Creative Accounting Meaning
Creative accounting is a method, which is used to make or interpret accounting policies falsely with the objective of misusing the accounting techniques and standards, which are being set by the accounting bodies. The purpose of doing this type of practice is to make profits by not reporting the exact figures. It is an exploitation of loopholes in our accounting system as well as audit system after the accounts are finalized.
There are many ways of doing it. The most popular ones are to manipulate the profit figures to get rid of excessive taxation in futures, many a time the books of accounts through which these tax figures are found out are generally not correct the manipulation is done from the very primary level. The main adjustments regarding the accounts which the management wants to manipulate are made by adjusting the figures related to employee benefits or incentives. Some companies practice creative accounting to pretend that the financial condition of their company is sound and people can invest in our companies.
Methods of Creative Accounting
#1 – Wrong Estimation of Inventory in Stores
The management of some of the companies do this type of practice to overstate the inventories’ valuation. They do this to just show that their cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. is understood thus tries to show the increased profits that their company is going to earn this year.
#2 – Failures to Make Proper Contingent Liabilities
It is a very technical method of creative accounting. The contingent liabilitiesContingent LiabilitiesContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company's control. are not shown properly in the notes to accounts; thus, it will give the impression that the company is not having any liability and thus is free from that.
#3 – Booking Less Expense
The company sometimes, to show lower expenses, make client payment either by cash or by an outdated cheque. It helps the management to book the lower expenses per year, and their books of accounts will depict the fewer expenses figure, which may attract some investors.
#4 – Willfully Attempting to Manipulate Depreciation Figures and Methods
This technique is used by many companies to make a good impression on their investors. The depreciation calculation method is sometimes changed by simply giving a disclaimer. No estimation increases the life span of the assets. The management attempts to set an arbitrary life span, usually more than expected. It thus can have a less deprecation calculated on the above and corresponding to that increases the salvage value of the assetsSalvage Value Of The AssetsSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. of the company. Although depreciation is cashless, the calculation of the same makes a great impact on the finances of the company.
#5 – Lowering Personal Liabilities of the Company
A company does not usually tend to show their liability, so it is also a great technique of creative accounting.
#6 – Manipulating Revenues and Sales Figures
It is a very basic thing most of the companies are doing. Sometimes they lower the sales revenue in their books to get rid of taxes, and sometimes they increase the sales figure with some arbitrary transaction to show the revenue of the company to encourage their investors.
Examples of Creative Accounting
- The company raises invoices before the end of the accounting year to inflate its sales figures and but the actual transaction occurs on the post date. It is an example where the company attempts to show the boosted up revenue figures.
- The company sometimes gives loans to their known person to willfully hide the transactions made during the year.
- The company increases the useful life of an asset arbitrary to get rid of the higher depreciation charged.
- The company can show a smooth and good growing graph of the company. The management adopts this technique to show steady profits and good revenue to attract their investors.
- Creative accounting helps the company to set the required parameters for them, which is practically impossible.
- The company that makes losses can be benefited from this type of creative accounting. Investors can be hopeful by seeing the future gains in the companies’ budgeted accounts, and many times the company can cope with the given situation.
- The company, by adopting this method, can somewhere conceal the financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy. which they may tend to suffer.
- Although creative accounting is an ethical practiceAccounting Is An Ethical PracticeAccounting ethics refers to adhering to specific rules and guidelines established by governing bodies that every person involved in accounting should adhere to in order to prevent the misuse of financial information or their managerial position., sometimes it may be treated as illegal. When the values of the books of accounts are unethically or illogically misrepresented, then it can call for some qualifications.
- The company will always be at a high risk of losing its investors because in case the investors get to understand the manipulations, it will not be good for the company. The investor’s interest might get hampered.
- The biggest disadvantage is that if an expert does the manipulation, then it is fine, but if not so the financial literate director or CEO decides to make a change, then it will be a problem. Therefore, this may add to the cost of hiring a financial expert.
- In the long run, if this is disclosed that the company does a creative accounting practiceAccounting PracticeAccounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements., then the expectation from the company by their clients will also be at risk; thus, the company may lose its business.
Creative accounting is an accounting practice that helps the company to deviate the profits, revenues for the year by following rules and regulations. It is a skill, which is used by experts to manipulate the accounts of the company. The experts best handle the loopholes in the system, and the method should be ethical; otherwise, it can be a severe problem for the company’s management.
The most important thing here is that investors should be cautious while choosing companies for investment. They should know the financial arrangements which are possibly done by understanding the notes to the accounts. The management should ask any suspicious item, and if the management is unable to answer the query, the investor should not invest their money in these bogus companies.
This article has been a guide to what is creative accounting and its meaning. Here we discuss the top 6 methods of creative accounting along with examples, advantages, and disadvantages. You can learn more from the following articles –