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Creative accounting is a euphemism referring to accounting practices that may follow the letter of the rules of standard accounting practices, 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. Other synonyms include Cooking the books and Enronomics.
The term as generally understood refers to systematic misrepresentation of the true income and assets 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 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).
Creative accounting can be used to manage earnings. Earnings management occurs when managers 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.
The motivations of creative accounting
- Personal incentives
- Bonus-related pay
- Benefits from shares and share options
- Job security
- Personal satisfaction
- Cover-up fraud
- Tax management
- Management buyouts
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