ISCREATIVEACCOUNTINGAFORMOFMANIPULATION?

BalaciuDiana
UniversityofOradea,FacultyofEconomics,DepartmentofFinanceAccounting,Oradea,str.Universit
iinr.1,email:dbalaciu@uoradea.ro,tel:0259/408401
PopCosminaMdlina
UniversityofOradea,FacultyofEconomics,DepartmentofFinanceAccountingOradea,str.Universit
iinr.1,email:cpop@uoradea.ro,tel:0259/408401
Abstract: Manipulation of financial information which is called by several terms such as earnings
management, income smoothing, creative accounting practices, aggressive accounting or account
manipulation,preventstheallocationofresourcesinthemostefficientareasintheeconomy.Thescopeof
this paper is to relate the causes, the main motivations behind their application, the objectives, the
methodsandtheconsequencesofmanipulationinfinancialreporting.Creativeaccountingisnotanew
technique,butitcanbeseenasacostlyone.Businessesfeelthepressuretoappearprofitableinorderto
attractinvestorsandresources,butdeceptiveorfraudulentaccountingpracticesoftenconducttodrastic
consequences.
Keywords:creativeaccounting,windowdressing,fraud,accountmanipulation

Introduction
Accountingmanipulationisdefinedaswhenthemanagersofanorganizationintentionallymisstatetheir
financialinformationtofavourablyrepresenttheentitysfinancialperformance.Managersofnonprofits
organizationsmayhaveincentivestomanipulatetheirreportedprogramspendingratiosbecausedonors
usethemindeterminingcontributiondecisions.
Accountsmanipulationrepresentstheuseofmanagementsdiscretiontomakeaccountingchoicesorto
designtransactionssoastoaffectthepossibilitiesofwealthtransferbetweenthecompanyandsociety
(politicalcosts),fundsproviders(costofcapital)ormanagers(compensationplans).Inthefirsttwocases,
thefirmbenefitsfromthewealthtransfer.Inthethird,managersareactingagainstthefirm.Figure1
summarizestheprinciplesofaccountsmanipulation.
The accounts manipulation has a direct influence in modification of the apparent performance (as
measured, for example, by the earnings per share) and/or a modification of the companys financial
structure.

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....................................................................................................... Potentialwealthtransfer
Figure1PrinciplesofAccountsManipulation

TheoreticalAspectsofCreativeAccounting
Inspiteofthefactthattheconceptofcreativeaccountantisfrequentlyusedinbusinessliterature,we
cannotsaythatthereisadefinitiongenerallyaccepted.
Someauthorsconsidercreativeaccountantanassemblyoftechniques,optionsandfreedomroomleftby
accounting regulation, without moving away from laws or accounting requirements, allowing to the
managerstochangethefinancialresultorthefinancialstatementsface(Gillet,quotedbyShabouand
BoulilaTaktak,2002).Othersseecreativeaccountantasanassemblyofproceduresinordertochangethe
profit,byincreasingordecreasing,ortomisrepresentthefinancialstatements,orbothofthem(Stolowy
2000).
Thedevelopmentofeconomical,juridicalandsocialactivitiesandthestressoffinancialinformationusers
madetheaccountinginnovationanecessity,andfurthermorethedevelopmentofthecreativeaccounting.
This type accountancy evolved inBritannic economiesdue to thefreedom ensured tothe accounting
professionals and presently lies between legal form and the core of transactions or events. From the
practitioners view, the creative accounting development was encouraged by the base and alternative
treatmentspermittedforsolvingoneissue.Generally,anaccountingissuecanbesolvedinatleasttwo
methods,eachofthemwithdifferenteffectsonthecompanysfinancialpositionandperformance.The
academiciansconsiderthecreativeaccountingwasencouragedbytheflexibilityoftheregulations.
AsIFRS1Thefinancialstatementsreportinginordertobringoutandtopresenttherightfinancial
information,thefollowingconditionshavetobetakenintoaccount;

1 TheconcordancewithIFRSstipulations;
2 ThepossibilitytodepartfromIFRS,ifaccordingtothestipulationtherightinformationisnot
obtained;

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1 Thereportingofadditionalinformationinordertopresentacompleteimageoftransactionsand
events.

Generally,thecreativeaccountingisbadlytreated,asanegativecreation,designedtopreparethefinancial
statementsinordertorespondmanagersrequirementsregardingthecompanysfinancialpositionand
performance. Therefore, the financial statements are rather a misrepresentation of the companys
performancethatatruereporting.
Thenegativetreatmentofcreativeaccountingdoesnotexcludethepositiveone,beingconsideredasan
innovationthatleadstoengineeringcapableofrespondingthequestion:Howcanweadministratethe
resourcesinthemostefficientwayinordertobuildperformance?
Simultaneoustreatmentofcreatingaccountingasaninstrumenttoaccomplishtheaccountinginterests,but
also as accounting engineering, depend upon accounting policies agreed. According to IFRS 1 The
financialstatementsreporting,theaccountingpoliciesrepresentthespecificprinciples,fundamentals,
rulesorpracticesusedbythecompanysmanagementinordertobringoutandtopresentthefinancial
information.
Choosingthebestaccountingalternativetoreflectaccuratelytherealityandcompanysinterestdependson
thecreativeaccounting.Asaresult,someauthorsconsidertheBritainwindowdressingpracticeasformof
creativeaccounting.Thistechniqueconsistsinrealizingoperationthatleadtoprofitorloss,dependingon
theinterest.Differentaccountingpoliciesleadtodifferentresults.Inthisrespect,itisconsideredthatthere
havetobechosenthatpoliciesabletoreport:

