Creative Accounting-Meaning, Scope and Case Study

Creative accounting is the transformation of financial accounting figures from what they actually are to
what those who prepare them want, by taking advantage of existing rules or by ignoring some or all of
them - By Rajesh Gajra & Srikanth Srinivas

Creative accounting is the application of variability in the accounting principles, practices and
procedures to modify the books of accounts so that the organization objectives are fulfilled.
The term as generally understood refers to systematic misrepresentation of the true income
and assets by corporations. It’s the operation on financial data, usually within the purview of
the law and accounting standards but not providing a “true and fair” value. It is characterized
by excessive complication and the use of novel ways of characterizing income, assets, or
liabilities and the intent to influence readers towards the interpretations desired by the
organizations. It is also known as aggressive and sometimes innovative accounting.

Creative accounting has a wide scope, specifically in terms of manipulation of accounts. Under
creative accounting a company can inflate its sales as well as its profits, so as to smoothen out
the financial results. Companies can also inflate their EPS to bring out a rosy picture of the
company in the eyes of existing and prospective shareholders. Under creative accounting
manipulation is also done with regard to assets and liabilities value and capital of the
organization, thus leading to an effective financial position. It is also possible to adjust the
profits from one year to the other leading to a more impressible management of the financial
performance of the company. There is also the scope of movement of sales between subsidiary
and parent company leading to a depiction of higher than actual sales growth.

Methods of Creative Accounting

The various methods of creative accounting can be considered to fall in four broad categories:
(1) Sometimes the accounting rules allow a company to choose between different accounting
methods. A company can therefore choose the accounting policy that gives their preferred
image.
(2) Certain entries in the accounts involve an unavoidable degree of estimation, judgment, and
prediction. In some cases, such as the estimation of an asset's useful life made in order to
calculate depreciation, estimates are normally made inside the business and the creative
accountant has the opportunity to err on the side of caution or optimism in making the
estimate.
(3) Artificial transactions can be entered into both to manipulate balance sheet amounts and to
move profits between accounting periods. This is achieved by entering into two or more related
transactions with an obliging third party, normally a bank. For example, supposing an
arrangement is made to sell an asset to a bank then lease that asset back for the rest of its
useful life. The sale price under such a 'sale and leaseback' can be pitched above or below the
current value of the asset, because the difference can be compensated for by increased or
reduced rentals.
(4) Genuine transactions can also be timed so as to give the desired impression in the accounts.
As an example, suppose a business has an investment of Rs 1 million at historic cost which can
easily be sold for Rs 3 million, being the current value. The managers of the business are free to
choose in which year they sell the investment and so increase the profit in the accounts.

Reasons for Creative Accounting

It is the higher authorities who are the main culprits behind using Creative Accounting. The
reasons for the directors of listed companies to seek to manipulate the accounts are as follows:
(1) Companies generally prefer to report a steady trend of growth in profit rather than to show
volatile profits with a series of dramatic rises and falls. This is achieved by making unnecessarily
high provisions for liabilities and against asset values in good years so that these provisions can
be reduced, thereby improving reported profits, in bad years. Advocates of this approach argue
that it is a measure against the 'short-termism' of judging an investment on the basis of the
yields achieved in the immediate following years. It also avoids raising expectations so high in
good years that the company is unable to deliver what is required subsequently.
(2) A variant on income smoothing is to manipulate profit to tie in to forecasts.
(3) Company directors may keep an income-boosting accounting policy change in hand to
distract attention from unwelcome news.
(4) Creative accounting may help maintain or boost the share price both by reducing the
apparent levels of borrowing, so making the company appear subject to less risk, and by
creating the appearance of a good profit trend. This helps the company to raise capital from
new share issues, offer their own shares in takeover bids, and resist takeover by other
companies.
(5) If the directors engage in 'insider dealing' in their company's shares they can use creative
accounting to delay the release of information for the market, thereby enhancing their
opportunity to benefit from inside knowledge.

Methods to curb Creative Accounting

Accounting regulators who wish to curb creative accounting have to tackle each of these
approaches in a different way:
(1) Scope for choice of accounting methods can be reduced by reducing the number of
permitted accounting methods or by specifying circumstances in which each method should be
used. Requiring consistency of use of methods also helps here, since a company choosing a
method which produces the desired picture in one year will then be forced to use the same
method in future circumstances where the result may be less favorable.
(2) Abuse of judgment can be curbed in two ways. One is to draft rules that minimize the
use of judgment. Auditors also have a part to play in identifying dishonest estimates. The other
is to prescribe 'consistency' so that if a company chooses an accounting policy that suits it in
one year it must continue to apply it in subsequent years when it may not suit so well.
(3) Artificial transactions can be tackled by invoking the concept of 'substance over form',
whereby the economic substance rather than the legal form of transactions determines their
accounting substance. Thus linked transactions would be accounted for as one whole.
(4) The timing of genuine transactions is clearly a matter for the discretion of management.
However, the scope to use this can be limited by requiring regular revaluations of items in the
accounts so that gains or losses on value changes are identified in the accounts each year as
they occur, rather than only appearing in total in the year that a disposal occurs.

