8th International Scientific Conference on Economic and Social Development and 4th Eastern European ESD

Conference: Building Resilient Economy, Zagreb, Croatia

EFFECT OF CREATIVE ACCOUNTING ON THE COMPANY

Vlora Berisha
University “Haxhi Zeka”, Kosovo
vlora.berisha@unhz.eu

Albulena Shala
University “Hasan Prishtina”, Kosovo
albulenashala@hotmail.com

ABSTRACT
Objective of this research is to show the effect of creative accounting on the performance of
the company, creative accounting techniques that are used by companies for the purpose of
manipulating the numbers in their annual accounts to reach out to their financial desired
results. 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.
Keywords: Creative accounting, earnings management, financial reporting

1. INTRODUCTION
Creative accounting is applied in order that the view of the company to look financially
stronger or weaker depending on the aspirations of management. Using creative accounting
practices, managements can alter impressions about their firms’ business performance.
Periods of crisis represent in fact tests for companies and managers who are tempted to resort
to ingenious methods, often questionable, in order to improve the presentation of financial
statements. The 1990s were characterized by mass use of manipulative practices in
accounting more prestigious American firms, for example as Enron, Worldcom, AOL, which
was renuan like a castle of sand within a very short period. Their involvement in abuses
accounting system has caused more damage, which extend beyond the financial costs.
Speaking glancing different reports written after the failure of these companies, almost all the
actors involved in rigging have tried to justified with the excuse that the introduction of an
accounting "creative" can not be called fraud, while manipulation were legal frameworks that
GAAP has set. Even if there exist strong accounting standards (GAAP and IAS) to guide
financial accounting activities, sometimes it becomes impossible to prevent the manipulative
behavior of financial statement preparers, who wants to effect the decisions of the financial
statement users in favor of their companies. Most manipulations have passed the limits of the
use of space to let GAAP, passing by really creative in rogue, using illegal practices, totally
contrary to the rules, distorting, add or remove many of the factual data, and this order to
reflect their situation in a way that will help them to achieve their goals. The difference
between creative accounting and fraud is that creative accounting operates within the
regulatory framework, while fraud involves a violation of law or breach of regulatory
framework (Jones, 2011, pp.8). The remainder of this paper is organized as follows: Section 2
lists the methodology of the study. Section 3 and 4 gives a short overview of the empirical
literature on Creative accounting. Section 5 presents the conclusion.

2. RESEARCH METHODOLOGY
The research method in this paper is deductive, the basic method that give us the necessary
preconditions for future research.
The methodology employed in this paper consists of the following phases:

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Conference: Building Resilient Economy, Zagreb, Croatia

1. The problem that is identified on the research of the effect of creative accounting on the
performance of the company.
2. The elaborate plan of research which is therefore also collected literature bibliography is
set to be used.
3. The defined structure and sections of the paper.
4. The paper discussed on the structure based on the knowledge gained through the
qualitative data obtained mainly from books, articles, studies, and Internet sources.

3. LITERATURE REVIEW
Until recently many researchers have shown interest in the field of creative accounting. They
have carried out numerous theoretical and empirical studies and field observations to
illuminate the brightness and darkness of this field. Their findings and suggestions are
reviewed here:
Hussey & Ong (1996) stated that creative accounting first became very prevalent in the 1980.
Due to loopholes of accounting regulations, companies could produce accounts which
flattered their financial performance.
Blake & Salas (1996) explained that creative accounting is seen as widespread in the U.K.
and undermines the credibility as a disease. During 1990-s, creative accounting problem
identified in Spain within the “Continental European” model of accounted regulations. There
was an empirical work in Spain in which questionnaire was sent to 100 partners in Spanish
audit firms. 29 replied, which was well above the average. They compared Spanish survey
with two survey of U.K. on this topic with total 42 respondents. In both countries 30% of
auditors consider creative accounting as legitimate business tool, while over 60% see
creative accounting to be a serious problem. Where as in Spanish auditors, 28% think that
creative accounting cannot be solved completely and in U.K. 95% thinks so. They also
compared Anglo American with continental European.
Rucsandra, Sorin, Cristina (2010), in their research paper titled “Fighting the enemy of fair
view principle – Getting to know Creative Accounting”, discussed the role of creative
accounting as a technique of accounts manipulation in contrast with the fundamental
principle of accounting – fair view presentation, and the ethics of the accounting profession.
In this paper the authors analyzed the role of auditors and corporate governance in winning
the fight over this kind of accounting practices.
O. Effiok, Okon E. Eton (2012), their study was conducted to appraise the impact of creative
accounting on management decisions. The authors recommendation is that effective
regulation of financial reporting should be encouraged to minimize miss representation of
facts. The tenet of good covenants should be the watch word in ensuring abuse of financial
statement. Management of firms should try to base their investment decision on financial
report that as not been manipulated.
Cosmin (2010) described the various techniques used by the managers to get desired results.
Oriol Amat, Catherine Gowthorpe (2010), in their research paper titled “Creative
Accounting: Nature, Incidence and Ethical Issues”, discussed the various ways in which
creative accounting can be undertaken and summarizes some empirical research on the nature
and incidence of creative accounting.
Syed Zulfiqar Ali Shah, Safdar Butt, and Yasir Bin Tariq (2011), in their study “Use or
Abuse of Creative Accounting Techniques”, explored and tried to answered a very important
question, why managers do creative accounting and how they become successful in
performing such practice in the presence of stringent rules and procedures. At the end they
concluded that the complex and diverse nature of the business transactions and the latitude
available in the accounting standards and policies make it difficult to handle the issue of

