Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. The creativity in those practices is motivated by greed and intended to deceive the public, potential investors and shareholders and increases the rate of enterprise failures at a decreasing rate. Examples of Creative Accounting The company raises invoices before the end of the accounting year to inflate its sales figures and but the actual transaction occurs on the post date.
The company sometimes gives loans to their known person to willfully hide the transactions made during the year. Creative accounting is the practice which is adopted with the framework of accounting system or in other words taking undue advantages of loopholes of accounting system.
It is an art of manipulating the books in a manner that desired results can be drawn. Tax is mentioned as a significant motivator also by Niskanen and Keloharju in a Finnish context and in Japan by Herrmann and Inoue In countries with highly conservative accounting systems the 'income smoothing' effect can be particularly pronounced because of the high level of provisions that accumulate.
Another bias that sometimes arises is called 'big bath' accounting, where a company making a bad loss seeks to maximise the reported loss in that year so that future years will appear better. Beidleman observes the positive effects of income smoothing on expectations, securities valuation and some element of risk reduction for analysts. A variant on income smoothing is to manipulate profit to tie in to forecasts. Fox reports on how accounting policies in some companies are designed, within the normal accounting rules, to match reported earnings to profit forecasts.
When these companies sell products a large part of the profit is deferred to future years to cover potential upgrade and customer support costs. This perfectly respectable, and highly conservative, accounting policy means that future earnings are easy to predict. Company directors may keep an income-boosting accounting policy change in hand to distract attention from unwelcome news. Kamin and Ronen observe a difference in motivation between managers in owner-controlled and management-controlled firms.
Owners who wish to retain control of a sizeable stake and who are therefore not interested in immediate exit strategies are less likely to be motivated to manage earnings. 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 the appearance of a good profit trend.
This helps the company to raise capital from new share issues, offer their own shares in takeover bids, and resist takeover by other companies. If the directors engage in 'insider dealing' in their company's shares they can use creative accounting to delay the release of information for the market, thereby enhancing their opportunity to benefit from inside knowledge. It should be noted that, in an efficient market, analysts will not be fooled by cosmetic accounting changes.
Indeed, the alert analyst will see income-boosting accounting changes as a possible indicator of weakness. Naser and Pendlebury questioned senior corporate auditors about their experience of creative accounting. They were able to conclude that a significant proportion of all categories of companies employ creative accounting techniques to some extent.
Many research studies examine a particular aspect or technique of creative accounting. All tend towards the conclusion that creative accounting using that particular technique does exist. McNichols and Wilson model the nondiscretionarycomponent of the bad debts provision so as to identify the discretionary element of the accrual. A later large scale study of classificatory smoothing Dempsey et al.
Moreover, this research found that the propensity to report in this way was significantly greater in non-owner managed firms. Dascher and Malcom analysed data over several years for 52 firms in the chemical industries sector relating to four income smoothing variables: pensions costs, dividends from unconsolidated subsidiaries, extraordinary charges and creditsand research and development costs. They concluded that their results were consistent with the hypothesis that deliberate smoothing had taken place.
Large provisions against uncertain levels of future loss are highly dependent upon the judgements made by management. Black et al. They find that, where the relevant accounting standards are permissive as in the UK up till managers will exploit the potential for creative accounting via timing of asset sales. Such behaviours are curtailed once the provisions of accounting standards are tightened. So, even if certain loopholes in regulation are eliminated, creative accounting behaviour is likely to persist.
Amat et al report about a study that identified creative accounting practices in some of the 35 large Spanish listed companies. It should be noted that, therefore, any creative accounting behaviour identified in the study was relatively overt, and almost certainly legal.
The following occurrences were classified for the purposes of thisstudy as possible indicators of creative accounting: - Auditor report qualifications. Techniques of creative accounting-Tapping the loopholes The potential for creative accounting is found in six principal areas: regulatory flexibility, a dearth of regulation, a scope for managerial judgement in respect of assumptions about the future, the timing of some transactions, the use of artificial transactions and finally the reclassification and presentation of financial numbers.
Even in a highly regulated accounting environment such as the USA, a great deal of flexibility is available Largay, ; Mulford and Comiskey, Taking each of the six areas in turn: 1. Regulatory flexibility: Accounting regulation often permits a choice of policy, for example, in respect of asset valuation International Accounting Standards permit a choice between carrying non-current assets at either revalued amounts or depreciated historical cost.
Business entities may, quite validly, change their accounting policies. In the s, the energy, commodities, and services company engaged in all sorts of unethical accounting practices.
It hid debt, understated losses and manipulated various financial figures to create an illusion of profitability, before filing for bankruptcy in The WorldCom scandal is another high profile example of creative accounting leading to fraud.
To hide its falling profitability, the company inflated net income and cash flow by recording expenses as investments. Analysts , asset managers , and financial journalists failed to see many of the above scandals coming, proving that it is not always easy to spot questionable accounting practices.
However, that does not mean that investors should sit back and do nothing. Being skeptical and reading financial statements a little more closely, rather than just focusing on what management highlight, can go a long way to detecting suspicious activity.
A good starting point is to carefully read company footnotes , assess the reliability of auditors and pay careful attention to any unusual variations in figures. Financial Statements. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.
Create a personalised content profile. Measure ad performance. Select basic ads. Most studies view this practice as unethical and should be stopped; others admit that although it contributes to enterprise failures, loss of investments and… Expand. View via Publisher. Save to Library Save. Create Alert Alert. Share This Paper.
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