Creative Accounting

Creative accounting and earnings management are euphemisms referring to accounting practices that may or may not follow the letter of the rules of standard accounting practices but certainly deviate from the spirit of those rules. They are characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities. The terms “innovative” or “aggressive” are also sometimes used.

The term as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations. “Creative accounting” is at the root of a number of 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 Enron, Worldcom, and other firms 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 Barron’s 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 but much of what he advocated has been forced on the industry in the wake of the Enron scandal (See Sarbanes-Oxley).

A lesser usage is in professional humour when accountants poke fun at each other’s more esoteric accountancy practices.

According to critic David Ehrenstein, the term “Creative Accounting” was first used in 1968 in the film The Producers by Mel Brooks.

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 lawsuit settlement amount would be taken out of the reported profit in one big chunk, even if it is 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 lawsuit, 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 supply 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 was 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.
• Creative accounting is not limited to large firms with banks of accountants. Smaller companies often use creative accounting, but for tax saving purposes rather than meeting bonuses or shareholder expectations. Salaries are sometimes included in profits to benefit from corporation tax rates being lower than personal tax rates and spouses are sometimes put on the books as employees though they may never have worked for the company. As smaller companies are generally subject to less onerous rules – and many of them fall below the limit required for a full annual audit every year – much of the creative accounting in this sector does not get a lot of publicity.

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. 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 errors 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 as follows:

• 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.

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