Creative accounting 2
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University of Texas**We aren't endorsed by this school
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B A 640
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Accounting
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Jan 8, 2025
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14
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Creative Accounting and Financial ReportingNameAffiliate InstitutionDate
Introduction Creative accounting is involved in financial reporting and information engineering as is concerned with the disclosure of financial information in ways that make the company be performing better as compared to how it would appear if the accountant were honest. Trustworthy, relevant, and accurate discloser of financial information is considered to play a critical role in the improvement of the business image, lowering the financing cost, and increase of the stock marketability. Financial reporting focus on providing stakeholders of the business with timely, accurate, and reliable financial information to make decisions about the company operations. The objective of financial reporting is to communicate the financial performance of the organization to all the stakeholders so that they can make informed financial and investment decisions. however, contemporary accounting systems permit flexibility in accounting systems and policies as well as application of criteria, measurement rules, and accounting information classification. In other words, different firms use different accounting standards in financial reporting Farhan Jedi and Nayan 2018) As a result financial and accounting professionals can deliberately conceal and manipulate financial information to make the company reflect better performance to the user of the company's financial statements. Such manipulations are intended to deceive financial information users and investors that the company is financially stable and more profitable hence misleading investors and other financial users through the application of disinformation which plays a critical role in hindering investment mobilization and corporate growth. . Such practices can mislead users and investors by using disinformation, which is a significant hindrance to corporate growth and investment mobilization (Campello et al. 2010)To generate credible and reliable financial statement accountant are required to follow the generally accepted accounting principles (GAAP) and the international financial reporting
standard (IFRS) when reporting financial information. Despite the presence of International accounting standards, IFRS and GAAPs accountants continue to present manipulated financial statements to influence the decision of the users of financial statements. As a result of the unpredictable and complex business environment, it has become difficult for policy setters to seal all the loopholes that promote financial statements manipulation using accounting and financial reporting standards. According to Jones, (2010), the current accounting regulations and standards are not able to prevent the manipulation of financial statements in advance however they can curb it afterward. Therefore, this paper aims to critically analyze companies' use of creative accounting in financial reporting. Motivations of creative accounting Creative accounting in the business landscape is influenced by various factors. A projected increase in the company stock price is one of the primary incentives of creative accounting. All businesses and companies exist to maximize the wealth of shareholders. Companies with sustainable profits are perceived to be performing well and therefore potential investors believe that such companies have high value as companies that are operating on losses. Therefore, companies with high profit and cash flows attract investors who are willing to pay high for the stock. With this illusion accountants and the management of the company will be tempted to manipulate the company's financial statements to create a perception that the company is performing well hence increasing the company stock prices. Another incentive that makes companies engage in creative accounting activities is higher credit and low-interest rates. Creative accounting practices help the business to adjust the company profit margins, debt ratios, and other efficiency ratios. Understatement of liabilities and inflation of company assets in the statement of financial positions improve some of the key performance
ratios measured and evaluated by creditors. Additionally, inflations of revenue and understatement of the company expenses result in the overstatement of the company profits. Companies with high profits are perceived that they have enough cash flows to service the loans. Additionally, the company engages in creative accounting to prevent hostile stock takeovers and stock fluctuation. Companies with poor financial performance are valued at low prices and bigger companies may be interested to acquire them at lower prices. Therefore, to present this the management of such companies manipulates the financial information of the company. during mergers and acquisitions, the company can practice creative accounting to show that the company is performing well. Hence, increasing the company's bargaining power. Furthermore, companies may manipulate their profit downward for tax purposes. In some instances, companies do not want to pay higher taxes. As result, the management conceals some of the company's profit through revenue understatement and expenditure overstatement. Additionally, companies engage in creating accounting to conceal fraud cases in the company. When the management has committed fraud in the company they may be tempted to manipulate the financial statement of the company hence deceiving the shareholders that the company financial statement represents a fair few of the company's financial position which is not the case. Management may also manipulate financial statements for their selfish gains. For example, companies that reward their management for good performance may make the management and employees manipulate financial statements show as to make the board recommend salary and bonus increases.
