It is about how businesses use the flexibility inherent in accounting to manage their results. In itself, flexibility is good because it allows companies to choose accounting policies that present a ‘true and fair view’. However, by the judicious choice of accounting policies and by exercising judgement, accounts can serve the interests of the prepares rather than the users. Creative accounting is not illegal but effectively, through creative compliance with the regulations, seeks to undermine ‘true and fair view’ of accounting. Creative accounting can involve manipulating income, expenses, assets or liabilities through simple or exceedingly complex schemes.
The current regulatory framework can partially be seen as a response to creative accounting. It attempts to ensure that accounting represents economic reality and presents a true and fair view of the company’s activities. However, new regulations bring new opportunities for creative compliance and thus creative accounting.
Example of companies indulged
Enron, once the seventh biggest US company, which went into liquidation in 2001 is believed to have indulged in creative accounting. Other US companies such as WorldCom have been involved in accounting scandals in which creative accounting has played a contributory role.
Accounting is very flexible. There are numerous choices, for example, for measuring depreciation, valuing inventory or recording sales. This flexibility underpins the idea that the financial statements should give a ‘true and fair view’ of the state of affairs of the company and of the profit. Accounting policies should thus, in theory, be chosen to support a true and fair view. In many cases they are, but the flexibility within accounting does sometimes enable managers to presents a more favorable impression of the company’s performance than is perhaps warranted.
Indeed within accounting there is a continuum. This continuum starts with a completely standardized accounting system. This gives way to flexibility so as to present a true and fair view. Next we have flexibility to account creatively. Finally, there is a fraud, which involves non-compliance with the regulations rather than ‘bending’ them.