by Munya Mtetwa

So what is creative accounting? Creative accounting can be defined as the process of giving financial statements such as the profit and loss account and the balance sheet the appearance which does not reflect the true and fair of the business’ affairs. Creative accounting disguises the true substance, the true financial performance, or true financial position of the reporting business.

Most organisations agree that creative accounting is bad for both the managers and investors as it misleads them thereby allowing them to make judgements about a business based on misleading or doctored accounting information. As a result of this accountants and businesses never admit that they use creative accounting.

How Creative Accounting is Achieved

Below are some of the ways businesses or accountants present a better picture than the actual picture of the business. These are not all the ways but they are the most common methods used by creative accountants:

• Manipulating of inventory or stock values to change the reported profits. This is usually done by overstating the value of the business’ stock or inventory. The effect of a higher inventory or stock figure is that the business will report a lower cost of sales figure. A lower cost of sales figure will result in a higher profit. The other benefit of assigning a higher stock or inventory value is that the current assets figure will also be overstated thereby showing a higher working capital on the business’ balance sheet.
• Businesses that are involved in long-term contracts can manipulate profits by recognising revenue too early. The front loading of revenue to the earlier years will result in a higher profit and this is also against the prudence concept. This practice is akin to counting the chicken before the eggs are hatched.
• Window dressing is a method that businesses use to achieve the profit that the business wants to report to the outside world. It can be achieved by deliberately manipulating the events that happen prior to or just after the cut-off date. Businesses can report next financial year’s sales into the current year or it can also ignore or hide current year expenses so that they are charged into the following financial year.
• Income smoothing is done so that businesses achieve market expectations. It is done to reduce sales volatility and to ensure that a business reports sales showing a certain pattern as anticipated by financial markets. A business can either create fictitious sales to achieve the target sales or it will put some sales into reserves or deliberately ignore them so that they can be used at a future date when the business fails to achieve sales figure expected by the market. Businesses do this to please stock market analysts who would otherwise punish the business if the sales figuress are demonstrating some volatility. High volatility in sales is associated by financial markets with high risk.
• Businesses can also under depreciate non-current assets or fixed assets. This will result in a higher profit being reported. The fixed assets’ carrying value will also be overstated and therefore the net assets will also be overstated. Net assets equal to the business capital therefore this means that the business capital will also be overstated. This can mislead lenders and creditors into believing that the business has enough collateral to insure against the business’ liabilities.
• A business can also incorrectly classify some costs, for example, its research and development expenditure. A business will classify research as development costs and will therefore capitalise research costs. This has the impact of understating business expenses and therefore leading to a higher profit. Capitalising research costs will also lead to a higher carrying value for net assets and therefore the capital of the business
• Business can also use off the balance sheet techniques such as deliberately failing to disclose its financial liabilities such as finance leases. This has the impact of understating the business’ gearing ratio. This approach also leads to a higher rate of return on capital being achieved because some assets will not be reflected in the capital employed figure used to calculate the rate of return on capital. This would deliberately mislead the user of accounting information into believing that the business is efficient as it is achieving a higher profit with less capital resources.