Creative accounting. Reasons and ways to minimize

Annotation. The article describes ‘creative accounting’ phenomenon, analyses what leads to its application and suggests the means of its minimization.

Creative Accounting is the application of accounting knowledge that aims to influence reported figures, while conforming to legal rules and standards, so that instead of showing the actual performance or position of the company, they reflect what the management wants to tell the stakeholder.

The first mention of creative accounting belongs to Luca Pacioli, the founder of accounting. Thus, the concept of altering accounting figures extends back over five centuries. It becomes prevalent in the second middle of the 20th century. The recent financial crisis made this issue urgent to address.

Creative accounting bases on the opportunity to manipulate financial data using the flexibility in accounting within the regulatory framework. Notably, that financial statements are aimed to provide ‘true and fair view’, whereas the mentioned flexibility allows reporters to present not only creative, but also fraudulent view. [3, p.3-19]

The most common motives for creative accounting include:

• 1.    Personal needs of managers. It happens when their income depends on a company’s profitability, there are some special individual circumstances, for example, facing bankruptcy.

• 2.    Stock market pressure meaning the situation when investors expect a company to perform at a certain level.

• 3.    Tax minimization

• 4.    Cheaper financing achieved by showing better financial structure, gearing ratio.

To minimize creative accounting, it is important to address following areas for improvement:

• 1.    Better regulations and better enforcement. Countries worldwide should adopt laws like the Sarbanes-Oxley Act in the USA to increase the independence of external auditors and oversight role of boards of directors, introduce severe penalties for fraudulent activities. Such a rule as the separation of the roles of CEO and chairman should be in every country, this might considerably enhance the potency of internal controls. It is crucially important to write corporate governance policies and guidelines to dearly break the bonds between management and the independent auditor, and to spell out the responsibilities of boards of directors and audit committees to shareholders and the investing public. Also the clear definitions of creative accounting and fraud should be set to improve the legislation base for regulations enforcement. Longer sentences for fraud would signal that a country takes creative accounting seriously.

• 2.    Reward and incentive structures. Usually top managers have performance-related pay to increase loyalty of a manger to a company. It includes not only percentage from profit payment but also share options incentive. But in terms of creative accounting, such measures encourage managers to show better profits and ratios that would lead to share price increase. Therefore, there should be the golden mean.

• 3.    Increase of supervision. Following issues should be addressed within

• 4.    Codes of ethics. It is important to improve the ethical awareness of individuals. It be done nationally, through companies, or professionally. National codes of ethics, company codes or professional ethical codes should be developed, and where they exist already, strengthened. Such written codes of ethics will set forth what the government, company or profession expects from its citizens, employees or professionals.

internal environment of a company to ensure transparency: supervisory boards should consist from more independent non-executive directors, internal controls should be improved, external auditors should pay more attention to ‘risky’ areas such as transactions with related parties, revenue recognition, provisions, assets valuation, off-balance sheet financing, etc.

Overall, there will be always loopholes to conduct creative accounting and fraud, but suggested ways can minimize its scope. Ethical awareness enhancement should be targeted the most in this regard.