1) significantinformationforbusinessdecisions;
2) believableinformationableto
b1)reportfairly,correctlyandhonestlythetransactionsandevents;
b2)reflecttheeconomicalsubstanceofthetransactionsandevents,notonlytheirjuridical
form;
b3)beimpartialagainstalltypesofusers;
b4)becautious,bypreventingtheovervaluationoftheresult;
b5)becomplete,throughthesignificanceandcostofinformation.
Oneofthecreativeaccountingaimsisrepresentedbytheincomesmoothingtechnique.Thisconsistsin
deliberateusingofaccountingpoliciesaimedtoreportanetincomeserieswithalowfluctuationswithin
overaperiodinordertoavoidthefairlyreporttotheshareholders.Thisway,themanagementpursueto
reducethenetincomesfluctuationsfromoneperiodtoanother.
Themultitudeofmethodsusedbycreativeaccountingandengineeringdifferwiththesubstance.Recently
thecreativeaccountingwasassociatedwithfraudinaccountancyandtheaccountsliftingasamethodin
fraudswaitingroom.
Evenifboththecreativeaccountingphenomenonandaccountingfraudappearincompanieswithfinancial
difficultiesandareaimedtomisreport,therehastomakeadifferencebetweenthem:creativeaccounting
representsthemanipulationoftheaccountsaccordingtoaccountingregulationandthelaw,whilethe
techniques that break the law are considered accounting fraud. Therefore, we can conclude that the
companyusingthecreativeaccounting,benefitfromthelegislativenichesandtheflexibilityofregulation
inordertomisreportthefinancialstatements.
Consequently,evenifthecreativeaccountinguseisnotanillegalpractice,itisclear,thatmanagersin
financialdifficulties,arelookingtosolutions,nomatterthereareunethical.Otherwise,thehalftruthand
theliecanbesuspectedasfraud.

Techniquesofcreativeaccounting
Six main areas are considered the source of inspiration for the creative accounting: flexibility in
regulation,alackofregulation,ascopeformanagementthatassumedsometargetsforthefuture,the
timingofsometransactions,theuseofartificialtransactions,butalsothereclassificationandpresentation
of financials. It was proved, that even in highly regulated countries such as USA the accounting
environmentafford,agreatdealofflexibility(Largay,2002;MulfordandComiskey,2002).Inordertobe
understood,weproceededtothedetailofthese:
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1. Flexibility in regulation. Generally the regulation, particularly the accounting regulation

permitsflexibilityinchoosingapolicytofollow;theInternationalAccountingStandardslet
the financial management to choose between valuation of the noncurrent assets at
depreciatedhistoricalvalueoratrevaluatedvalue.Themanagementmaydecidethechange
ofthepolicies,andtheseshiftsaredifficulttobeidentifiedafewyearslater(Schipper,1989).

2. Lackofregulationismeetinginsomeareasineverydomain.Inmostcountriesaccounting

regulation is limited in some areas, for example in Romania there is few mandatory
requirements for transactions with futures and stock options or for the recognition and
measurementofpensionliabilities.

3. Managementcanusetheirdiscretionarypositioninordertoobtainthefinancialpositionand

stability they assumed; for example, the managers decide the increase or reduce of the
provisionsforbaddebts(McNicholsandWilson1988).

4. Thetimingofsometransactionsofferstothemanagementtheopportunitytoincreasethe

revenues,whentheoperatingprofitisnotsatisfactory,andtocreatethedesiredimpressionin
theaccounts.Theexistingstocksincompanyspatrimony,that haveasignificant higher
valuecomparedtothehistoricalvalue,maybesoldonlywhentheoperatingprofitisnot
satisfactory.

5. Theartificialtransactionsareoftenusedinordertomanipulatethebalancesheetamountsor
tomovetheprofitsbetweenaccountingperiods.Thesetransactionsarerealizedbyenteringin
acontrolledtransactionwithtwoorthereparties,oneofthem,mostofthetimes,abank.
Such arrangements consists in selling of an asset at a higher/lower rate than in an
uncontrolledtransaction,andthenleasingitbackfortherestofitusefulperiod,compensating
throughtherentalsthepricedifference.

