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Creative Accounting Practices

Paper Type: Free Essay Subject: Business
Wordcount: 3571 words Published: 13th Sep 2017

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Find and Prevent Creative Accounting

Accounting is one of the most important science in the business world. Accounting is always needed in the company, both small companies and large companies require their accounting processes. With the existence of science of accounting, the financial bookkeeping easier and more accurate, and can assess the performance of the company. However, in reality a lot of financial accounting that does not comply with the existing financial. This happens because the mistake of making the financial statements or any fraud committed by certain parties.

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In conducting the preparation of financial statements, an accountant must follow the rules that exist in financial reporting, which is in accordance with the rules applicable accounting standards. However, in reality many companies that creatively manipulating financial data to get a good response from some. This is called creative accounting. Creative accounting is nothing new in the world of accounting, because many companies are doing it.

Creative accounting by some circles is considered unethical for manipulating data. However, creative accounting in view of the positive accounting theory, all the creative accounting does not contradict to the principles of accounting generally acceptable no matter who should be disputed.

Many factors might cause companies use creative accounting to maintain the company’s existence middle of very intense competition today. Therefore we need creative ways in financial accounting in the business world, although it is often considered the less ethical. The fact is in line with the opinion of Brass et.al. (1998) which states that unethical behavior is caused by two major factors, namely the individual factors and organizational factors. Individual factors for example consists of locus of control and moral cognitive development. While such organizational factors consist of organizational climate, compensation systems, codes of conduct and norms.

Definition of Creative Accounting

Experts define creative accounting as an activity of manipulating financial data on companies. Etymologically, the words of creative accounting consist of two words, namely creative of skill which means it someone invents a new idea that is effective, and an accounting term that means the bookkeeping about financial events are always trying to faithful representation of financial events. Creative accounting by Amat, Blake and Dowd (1999) is a process where some of the parties to use the ability of understanding includes knowledge of accounting standards, the techniques used by the company and use it to manipulate financial reporting. While, Stolowy and Breton (2000) called creative accounting is a part of the accounting manipulation, which consists of earnings management, income smoothing and creative accounting itself.

So that the meaning of creative accounting that is the root of a number of accounting scandals, and many proposals for accounting reform usually centers on an updated analysis of capital and production factors that really will reflect how the added value. Creative accounting and earnings management is a euphemism referring to the accounting practices that may follow the letter of the rules of standard accounting practices, but clearly deviated from the spirit of the regulation.

Elements of Creative Accounting

According to Charles W. Mulford and Eugene E. Comiskey Creative Accounting split into several elements, namely:

  1. Recognizing Premature or Fictitious Revenue

Recognizes income premature or fictitious income is different if the terms of aggressive accounting. For premature revenue, recognition is in accordance with GAAP. Meanwhile, for the fictitious revenue, income is recorded in the absence of sales that occurred.

The shape of the premature revenue recognition of sales can be done when the goods are already booked, but has not been sent or the goods have been shipped, but not yet booked. Meanwhile, examples of fictitious sales are backdated invoices, delivery date modified, or deliberately false record sales.

  1. Aggressive Capitalization & Extended Amortization Policies

In an aggressive capitalization policy, the company reported expense or loss for the year as assets. As a result, the cost of admission is delayed and increased profit. Furthermore, assets or deferred expense is amortized over several years.

  1. Misreported Assets & Liabilities

In many cases, the value of overvalued assets and / or liabilities undervalued with the aim of earning power is higher and stronger financial position. With a high profit, automatically retained earnings and equity value will rise.

Some potential asset accounts are reported overvalued accounts receivable, inventory, investments (which are classified as trading, held to maturity or available for sale). Liability account which recorded undervalued them are accrued expense payable, accounts payable, tax liabilities, and contingent liabilities.

  1. Getting Creative with the Income Statement

The game the numbers in the income statement occurs at speeding up or slowing down the recognition of revenues and expenses. In this case the profit is set for some of the reporting period.

