Creative Accounting – Definition, Techniques and Ethical Considerations

Definition of Creative Accounting

Creative accounting is accounting practice that falls outside the regulation and give benefit to certain people. It can be described as a practice with a clear aim to interrupt the financial reporting process which affects reported income to make it looked normal and provides no true economic advantages to relevant parties like shareholders. Concisely, creative accounting is the transformation of financial accounting figures from what they actually are to what users’ desire by taking advantage of the accounting policies which is permitted by accounting standards.

Creative accounting is a practice that potentially being undertaken as a result from some individual care more on their own interest and indirectly causes issues arise in ethical dimension of creative accounting. From information perspective, agency theory gives a clear picture on creative accounting scenario. Whereby managers misuse their privileged position in manipulating financial reporting in their own interest which providing superior information content to shareholder. Lack of personal skill or unwillingness to carry out detailed analysis making individual shareholders do not have the clear view on the effect of accounting manipulation give a high possibility in the incidence of creative accounting.

Motivation for Creative Accounting

There are several motivations have been identified in stimulating the behavior of creative accounting in the organization. Firstly, the significant motivator for creative accounting is to report a decrease in business income to lower the tax paid. Second, to enable the company’s performance appear better in future, company will maximize the reported loss to make bad loss in that year. This is called ‘big bath’ accounting for the purpose in smoothing the income. Thirdly, to provide positive view on expectations, securities valuation and reduction on risk for analysts in anticipated capital market transactions and maintain firm’s performance in analyst’s expectation.

Other motivations are to manipulate profit in order to match the reported income to profit forecasts and to distract attention from negative news by boosting company’s profit figure though change in accounting policies. Managers motivations in managing earning aim to report a stable growth in profit not only to reduce the perception of variability toward organisation’s earnings, but also are in relation to income measurement. In order to make company faces less risk and gain more benefit in aspect of raising fund, takeover bids as well as prevent takeover by other company.

Creative accounting is needed to maintain or promote the share price and create a good profit growth. To gain benefit from inside knowledge, director of the company engage creative accounting to postpone the release of information to the market. Last but not least, many types of contractual right, obligation and constraints based on the amount reported in the accounts also motivate company to apply creative accounting.

Techniques of Creative Accounting

Creative accounting is actively applied in six areas. The first area is regulatory flexibility, whereby changes in accounting policy are permitted by accounting regulation. For example, IAS permit carrying non-current asset can be recovered at either revalued amount or depreciated historical cost in asset valuation. Secondly, dearth of regulation by which some accounting treatment might not be fully regulated as there is few mandatory requirements. The third area is management has large extent of estimation in discretionary areas, such as assumption in bad debts provision. Fourthly, some transactions can be timed as to show the desired appearance in accounts. For example, the manager is free to choose the timing to sell the investment just to increase earning in the accounts. Fifthly, to manipulate balance sheet amounts by using artificial transaction. Last but not least, by reclassification and presentation of financial amounts through balance sheet manipulation in order to smooth financial ratios and also based on cognitive reference point in financial numbers’ presentation.

Existence of Creative Accounting

Theoretically, managers motivation in creative accounting is acceptable. However, certain of companies apply a particular techniques of creative accounting to some extent, for example, applied in non-discretionary component of the bad debts provision. Other evidence is classificatory smoothing by using the extraordinary items, such as pensions cost, dividends from unconsolidated subsidiaries, extraordinary charges and credits and research and development costs in manipulating the figure of income in financial statements.

Creative accounting behaviors can be identified by having thoughtful analysis of financial statement or observed by reasonably well- informed user of financial statement. But, how clearness the users of statement observe creative accounting is questionable. Anyway, value of information content in financial statement is concerned even though financial statements give adequate information enable users to adjust for creative accounting as certain investors rely on reported earning numbers in income statement.

Ethical Perspective of Creative Accounting

There are some ethical issues concerning the exercise of creative accounting. Loopholes in accounting standards provide manager some spaces in the sense of manipulate the timing in income reporting. Accounting is a tool to supervise contracts between managers and financial groups, identify possibility of accounting manipulation and how properly it reflected in pricing and contracting decisions. Ethics of bias in choosing accounting policy which implied in creative accounting can be seen through accounting regulators and management level.

Managers tend to misapply accounting principles to give better appearance in financial statement to investors. Conflict of interest, client requests to alter account and for tax evasion are the most frequent ethical issues. Accountants’ attitudes toward creative accounting depend on whether it is arisen from misuse of accounting principle and manipulation of transactions. Accountants more critic in misuse of accounting principles as accountants duty is on rule-based and it falls within their expertise. Failure to act ethically may damage the reputation as an accountant unless he or she reports the abuse to the appropriate party. Slotting is not an acceptable accounting treatment in company practices.

There are some action can be taken by accounting regulators in order to restrain creative accounting:

  1. Decrease allowable accounting method or fix method used in different condition so that scope for choosing accounting method can be narrow downed. Companies should also be consistent in using method chosen by them.
  2. Some rules should be established to reduce the abuse of judgement. For instance, International Accounting Standards presently have almost removed the “extraordinary item” from operating profit. Also, companies should be consistent in applying accounting policy to restrain the abuse of judgement.
  3. Implementation of “Substance over form” can decrease artificial transaction and this can make linked transaction become one as whole.
  4. To restrict the use of timing of genuine transaction, item in account should be regularly revaluated. The increase or decrease in value should be stated in the account each year the revaluation occurs. International Accounting Standards also tends to value item at fair value rather than historical cost.
  5. Besides alteration in accounting regulations, ethical standards and governance codes must be properly executed to avoid individuals from performing creative accounting.

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