THE FINE LINE:

CREATIVE ACCOUNTING VS
UNETHICAL PRACTICES
Arohan: Conquering the New Horizons with Integrity & Innovation

Research Paper by: Aayush Gupta 12/10/23 International Conference 2023

 CREATIVE ACCOUNTING VS
UNETHICAL PRACTICES
Future-Proofing Financial Professions with Integrity and Ethics at
the helm

ABSTRACT

• The use of creative accounting has become a controversial issue, as there

are parties both in favor of and against its use. While management
presents its own arguments in favor of creative accounting, its critics hold
a different opinion and have apprehensions regarding its practices.

• Although it is a controversial topic, studies still reveal that the practices of

creative accounting can be judiciously applied with ethical
considerations. The present paper attempts to highlight the fine line
between Creative Accounting and Unethical Practices.

• The study reveals that creative accounting helps solve many problems
faced by management in today’s complicated and dynamic business
environment. However, due to the dynamic and complicated nature of
business transactions, as well as the latitude allowed in accounting
standards and procedures, it is difficult to handle the issue of creative
accounting, as it sometimes resorts to unethical practices.
 Some Definitions of Creative Accounting

• “Creative Accounting is the transformation of financial accounting figures

from what they actually are to what preparer desires by taking advantage
of the existing rules and/ or ignoring some or all of them”.

• “Purposeful intervention in the external financial reporting process with

the intent of obtaining some exclusive gain”.

Motives for Creative Accounting

• Smoothing of income: Companies generally aim to demonstrate a

consistent trend of income and profit growth rather than exhibiting year-
to-year volatility in profits. This can be achieved by creating unnecessary
high provisions for liabilities and against asset values during prosperous
years. Such provisions can then be utilized in challenging years to make
necessary adjustments.
• A variant on income smoothing is to manipulate profit to tie into
forecasts: Companies typically strive to present their performance in a
manner that enables them to meet their targets or forecasts. As a result,
they aim to attract potential customers.

• Income-boosting accounting policy: Company directors may keep

income-boosting accounting policy changes in reserve to divert attention
from unwelcome bad news. This approach is deemed necessary to
achieve their goal.

• Maintain or boost share price: Maintaining or boosting share prices

by reducing apparent levels of borrowing can be achieved through
creative accounting. This practice makes companies appear less risky and
gives the impression of a positive profit trend.
Consequently, it aids companies in raising capital through new share
issues, offering their own shares in takeover bids, and resisting takeover
attempts by other companies.

• Insider dealing: If directors engage in insider dealing, they may use

creative accounting to delay the release of information to the market,
thereby enhancing their opportunities to benefit from inside knowledge.

• Option to choose accounting method: Management or directors have

the freedom to choose accounting methods, which can serve as
motivation to employ creative accounting in critical situations. For
instance, when obtaining loans from lenders, certain restrictions may
apply. Management can circumvent these restrictions by embracing
alternative accounting methods and employing creative accounting.

• Bonus scheme: If the directors' bonus scheme is tied to profits or the

company's share price, the directors will be motivated to present accounts
that make a favorable impression on the stock market or profits. In cases
where a bonus is contingent on reported profit, the scheme often specifies
 that the bonus is a percentage of profit above a minimum level and is paid
up to a maximum level.

Thus:

• Profit position: If the profit figure falls between the two levels, directors
will choose accounting methods that increase profits toward the
maximum.

• Low profit: If the profit is below the minimum level, directors will choose
accounting methods that maximize provisions made so that, in future
years, these provisions can be written back to boost profits.

• Higher profit: Similarly, if the profit is above the maximum level,

directors will seek to bring the figure down to that level so that profits can
be boosted in later years.

• Profit sharing arrangement: A profit-sharing arrangement may

influence accounting methods. In order to obtain a share of the profit,
directors and management may manipulate the reported profits by
accepting alternative accounting policies.

• Taxation: Taxation may also be a crucial factor in creative accounting.

In situations where taxable income is determined in relation to
accounting figures, directors manipulate the accounts in those
circumstances.

• New managers: When a new manager takes over responsibility for a

unit, there is a motivation to make provisions to ensure that any losses
appear as the responsibility of the previous manager.
 Opportunity for Creative Accounting

There are gaps or unnecessary benefits in accounting methods that create

opportunities for creative accounting. Accounting methods provide
opportunities for creative accounting in the following ways:

• Choice of accounting method: A company is free to choose between

different accounting methods.

In many cases, a company is allowed to choose between a policy of

writing off development expenditure as it occurs and amortizing it over
the life of the related project. Therefore, a company can choose the
accounting policy that presents their preferred image.
• Bias estimates and prediction: Some entries in the accounts involve
an unavoidable degree of estimation, judgment, and prediction. In some
cases, such as estimating an asset's useful life to calculate depreciation,
these estimates are typically made within the business, providing the
creative accountant with the opportunity to decide on the side of caution
or optimism in making the estimate.
• Enter into artificial transaction: Artificial transactions can be entered
into both to manipulate balance sheet amounts and to move profits
between accounting periods. This is accomplished by engaging in two or
more related transactions with an obliging third party.

