LECTURE 7

CREATIVE
ACCOUNTING

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 LEARNING OBJECTIVES

At the end of this lecture, the student will

understand :
1. The definition and various terminology used to
describe Creative Accounting
2. The factors motivating companies to engage in
creative accounting
3. The techniques applied in creative accounting
4. The mechanism used to overcome creative
accounting problems
5. The ethical perspective of creative accounting
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LEARNING OBJECTIVE 1

What is creative
accounting ?

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Creative Accounting

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An introduction
Not a new phenomenon, an old accounting
problems that goes as far back as in the
1920s
a perennial problem since separation of
ownership and management
But continuously receive mounting attention
due to corporate scandals especially after the
Asian Financial Crisis
Thus, preparers and auditors are under
pressure to curtail the practice

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Definition – Creative Accounting
 Various definition available
 Depending on the perspective of user
 Two main category of definition:
 Macro-Manipulation
 Alteration of figures by taking advantage of
loopholes in regulation
 Micro-Manipulation
 Restructuring of transaction with the aim to
achieve desired results
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Definition – Creative
Accounting
 Orio Amat et al (1999) define creative
accounting as a process whereby accountants
use their knowledge of accounting rules to
manipulate the figures reported in the
accounts of a business
 Naser (1993) define creative accounting as
the transformation of financial accounting
figures from what they actually are to what
preparers desire by taking advantage of the
existing rules and/or ignoring some or all of
them.

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Creative Accounting – Other names

Earnings
Financial Management
Engineering
Window
Dressing Income
Smoothing

Cosmetic
Accounting
The art of Cooking
the books 8
LEARNING OBJECTIVE 2

Why –
Creative Accounting ?

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 Agency Theory
 Based on the assumption that
 Individuals seek to maximise their own interest
 In the context of company, the management and
shareholders may have different objectives
 Hence, a conflict of interest may occur when managers
do not act in the best interest of shareholder
 Agency theory can also used to describe the
conflict of interest between management and
accountant
 The conflict of interest are mitigated through
creative accounting
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Motives for creative
accounting
 Stock Market based incentive
 Regulatory concern
 Contracting Motivation

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Stock Market based incentive
 Prior to management buyout
 Prior to equity offer
 To increase the value of the company
 To reduce cost of capital
 To meet the expectation of financial
analyst
 To meet profit forecast/projection made by
company which was publicly announced
 To influence certain group of stakeholders-
institutional investors
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Regulatory concern
 Imposition of limitation
 Utility company, banks
 Seeking government subsidy or protection
 Inadequacy of accounting standard
 Complex business environment
 Vagueness and flexibility of accounting standard
 Permitted choices of accounting policies
 Application of judgment
 Undefined concepts such as “true and fair view”
and materiality
 To reduce taxes
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 Contracting motivations
 Management compensation
 Compensation package linked to financial
figures
 Lending contracts
 Loan covenants based on financial figures

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LEARNING OBJECTIVE 3

How –
Creative Accounting ?

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Techniques of creative
accounting
 Income Smoothing
 Window Dressing
 Off Balance Sheet Financing
 Big Bath Accounting

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 Income Smoothing
 The process of deflating the reported profits in
good periods and deferring them to loss making
period
 Minimise variance in earnings
 Focused on profit and loss statement
 Example
 Recording of discretionary expenses
 Capitalisation of expenses
 Over/under provision
 Expenses offset against reserves

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 Window Dressing
 The process of adjusting the financial statements
of a company to achieve the maximum effect on
its financial position at a particular date
 To obtain desired financial ratios
 Focused on balance sheet
 Example:
 debtors and creditors stated at either gross figures or
net of discounts
 Valuation of assets

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 Off Balance Sheet Finance
 The funding or refinancing of a company’s
operations in such as way that under legal
requirements and existing accounting conventions,
some or all the finance may not be shown on its
balance sheet
 Removal of assets and / or liabilities from the
balance sheets
 To show better gearing ratio, allows additional
funds
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 Off Balance Sheet Finance
 Problems
 Financial risk to shareholders, unsecured to
creditors → gearing too high
 Economic effects no apparent to users as
information is not disclosed
 Most common example:
 Special purpose entities

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 Big Bath Accounting
 Reduce current earnings through excessive
provision in order to increase future
earnings
 Usually occurs during takeover or
restructuring period
 To highlight the ‘efficiency’ of new
management

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LEARNING OBJECTIVE 4

Can the problem of

creative accounting be
solved ?

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 Suggested ways to combat
creative accounting
 Continuous development of a Conceptual
Framework (CF)
 CF is a statement of generally accepted theoretical
principles which form the frame of reference for
financial reporting
 More refined standards
 Upgrading accounting standards
 Reduce accounting choices
 Minimise subjective opinions

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 Suggested ways to combat
creative accounting
 More empirical research
 To seek examine factors contributing to
creative accounting
 Educate
 Users of financial statements
 To be aware of issues surrounding creative
accounting
 Preparers
 To be more ethical
 Be aware of consequences of creative
accounting 24
Suggested ways to combat
creative accounting
 High quality of auditing standards and practices

 Effective enforcement / oversight mechanism:

- Independency of audit committee & effective internal controls

are fundamental in achieving good corporate governance

- Independent audit committee should always have someone with

a strong accounting background and audit experience who deals
directly with outside auditors.

- To enable the members of the audit committee and

independent non-executive directors to carry out their tasks and
duties effectively, they must be appropriately compensated and
adequate resources must be provided by the company to
support them in their duties.
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 Points to Ponder
 Are there any real solutions?
 Nasser (1993) study the attitudes of
auditors in the UK on the usage of
creative accounting. His study found
that 91% of the respondents assert that
problem of creative accounting cannot
be solved

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LEARNING OBJECTIVE 5

Is Creative Accounting
Ethical ?

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The Ethical Perspective
Amat and Blake (1996) report on a
survey of Spanish auditors’ views on
creative accounting.
One third of the respondents agreed that
creative accounting was a legitimate
business tools

65% of the respondents considered it to be

a serious problems
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Creative Accounting & Ethics
Used in 2 different contexts

“Good” “Bad”
Creative Creative
Accounting Accounting

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 “Bad” Creative Accounting

 It will become negative when it is used

by unscrupulous management to
mislead and defraud users of accounts
 Transactions that break accounting
rules
 The type of creative accounting that
was discussed today this lecture…
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 “ Good” Creative Accounting
 Conveying information
 If it is done with the intention not to

defraud the users. For example,

income smooting is done to signal
future prospects of the company or to
reduce the volatility with view to
stabilize the share price movement.

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“ Good” Creative Accounting
 To be more informative
 Managers can also use accounting
judgment to make financial reports to be
more informative for users
 This can arise if certain accounting choices
or estimates are perceived to be credible
signals of a firm’s financial performance eg.
estimates of net receivables will be viewed
as credible forecast of cash collections

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 Conclusion…
Good or bad depends on the intention of creative
accounting and the consequence of the actions
 Ultimately, creative accounting should be used if, and
only if, it is within the ramifications of the law and it
achieves the company’s ultimate goal of increasing
stock value
 Hence, when using creative accounting, management
cannot just benefit the company in the short run.
 The creative accounting must also benefit the
company in the long run, which is what ultimately
matters.
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