What is Creative Accounting?
Creative accounting consists of accounting practices that follow required laws and regulations, but capitalize on loopholes in accounting standards to falsely portray a better financial image of a company. Creative accounting techniques vary and evolve as regulations change to close the loopholes that allow them.
- Creative accounting capitalizes on loopholes in accounting standards to falsely portray a better financial picture of a company.
- Creative accounting tricks vary in nature and consistently evolve as regulations change.
- Getting caught can ruin a company's reputation—and sometimes result in criminal charges, convictions, and prison time.
- Investors should always be skeptical and read financial statements from top to bottom for any signs of foul play.
How Creative Accounting Works
A primary benefit of public accounting statements is that they allow investors to compare the financial health of competing companies. But when firms indulge in creative accounting, they often distort the value of the information that their financials provide.
Creative accountants can 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. 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.
Types 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.
Real-World Examples of Creative Accounting
In the 1990s, energy, commodities and services company Enron Corp. 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. Twenty-two executives pled guilty or were convicted, and a number went to prison for lengthy terms.
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. Among others, the former CEO and CFO were sent to prison.
In the wake of the Enron and WorldCom scandals, among others, the Sarbanes-Oxley Act (SOX) was enacted in 2002 to deter fraud and require greater transparency of public companies.
Watching for Creative Accounting
Analysts, asset managers, and financial journalists failed to see many of the above scandals coming, proving that it is not always easy to spot questionable accounting practices. However, that does not mean that investors should sit back and do nothing. Being skeptical and reading financial statements a little more closely, rather than just focusing on what management highlight, can go a long way to detecting suspicious activity.
A good starting point is to carefully read company footnotes, assess the reliability of auditors, and pay careful attention to any unusual variations in figures.
What Are Examples of Creative Accounting?
Examples of creative accounting include overestimating revenues, lowering depreciation charges, and delaying expenses. Other common examples include underestimating potential liabilities, undervaluing pension obligations, and manipulating inventory.
Is Creative Accounting Legal?
Creative accounting is legal in that it exploits loopholes in laws and regulations. But it can ultimately lead to accounting fraud, as was the case in the Enron and WorldCom scandals.
What Are US Accounting Standards?
The generally accepted accounting principles (GAAP) are used in the United States for preparing financial statements. Outside of the U.S., companies follow the International Financial Reporting Standards (IFRS).
The Bottom Line
Creative accounting takes advantage of loopholes to falsely portray a company’s financial health as better than is actually the case. While creative accounting isn’t exactly illegal it can lead to accounting fraud, which is. Extreme examples include the Enron and WorldCom scandals.