CREATIVE ACCOUNTING

Accounting is the science and art of business control, for which purpose it deals with
"measuring, evaluating, knowing, managing and controlling assets, liabilities and equity, as well
as the results obtained from the activity of natural and legal persons", for which purpose "they
must" ensures the chronological and systematic recording, processing, publication and retention
of information regarding financial position, financial performance and cash flows, both for their
internal requirements, as well as in relations with present and potential investors, financial and
commercial creditors, clients, institutions public and other users ". - Accounting Law no.82 /1991.
In this complex area we have an “undercover” accounting, named creative accounting,
which it is used quite often. Even the name is so interesting, it means something completely
different. So, is this creative accounting good or bad?
Will be no longer such a mystery after we find out what it really means. We will follow
this structure to understand it:
 What is Creative Accounting?
 How Creative Accounting works?
 Methods of Creative Accounting.
 Real world examples of Creative Accounting.
 Motivation behind Creative Accounting.
 Prevention of Creative Accounting.
  What is Creative Accounting?
Creative accounting consists of accounting practices that follow required laws and
regulations, but deviate from what those standards intend to accomplish. Creative accounting
capitalizes on loopholes in the accounting standards to falsely portray a better image of the
company. Although creative accounting practices are legal, the loopholes they exploit are often
reformed to prevent such behaviors.
They are characterized by excessive complication and the use of novel ways of
characterizing income, assets, or liabilities and the intent to influence readers towards the
interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes
used. Other synonyms include "cooking the books" and "Enronomics", named after
the Enron fraud. Creative accounting is oftentimes used in tandem with outright
financial fraud (including securities fraud), and lines between the two are blurred. Creative
accounting practices are known since ancient times and appear world-wide in various forms.
"Every company in the country is fiddling its profits. Every set of published accounts is based on
books which have been gently cooked or completely roasted. The figures which are fed twice a
year to the investing public have all been changed in order to protect the guilty. It is the biggest
con trick since the  Trojan horse.  ... In fact this deception is all in perfectly good taste. It is
totally legitimate. It is creative accounting." - Ian Griffiths in 1986, describing creative
accounting

 How Creative Accounting works?

A primary benefit of public accounting statements is that they allow investors to
compare the financial health of competing companies. However, when firms indulge in
creative accounting, they often distort the value of the information that their financials
provide.

Creative accountants will always find bizarre and novel ways to tweak figures to a
company’s advantage. Their goal is to make a firm look as successful and profitable as
possible and sometimes they will go about doing this by twisting the truth. If a gray area
in accounting is found, it may be exploited, even if it results in misleading investors.

Getting caught can ruin a company's reputation overnight. However, some

management teams are willing to run that risk, condoning the use of creative accounting
because failure to meet short-term expectations of Wall Street or year-end financial
targets can have a hugely adverse impact on share prices.

It is also worth remembering that more attractive figures may lead to higher bonuses
for directors, help convince a lender to give a firm a loan and inflate the company’s
valuation in the event of a sale.
  Methods of Creative Accounting.
Creative accounting tricks vary in nature and consistently evolve as regulations to police
them change. Here are some examples of common techniques:

 Overestimating revenues: One of the most common techniques used by public

companies looking to artificially boost their income is to prematurely
recognize revenue. Revenue recognition is an accounting method that enables companies
to recognize sales before they deliver a product or perform a service. It is open to
exploitation.
 Lowering depreciation charges: Companies often spread out the cost of assets, rather
than expensing them in one hit. Methods to reduce annual charges on these items can
include extending the useful life estimate of the asset or increasing its assumed salvage
value.
 Delaying expenses: Deferring the recording of current period expenses, such as
payments to suppliers and rent, to a subsequent period makes current period earnings
look better.
 Masking contingent liabilities: Failure to record potential liabilities that are likely to
occur and underestimating how much they are likely to cost can boost net
income or shareholders' equity.
 Undervaluing pension liabilities: Pension obligations can easily be manipulated because
the liabilities occur in the future and company-generated estimates need to be used to
account for them. 
 Inventory manipulation: Inventory represents the value of goods that were
manufactured but not yet sold. Overstating the value of inventory will lead to an
understatement of cost of goods sold, and therefore an artificially higher net income,
assuming actual inventory and sales levels remain constant.

 I. Real world examples of Creative Accounting

1. Laribee Wire Manufacturing Co. offers a good example of inventory manipulation. The
copper-wire maker was in trouble in the late 1980s as sales to the troubled construction
industry faltered and a big acquisition left it with massive debt. Laribee recorded
phantom inventory and carried other inventory at bloated values to convince banks to
lend it $130 million. The company reported $3 million in net income for the period,
when it really lost $6.5 million.

