Background and baseline
Financial statements are bound by laws and accounting standards. To break these is an offence and enforced as such. Judges enforce the letter of the law and where there are loopholes, the law may be changed. For judges the spirit of the law does not exist. However finance is too complicated to have a set of water-tight rules. For example an ASB working committee was meant to resolve how goodwill should be handled and in 1995 they came up with 5 alternatives which did not even cover all eventualities.
There is advisory recommended practice (such as the Cadbury guidelines) to resolve larger gaps. The Cadbury report intends to extend best-of-practice, for example recommending that directors report on the effectiveness of the company's internal controls i.e. taking the responsibility actively and personally. However even following the law, the standards and the recommended practice, and even with the results audited by external companies, the scope for creative accounting remains large.
Why creative accounting? An annual review provides information on the financial position of a company. It is a snapshot of the company situation, as well as a history of change. However the message the review gives is often taken to be about the future position of the company. In particular investors and the capital market will base their decisions on results to date and the prognosis for the future. The shareholder and market reaction is related more and more to managers' actions and directors are increasingly judged on profit, growth and EPS and have large bonuses at stake. So companies (and directors) want to use the report to present the message they want investors to see, and at times this needs creative accounting. There may be one-off events which so distort the figures that the underlying health of the company is obscured. Accounting techniques may be used to produce more meaningful figures and avoid unjustified market pessimism. In such caes the changes may be clearly indicated in the notes to the accounts..
However more often than not creative accounting is used to: hide a particularly bad year for the company; force an exceptionally good year or continue the pressure to always be the best; smooth out results to give an impression of stability or sustained improvement; hide large profits by monopolies under anti-trust threat; boost assets to avoid take-over.
Distortion in one year often increases the need to distort the next year. Typically the bad year continues (Argenti 1983) and the company gets more tied into misleading figures, often seeming to devote more time to presentation of figures rather than management of the company. Examples of creative accounting What sort of things can be done as creative accounting? Acquisitions can hide poorer results (Watts) or boost EPS. A large provision can be taken to cover reorganisation costs.
These do not affect profitability but are taken against the assets of the company. Off-balance sheet financing. Items of the financial reports are omitted. This could be done via a partial subsidiary which the company controls. For example assets could be sold to this subsidiary. This produces a profit in the balance sheet, but nothing has changed. It is simple a shuffling of debt/credit between companies producing no overall increase in health or profitability. Good-will and brand names.
While brand names are a powerful marketing tool, companies that have included them in their assets have done so to increase the value of the assets when they would otherwise have seemed poor. A further problem is the valuation of a brand name which can be arbitrary and is not independently verifiable. Capitalising R&D. The Austrian company MTM capitalised its R&D expenditure. Instead of writing it off as cost, it was added to assets in "know how". The approach is similar to the way brand names can be handled. Depreciation. The British Airport Authority depreciate runways over 99 years. This means in effect they ignore depreciation of the runways. However they are at least open and consistent.
Moving operating costs to reduced assets. Akzo Nobel had to renew the pipes in a major chemical complex. This was simply to replace old equipment. Akzo Nobel did not record this as an operating cost, but classified it as "environmental activity" and wrote it off against assets.
Something clearly a cost, and affecting the year's results, has been moved from the cash stream of the company. Creativity versus complicity Creative accounting affects the value of assets and liabilities, and also the allocation of changes to assets/liabilities or profit/loss. Infamous cases are not creative accounting but fraud. However a typical feature of creative accountancy is that it is to a greater or lesser extent hidden and is often result of sustained poor performance.
Engaging in creative accounting is then a possible first step towards pushing at the boundaries of the law. And the danger is that respectable executives lose sight of where the boundaries are, and end up like directors committing fraud (compare Griffiths 1992).
Creative Accounting is increasing (Jones 1992) and will remain with us.
As a personal rule of thumb: where the accounting is open and documented it is there to handle special situations.
Where it is hidden or disguised, it is a case of a company hiding its true position. And given that the annual and half-yearly reviews are the only financial statements the shareholders receive, hiding the true position of a company is simply misleading the owners of the company and should be regarded.