Question

Discuss the nature, and pros and cons, of creative accounting, using examples to support your arguments. and address the point of view that ‘creative accounting is an essential part of accounting innovation and the response to change and developing exigencies

Answer 1

Creative accounting is referred to also as income smoothing, earnings management, earnings smoothing, financial engineering and cosmetic accounting.Creative accounting consists of accounting practices that follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.

A primary benefit of public accounting statements is that they allow investors to compare the financial health of competing companies. However, when firms indulge in creative accounting, they often distort the value of the information that their financials provide.

Creative accountants will 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.

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.

  Laribee Wire Manufacturing Co. offers a good example of inventory manipulation. The copper-wire maker was in trouble in the late 1980s as sales to the troubled construction industry faltered and a big acquisition left it with massive debt. Laribee recorded phantom inventory and carried other inventory at bloated values to convince banks to lend it $130 million. The company reported $3 million in net income for the period, when it really lost $6.5 million.

  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.

PROS AND CONS

Creative accounting is a euphemism referring to accounting practices that may follow the rules of standard accounting practices, but deviate certainly from what those standards stand for or are meant for accomplishing. This would lead us to know since when the aforementioned term makes an appearance in the profession and why it holds such euphemism including other terms like, “innovative” or “aggressive” and sometimes

A fraudulent accounting technique that involves a parent company making artificial paper-only transactions with its subsidiaries to hide losses the parent company has incurred through business activities.

According to critic David Ehrenstein, the term “Creative Accounting” was first used in 1968 in the film The producers by Mel Brooks. In addition, ever since the Enron and WorldCom Financial reporting disaster, which revealed systematic and creatively planned accounting fraud, the term creative accounting has given rise to create the images of acts or instances of embezzling in terms of accounting. It may be said that all that happens is due to creating the culture of greed, corruption and deception. And these bankruptcies are caused by unethical and irresponsible decisions of those officers who are involved in these activities. It’s like some people suffer for the sins of others.

While it’s being discussed why creative accounting is regarded as deceptive accounting, it’s important to know what motivates for creative accounting. Creative accounting has been defined as the exploitation of loopholes in financial regulation in order to gain advantage or present figures in a misleadingly favorable light. Creative accounting methods are adopted by those who want to gain personal incentives. Evidences reveal that in most cases creative accounting is used to cover up frauds. Bonus related pay or issues can be a great cause for motivating accountants towards creative accounting. With so many widely-publicized scandals of creative accounting, it is clear that the intention behind this is to gain benefits of shares and share options, while it’s done for attaining self-satisfaction as well. In addition, job security can also be one of the greatest reasons to motivate the accountants for adopting creative accounting. However, financial accounting reports are produced to show the true and fair state of affairs of business entities, so that the stakeholders and other users of that information can take the informed decision. And creative accounting involves destroying financial records and information by altering or fabricating.

Now the question is how one could be creative in the field when creativity has been coined with accounting to connote deceptive accounting. In fact, the point is not that creativity is bad, but creative accounting is bad. Neither does the term accounting innovation seems to have been fit with GAAP. Hence, it’s important that accountants should not allow personal prejudice or bias to override the rules of standard accounting practices. It’s not that creative accounting solutions are always wrong. Creativity is as much important in accounting profession, as it’s in other professions provided that the intention is not bad while it leads to follow the rules accordingly. Accountants should find better ways to bring improvements to perform their tasks more efficiently and effectively by giving a boost to their creativity. This could lead to create automated tasks that run automatically with no manual intervention.

Creativity can be used to track and get the accounting right. It can help in bringing the developments in doing things more accurately and quickly to produce financial reports that facilitate management to have quick and reliable quantitative information.