What is creative accounting? Definition and meaning

Creative accounting refers to imaginative ways to present accounts that deviate from the spirit of accounting laws, but are not illegal – the aim is to make the company appear financially healthier than it really is. The accounting practices follow the required regulations and laws, but deviate from what those rules were intended to accomplish. Some people refer to it as innovative accounting, aggressive accounting, or window dressing.

The terms accounting and accountancy refer to the process of keeping financial records.

Creative accounting, while not the same as ‘cooking the books’ – fraudulent activities performed by corporations in order to falsify their financial statements – is seen in a similar light, because the company is trying to give a false impression. However, unlike creative accounting, cooking the books is illegal.

Creative accounting is characterized by excessive complication and the use of novel and bizarre ways of characterizing assets, liabilities, or income. The authors aim is to influence the readers towards a desired interpretation.

Creative AccountingThe aim in creative accounting is to make the company look better than it really is. The creative accountant manipulates the positioning of assets, liabilities, etc., so that the business looks more profitable than it actually is.

A creative accountant does not provide the ‘true and fair’ view of a company that accounts are supposed to.

The creative accountant exploits loopholes in the rules and regulations to falsely portray an enhanced image of his or her company. Even though creative accounting practices are not illegal, the loopholes they capitalize on are usually reformed to prevent such behaviors.

According to FT Lexicon, the Financial Times’ glossary of terms, creative accounting is:

“A lightly ironic term for deceptive accounting practices that make figures appear other than they really are.”

Aim of creative accounting

The creative accountant often attempts to inflate profit figures. Some firms may also minimize reported profits during their good periods to smooth out their results.

Embellishing things creative accountingCreative accounting is all about embellishing things – making them appear nicer and better than they really are, without breaking the law.

The company’s assets and liabilities are often manipulated, either to conceal problems or remain within limits.

The creative accountant may have practiced off balance sheet accounting, posted exaggerated non-recurring items, or might be over-optimistic regarding revenue recognition.

Creative Accounting – a game of cat and mouse

Creative accounting techniques change as time goes by. As accounting standards, rules and regulations change, the techniques that will work also need to be altered.

Several accounting standards changes are intended to stifle particular ways of massaging accounts, which means that persistent creative accountants have to find new ways of doing things.

Well-intentioned changes in accounting standards, however, open up new opportunities for the avid creative accountant. The secret for both accountants and regulators is to try to be one step ahead – it is a game of cat and mouse.

What Charlie Munger said about creative accountingCharles (Charlie) Munger is an American businessman, investor, and philanthropist. He is vice chairman of Berkshire Hathaway, the giant conglomerate controlled by Warren Buffett. Mr. Buffett describes Mr. Munger as ‘my partner’. (Image: Adapted from Wikipedia)

Examples of creative accounting

Invoicing: if sales are invoiced to the client before the end of the period, but the goods are not actually delivered until after the end of the period, that first period gets a boost in sales and profit.

Service Contracts: Imaging a company that services central heating systems, it has service contracts with customers. The amount payable on the contract will typically be charged to customers before the work is carried out.

If the amount charged to customers is posted in the accounts for, for example, the first quarter of the year, and the carrying out of the work is included in the second quarter, the accounts for Q1 will show a profit because there is just income but no costs, while the accounts for Q2 will show a loss because there is no income but lots of costs.

If you only see the accounts for Q1, you will get a very distorted view of how the company is doing.

Property Values: – while a property may be included in the balance sheet at the value the company bought it for, the accountant can legitimately revalue the property so that the amount in the balance sheet is greater. If the revaluation is over-optimistic, the financial health of the company can look better than it really is.

Loans: if a company lends money to somebody connected to the business and there is doubt about his or her ability to ever pay it back, there may be some attempt to hide the transaction from people who read the accounts.

One way is to set things up so that the loan is repaid just before the end of the period and a new loan (for the same amount) is made at the beginning of the next period.

Video – Creating Accounting

This eHow video explains that creative accounting is all about coming up with different ways to position assets to ‘puff the picture up’, i.e. make the company appear financially healthier than it really is.