For example, supposing an arrangement is made to sell an asset to a bank

then lease that asset back for the rest of its useful life. The sale price under
such as ‘sale and leaseback’ can be pitched above or below the current
value of the asset because the difference can be compensated for by
increased or reduced rentals.

• Timing of genuine transactions: Genuine transactions can be timed

so as to give the desired impression in the accounts.

As an example, suppose a business has an investment of Rs. 1 crore at

historical cost which can easily be sold for Rs. 3 crores, being current
value. The managers of the business are free to choose in which year they
sell the investment and so increase the profit in the accounts.

Dearth of regulation: Some areas are simply not fully regulated. For
example, there are very few mandatory requirements regarding
accounting for stock options. Accounting regulation in certain areas is
limited, such as the recognition and measurement of pension liabilities
and certain aspects of accounting for financial instruments.
 Ethical & Unethical Perspective

OVERVIEW

Creative accounting is a matter of approach, not an objection per se. However,

when unethical elements intrude, the resulting accounting details become
anything but true and fair. Creativity in such a context is akin to referring to a
half glass of water as half full instead of describing it as half empty. While both
statements are factually correct, they paint different pictures and convey
different images. Creativity in company accounting may arise under at least
three different financial market conditions.
 • First, when a company floats its shares to attract investors to subscribe
to such shares either at par or at a premium, depending on the financial
market evaluation of the company’s future prospects.

• Second, when the company whose shares are already listed in a stock
exchange, wants to paint an attractive picture of its financial conditions
so that the shares may be quoted at a premium.

• Finally, A company having its shares listed in the stock exchange may
declare and pay high dividends based on inflated profits through
overvaluation of assets, undervaluation of liabilities and change in
systems of stock valuation that may boost the image of the company at
least in the short run. Unethical considerations in creative accounts have
developed to such depths that terms like fraud audit and forensic
accounting have gained currency and are becoming new professions.

Creative Accounting from Negative Viewpoint

The term creative accounting is widely used to describe accepted techniques

which permit corporations to report financial results that may not accurately
portray the substance of their business activities.

Creative accounting is recognized as a synonym for deceptive accounting.

Creative accounting methods are noteworthy because these remain in use as

generally accepted accounting principles, even though they have been shown
to be deceptive in many cases.
H. Bosch (1999) refers to a situation with regard to creative accounting in the
following ways:

• It was common for the so- called entrepreneurial companies to include

capital profits from the sale of properties or shares as operating
profits…on the ground that speculation was a major element in their
business.

• Some of the companies booked unrealized capital gains as operating

profit.

• Some of the transactions which gave rise to these “profit”, were done with
business associates or even within the same group of associated
companies.

• The values put on the assets “sold” often looked very suspicious, with
secret put and call option arrangements.

• Sometimes allowing the “buying” company to transfer the asset back to

the seller at a later date- in some cases just after balance sheet date.

• It was common for companies to include their “shares” of the net profits
of associated companies in their own results.

• There were many companies that were not consolidated into group
accounts to keep debt off a group’s balance sheet and thus to give a
misleading appearance of its capital structure.

• Associated companies and interposed trusts were also used to conceal

other favorable information from the eyes of investors.
From a Positive Viewpoint

It may seem that creative accounting connotes invention of accounting

principles and techniques to recognize changes in economic, social, political,
and business environments.

But real-world experience reveals that it is in most cases practiced in an

undesirable way to attract investors by presenting an exaggerated,
sometimes misleading, and deceptive state of an organization’s financial
affairs.

Causes and Effects of Creative Accounting

The real causes of creative accounting lie in the conflicts of interest among
different interest groups.

For example:

• managing shareholders’ interest is to pay less tax and dividends.

• Investor-shareholders are interested to get more dividends and capital
gains.
• Country’s tax authorities would like to collect more and more taxes.
• Employees are interested to get better salary and higher profit share.

And the effect is that creative accounting puts one group or two to
advantageous position at the expense of others.
The obvious effects of creative accounting:

• There are companies listed on the stock exchange that show inflated
profits and a better financial position in their creative accounting
statements to attract investors. This creation of accounts not only
misguides but also creates confusion.

• Some company prospectuses may not always depict the reality of the
financial positions of the listed companies.

• Processes adopted for created accounting systems may hold out untrue
hopes to investors for a shorter period but cannot continue to succeed for
a longer period.

• Ultimately, the concerned companies listed in the stock exchange

collapse and the investors lose confidence in them and stock market.

• Examples of victims of creative accounting are many, such as “Enron”,

“WorldCom”, “Brent ford”, “Polly peck”, etc. in recent times.
 CONCLUSION

This crucial concept of creative accounting is strongly related to the

ethical standards of accounting and general ethics. The study will
provide numerous benefits if we find ways to prevent the unethical use
of creative accounting through appropriate measures in the future. If
the unethical use of creative accounting is prevented, the rights of
stakeholders will be established. It is clear from the discussion that
creative accounting practices exist, and many companies are victims
of them. Therefore, to detect and prevent the pitfalls of creative
accounting, punitive measures have to be taken by national
accounting bodies, courts, and the government.