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Conference: Building Resilient Economy, Zagreb, Croatia

creative accounting. It is not that creative accounting solutions are always wrong. It is the
intent and the magnitude of the disclosure which determines its true nature and justification.
Dilip (2006) conducted a research to find out the reasons for the sudden collapse of seventh
largest company of USA. He found that the company was hiding the losses using a
complicated web of partnerships, subsidiaries and SPEs.
Naser and Pendlebury (1992) questioned senior corporate auditors about their experience of
creative accounting. They were able to conclude that a significant proportion of all categories
of companies employ creative accounting techniques to some extent. Many research studies
examine a particular aspect or technique of creative accounting. All tend towards the
conclusion that creative accounting using that particular technique does exist.

4. OVERVIEW- CREATIVE ACCOUNTING

'Creative accounting is the root of many of recent accounting scandals, and many
proposals for accounting reform - usually centering on an updated analysis of capital and
factors of production that would correctly reflect how value is added’ (Wikipedia.org,
2006).
As soon as these words “Creative Accounting” are mentioned, the image that emerges in
one’s mind is that of manipulation, dishonesty and deception.
The reliability of the financial statements are crucial for the stakeholders of the firms in order
to make appropriate decisions. This fact has become more important in recent years starting
from 2001 by the collapse of Enron and its importance has intensified with the recent
financial crisis because of the bankruptcy of major financial institutions. Even if there exist
strong accounting standards (GAAP and IAS) to guide financial accounting activities,
sometimes it becomes impossible to prevent the manipulative behavior of financial statement
preparers, who wants to effect the decisions of the financial statement users in favor of their
companies. These manipulative behaviors are often called “creative accounting” and/or
“earnings management” “Creative accounting” is the more preferred term in Europe, whereas
it more common to use “earnings management” in the USA (Türker Susmus, Dilek
Dermihan, 2013, pp. 2).
The term “Creative Accounting” was first originated with the movie “The Producers” by Mel
Brooks in 1968. One of the early researchers who defined the account manipulation was
Copeland (1968). He defined it as some ability to increase or decrease reported net income at
will. The term ‘creative accounting’ can be defined in various ways. Including the following:
‘Is the deliberate dampening of fluctuations about ‘some level of earnings considered being
normal for the firm’ (Barnea 1976).
Kamal Naser (1993), offers this definition of creative accounting which presenting an
academic view: creative accounting is the transformation of financial accounting figures from
what they actually are to what preparers’ desire by taking advantage of the existing rules
and/or ignoring some or all of them.
Another defination about creative accounting is from Amat (1999) - Creative accounting is
the process whereby accountants use their knowledge of accounting rules to manipulate the
figures reported in the accounts of a business.

4.1. Creative accounting vs Fraud

Manipulation that does not lie within the law and standards is considered to be a fraud,
according to Diana and Madalina. Engaging in the practices of creative accounting or
manipulation accounting is within the law and thus is not considered to be a fraud. Fraud
occurs when a firm commits an illegal act, for example if the firm decides to falsify invoices

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Conference: Building Resilient Economy, Zagreb, Croatia

so it can increase its sales figures. On the other hand making a false estimation on bad debts
is not considered to be a fraud.
According to Belkaoui (1989), real fraud is defined as ‘falsifying or altering documents,
deleting transactions from records, recording forged transactions or concealing significant
information’. Due to the difficulty of the distinction between the two, the commission
responsible for fraudulent financial reporting defined fraud as ‘materially misleading
financial statements’ ( NCFRR 1987).
To conclude, creative accounting deals with the misrepresentation of accounting figures, by
following the standards set by the accounting conventions, while fraud is falsification of
accounting figures made, by disobeying the law.

