Creative Accounting, also called aggressive accounting, is the manipulation of financial numbers, usually within the letter of the law and accounting standards, but very much against their spirit and certainty not providing the true and fair view of a company that accounts are supposed to. A typical aim of creative accounting will be to increase profit figures. Typical creative accounting tricks include off balance sheet financing, over optimistic revenue recognition and the use of exaggerated non- recurring items.
The technique of Creative accounting has changed over time. As accounting standards change, the techniques that will work will also change. Many changes in accounting standards are meant to block particular ways of manipulating accounts, which means that intent on creative accounting need to find new ways of doing things. At the same time, other well mentioned changes in accounting standards open up new opportunities for creative accounting.
According to critic David Ehrenstein, the term Creative Accounting was first used in 1968 in the film The Producers by Mel Brooks. Many creative accounting techniques change the main numbers show in the financial statements, but make themselves evident elsewhere, most often in the notes to the accounts. The term creative accounting as generally understood refers to systematic misrepresentation of the true income and assets of corporations and other organizations. Creative accounting is at the root of a number of accounting scandals.
“Window Dressing”
The term window dressing has similar meaning when applied to accounts, but is a broader term that can be applied to other areas. it is often used to describe the manipulation of investment portfolio performance numbers. In the context of accounts, window dressing is more likely than creative accounting to imply illegal or fraudulent practices
Earnings Management
Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company of influence contractual outcomes that depend on reported accounting numbers. Earnings management involves the artificial increase of revenues, profits or earnings per share figures through aggressive accounting tactics.
Aggressive earnings management is a form of fraud and differs from reporting error. The main forms of earnings management are:
·
unsuitable revenue recognition
·
inappropriate accruals and estimates of
liabilities
·
Excessive provisions and generous reserve
accounting
·
Intentional minor breaches of financial
reporting requirements that aggregate to a material breach.
i.
Personal incentives
ii.
Bonus related pay
iii.
Benefits from shares and share options
iv.
Job security
v.
Personal satisfaction
vi.
Cover-up fraud
vii.
Tax management
viii.
Management Buy outs
Description and Characteristics of Fraud
Fraud is a broad legal concept and auditors do not make legal determinations of whether fraud has occurred. Rather, the auditor's interest specifically relates to acts that result in a material misstatement of the financial statements. The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. Therefore, fraud is an intentional act that results in a material misstatement in financial statements that are the subject of an audit.Two types of misstatements are relevant to the auditor's consideration of fraud—misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets.
- Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles, Fraudulent financial reporting may be accomplished by the following:
- Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared
- Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information
- Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure
Fraudulent financial reporting need not be the
result of a grand plan or conspiracy. It may be that management representatives
rationalize the appropriateness of a material misstatement, for example, as an
aggressive rather than indefensible interpretation of complex accounting rules,
or as a temporary misstatement of financial statements, including interim
statements, expected to be corrected later when operational results improve.
- Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation) involve the theft of an entity's assets where the effect of the theft causes the financial statements not to be presented. Misappropriation of assets can be accomplished in various ways, including
o
Embezzling receipts
o
stealing assets, or
o
Causing an entity to pay for goods or services
that have not been received.
Misappropriation
of assets may be accompanied by false or misleading records or documents,
possibly created by circumventing controls. The scope of this section includes
only those misappropriations of assets for which the effect of the
misappropriation causes the financial statements not to be fairly presented.
Examples
of situations where accounts are manipulated
1. Revenue
Revenues can be misstated by for example recording
deferred revenue and unearned revenue as part of the current revenue already
earned. For example recording rent received in advance as income instead of
liability.
Revenue can also be accelerated by for example
recognizing service agreements tied to sales as part of revenue even before
actual service is carried on non-current assets. Further, non operating revenue
such as the gain on disposal of non-current assets may be lumped together with
operating revenue when in effect it should be part of other comprehensive
income.
Revenue can also be understated if the objective is to
evade tax.
2. Expenses
Depending on what the manipulators are bent on
achieving, the expenses may be overstated or understated. For example, with a
view to delay expenses and hence understate them, an organization may choose to
capitalize some purchases instead of expensing them. Understating closing stock
may also help overstate cost of sales and hence “depress” net income.
3. Statement of financial position
Items may also be misstated or misclassified. For
example, a company may decide to report a finance lease as an operating lease
and hence avoid reporting both a non-current asst and non-current liability and
hence at the same time avoid reporting depreciation expense associated with the
asset. Still on the statement of financial position a company may deliberately
understate liabilities so as to overstate its net assets: one way of
accomplishing this is by not recognizing provisions and contingencies
4. Cashflow statement
A company may “park” long term investment under cash
and cash equivalent so as to apparently overstate the cash balances
MECHANISMS TO DETER STRATEGIC MANIPULATION
There
are a number of mechanisms designed to prevent strategic manipulation such as:
a) An independent audit
The auditor expresses an opinion as to whether the
financial statements conform GAAP, the estimates are reasonable, and the data
includes no material errors. The auditor also examines the firm’s internal
control and reports any weaknesses to the audit committee of the board of
directors
b) The board of directors
Though the audit committee and the firms internal
auditors, the board can discourage unwanted behavior
c) Certification of senior management
The Chief Executive Officer (CEO) and Chief Finance
Officer (CFO) must certify the financial statements, which increase their
personal risk.
d) Class action litigation
Law suits serve as deterrent to manipulating results
e) Regulators
Regulators can use fines as well as criminal
prosecution as a deterrent.
f) General market scrutiny
Business journalists, financial analysts, short
sellers, and unions are constantly trying to identify manipulative behavior.
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