of the report presented by such auditors is high compared to the report prepared by internal auditors.
Due to easy detections of fraud by the external auditors, some firms have opted to use a sophisticated earnings management in order to cover up this (Dr. Hsieh & Tsai, 2005, p.10). In order to avoid such occurrences auditors have been cautioned to distinguish between error and fraud by identifying some of the intended purposes which may be deeply hidden in the reports. This move has been taken as the management mostly defends their fraudulent motives by terming them as errors. The external auditors are also well equipped to determine the unsuitable revenue recognition methods that the firm might be using in its accounting systems. With the newly adopted accounting practice which is aimed at reinforcing the GAAP, more reliable and efficient accounting practices will be put in place. The improvement is aimed at ensuring that firms reflect their fair value in the financial reports. The credibility of the report will enhance the internal and external users to evaluate the financial position.
Creative accounting though established to check on the inadequacies in the GAAP have a lot of deficiencies as they encourage inconsistencies in the accounting practice. The practice tends to follow the set standards and principles but deviates from their spirits and norms. Firms can therefore decide to manipulate some of the financial reporting techniques to achieve some self-set objectives. The practice therefore misleads the general public who solely depend on the reports to make some viable and economical decisions. The practice also employs unsuitable revenue recognition techniques which are aimed at benefiting the firm’s objectives. The firm may therefore understate its incomes and make some intentional delays when it wants to lower its tax liability. In such a scenario the firm usually uses some aggressive accounting tactics which seek to reduce its profit levels.
In order to falsify the current debt position, the firm may seek to inappropriately estimate its liabilities and other financial obligation. The practice encourages some unfair and illegal practices which may end up ruining the decisions of the report users. For instance, the overstatements of the profits will negatively lure the potential investors to incorrectly invest their amounts in uneconomical areas. Since the economic viability of many firms is usually measured from the financial reports, potential misrepresentation will significantly influence the report’s objective and focus. The government also loses huge sums of money through fraudulent tax evasion and avoidance in the firms. The loopholes and irregularities that are necessitated by creative accounting practice, therefore, make it receive many criticisms. The practice can also be exploited by selfish and greedy personnel to achieve their goals. The practice should be discouraged since it can adversely affect the normal and fair accounting practices that are represented in the GAAP.
Abdel-Khalik, R.A., 1998. The Blackwell encyclopedic dictionary of accounting. London, Wiley-Blackwell (Online). Web.
Baralexis, S., 2004. Creative Accounting in small advancing countries, Greece. University of Macedonia, Vol.19 (3).
Barreveld, D.J., 2002. The Enron collapse: creative accounting, wrong economics or criminal acts? A look into the root causes of the largest bankruptcy in U.S. history. New York, PublisheriUniverse. (Online). Web.
Beneish, D. M., 2001. Earnings Management: A perspective, Bloomington. Indiana University, Vol.27. No.12.
Benito, B. et al., 2007. Critical perspectives on accounting. (Attached material)
Bragg, S.M., 2004. GAAP implementation guide. New Jersey, John Wiley and Sons. (Online). Web.
Bragg, S.M., 2006. The ultimate accountants’ reference: including GAAP, IRS & SEC regulations, leases, and more. New Jersey, John Wiley and Sons. (Online). Web.
Bragg, S.M., 2007. Wiley GAAP Policies and Procedures. New Jersey, John Wiley and Sons. (Online). Web.
Clarke, F.L., Dean, G.W. & Oliver, K. G., 2003. Corporate collapse: accounting, regulatory and ethical failure. London, Cambridge University Press. (Online). Web.
Dr. Hsieh, L. & Tsai. Y., Information asymmetry, creative accounting and moral choice: An apocalypse of procomp informatics ltd. London, American academy of business journal, Cambridge.
Duncan, C., 2002. WorldCon puts the markets on a knife-edge. (Online). Web.
Epstein, B.J., Nach, R. & Bragg, S.M., 2009. Wiley GAAP 2010: Interpretation and Application of Generally Accepted Accounting Principles. New Jersey, John Wiley and Sons. (Online). Web.
Epstein, B.J., Nach, R. & Bragg, S.M., 2009. Wiley GAAP Codification Enhanced. New Jersey, John Wiley and Sons. (Online). Web.
Mulford, C.W. & Comiskey, E.E., 2002. The financial numbers game: detecting creative accounting practices. New York, John Wiley and Sons. (Online). Web.
Reynolds, B., 2005. G8 deal criticized for “creative” accounting. Accountancy magazine. (Attached sources).
Riahi-Belkaoui, A., 2004. Accounting theory. London, Cengage Learning EMEA. (Online). Web.
Ruppel, W., 2009. Wiley GAAP for Governments 2009: Interpretation and Application of Generally Accepted Accounting Principles for State and Local Governments. New Jersey, John Wiley and Sons. (Online). Web.
Shah, A.K., 1998. Exploring the influences and constraints on creative accounting in the United Kingdom. European accounting review, Vol.7 (1). London, University of Essex.
Vinnari, E.M. & Nasi, S., 2008. Creative accrual accounting in the public sector: “Milking” water utilities to balance municipal budgets and accounts. Financial Accountability & management, Vol.24 (2).