Business, Legal & Accounting Glossary
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.
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:
To help you cite our definitions in your bibliography, here is the proper citation layout for the three major formatting styles, with all of the relevant information filled in.
Definitions for Creative Accounting are sourced/syndicated and enhanced from:
This glossary post was last updated: 19th April, 2020 | 58 Views.