6. Reclassification and presentation of financials are relatively less analysed in accounting

literature.However,inrealitythecompaniesoftenproceedtomakeuptheamountsinorder
to obtain good level of profitability, liquidity or leverage ratios. Most of the times, the
numbersaresmoothlymodifiedinordertoimprovetheinvestorsperception.Asexplained
by Niskanen and Keloharju (2000): the idea behind this behaviour is that humans may
perceiveaprofitof,say,301millionasabnormallylargerthanaprofitof298million.Their
studyandothers(e.g.vanCaneghem,2002)haveindicatedthatsomeminormassagingof
figuresdoestakeplaceinordertoreachsignificantreferencepoints.

Techniquesthatdefinecreativeaccountingarenotnew,butexperiencehasshownthatmostofthetimes
mayproveextremelyexpensive.Inordertoattractinvestorsandtoappearprofitabletotheshareholders,
employees,creditors,suppliersandothercategories,thecompaniescandecidetomisstatethefinancials;
thispractiseoftenleadtodrasticconsequences.Themanipulationoftheconducttoamismatchofthe
financialpositionandoftheresultswiththefairpresentationzone,asshowninFigure2,whichimplies
thattheprofitwillnotrepresentthelongtermcapacityofthefirmtogenerateearnings.
...................................................................................

Fraud
Fraud
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Manipulation
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Figure2
Accountsma
nipulationa
ndfairprese
ntation

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Reasonsandconsequencesofcreativeaccounting
Theconflictsofinterestamongdifferentinterestgroupsrepresenttherealcausesofcreativeaccounting:
themanagersareinterestedinpayinglesstaxesanddividends,theshareholdersingainhigherdividends,
theemployeestoobtainbettersalaryandhigherprofitshare,theauthoritiestocollectmoretaxes.Itcanbe
easilyseenthattheinterestsaretremendousdivergentandcreativeaccountingisdeepeningit.Inthis
respect,DavidSchiff(1993:94)haswarnedtheinvestorsthattakingacompanysfinancialstatementsat
facevaluecanbearecipefordisaster.
Managingshareholdersinterestistopaylesstaxanddividends.Investorshareholdersareinterestedtoget
moredividendsandcapitalgains.Countrystaxauthoritieswouldliketocollectmoreandmoretaxes.
Employeesareinterestedtogetbettersalaryandhigherprofitshare.Butcreativeaccountingputsone
group or twoto advantageous position at the expense of others. One day the present authors had an
opportunitytohaveadiscussionwiththeChiefAccountantofanenterpriseinthisregard.TheChief
Accountanttold,inthecourseofconversation,thathewasdeterminedtoretainprofitfortheexpansionof
hisexistingunitandestablishmentofnewones.Quitenaturally,hisinterestwastopaylesstaxandless
dividendand,accordingly,tocreatefinancialstatements.ThistypeofcreativeaccountinghasledDavid
Schiff(1993:94)towarninvestors;ingeneralthattakingacompanysfinancialstatementsatfacevalue
canbearecipefordisaster.
Theinvestorsoftengowrongbytakingintoconsiderationonlyoneratio,asearningspershare(EPS),ratio
thatcanbeboostedbythestrokeofanaccountantscreativepen.DavidSchiff(1993:9495)considers
thattherearesixmainwaysusedbythecompaniestoincreasetheirearnings:(1)byhiddenofthepension
liabilities,(2)bycapitalizingtheexpensesinsteadofwritingthemoff,(3)byrealizinganfasterincreaseof
thereceivablesorinventoriesversussales,(4)byreachingnegativecashflow,(5)byconsolidatingthe
affiliatesincomesandnetworth,and(6)byfollowingseeminglyconservativepracticeinasituationof
reverse direction. Jim Kennan, the Attorney General of Victoria, in a speech before members of the
Australian Society of Accountants, pointed out that financial statements, which inflate the financial
positionandtheperformancesofcompaniesbymanipulatingthefigures(i.e.,throughcreativeaccounting)
shouldbestampedout,becausebringtheinvestoringreatdifficultiesinordertodistinguishbetweenthe
madeupfinancialsandthetrulyfinancials.Weconsideredthismessagemaybeusedtostressthemain
effectsofcreativeaccounting:

1. Theconfusioncreatedamongthestockexchangeinvestors,becausethefiguresshownby

financialstatementsareofteninflatedandthedifficultyofinvestorstodistinguishbetween
thefairandunfairstatements.

2. Theprospectusesofthelistedcompaniesdonotalwaysofferadetailedpicturethefinancial
positionsandperformance.

3. Thetechniquesusedbycreativeaccountingcanimpresstheinvestorsonlyovershorttime
periods, while the financial position goes worse, this cannot be hide anymore and these
methodsarehelpless.

4. Thelongtimeeffectofsuchpractiseisthedistrustoftheinvestorsconductedbythecollapse
ofcompaniesthattakeadvantageofthesetechniques.

Thequestionweraiseis:Arethesecreativepracticesalwaysabadthingorcantheyeverbejustified? As

figure2shows,manipulationisnotfraud.Itisamatterofinterpretation. Thiswillbeacasestudy
ofourfutureresearch.

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