Creative accounting
Encyclopedia
Creative accounting and earnings management are euphemism
s referring to accounting practices that may follow the letter of the rules of standard accounting practice
s, 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 and the intent to influence readers towards the interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes used.
The term as generally understood refers to systematic misrepresentation
of the true income
and asset
s 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).
According to critic David Ehrenstein
, the term "Creative Accounting" was first used in 1968 in the film The Producers
by Mel Brooks
.
use judgment 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 influence contractual outcomes that depend on reported accounting numbers.
Earnings management usually involves the artificial increase (or decrease) of revenue
s, 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 error, 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:
Euphemism
A euphemism is the substitution of a mild, inoffensive, relatively uncontroversial phrase for another more frank expression that might offend or otherwise suggest something unpleasant to the audience...
s referring to accounting practices that may follow the letter of the rules of standard accounting practice
Standard accounting practice
Standard accounting practices require publicly-traded companies to follow certain accounting rules when presenting financial statements so that the readers of the statements can easily compare different companies...
s, 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 and the intent to influence readers towards the interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes used.
The term as generally understood refers to systematic misrepresentation
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...
of the true income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
and asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s of corporations or other organizations. "Creative
Creativity
Creativity refers to the phenomenon whereby a person creates something new that has some kind of value. What counts as "new" may be in reference to the individual creator, or to the society or domain within which the novelty occurs...
accounting" is at the root of a number of accounting scandals
Accounting scandals
Accounting scandals, or corporate accounting scandals, are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations...
, and many proposals for accounting reform
Accounting reform
Accounting reform is an expansion of accounting rules that goes beyond the realm of financial measures for both individual economic entities and national economies...
- usually centering on an updated analysis of capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
and factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
that would correctly reflect how value is added.
Newspaper and television journalists have hypothesized that the stock market downturn of 2002
Stock market downturn of 2002
The stock market downturn of 2002 is the sharp drop in stock prices during 2002 in stock exchanges across the United States, Canada, Asia, and Europe...
was precipitated by reports of accounting irregularities at Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
, Worldcom
MCI Inc.
MCI, Inc. is an American telecommunications subsidiary of Verizon Communications that is headquartered in Ashburn, Virginia...
, and other firms in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
.
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
Executive compensation
Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage...
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
Barron's Magazine
Barron's is an American weekly newspaper covering U.S. financial information, market developments, and relevant statistics. Each issue provides a wrap-up of the previous week's market activity, news reports, and an informative outlook on the week to come....
that constantly analyzed breaches of ethics and audit professionalism among CPA
Certified Public Accountant
Certified Public Accountant is the statutory title of qualified accountants in the United States who have passed the Uniform Certified Public Accountant Examination and have met additional state education and experience requirements for certification as a 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
Enron scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...
(See Sarbanes-Oxley).
According to critic David Ehrenstein
David Ehrenstein
David Ehrenstein is an American critic who focuses primarily on issues of homosexuality in cinema.-Life and career:Ehrenstein was born in New York City. His father was a secular Jew with Polish ancestors, and his mother was of African American and Irish descent. His mother raised him in her...
, the term "Creative Accounting" was first used in 1968 in the film The Producers
The Producers (1968 film)
The Producers is a 1968 American satirical dark comedy cult classic film written and directed by Mel Brooks. The film is set in the late 1960s and it tells the story of a theatrical producer and an accountant who want to produce a sure-fire Broadway flop...
by Mel Brooks
Mel Brooks
Mel Brooks is an American film director, screenwriter, composer, lyricist, comedian, actor and producer. He is best known as a creator of broad film farces and comic parodies. He began his career as a stand-up comic and as a writer for the early TV variety show Your Show of Shows...
.
Earnings management
"Earnings management" occurs when managersManagement
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
use judgment 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 influence contractual outcomes that depend on reported accounting numbers.
Earnings management usually involves the artificial increase (or decrease) of revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
s, profits
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
, or earnings per share figures through aggressive accounting tactics. Aggressive earnings management is a form of fraud
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...
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 error, 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.
The motivations of creative accounting
- Personal incentives
- Bonus-related pay
- Benefits from shares and share options
- Job security
- Personal satisfaction
- Cover-up Fraud