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Creative accounting – Motives, techniques and possibilities of prevention

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Branka Remenarić, Ivana Kenfelja, Ivo Mijoč: Creative accounting – Motives, techniques and possibilities licenca dopušta d
of prevention
nekomercijalne svrhe
Branka Remenarić Ivo Mijoč UDK: 657.3:343.537
licenciraju svoja djela
Zagreb School of Economics Josip Juraj Strossmayer Review article
and Management University of Osijek
Jordanovac 110, Faculty of Economics in Osijek Received: December 14, 2017
10000 Zagreb, Croatia Trg Ljudevita Gaja 7, Pogledajte
Accepted for publishing: January 19, 2018 sažetak lic
[email protected] 31000 Osijek, Croatia
Phone: +38512354151 [email protected] This work is licensed under a
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Ovo je najrestriktivnija

CREATIVE ACCOUNTING – 5 od 6

MOTIVES, TECHNIQUES AND

POSSIBILITIES OF PREVENTION
Abstract
Creative accounting can be described as an accounting practice that may or may not follow the account-
ing standards and principles. However, it deviates from the main idea of those standards and principles in
order to present the desired picture of the business. Creative accounting is not illegal, but unethical since it
doesn’t meet the main objective of financial reporting – to present fair and objective picture of the business.
The practice of creative accounting usually includes overstating assets, high stocks, decreasing expenses,
changes of depreciation methods, or presenting provisions as an asset. Creative accounting techniques
follow the changes of accounting standards, which are modified in order to reduce financial information
manipulation. However, such changes in accounting standards often result in new opportunities for ac-
counting manipulation. Although entities follow the accounting standards, they also use “loopholes” to
enhance key financial ratios. Therefore, it is very important to adopt measures that will prevent the abuse of
creative accounting practices. The aim of the paper is to present the main motives for financial information
manipulation, as well as the most common techniques, and finally the measures that have to be taken in
order to minimize creative accounting practices.
Keywords: Creative accounting, earnings management, accounting manipulations, financial statements

1. Introduction statements must be accurate and reliable. However,

companies nowadays are increasingly resorting to
Financial statements are the mirror of every com-
“cooking” financial statements in order to present a
pany’s business. They also represent a medium
through which information on the financial posi- more attractive business image and attract as many
tion and business success of a company are com- investors as possible. This is precisely why the con-
municated, primarily to external interest groups, cept of creative accounting has appeared. In other
which make different decisions based on such in- words, there is a distortion of financial information
formation. In order to be able to make the right and presumptions of accuracy and reliability are
decisions, the information contained in financial brought into question.

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Branka Remenarić, Ivana Kenfelja, Ivo Mijoč: Creative accounting – Motives, techniques and possibilities of prevention