4.1.1. Motivations for Creative Accounting

There are many factors regarded as the reasons of applying creative accounting or earning
management techniques. One of the most cited incentive in the literature is the expected
increase in the stock prices. It can be concluded easily that the incentives of creative
accounting is the following advantages: presenting the best possible earnings picture so as to
maximize the price at which the issue is sold; causing earnings to remain between the
minimum and maximum earnings level so as to maximize incentive compensation;
minimizing the political costs of size and/or industry membership by avoiding what might be
considered excessive profit levels; avoiding the potential adverse effects of a covenants
violation (for example, an interest rate increase, a demand for security or immediate
repayment); avoiding an improper market response to earnings being temporarily off trend;
reducing earnings volatility so that a valuation penalty, associated with a perceived higher
level of risk, is not assessed; taking large write-offs immediately upon the arrival of new
management, relieving future results of the charges and permitting blame to be assigned to
outgoing management; reserving any overstated portion of the accruals in order to achieve
earnings goals in later periods (Mulford, 1951).

Figure 1. Classification of Accounts Manipulation, Source: Hervé Stolowy and Gaétan

Breton, “A Framework for the Classıfıcatıon of Accounts Manıpulatıons”, HEC Accounting
& Management Control Working Paper No. 708/2000, 2000,Volume 3, No:1, p.4

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Conference: Building Resilient Economy, Zagreb, Croatia

4.1.2. Techniques of Creative Accounting

According to Beidleman (1973) and Lipe (1990) creative accounting techniques reduce the
variability of earnings and, therefore, shareholders benefit because the reduced uncertainty
and improved predictability of future earnings help in enhancing price/earning multiples.
However, they claim that abnormal accruals over time tend to reverse and are readily
detected by investors. This clearly calls for moderation in using even healthy techniques for
managing earnings.
Big bath charges
In this technique, instead of showing losses for a couple of years, a big loss is shown for a
single year by charging all expenses in that year. This may be done if there are apparent
reasons for poor profitability in that year and the management feels that by lumping all
expenses in one bad year, they can start showing better profits in following years.
Creative acquisition accounting
IFRS 3 provides extensive guidelines on how the purchase price of business acquisitions
should be allocated. The SEC also has a check on allocation of R& D costs. Yet it leaves
room for manipulation of amortizing levels.
Cookie jar reserves
Over-provisioning for accrued expenses when revenues are high helps to bring down profits
to a level that is safe to maintain in the future. Similarly, failure to provide all the accrued
expenses can help show larger profits during tougher times when such is the need of the hour.
Materiality
A change in an immaterial item can help the firm billions of dollars. For example, some
companies do not recognize an expenditure under say $5000 as an asset, even if its benefits is
likely to be spread over several years. Varying this limit to say $2,000 can easily increase
profits while hiking up this limit may lead to lower profits.
Revenue recognition
Firms virtually have a free hand in timing the booking of their revenues at any stage starting
from the moment sales contracts are signed till the promised product or service has been fully
delivered to and accepted by the clients. For this we can refer to a classic example of
Microsoft which was heavily fined by US SEC for its manipulative revenue recognition
policy. Microsoft recognized only a small percentage (20- 30%) as revenue at the time of the
sale and remaining amount was kept as provision for future after sales services. Why
Microsoft adopted that strategy. The answer is to (1) hide substantial profits, (2) signaling
effects, (3) avoiding complacency and last but not the least (4) to report smoothed earnings to
its shareholders & stakeholders.

Smith (1998) reported on the accounting manipulations employed by 208 of the largest
quoted UK companies and identified 12 different techniques in the common use, all of which
would impact on the Profit and Loss account and Balance Sheet of the companies concerned.
The techniques specified can be described as follows:
1. Extra ordinal and exceptional items,
2. Pre-acquisition write down,
3. Deferred consideration on acquisition,
4. Disposals- profits on sales of asset taken “above the line” and deconsolidation of
subsidiaries in anticipation of sale.
5. Brand Accounting- capitalization of assets,
6. Off-balance sheet finance,
7. Contingent liabilities,
8. Changes in depreciation policy(Method),
9. Capitalization of costs (interest and R&D ),

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Conference: Building Resilient Economy, Zagreb, Croatia

10. Currency mismatching between borrowing and depositions,

11. Pension fund surplus used to reduce annual charge,
12. Convertible with premium put options or variable rate preferred stocks.

Figure. 2.Creative Accounting techniques and their effect in business performance. Source:
N. Feleagă, L. Malciu, “Accounting Policies and Options”, Economica Publishing House,
Bucharest, 2002, p. 391.

Creative accounting implies that the entity takes advantage of the existing loopholes in the
rules, and their flexibility to prepare and publish embellished financial statements. Although
not illegal, creative accounting indicates that managers are under financial pressure to seek
solutions without questioning regarding their ethical actions.

5. CONCLUSION
Creative accounting means finding loopholes in the accounting standards and using them to
manipulate the accounts. Companies can use different methods to manipulate the accounts.
The improper use of such creative accounting practices had fooled both auditors and
regulators in the past (e.g. Enron, Bank of Punjab etc) and it continues to do the same. So we
can say that creative accounting is the negative and unethical aspect of accounting but it can be
considered a positive aspect of accounting when new standards are introduced to develop the
accounting system and to introduce more reforms in business governance.

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Conference: Building Resilient Economy, Zagreb, Croatia

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