In addition, the presentation of the report may be either single-step or step allows the company plays subtotal numbers, classification of accounts, financial statements and notes. For example, elements of business income reported as income beyond business or otherwise, expenses included in cost of sales in the group reclassified to operating expense account or opposite. Thus reclassification of course will affect the sub total gross profit or operating profit postscript is often used as a source of information for decision making.

Other examples are included in the accounting creativity in the income statement occurs in:

  • The group accounts of expense / income are often in the netting. The company only reported a total of expense / income without elaborating the details of the account group. An example is a study conducted by the General Accounting Office (GAO) United States indicate the occurrence of a series of forms of creative accounting. The results of the study as quoted Stalebrink and Sacco (2007) found evidence that the US Department of Defense intentionally abusing accounting principles to shift the salary expense for the next reporting period in order to fulfill the mandate of the budget that has been set. The use of terminology in the income statement, as the term is the restructuring that turned out to cost restructuring included the elimination of inventory, severance payments and the cost of layoffs, elimination of assets, relocation expenses and asset impairment charges.
  • Determining the level of materiality of a transaction. With the concept of materiality, companies can categorize transactions are actually material becomes immaterial.
  1. Problems with Cash-flow Reporting

As previously described in the Share Price Effect, investors are interested in companies that have a good earning power and sustainable. Thus, future cash flow is to be good anyway. For the creditors, with good cash flow, debts to be smooth.

It has become a common thing that the net cash flow from operating activities is a manifestation of operating income in the income statement. The net cash flow is becoming the main measuring tool on the company’s ability to gain a sustainable cash flow.

In the reporting of cash flows in accordance with GAAP, cash flow is divided into cash flows from operating activities, financing activities and investing activities. Form of presentation of cash flow statement consists of the indirect method and direct method. In the indirect method, cash flows from operating activities are calculated from net income adjusted for non-cash transactions in the income statement. Meanwhile, the direct method cash flow from operating activities is shown based on cash transactions in income.

In practice, cash flow from operating activities is only known by some users of financial statements, but is not known by the investors and creditors. Both of these stakeholders to focus more on financial performance. As a result, they tend to assume that the cash flow statement is correct. In fact, cash flow statement, in particular the operating cash flow, is also of creative accounting.

Causes and pattern of Creative Accounting

Stolowy and Breton (2000) called creative accounting is a part of the accounting manipulation, which consists of earnings management, income smoothing and creative accounting itself. In this understanding of the creative accounting that does not mean accountants who use the accounting understanding, but the parties who have an interest and the power to use creative accounting, such as managers, accountants, government, industry associations, and so on. Things that because creative accounting is due to the policy of the company that caused a lot of the management of data manipulation in order to gain a more in particular the manager of the company. The manager reacted to the financial reporting by Watts and Zimmerman (1986) are classified into three hypotheses that the founder positive theory still assumed reasonable creative accounting, namely:

  1. Bonus plan hypothesis

Healy (1985) in Scott (1997) suggest that managers often behave in line with the bonus will be awarded. If the bonus is awarded depend on the profits that will be generated, then the manager will do ‘creative accounting’ to increase profits or reduce profits to be reported. The owner usually puts a floor under the most minimal profit in order to get the bonus. From the pattern of this bonus manager will raise earnings up to above the minimum level earlier. But if the owner of the company making the upper limit to get the bonus, then the manager will seek to reduce the upper limit earlier profit and current profit transfer to future periods. This he did because if earnings past the upper limit of the manager is not getting an extra incentive for their efforts to make a profit above the limit set by the owners of the company.

Formula bonus used Healy based on the assumption that the company consists of managers who risk averse so that the manager will choose discretionary accrual to lower earnings as earnings before decisions accrual smaller than bogey (lower limit) or exceeding the cap (upper limit) to raise earnings as earnings before decision accrual exceeds bogey but does not exceed the cap. Implications proposed by Healy is that managers will behave in an opportunistic face intertemporal choice.