Increasing competition and the economic environ- however, do not bring true economic benefits to the
ment are just some of the reasons why companies company, but can instead result in great damages
resort to various accounting manipulation tech- in the long term (Merchant, Rockness, 1994). Shah
niques, with the aim of concealing possible losses (1998), in turn, defined creative accounting as a pro-
and presenting the business in the best possible cess in which managers utilise the so-called loop-
light. This does not necessarily mean that there is holes and ambiguities in accounting standards to
violation of accounting standards and legal regula- demonstrate financial success in a biased manner.
tions, but the so-called “loopholes” in laws are used Since creative accounting often does not violate le-
to present a better image of the business. It should gal rules, the question is whether it is good or bad.
be noted that the practice of creative accounting is This depends on the basic purpose for which it is
not illegal – which is why auditors often neglect it, used and the manner in which it is applied. Bhasin
but these are unethical procedures. (2016) describes it in a very picturesque way: crea-
The aim of this paper is to analyse the results of tive accounting is like a double-edged sword – man-
recent research on the topic of creative account- agement can either use it in a positive sense, or it
ing and to present the main conclusions. The most can abuse it. Thus, the idea to present the business
commonly used methods of creative accounting will in a better light can ultimately result in a total loss
be shown, as well as possible solutions that would of company image.
contribute to minimising the manipulation of finan- The use of creativity in financial reporting can be
cial information and encourage companies to act in described as playing with the elements of financial
accordance with basic ethical standards. statements. Doing so may result in overestimation
of the value of assets, high inventory levels, reduc-
2. The concept of creative accounting tion in expenditures, changes in depreciation meth-
ods, showing provisions as assets, etc. (Shahid, Ali,
Accounting is one of the basic functions of each
2016). The techniques of creative accounting fol-
company. The financial information that it provides
is very important for both managers and decision- low the changes of accounting standards, which
makers outside the company. The basic objective of are modified with the aim of reducing accounting
financial reporting is to provide a fair and objective manipulation. However, well-intended changes in
picture of the business to all interested stakehold- accounting standards often result in opening up of
ers. This can often lead to a conflict of interest. new opportunities for accounting manipulations.
Namely, on the one hand, investors expect reliable Although companies apply accounting standards, at
and credible financial information so that they can the same time they use “loopholes” to enhance the
make the right decisions. On the other hand are the key indicators (Karim et al., 2016).
companies that, due to increasing competition and Creative accounting can have a positive impact on
economic conditions, are seeking to attract inves- a company’s business in the short term, but in the
tors, because of which they often resort to unethical long run it may result in decreased stock prices,
methods of creative accounting, that is, manage- insolvency, and even bankruptcy. It is the root of
ment of earnings. numerous accounting scandals, as well as many ac-
There are various definitions of creative accounting counting reforms, which is why doubts in the trans-
in the literature, but they all boil down to the same parency and honesty of financial reporting arise.
idea. Bhasin (2016) describes creative accounting as For this reason, Bhasin (2016) emphasises the role
an accounting practice that may (or may not) adhere of forensic accounting. Moreover, he points out that
to accounting principles and standards, but deviates forensic accounting will be on the list of 20 most im-
from what those principles and standards intend to portant and sought-after professions of the future.
achieve, in order to present the desired business im-
age. In other words, creative accounting is the pro- 3. Overview of recent research
cess of transforming accounting information from Bhasin (2016) points out that many dimensions of
what it actually is to what the company wants it to creative accounting have been analysed in previous
be, using the benefits (or loopholes) in the existing research, but that no one has actually investigated
rules or by ignoring part of the rules. what the people who prepare financial statements
Creative accounting can also be described as a se- think about creative accounting, as well as their us-
ries of actions initiated by the company’s manage- ers. Based on this, a survey was conducted in In-
ment that affect the reported business result, which, dia, which showed that the majority of respondents