Creative Accounting TechniquesThe primary objective of creative accounting is to identify the present loopholes in the [prevailing laws and accounting standards and exploit them in improving the company's financial indicators. Companies apply creative accounting to project them as performing positively. According, to Cernusca et al., (2016) creative accounting is successful when done with a positive application and minimum effect on financial statements. Creative accounting does not only violate the accounting regulations but has a catastrophic implication for the company's financial performance. Therefore, creative accounting can be concluded to have an adverse effect on financial reporting. In most cases, the company's internal management is responsible for financial statement manipulation (Vladu et al. 2017). The employees engage in questionable practice and financial information misrepresentation with full knowledge of the management. Banks, manufacturing, and other businesses operating in the retail sector practice creative accounting using various techniques to facilitate the management achieve their goals. Some of the techniques applied by the companies to facilitate creative accounting include revenue recognition. In this case, the company may recognize prepaid income in the current years in the income statement. Future profits for the business, which are not realized, are also reported in the current accounting period (Cernusca et al. 2016). Additionally, line managers may defer expense recognition in the current accounting period hence resulting in the understatement of profits. The commonly applied creative accounting techniques are explained below. Tangible assets
In most cases creative accounting when depreciating for tanging assets (PPE). According to, IAS 36 the statement's financial position is analyzed and the corresponding depreciation for assets is evaluated. In case the management is away the residual value of the asset is less compared to the reported then the asset is said to be impaired. In some cases, the management may opt to report the asset in the long financial statement.Inventory manipulation For retail and wholesalers inventory manipulation is the most used technique used for creative accounting. Inventory is characterized by immense subjectivity and hence it is susceptible to creative accounting. Deliberate manipulation of inventory in financial reporting can result in to change in asset value (Lazo and Billings 2012).This indicates that the difference (positive or negative) in inventory reporting affects the present and future accounting periods’ results. If finance costs are accounted for in production costs, financial outcomes differ because expenses are already accounted for (Lucchese and Di Carlo 2020). On the contrary, if the projected outcomes are adverse, the same method is used differently; interest expenses are accounted for in production costs (Tanaka, 2017). Most retail shops value inventory at the whole price or cost. However, after the sales of inventories, they are recorded at the whole price markup. In this case, the cost of inventory is recorded as the cost of sale while the selling price is recorded as revenue. Thus increasing the inventory of any company may result in to decline in the cost of goods sold hence increasing the company's cash flow assuming that revenue is not changed. With the illusion that high cash flow is highly valued, more investors will be willing to purchase stocks in the company. In the 1980s Laribee Wire Manufacturing Company Plc decided to overstate its inventory to create a positive impression on its creditors. In its financial statement, the company reported a
profit of $ 3 million while in the real sense the company had recorded a loss of $ 6.5 million. The company uses this tactic to help them in securing $130 million against the manufacturing company inventories. Provision for liabilities Companies can manipulate provisions to change the income for the current and future accounting period. An increase in provisions for liabilities will result in a reduction in profits while the reduction in provisions for liability results in an increase in company profit hence creating a positive impression to the investors. Most managers in financial institutions use this technique to create a favorable income change (Remenarić et al. 2018). An example of liability of provision which manipulated frequently is pension obligations since the businesses are required to account for future expenses. The management may intentionally adjust provision downward by considering the debt that is uncertain to recover. An increase in the net realizable value may help to reduce provisions (Suer 2014). Additionally, the management may use contingent liabilities to reduce profit through forecasting debt uncertainty. Additionally, most companies apply the accrual accounting principle to record the revenue anticipated in the account receivable immediately after completing the sale transaction. In most cases, the management and accountant manipulate the account receivable in the balance sheet. In some instances, the company may understate the provisions of doubtful debt to create an impression that there are fewer cases of debt uncertainty. Other provisions used to practice creative accounting by businesses are the use of provision for depreciation and asset useful life (Olusegun & Olusegun, 2021,). The management can amortize
the value of assets thus decreasing the annual depreciation asset which results in to increase in the company's profitability. Revenue and expense manipulation (income smoothing)Coperland (1998) defines income smoothing as a professional accountant's ability to even out the company's net return over a specific period may three financial reporting periods. This creative accounting technique is practiced to create an impression that the company has stable and steady cash flow. Companies with higher and stable cash flows are highly valued unlike those with fluctuating cash flows and hence investors will pay more for companies with stable incomes. Companies with unpredictable cash flow are considered riskier and most investors will avoid such companies. Hence, this resulting to decline in the stock prices of such companies. Accountants use the loopholes in international accounting standards and generally accepted accounted principles to manipulate the income and expenses of the company thus income smoothing is not illegal. For example, the company may delay the recognition of income to the following year if it expects the future financial period to be unsuccessful. For example, if the company is projecting that the company will record less revenue in the coming year due to the general election the company may delay the recognition of some revenues. Additionally, the company may delay recognition of some expenses such as operating expenses, salaries, and rent as well supply payments can be delayed to the subsequent financial period to make the company financial statement look better. The application of this creative accounting technique attracts the investors to the company thinking that the company is performing better. However, the manipulated financial statement does not reflect the true and fair view of the company's financial information.