2. Then there is Enron Corp. In the 1990s, 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 2001.
 3. 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. By capitalizing expenses, it exaggerated profits by
around $3 billion in 2001 and $797 million in Q1 2002, reporting a profit of $1.4 billion
instead of a net loss.

Examples that is usually meet: 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. This is
an example where the company attempts to show the boosted up revenue figures; the
company sometimes gives loans to their known person to willfully hide the transactions
made during the year; the company increases the useful life of an asset arbitrary to get rid of
the higher depreciation charged.

 II. Types/Examples of Creative Accounting schemes

1. Earnings management
Creative accounting can be used to manage earnings. 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 or influence contractual outcomes that depend on reported accounting
numbers.
2. Hollywood accounting
Practiced by some Hollywood film studios, creative accounting can be used to conceal earnings
of a film to distort the profit participation promised to certain participants of the film's earnings.
Essentially, participants in the gross revenue of the film stay unaffected but profit participants
are presented with a deflated or negative number on profitability, leading to less or no payments
to them following a film's success.
3. Tobashi schemes
This form of creative accounting—now considered a criminal offense in Japan, where it
originated—involves the sale, swap or other form of temporary trade of a liability of one
company with another company within the holding's portfolio, often solely created to conceal
losses of the first firm. The Enron scandal revealed that Enron had extensively made use of sub-
corporations to offload debts and hide its true losses in a Tobashi fashion.
4. Lehman Brothers' Repo 105 scheme
Lehman Brothers utilized repurchase agreements to bolster profitability reports with their Repo
105 scheme under the watch of the accounting firm Ernst & Young. The scheme consisted of
mis-reporting a Repo (a promise to re-buy a liability or asset after selling it) as a sale, and timing
it exactly in a way that half of the transaction was completed before a profitability reporting
deadline, half after—hence bolstering profitability numbers on paper. Public prosecutors in New
York filed suit against EY for allowing the "accounting fraud involving the surreptitious removal
of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to
deceive the public about Lehman's true liquidity condition".

 Motivation behind Creative Accounting

-Personal incentives -Market and stockholder expectations of profits
-Bonus-related pay -Benefits from shares and share options
-Job security -Personal satisfaction
-Cover-up fraud -Tax management
-Management buyouts -Debt covenant
-Manager's self-interest -Mergers and acquisitions

 Prevention of Creative Accounting

Those companies most at risk for fraudulent financial reporting tend to be those that have
one or more of the following attributes: weak internal control; no audit committee; a family
relationship among directors and/or officers; assets and revenue less than $ 100 million;
and/or a board of directors dominated by individuals with significant equity ownership and
little experience serving as directors of other companies.

To prevent creative accounting, the experts opine that accountants and managers should
divide the duties of an internal control checklist. Furthermore, an independent audit
committee should always have someone with a strong accounting background and audit
experience who deals directly with outside auditors. The investors should diversify their
investment portfolio to circumvent the problems related to the creative accounting by few
unscrupulous companies.

Creative accounting can have a positive impact on a company’s business in the short term, but
in the long run it may result in decreased stock prices, insolvency, and even bankruptcy. Since
creative accounting is increasingly being used in a negative sense, it is necessary to establish
efficient methods that will limit manipulation of financial information. Efficient techniques for
preventing creative accounting include:
• •adaptation of accounting standards in terms
• adaptation of accounting standards in terms of limited use of estimates and consistency in the
application of accounting methods;
•• •recognising and insisting on the role of in-
• recognising and insisting on the role of internal and external audit in identifying and reporting
unfair estimates, and preventing accounting manipulations
•• •adaptation of accounting standards in terms
• change of audit service providers from one accounting period to another;
• hiring independent directors and members of the audit committee;
• establishing effective corporate governance controls;
• company persistence in developing a whistle-blower policy;
• continuously making employees aware of the code of ethics;
• placing emphasis on the development and application of forensic accounting;

Conclusion

Creative accounting refers to imaginative ways to present accounts. The aim in creative
accounting is to make the company appear financially healthier than it really is. It is hidden in
many techniques, but many preventions are taken to slow it down.

So, creative accounting left its mark in time and it is used until the present. In my opinion, is
good to follow the “normal” accounting, because in this way we do not deceive investors about
the evolution of our company and we need to be honest people and to do the things right, such
that company have a long-term development; even this creative accounting is legal, is a thin line
between legal and illegal.

In the future, the use of creative accounting certainly can not be completely removed, but it
can be minimised using various solutions. If it is implemented in a minimal scope and with
positive intent, creative accounting can be considered good practice, but since it is often misused,
it is necessary to insist on measures that will reduce the practice of manipulating financial
statements in order to prevent false financial reporting.
The creative accounting will exist as long as will be professional accountants able to make an
artifice through which company can improve apparently performances.
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