For most people, mention the words ‘Creative Accounting’ and it conjures an image of manipulation, dishonesty and deception in the presentation of financial information. For “Creative Accounting” you can use the term “Earnings Management”: both mean the disclosure of financial results with the aim of deceiving the reader, or at least in my view they do.

magAccording to a respected academic paper by Healy and Wahlen as long ago as November 1998, “earnings management” occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers. In other words, earnings numbers are deliberately manipulated by a company’s management for the purpose of meeting it corporate objectives whatever they might be.

Contrary to what might be thought, most earnings management techniques are often within the permissible ambit of Generally Accepted Accounting Principles (GAAP). In his remarks entitled “The Numbers Game” made on September 28, 1998 at the New York University Center for Law and Business, then-SEC (Securities and Exchange Commission), Chairman Arthur Levitt described five techniques of “accounting hocus-pocus” that summarised the most glaring abuses of the flexibility inherent to accrual accounting. He called them: big bath charges, creative acquisition accounting, cookie jar reserves, materiality, and revenue recognition.

When looking at what was going on in 1998, I came across a research paper on this subject. The paper, available here, considered whether creative accounting is good for companies or whether it actually brings about crises situations. At the end, the paper concluded that it is not that creative accounting solutions are always wrong but it is the intent and the magnitude of the financial disclosure that determines its true nature and justification.

If this means that creative accounting is always wrong when it is designed to cause a reader to make the wrong conclusion about information being communicated, I agree with that completely. And, it seems to me that most creative accounting initiatives do exactly that: deceive through obfuscation.

According to the FT, here, corporate boards continue to rubber stamp financial statements in which “earnings are engineered, toxic debt is hidden “off” the balance sheet, and wishful thinking determines valuations of complex financial products.”

Deloitte, the accounting giant, said some sensible things on this subject, here:

Accounting suffered a series of major reputational blows in the 1980’s and 90’s. The “creative accounting” practices used made some businesses appear to be more profitable (or less profitable for tax reasons) and financially stronger than they really were. Lenders and investors lost millions as a direct result of these practices. However, it would be wrong to simply conclude that those were the ‘bad old days’ and financial reports are no longer manipulated for gain. Unfortunately, ‘creative accounting’ is not a dying art and is still used by some for financial gain.”

In an article in Harvard Business Review, here, the authors said: Why Good Accountants Do Bad Audits. It followed the passing of the Sarbanes-Oxley Act of 2002 addressing corporate accountability. Because of the often subjective nature of accounting and the tight relationships between accounting firms and their clients, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company’s true financial status, thereby misleading investors, regulators, and sometimes management itself.

Today, we live in a culture obsessed with measuring and auditing and overseeing by regulators, but creative accounting lurks in the background. It’s insidious. Much of it is downright wrong and dishonest and should be banned.

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Martin Pollins
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