The most common methods of creative accounting include:– write-off of expenses not to those accounts of the account which are defined by the legislation;
– the sale of the same goods between companies by collusion in order to increase sales;
– barter transactions for the exchange of services for shares, software or other technologies that are conducted not at market prices but at contractual prices and lead to a deliberate distortion of the company’s revenues and profits;
– off-balance-sheet financing, whose sources are not reflected in the balance sheet, artificially improves the capital structure, which, in turn, allows to attract additional financing at lower prices.
All these measures contribute to the inflation of sales volumes, revenues, and, as a result, to the market value of the enterprise. At the same time, managers can pursue different goals:
– improve the company’s development prospects;
– to achieve in any way a high market value of the company with a view to extracting benefits for itself through a system of options and obtaining income from owning shares.
On the first place in many cases is the most obvious desire to meet the expectations of investors. In most cases, there is a simple rule: if published results are consistent with investors’ expectations, the value of the company or the company’s share is increased.
Creative accounting, by its nature, is a choice from the whole number of alternatives proposed by the state legislation to enable the formation of reports taking into account the interests of the company’s management personnel.
Conducted by Western analysts, sociological research shows that the attitude to creative accounting is differentiated by country. As a base of comparison, two European countries were taken – Spain and the United Kingdom. The research gave very interesting results: the attitude towards the legality of creative accounting as a tool of business turned out to be approximately equal, and the relation to the solvability of the problem of creative accounting in the UK and Spain turned out to be exactly the opposite. 91% of British respondents have recognized creative accounting as an insoluble problem, while in Spain the same view is held by only 38% of respondents.
To get acquainted with the elements of creative accounting, consider an example of accounting for fixed assets – determining the useful life of an asset. Under IAS 16 Property, plant and equipment, the amortized cost of the asset is to be allocated on a systematic basis for its useful life.
For example, Table 1 shows the range of variations in the established useful lives for aircraft and engines used in the reporting of aviation groups Lufthansa, BritishAirways and AirFrance-KLM.
Timing of useful service for aircraft and engines of Lufthansa, BritishAirways and AirFrance-KLM
Company Depreciation method Useful life Liquidation value Effective useful life
1 2 3 4 5
New aircraft and engines Linear 12 years 15% 14 years
Fleet Linear 18-25 years The value of the liquidation value is absent From 3.9 to 4.9% per year or 20-27 years
Motors used in contracts Linear 18-25 years The value of the liquidation value is absent From 3.9 to 4.9% per year or 20-27 years
Expenses for engine overhaul Linear 54-78 months Without liquidation value 54-78 months
AirFrance – KLM
Fleet Linear Average 20 years Without liquidation value Average 20 years
We analyze the financial statements of companies in industries with significant fixed assets. In the balance sheet, a comparison of the disclosure of useful lives with information about competitors gives users of financial statements a first view of the prosecution of an aggressive accounting policy in this area. In this example, analyzing the information, we can assume that of the three groups BritishAirways pursues the most aggressive policy. An additional fact disclosed in the latest published annual consolidated financial statements of BritishAirways is the increase in the depreciation period for the cost of overhauling engines used in certain types of aircraft from 54 to 78 months, which reduces the cost of depreciation per year by 32.5 million pounds.
To identify possible cases of aggressive policies, users of financial statements can calculate the ratio of annual costs for depreciation and the average gross book value of fixed assets subject to depreciation. The calculated indicator is compared with the indicators of previous periods and with indicators of other companies from the same industry.
Creative accounting, therefore, can lead to deception and misrepresentation of external and internal users of financial statements. There are various ways to detect creative accounting.
In the developed countries of Europe and the United States, the problem of accounting manipulation is solved by raising the level of professional ethics of accountants and auditors. The intensification of work on the creation of a code of accounting ethics, primarily in the United States, marks an attempt to eradicate such abuses by the accounting community itself. In this regard, the experience of New Zealand is of great optimism among accounting associations, where the system of accounting standards and legislative regulation of accounting, combined with the activities of self-regulating organizations of bookkeepers, have reduced the possibilities for using creative accounting technologies.
It should also be taken into account that the development of accounting goes along the path of complicating the rules for recognizing assets and liabilities, assessing and reflecting facts and phenomena of economic life. Of course, the more complicated the rules, the easier it is to interpret them in the right aspect, hide the distorting entries and mislead both the auditors and the users of the financial statements. Therefore, one of the ways to combat falsification of financial statements, along with stricter measures of responsibility, should be to simplify the rules of financial accounting and reduce them to a reasonable amount.