CREATIVE ACCOUNTING

Week 3
 RECOMMENDED READING

• Thomas A Lee (2006) Chapter 9

• William Scott (2015) Chapter 11
 Areas to be covered
• Introduction
• Definitions
• Examples of creative accounting and earnings
management
• Reasons for creative accounting
• Role of regulators and standard setters
 Introduction
• What do you associate with the names of
these companies: Enron, WorldCom, Lehman
Brothers, Olympus, Satyam, Tesco, Wirecard?
 Distortion of accounting information
• Difference between reported accounting
numbers and what is supposed to be revealed

• Misleads investors and could damage

company reputation

• Underlying problem inherent in principal-

agent relationship – opportunistic behaviour
 Definitions
• Accounting misstatement
Reported accounting numbers are different from what they should have been
if they had been affected by either accounting error or accounting fraud
Prior period adjustment required for material items
• Earnings management
Manipulating reported profits to ‘ideal’ or ‘target’ level which are
greater or less than those generated by a conventional use of GAAP’
Effected by choice of accounting policies, or real actions, affecting earnings

• Creative Accounting
Creative accounting means using inappropriately accounting standards with the aim
of misleading investors by presenting them with what they want to see.
...... mainly includes earnings management and focuses a lot on classificatory
manipulations (either related to the income statement or the balance Sheet)
(Stolowy, Lebas & Ding, 2013)
 Creative accounting
• Accounting practices that attempt to manage
earnings and other aspects of corporate
financial statements

• Carried out within the letter of the rules

– exploiting choices within existing accounting
regulations and GAAP
– Projecting the legal form rather than economic
substance/reality
 Specific examples of creative accounting

Off balance sheet financing

• Finance leases (previously) treated as
operating leases
• Borrowings (usually convertible loan classified
as equity)
• Sale and repurchase agreements
– Lehman Bros used Repos 105 to cover up its debts
• Offsetting liabilities against assets
 Examples of creative accounting (cont’d)

Increasing profit or income smoothening

• Revenue recognition
• Use of inappropriate provisions
• Providing for expenses as they arise (e.g.
decommissioning costs)
• Classifying expenses as capital expenditure
• Reducing expenses e.g. depreciation charge
 Highly subjective and complex accounting
areas subject to manipulation
‘The accounting areas that tend to be the focus of
SEC enforcement actions are revenue recognition,
expense recognition, valuation issues, asset
impairments, and earnings management.
Revenue recognition and valuation issues were
common among enforcement actions that
identified [Internal Control Over Financial
Reporting]ICFR problems’ (Observations and
Recommendations from Anti-Fraud Collaboration Workshop, March 2017)
 Illustration
• Cyber, a wine manufacturing company contracted to sell part
of its inventory of wine to a bank for £10m on 1 January 2020.
The agreement made provision for Cyber to buy back the
goods two years later for £12.1m. The goods remained located
at Cyber’s premises. Cyber had treated the transaction as a
sale. The market rate of interest for an advance to a wine
manufacturing company was known to be 10%.

Required:
• Explain the substance of this transaction and how it should be
correctly accounted for in the statement of profit or loss and
statement of financial position of Cyber at the year ended 31
December 2020 and 2021.
 Cyber
Substance of transaction

Correct accounting treatment

Solution - Cyber
 Reasons for creative accounting

• Ensuring dividends can be paid to shareholders

• Maintaining share price – meeting market’s expectation
• Maintaining borrowing capacity with lower the liabilities
• Keeping borrowing cost on future borrowing low
• Influence of bonuses and performance related pay
• Off-balance sheet schemes reduce borrowing costs
recognised, thus improving earnings
 Covering up creative accounting
• Tendency to keep digging to get out of a hole!

• Satyam boss, Mr Raju said attempt to hide

losses from investors and shareholders was
like "riding a tiger, not knowing how to get off
without being eaten“ (BBC news 8 Jan 2009).
 Role of regulators and standard setting bodies
• FRC - What we do
https://www.frc.org.uk/getattachment/d5139624-9459-43d1-8e1a-935db13458ec/FRC-Who-we-are_2022.pdf

• FRC’s FRC Annual Review of Corporate Reporting

https://www.frc.org.uk/getattachment/187eaa07-0de8-40fb-b575-63673f2c638b/FRC-CRR-
Annual-Review-Highlights_October-2021.pdf

• Conceptual framework and accounting standards

Framework definition of assets, liabilities, expenses and revenues
Recognition and measurement guidelines

Relevant accounting standards to check creative accounting:

E.g. IAS 37 Provisions; IAS 16 PPE; IAS 38 Intangible assets;
IFRS 10 Consolidated financial statement, IRFS 16 Leases etc
 Is regulation working?
• Financial reporting landscape is littered with
numerous pronouncements
• Prescriptive nature of some standards make
them susceptible to financial engineering
• Inherent problems associated with financial
reporting
– Subjectivity
– Self-reporting bias