Case study: Creative accounting practices by Xerox

Management at Xerox Corporation when faced with strategic mistakes and a tough economic
environment, including Japanese competition resorted to creative accounting practices to meet
financial targets and Wall Street expectations.

On April 11, 2002, the Securities and Exchange Commission filed a complaint against Xerox. The
complaint alleged Xerox deceived the public between 1997 and 2000 by employing several
"accounting maneuvers," the most significant of which was a change in when Xerox recorded
revenue from copy machine leases —recognizing a 'sale' in the period a lease contract was
signed, instead of recognizing revenue ratably over the entire length of the contract. The issue
was when the revenue was recognized, not the validity of the revenue. Xerox's restatement
only changed what year the revenue was stated.

Prior to 1997, Xerox had recognized revenue from equipment (copy machine) rentals, or leases,
as required by US generally accepted accounting principles (US GAAP). US GAAP (specifically
FAS 13) prohibits companies from recognizing the entire proceeds of the sale of equipment
unless certain criteria are met, such as transfer of ownership. If none of the criteria are met, the
'sale' is considered a lease, and only the rental payments owed to the company in the current
period can be treated as revenue in the current period.

The SEC charged that the change in how Xerox applied accounting principles not only violated
GAAP, but was intentionally designed to fool Wall Street into believing the new management
team was working wonders, exceeding Wall Street's expectations nearly every quarter from
1997 through 1999. The SEC further charged that the accounting irregularities increased fiscal
year 1997 pretax earnings by $405 million, 1998 pretax earnings by $655 million, and 1999
pretax earnings by $511 million (in each quarter of each year, earnings were inflated just
enough to exceed the Wall Street's First Call Consensus EPS).

The SEC also alleged that Xerox's senior management was aware of, either by directing or
approving, the accounting actions that were taken for the purpose of what management called
"closing the gap" to meet revenue and profit goals. When Xerox's auditors, KPMG, questioned
the legitimacy of the company's accounting practices, senior management requested that a
new partner be assigned to its account. In order to keep the relationship with Xerox that had
lasted nearly 40 years, and to protect the $82 million in audit and non-audit fees KPMG would
collect from Xerox between 1997 and 2000, KPMG complied with management's request.
Of course, fool's gold becomes tarnished quickly, and the deception employed by Xerox's
management soon came to light. The "accounting tricks" employed by Xerox were a double-
edged sword: by accelerating future revenues into present periods, it became increasingly
difficult for management to meet investors' expectations in future periods, especially as the
economy began to worsen in 1999 and later years.

In response to the SEC's complaint, Xerox Corporation agreed to pay a $10 million penalty and
to restate its financial results for the years 1997 through 2000. On June 5, 2003, six Xerox senior
executives accused of securities fraud, including its former chief executive officer, Paul A. Allaire
and G. Richard Thoman, and its former chief financial officer, Barry D. Romeril, agreed to pay
$22 million in penalties, disgorgement, and interest.

On January 29, 2003, the SEC filed a complaint against Xerox's auditors, KPMG, alleging four
partners in the "Big Five" accounting firm, Michael A. Conway, 59, Joseph T. Boyle, 59, Anthony
P. Dolanski, 56, and Ronald A. Safran, 49, permitted Xerox to "cook the books" to fill a $3 billion
"gap" in revenue and $1.4 billion "gap" in pre-tax earnings. As noted in the complaint: "There
was no watchdog at Xerox. KPMG's bark sounded no warning to investors; its bite was
toothless."

Case Analysis

The Xerox scandal to a certain extent was indirectly the result of lack of innovation on the part
of the Xerox team. In the digital age, Xerox developed many technologies but then failed to
take advantage of them. While other companies were continuously innovating, Xerox failed to
capitalize on new technologies and thus gradually lost market share. Slowly the company
reached a point where the management began resorting to unfair accounting practices,
sometimes also referred to as creative accounting, to show a rosy picture of the financials of
the company.

Ethics and values should be demonstrated by the top management in order to set up a positive
work culture for the organization. One of the major factors impeding Xerox’s feasibility to
change was its organizational culture. Xerox’s culture had declined to the point that the
directors were culturally disinclined to question management, as the director’s personal gains
were at stake.

Xerox’s story also demonstrates the desperate need for moral values in a business. Xerox’s
recent success story is due to Mulcahy’s creation of an organizational culture built on a
foundation of ethics and accountability, precisely the kind of culture that Xerox lacked under
Allaire. Indeed, Xerox was guilty of a considerable number of accounting tricks that involved
manipulating reports. It improperly recognized revenues with an intention to increase short-
term results, by overstating the value of future payments from leasing agreements. It also failed
to write off its mounting bad debts, another example of attempting to paint a rosier picture of
the company’s finances through fraudulent means in order to increase investor confidence.
Thus it is clear from the case that creative accounting offers a formidable challenge to the
accounting profession and the business world as a whole. Even though it is legally acceptable, it
is no way ethical on any account. Thus companies should avoid using Creative Accounting, also
on account of the fact that sooner or later it leads an organization into such a spiral from which
it can never recover.