194 God. XXXI, BR. 1/2018. str. 193-199

 UDK: 657.3:343.537 / Review article

believe that creative accounting has adverse effects more attention to the code of ethics for accountants,
on financial reporting and that it is quite difficult which would have a positive impact on reducing the
to detect. Nevertheless, opinions are divided as to use of accounting manipulations. Based on the con-
whether the practice of creative accounting is legal ducted research, it follows that the solution to the
or not. The persons responsible for manipulating fi- abuse of creative accounting lies in the imposition of
nancial information and applying creative account- penalties by national authorities, practicing forensic
ing are mainly managers and accountants, and the accounting in order to monitor such practices, em-
main motives for these practices are the benefits phasising the code of ethics for accountants, and
of manipulators, increasing competition and at- raising investors’ awareness of such practice.
tracting foreign investment. Methods of financial Lau and Ooi (2016) conducted a study on fraudulent
statement manipulation most frequently include financial reporting in Malaysia, focusing on the cre-
off-balance sheet financing items, changes in ac- ative accounting methods used and the motives for
counting policies and depreciation methods, other such actions. The research results showed that the
income and expenses, and changes in the value of most commonly used method of creative account-
money. Research has shown that a well-established ing was the overestimation of revenues through rec-
accounting framework plays a key role in limit-
ognition of fictitious revenues from product sales
ing creative accounting, and accounting standards
to bogus customers. The main motive for this is
should therefore be adapted accordingly in a way
increasing the company’s capital, not settling debts
that limits the leeway of managers to decide be-
and maintaining the level of capital. One of the key
tween several accounting methods. Misuse of esti-
conclusions of the research is that auditors should
mates in accounting can be reduced by a simple rule
review the effectiveness of their analytical and ma-
that an initially determined accounting policy must
terial procedures since there is a significant number
be used in all future similar circumstances, which
of cases of creative or fraudulent accounting that
would minimise the use of estimates and achieve
remain undetected by the audit process. Also, the
consistency. It is also important to highlight the role
bodies that set accounting rules should reconsider
of internal and external auditors in identifying and
whether managers have too much discretion in the
reporting unfair estimates, and emphasise the re-
application of accounting standards. In other words,
sponsibility of detecting and preventing accounting
the question arises whether they use this discre-
manipulations. Auditors have to be changed peri-
tion to provide useful information to the decision-
odically, they must not work under pressure from
makers or to obtain personal gain. It turned out that
management, and it is necessary to hire independ-
in most accounting scandals, unethical decisions
ent directors and members of the audit committee,
of managers have led to significant adverse conse-
which are selected by shareholders. Companies
quences for decision-makers and society as a whole.
need to integrate and promote accounting rules
Therefore, managers should re-examine their own
and regulations that will disallow individuals to find
responsibilities and role in financial reporting.
“loopholes” and thus gain benefits. Finally, compa-
nies should have a developed whistleblower policy Furthermore, Alzoubi (2016) analyses the connec-
to protect people who report financial irregularities tion between company management and earnings
to the top management. management in Jordan. He arrived to the conclu-
Karim et al. (2016) conducted a survey on the exist- sion that ownership structure has a significant in-
ence of a gap between accounting and auditing per- fluence on earnings management. Thus, managerial
ceptions of creative accounting, and possible solu- ownership, institutional ownership, shareholders,
tions to regulate such practices in Bangladesh. The as well as family and foreign ownership affect the
survey has shown that there is no reason to punish ei- quality of financial reporting, because they greatly
ther auditors or accountants for applying creative ac- reduce the ability to manage earnings.
counting. Accountants are only company employees Write-off management is one of the frequently used
that follow management instructions. Therefore, if creative accounting tools. Based on a study conduct-
management demands that financial statements are ed in South Korea, Lee (2016) came to the conclu-
prepared in a certain way, accountants will primarily sion that write-off management is the ideal item for
be concerned about keeping their jobs, and will fol- manipulating accounting information because it is
low the instructions accordingly. Therefore, manage- based on management’s estimates. Companies usu-
ment should be held criminally liable for the abuse ally manipulate write-offs of receivables to avoid re-
of creative accounting. Accountants and auditors be- porting losses, to maintain an equal level of earnings
lieve that national accounting authorities should give over the years, and to meet the analysts’ forecasts.

God. XXXI, BR. 1/2018. str. 193-199 195

Branka Remenarić, Ivana Kenfelja, Ivo Mijoč: Creative accounting – Motives, techniques and possibilities of prevention

