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Creative accounting – definition and meaning

Creative accounting refers to imaginative ways to present accounts. These ways deviate from the spirit of accounting laws. However, they are not illegal. The aim in creative accounting is to make the company appear financially healthier than it really is.

Creative accounting practices follow the country’s regulations and laws. However, they deviate from what the makers of those laws intended.

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 not illegal – ‘but’

Creative accounting, while not the same as ‘cooking the books,’ is seen in a similar light. Cooking the books refers to falsifying a company’s their financial statements.

Ethical accountants see creative accountants in a bad light because they are trying to give a false impression. However, unlike creative accounting, cooking the books is illegal.

Creative accounting is characterized by excessive complication. Creative accountants commonly use novel and bizarre ways of characterizing assets, liabilities, or income.

Put simply; they aim to make their companies appear more successful and profitable than they are.

Creative accounting - puffing up the picture
The aim in creative accounting is to make the company look better than it is. The creative accountant manipulates the positioning of assets, liabilities, etc.

A creative accountant does not provide a ‘true and fair’ view of a company. That is what honest and ethical accountants should do.

Creative accountants exploit loopholes in the rules and regulations. They falsely portray an enhanced image of their company.

Even though creative accounting practices are not illegal, governments are forever trying to reform the law. Lawmakers want to close those loopholes 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 profits during their good periods to smooth out their results.

Creative accountants commonly manipulate their company’s assets and liabilities. They often do this to conceal problems, and also perhaps to remain within limits.

The creative accountant may practice off-balance-sheet accounting or post exaggerated non-recurring items. The accountant may also be over-optimistic regarding revenue recognition.

A game of cat and mouse

Creative accounting techniques change over time. As accounting standards, rules, and regulations change, creative accountants need to alter their techniques.

When regulators reform accounting standards, they aim to stifle particular ways of massaging accounts. Subsequently, creative accountants have to find new ways of doing things.

Some 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. In fact, it is a game of cat and mouse.

What Charlie Munger said about creative accounting
Charles (Charlie) Munger 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

A company may send its client an invoice before the end of the accounting period but deliver after that period. That first period will subsequently get a boost in sales and profit.

Service Contracts

Imagine a company that services central heating systems has service contracts with customers. The company will typically charge the amount payable on the contract to customers before carrying out the work.

Let’s suppose the accountant posts the amount the company charges the customers in the first quarter of the year. However, he records the work taking place in the second quarter.

The accounts for the first quarter will show a profit because there are no costs. However, the second quarter will show a loss because there are costs but no income.

What happens if you only see the accounts for the first quarter? You will get an unrealistic view of how the company is doing.

Property Values

You should include the value of a property in the balance sheet according to its purchase price.

However, accountants can legitimately revalue the property so that the amount is greater. In other words, the amount in the balance sheet increases.

The accountant can distort the company’s apparent financial health by being ‘over-optimistic’ with the property’s revaluation.

Loans

The company might lend money to somebody connected to the business. 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 borrower repaid the loan just before the end of the period. Then, a new loan (for the same amount) appears 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. Creative accountants aim to ‘puff up the picture.’ In other words, they want to make the company appear financially healthier than it really is.