  1. Debt-covenant hypothesis

Research in the field of positive accounting theory also explains the accounting practices regarding how managers address the debt agreement. Managers in addressing any violation of the loan agreement has matured, will attempt to avoid it by selecting accounting policies that benefit themselves. Fields, Lys and Vincent (2001) suggests there are two events in the selection of accounting policies, which at the time of holding the debt agreement and the maturity of debt. Contract long-term debt (debt covenants) an agreement to protect the lender from the actions of the manager against the interests of creditors, such as excessive dividend, or let the equity is below a predetermined level. Increasingly likely a company to violate debt covenants then the manager will tend to choose accounting procedures to transfer the upcoming earnings period to the current period because it can reduce the risk of default. Sweeney (1994) in Scott (1997) suggests the behavior of ‘moving’ the profit made by the troubled company which threatened bankruptcy and a strategy for survival.

  1. Political-cost hypothesis.

In the view of agency theory, large companies will disclose more information than smaller companies. Great company to do so in an attempt to reduce the cost of the agency. Large enterprises face greater political cost because it is an entity that many highlighted by the public in general. The employees concerned saw profit rise as a reference to improve their welfare through salary increases. The government sees rise in corporate profits as subject to tax that will be charged. So the choice faced by the organization is in what way through the accounting process so that profits can be shown lower. It is often called the political cost hypothesis (Watts and Zimmerman: 1986).

Various kinds of patterns performed in the framework of creative accounting by Scott (1997) as follows:

  1. Taking Bath

Taking Bath, also called big bath. This pattern can occur for no organizational pressure at the turn of the new management is to acknowledge failure or deficit because the old management and new management wanted to avoid such failures. This technique can also recognize the costs in future periods and the loss of the current period when the plight of the unfortunate who can not be avoided in the current period. Consequently, the management do the cleaning themselves by charging the cost estimates to come and do clear the decks. As a result, the next period earnings will be higher than it should be.

Example is according Vinnari and N’Asi (2008) mentions that creative accounting in this case is more likely to lead to the intended use of the accounting for financial reports “misleading” users so as to preclude the user to achieve the purpose of the use of such financial statements. Once a common form used is to bring a wide variety of fictitious transactions for the purpose of manipulating the balance of the balance sheet or the aim of transferring profits between accounting periods.

  1. Income minimization

It is similar to ‘taking bath’ but less extreme. This pattern was made during the company’s profitability is very high with the intention that does not get noticed by the parties concerned (political aspects of cost). Measures taken by the write-off may be on capital and intangible assets, the imposition of advertising costs, costs of research and development, Efforts successful methods for the petroleum companies and so on. The deletion is done when the other techniques still show the operating results still seems to attract interested parties. The aim of this deletion is to achieve a rate of return on assets is desired.

  1. Income maximization

Maximization of profit for the purpose of obtaining a larger bonus, which reported earnings remained below the upper limit set.

  1. Income smoothing

Income smoothing is the most popular and frequently performed. The companies do this to reduce the volatility of net income. The Company may also flatten net profit for the external reporting with the intention of the company’s internal information delivery to the market in predicting long-term profit growth.

  1. The timing of revenue and expense recognition

This technique can be done by making a specific policy with regard to time or timing of a transaction such as the premature recognition on the sale.

How to Detect and Prevent Accounting Fraud in Creative Accounting Practices

Creative accounting has adverse implications for the company, either the owner of the company and investors who want to invest into the company. There are several methods and ways that can to detect creative accounting and how to prevent it.

Fraudulent financial reporting in a company is to be a big impact on all those who base their decisions on the information in the financial statements. Therefore, public accountant should be able to prevent and detect it early to avoid fraud. To determine the existence of fraud, usually indicated by the onset of symptoms in the form of red flags of fraud indicators, such as unethical behavior management. Red flag is usually always must be appear in every case of fraud is happening.