Mindak et al. (2016) investigated whether compa- 4. Motives, techniques and methods of
nies use creative accounting techniques to meet the limiting creative accounting
analysts’ forecasts and exceed last year’s earnings
and whether the market rewards or punishes such The basic idea of creative accounting is based on
manipulations. The conducted research has shown finding the so-called loopholes in laws and account-
that all the companies that have managed to beat the ing standards with the intention of enhancing fi-
targets have used creative accounting methods to nancial statements and presenting the business in a
artificially increase earnings and have been reward- positive light. Creative accounting can have a posi-
tive impact on business, but only when it is applied
ed by the market for doing so. In contrast, compa-
in a positive sense and in a minimal scope. However,
nies that have managed earnings in order to reduce
it often happens that companies cross boundaries
them (by increasing reserves, for example), so that
of minimalism and abuse such practice, which can
they barely meet the set goals, were not rewarded.
lead to fatal consequences. One thing is certain,
The reason is that most of the targeted earnings are
creative accounting most often has a negative effect
actually determined by analysts’ forecasts – so the
on financial reporting.
most important goal of earnings management is
to beat the forecasts, because companies that suc- In most cases, company management is responsible
ceed in doing so are considered “good” companies. for the manipulation of financial reporting, as their
Thus, companies trying to maintain the same level instructions are followed by the employees respon-
of earnings over the years are not considered “good” sible for financial reporting. The main motives for
since they do not surpass the expectations. applying creative accounting are:
Inaam and Khamoussi (2016) have explained the •• obtaining personal gain;
association between audit committee and audit
quality itself and the practice of earnings manage- •• competition;
ment. The basic function of corporate governance •• attracting investors;
in financial reporting is to ensure compliance with •• increasing or maintaining the level of capital;
accounting standards, and to provide reliable and
•• buying time for not settling debts;
credible financial information in financial state-
ments. Therefore, good corporate governance •• b
 eating analysts’ forecasts about future com-
should ensure effective controls and prevent un- pany performance.
ethical management behaviour. Although it is to be
In order to present their business in the best pos-
assumed that quality corporate governance, audit
sible light, companies use various techniques to
committees and quality audit implementation affect
manipulate financial information. Manipulations
the limited use of various earnings management
usually occur where accounting standards require
techniques, this study showed a negative relation-
accounting estimates. The most widely used crea-
ship with the practice of earnings management.
tive accounting techniques are:
Research carried out by Shahid and Ali (2016)
showed that creative accounting has a significant •• m
 anipulation of off-balance sheet financing
impact on fair and objective financial reporting in items;
Pakistan. In order to prevent the manipulation of fi- •• c hanges in accounting policies and deprecia-
nancial information, it is necessary to put emphasis tion methods;
on corporate governance and the strengthening of
•• m
 anipulation of other income and expense
ethical values. Limited and minimal use of creative
items;
accounting in a positive sense should actually not
affect the quality of financial reporting. •• changes in the value of money;
Since most research in the field of creative accounting •• o
 verestimation of revenues by recording ficti-
tries to explain how it affects business, Goel (2017) tious sales revenues;
conducted a study on the impact of creative account- •• manipulation of receivables write-offs;
ing on stock prices in the market. The results showed •• manipulation of accruals.
that companies use accruals for manipulating finan-
cial information, most often in periods when finan- Since creative accounting is increasingly being used
cial markets are uncertain about the prospects of the in a negative sense, resulting in numerous account-
business of such companies in the future. ing scandals with huge consequences, it is neces-

196 God. XXXI, BR. 1/2018. str. 193-199

 UDK: 657.3:343.537 / Review article

sary to establish efficient methods that will limit or Most often, managers are the ones responsible for ma-
minimise manipulation of financial information. Ef- nipulating financial information, as it is they who pro-
ficient techniques for preventing creative account- vide guidance to their subordinates regarding finan-
ing include: cial reporting. The main motives for this are obtaining
personal gain, attracting investors by presenting a false
•• adaptation of accounting standards in terms image of their business, struggle with the competition
of limited use of estimates and consistency in and economic conditions, increasing capital, buying
the application of accounting methods; time because of unpaid overdue liabilities, and beating
•• recognising and insisting on the role of in- analysts’ forecasts regarding business performance so
ternal and external audit in identifying and as to achieve overall benefit for the company.
reporting unfair estimates, and preventing In order to present business in a positive light, com-
accounting manipulations; panies use various methods of creative accounting.
•• change of audit service providers from one The basis for manipulative procedures lies in ac-
accounting period to another; counting estimates that are permitted within ac-
counting standards. The techniques used in creative
•• h
 iring independent directors and members of
accounting relate to manipulation of off-balance
the audit committee;
sheet financing items, changes in accounting policies
•• establishing effective corporate governance and depreciation methods, manipulation of other
controls; income and expense items, changes in the value of
•• c ompany persistence in developing a whistle- money, overestimation of revenues by recording fic-
blower policy; titious sales revenues, manipulation of receivables
write-offs, and manipulation of accruals.
•• c ontinuously making employees aware of the
code of ethics; If it is implemented in a minimal scope and with
positive intent, creative accounting can be consid-
•• p
 lacing emphasis on the development and ap-
ered good practice. But since it is often misused, it
plication of forensic accounting; is necessary to insist on measures that will minimise
•• m
 aking investors aware of the practice of ma- the practice of manipulating financial statements
nipulating financial information; in order to prevent false financial reporting. Such
•• consistent enforcement of penalties by na- measures include adaptation of accounting stand-
tional authorities. ards in the sense of limiting the use of accounting
estimates, and establishing consistency in the ap-
plication of accounting methods. It is necessary to
5. Conclusion recognise the role of internal and external audit in
Financial statements are used to communicate identifying and reporting unfair estimates, and pre-
the business, expressed in figures, to all interested venting accounting manipulations. Moreover, it is
stakeholders. The main objective of financial re- desirable to use services of different auditing com-
porting is to provide a fair and objective picture of panies in different accounting periods. Additionally,
the business, taking into account the fundamental it would be good for companies to hire independ-
ent directors and members of the audit committee,
accounting principles and assumptions. However,
establish effective corporate governance controls,
accounting standards often allow and require vari-
persist in developing a whistleblower policy, and
ous accounting estimates, which can lead to manip-
continuously work on raising employees’ aware-
ulation of financial information.
ness of the code of ethics. It is also necessary to
Creative accounting can be described as a process raise awareness of investors about the application of
in which managers exploit “loopholes” and ambi- creative accounting practices and persist in the de-
guities in accounting standards to demonstrate fi- velopment and application of forensic accounting.
nancial success in a biased manner. Looking at the Furthermore, national authorities should consist-
short-term, manipulating financial information can ently enforce penalties.
have a positive impact on business. But in the long Finally, the use of creative accounting certainly can-
run, it usually results in a fall in stock prices and not be completely removed, but it can be minimised
bankruptcy. using various solutions.