Other creative accounting techniques Other creative accounting techniques applied by companies include big bath accounting, use of cookies jar reserves, materiality concept abuse, income statement creative accounting, and cash flow manipulation. Big bag accounting refers to the practice where accountants manipulate the company's financial statements to make the company appear that is performing poorly so that to register significant influence in the future. In difficult years the manager manipulates the financial statements to increase the investors’ confidence. The executive applies different techniques to conduct big bag including taking write-offs, delay of revenue recognition, and prepayment expenditures. Additionally, companies can use the previous year's savings to inflate or maintain the operating income of the subsequent financial year. This is referred to as the use of cookies jar reserve. The intent is to create an impression that the company has steady and sustainable profits, therefore, attracting more investors to the company. as a result of the demand to invest in the company the stock prices increases. Furthermore, the abuse of materiality concept is used to manipulate the company's financial statements. The materiality concept requires the company to disclose all the material information of the company. material manipulation abuse involves the intentional publication of errors in the company revenue, expenses, liabilities, and assets. The company engages in this type of creative accounting intending to have a significant impact on investors' and other stakeholders' decision-making. Additionally, the company may manipulate the income statement. It involves changing the format or procedure in record transactions in the income statement. For example, the account may register non-recurring incomes as other income or recurring or non-recurring expenses may
be recorded as recurring expenses. Additionally, the management can manipulate their cash flow statement to make an impression that the company is performing well. The ability for the company to remain profitable over time is much great when there is steady cash flow. Therefore in most cases, the company will work toward ensuring that there are consistent and sustainable cash flows. In case this does not happen the management may record operating expenditure or operating items as investing or investing items. According to Jone (2010), though this practice may con change the total cash flows of the company it may read to increase operating cash flows. Other important issues As mentioned above creative accounting occurs as a result of changes in accounting standards ie international accounting standards, international financial reporting standards, the generally accepted accounting standard, and other local accounting policies and regulations. Though the accounting standard helps in the preparation of financial reports they are not able to prevent creative accounting. Accounting standards are reviewed constantly to address the current issues in the accounting profession. Through this review, loopholes are created in the standards which facilitate creative accounting. To address the issues of creative accounting the accounting professionals and policymakers should ensure that the accounting standards are clearly defined. The accountant and other professionals should work toward decreasing the adverse impact of creative accounting as it is not possible to seal all the loopholes that promote the manipulation of financial statements. RecommendationsDifferent professionals and scholars have different views about creative accounting. While other says that creative accounting is illegal and unethical others say that creative accounting legal and
ethical as accountant finds opportunities in accounting standards loopholes to improve the financial statement of their companies. However, it is good to recognize that most massive global financial frauds have been achieved through creative accounting. According to Milessi-Ferreti, (2004), creative accounting practice is caused by the inefficiency of the accounting standard framework, a slow judicial system that hinders the enforcement of accounting regulations and ethical code of conduct, and a lack of independence from government regulators and supervision bodies. To curb creative accounting practice the following recommendations should be considered1.The generally accepted accounting principles should be subjected to SAS and IAS to ensure that there is effective and comprehensive accounting practices rule and regulation in the business landscape2.The accounting professional and the organization management should embrace the application of international accounting standards (AIS) and international financial reporting standards (IFRS)3.Accounting professionals and regulatory bodies should ensure the enforcement of accounting regulations and codes of ethics by all stakeholders in the accounting profession. Continuous training and development of accounting professionals should be enhanced to ensure companies do not engage in unethical practices when preparing financial statements. 4.External auditors should be professional and honest in their work and should ensure that all dishonesty in financial reporting is reported. 5.Regulatory bodies should develop rules and regulations to minimize the application of estimations and judgmental prediction in treating specified items like provision for
doubtful debt in financial reporting. Specific standards should be developed to ensure that the accountant does not take advantage of such loopholes to manipulate the company's financial statements. Conclusions Trustworthy, relevant, and accurate discloser of financial information is considered to play a critical role in the improvement of the business image, lowering the financing cost, and increase of the stock marketability. Creative accounting has been applied to commit several financial fraud and scandals across the world. In evaluating why companies use creative accounting financial reporting it is identified that various techniques have been applied including manipulation of inventory, asset overvaluing, smoothing income, materiality concept abuse, and big bag accounting. Companies practice creative accounting to create a perception that the company is performing better hence increasing the stock price. Further, creative accounting is applied by the companies to prevent hostile takeovers by companies that are performing better. Creative accounting has a negative impact on the company's financial reporting and results in the abuse of accounting standards. Creative accounting also affects the shareholder's wealth and if not addressed it may result in the bankruptcy of the company as companies may enter into credit that they are not able to service using fake financial statements.
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