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Creative accounting

From Academic Kids

Template:Mergefrom Creative accounting is an euphemism referring to accounting practices that deviate from standard accounting practices. They are characterized by excessive complication and the use of novel ways of characterizing income, assets or liabilities. This results in financial reports that are not at all dull, but have all the complication of a novel by James Joyce, hence the appellation "creative." Sometimes the words "innovative" or "aggressive" are used.

In some cases, the term is used in professional humor, as when accountants poke fun at each other's more esoteric accountancy practices. In this usage the use of the term "creative accounting" has quite complex connotations: a good laugh, trying to encourage more honest practices, and sometimes despair at ever cleaning up the mess.

The term is used more seriously and disparagingly to refer to systematic misrepresentation of the true income and assets of business organizations. "Creative accounting" on this scale has led to a number of recent accounting scandals, and many proposals for accounting reform - usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added.

Newspaper and television journalists have hypothesized that the stock market downturn of 2002 was precipitated by reports of accounting irregularities at the Enron, Worldcom, and other business entities in the United States.

One commonly accepted incentive for the systemic over-reporting of corporate income which came to light in 2002 was the granting of stock options as part of executive compensation packages. Since stock prices reflect earning reports, stock options could be most profitably exercised when income is exaggerated, and the stock can be sold at an inflated profit.

The most notable activist is Abraham Briloff (professor emeritus of CUNY Baruch) who for years wrote a column for Barrons that constantly analyzed breaches of ethics and audit professionalism among CPA firms. His most famous book is called Unaccountable Accounting.

The profession, in turn, was not kind to Dr. Briloff [1] (http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm). Briloff was trying to save the profession from what it is now going through in the wake of the Enron scandal.

Contents

Creative Accounting Tactics

  • Although not technically wrong, many annual and quarterly reports and presentations dive heavily into theoretical scenarios where one time "charges" to earnings are excluded. What this means is for example, a law suit settlement amount would be taken out of the reported profit in one big chunk, even if its paid out little by little over time (this practice is called reserving). Often, when explaining the quarterly results, a CEO might say "Well if we didn't take this charge for the law suit, we would have made this much money". Very often, the hypothetical situations proposed get even more complicated. The main "creative" aspect to this is when a "one time" "exceptional" charge really is something that is very common to the business.
  • Banks are able to lend out most of the money they receive in deposit (they also can lend money they borrow from other banks). However, to protect against bad loans, banks must keep aside a stash of money called a "reserve". The bank, within general guidelines, gets to set the size of this reserve to what it feels is prudent compared to how risky its outstanding loans are. However, when the bank wants to make it look like it made more money this quarter than last, one way to do that is to take money from the reserve and call it profit with the excuse that the loans are safer now than before and that amount was no longer needed.
  • One of the main genres of "creative accounting" is known as slush fund accounting, whereby some earnings from this quarter are hidden away just in case the profit from next quarter is not enough for the management to make their bonuses. This happened most famously at Freddie Mac. As of 2004 there is a large investigation underway to see if retroactive insurance policies from insurers such as General Re of Berkshire Hathaway were used for slush fund accounting. The question is if these insurance policies truly transferred some risk or were merely a slush fund.

Earnings Management

According to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgement 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 to influence contractual outcomes that depend on reported accounting numbers.

Earnings management usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics. It is sometimes called 'creative accounting'. Aggressive earnings management is a form of fraud and differs from reporting error.

Management wishing to show earnings at a certain level or following a certain pattern seek loopholes in financial reporting standards that allow them to adjust the numbers as far as is practicable to achieve their desired aim or to satisfy projections by financial analysts. These adjustments amount to fraudulent financial reporting when they fall 'outside the bounds of acceptable accounting practice'. Drivers for such behaviour include market expectations, personal realisation of a bonus, and maintenance of position within a market sector. In most cases conformance to acceptable accounting practices is a matter of personal integrity. Aggressive earnings management becomes more probable when a company is affected by a downturn in business.

Earnings management is seen as a pressing issue in current accounting practice. Part of the difficulty lies in the accepted recognition that there is no such thing as a single 'right' earnings figure and that it is possible for legitimate business practices to develop into unacceptable financial reporting.

It is relatively easy for an auditor to detect error but earnings management can involve sophisticated fraud that is covert. The requirement for management to assert that the accounts have been prepared properly offers no protection where those managers have already entered into conscious deceit and fraud. Auditors need to distinguish fraud from error by identifying the presence of intention.

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.

References

Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

Further reading

  • How Companies Lie: Why Enron Is Just the Tip of the Iceberg, A. Larry Elliott, Larry Elliott, Richard Joseph Schroth, Random House, 2002, Hardback, ISBN 0609610813

See also

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