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Branka Remenarić, Ivana Kenfelja, Ivo Mijoč: Creative accounting – Motives, techniques and possibilities of prevention

References

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panies”, Australian Academy of Accounting and Finance Review, Vol. 2, No. 2, pp. 166-188.
6. Lau, K. C., Ooi K. W. (2016), “A case study on fraudulent financial reporting: evidence from Malaysia”,
Accounting Research Journal, Vol. 29, No. 1, pp. 4-19.
7. Lee, H. A. (2016), “Allowance for uncollectible accounts as a tool for earnings management: Evidence
from South Korea”, International Journal of Accounting and Information Management, Vol. 24, No. 2,
pp. 162-184.
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Journal of Accounting and Public Policy, Vol. 13, No. 1, pp. 79-94.
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198 God. XXXI, BR. 1/2018. str. 193-199

 UDK: 657.3:343.537 / Review article

Branka Remenarić
Ivana Kenfelja
Ivo Mijoč

Kreativno računovodstvo –
motivi, tehnike i mogućnosti sprječavanja
Sažetak
Kreativno računovodstvo predstavlja računovodstvenu praksu koja može, ali i ne mora slijediti računovod-
stvena načela i standarde, pri čemu odstupa od njihove osnovne ideje, s ciljem prikazivanja željene slike
poslovanja. Kreativno računovodstvo nije ilegalno, ali se smatra neetičnim jer ne zadovoljava osnovni cilj
financijskog izvještavanja – ne prikazuje poštenu i objektivnu sliku poslovanja. Praksa kreativnog računo-
vodstva obično podrazumijeva precjenjivanje vrijednosti imovine, visoke razine zaliha, smanjenje rashoda,
promjene metoda amortizacije, te iskazivanje rezerviranja kao imovine. Tehnike kreativnog računovodstva
se mijenjaju kako se mijenjaju računovodstveni standardi, a oni se pak mijenjaju s ciljem smanjenja ra-
čunovodstvenih manipulacija. Međutim, nerijetko dobronamjerne promjene računovodstvenih standarda
rezultiraju otvaranjem novih mogućnosti za računovodstvene manipulacije. Iako poduzeća slijede računo-
vodstvene standarde, istovremeno se koriste „rupama“ kako bi uljepšali ključne pokazatelje. Zbog toga je
potrebno donijeti mjere kojima će se spriječiti zlouporaba kreativnog računovodstva. Cilj rada je prikazati
glavne motive za manipuliranje financijskim informacijama, tehnike koje se pritom koriste, te mjere kojima
bi se praksa kreativnog računovodstva mogla minimizirati.
Ključne riječi: kreativno računovodstvo, upravljanje zaradama, računovodstvene manipulacije, financijski
izvještaji

God. XXXI, BR. 1/2018. str. 193-199 199

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