Mulford and Comiskey (2002) wrote a journal related to creative accounting, entitled “The Financial Numbers Game: Detecting Creative Accounting Practices”. The book although more focused for investors as learning to know quickly the accounting fraud, but keep in mind also by the auditor.

Some of the attributes that can be used to detect any risk of fraudulent financial reporting contained in the company, among others:

  1. There are weaknesses in internal control (internal control).
  2. The Company does not have an audit committee.
  3. There is a kinship (family relationship) between the management (director) with company employees.

Classification of Creative Accounting Practices according Mulfrod & Comiskey, consisting of:

  1. Recognition of fictitious revenue
  2. Aggressive Capitalization & Extended Amortization Policies
  3. misreported Assets and Liabilities
  4. Creative with the Income Statement).
  5. Problems with Cash-Flow Reporting

According to a report from the National Commission on Fraudulent Financial Reporting, prevention and early detection on fraudulent financial reporting should begin when preparing financial statements.

Rezaee (2002), in his journal, entitled “Financial Statement Fraud: Prevention and Detection”, discusses deep enough on techniques to prevent and detect fraud in the financial statements. In the book described the case of the collapse of Enron in the United States, which is horrendous business community clearly and completely, including the existence of collusion.

Creative accounting is often done by internal parties in the company not only to manipulate existing data but also to save their company. However, there is one factor that led to manipulate the data were made by firms to get a positive response from several parties and advantages both for internal party companies and to the public.

Cheating manipulate the data is in many ways to detect and Prevent it. It can be done by evaluating the existing data is that existing and check fraud can be detected and prevented. So how creative accounting is not abused by Certain parties for opening advantage not only for the survival of the company and the shareholders of the company.


  1. Amat, Blake and Dowd. 1999. The Ethics of Creative Accounting. Economics Working Paper.
  2. Brass, Daniel J., Kenneth D. Buterfield., dan Bruce C. Skaggs. 1998. Relationship and Unethical Behavior: A Social Network Perspective. Academic and Management Review, Vol. 23 No. 1, 14-31.
  3. Charles W Mulford, Eugene E Comiskey. 2002. The Financial Numbers Game. Cambridge: John Wiley & Sons Inc.
  4. Fields, T.H, Lys, Thomas Z., Vincent, Linda. 2001. “Empirical Research on Accounting Choice”. Journal of Accounting and Economics, 31,255-307
  5. Healy, P.M. 1985. The Effect of Bonus Schemes on Accounting Decisions. Journal of Accounting and Economics. 7: 85-107.
  6. Mulford, Charles and Eugene Comiskey. 2002. The Financial Numbers Game Detecting Creative Accounting Theory. New York: John Wiley and Sons, Inc.
  7. Rezaee, Zabihollah.2002. Financial Statement Prevention and Detection. John Wiley &sons,Inc.
  8. Scott, William R. 1997. Financial Accounting Theory, 2nd Edition, Canada Inc., Prentices Hall
  9. Stalebrink, Odd J., and John F. Sacco. 2007. Rationalization of financial statement fraud in government: An Austrian perspective. Critical Perspectives on Accounting 18 (2007) 489-507
  10. Stolowy, Hervé, and Gaétan Breton. 2000. A Review of Research on Accounts Manipulation. European Accounting Association: 23rd Annual Congress.
  11. Sweeney, A.P. 1994. Debt Covenant Violations and Managers Accounting Responses. Journal of Accounting and Economics 1
  12. Vinnari, Eija M., and Salme N’asi. 2008. Creative Accrual Accounting In The
    Public Sector: ‘Milking’ Water Utilities To Balance And Municipal Budgets
    Accounts. Financial Accountability and Management, 24 (2), May, 0267-4424
  13. Watts, R, L., and Zimmerman, J, L. 1986, Positive Accounting Theory. New York, Prentice Hall.


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