The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 1, No.

5, November-December 2013

Creative Accounting: A Literature

Review
Brijesh Yadav*
*Assistant Professor, Department of Commerce, Shaheed Bhagat Singh College (M), Delhi University, New Delhi, INDIA.
E-Mail: [email protected]

AbstractOur research objective is to show the effect of creative accounting on the performance of the
company which uses these techniques to manipulate their accounts to show desired results. We also discussed
about different types of creative accounting and parties involved in it and what are the motivation factors so
that people are involved in creative accounting techniques. We also talked about Anglo-Saxon and European
continental types of creative accounting in which they allowed different types of alternative method for
creative accounting. We also analysed involvement of different professionals in creative accounting like
accountant, lawyers and bankers. They help companies in deciding about the different instruments which help
company to involve in creative accounting. Corporate governance can play an important role in financial
reporting of the company because financial report shows the state of affairs of the company and investors take
decision on the basis of financial report of the company. So it is necessary that financial report should show
True and Fair view of the company. Professional and managers ethical responsibility is also discussed in our
study. In which it is analysed who will be responsible for the failure of the company.
KeywordsCorporate Governance; Creative Accounting; Creative Disclosure Framework; Financial
Reporting; Financial Scandals; Sarbanes-Oxley.
AbbreviationsFinancial Reporting Standard (FRS); Generally Accepted Accounting Principles (GAAP);
International Accounting Standard (IAS); International Accounting Standard Board (IASB); International
Financial Reporting Standards (IFRS); Securities and Exchange Commission (SEC).

I.

INTRODUCTION

HEN we open this true Pandoras Box: Creative

Accounting then we understands when and why
exactly the concept first appeared and what
influenced its development that arose many questions.
With hindsight a few favorable circumstances to this
concept can be identified, circumstances first related to the
economical advent of world states but at the same time to
need of economic entities to create for them a good reputation
in an increasingly competitive and tough economic
environment. About this particular moment, that is first
mention belongs to the founder of accounting Luca Paciolo.
This ambition of making figure more appealing or opposite is
as old as 500 years. Thus, Luca Paciolo was shaping in his
already renowned De Arithmetica, the first accounting
manual, practices of creative accounting.
Creative accounting refers to accounting practices that
may or may not follow the letter of the rules of accounting
standard practices but certainly deviate from those rules and
regulations. It may be characterized by excessive
complication and using innovative ways of characterizing
income, assets and liabilities. Some times word like
innovative or aggressive are also used for defining

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creative accounting. Creative accounting is a term which is

used as a systematic misrepresentation of the true and fair
income, liabilities and assets of corporations or organizations.
1.1. Definitions of Creative Accounting
Creative Accounting refers to the use of accounting
knowledge to influence the reported figures, while remaining
within the jurisdiction of accounting rules and laws, so that
instead of showing the actual performance or position of the
company, they reflect what the management wants to tell the
stakeholders.
Purposeful intervention in the external financial
reporting process with the intent of obtaining some exclusive
gain.
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 [Kamal Naser, 1992].
Every company in the country is fiddling its profits.
Every set of published accounts is based on books which
have been gently cooked or completely roasted. The figures
which are fed twice a year to the investing public have all
been changed in order to protect the guilty. It is the biggest

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con trick since the Trojan horse. . . In fact this deception is all
in perfectly good taste. It is totally legitimate. It is creative
accounting [Ian Griffiths, 1986].
Is the deliberate dampening of fluctuations about some
level of earnings considered being normal for the firm
[Barnea et al., 1976].
Is any action on the part of management which affects
reported income and which provides no true economic
advantage to the organization and may in fact, in the longterm, be detrimental [Merchant & Rockness, 1994].
Involves the repetitive selection of accounting
measurement or reporting rules in a particular pattern, the
effect of which is to report a stream of income with a smaller
variation from trend than would otherwise have appeared
[Copeland, 1968].
Schipper (1989) observes that creative accounting can
be equated with disclosure management, in the sense of a
purposeful intervention in the financial reporting Process.
Many terms can be used to describe the practices of
changing the facts in accounting, e.g. cooking the books,
aggressive accounting, massaging the numbers, window
dressing, earnings management, etc.
Table 1: Common Labels for Financial Numbers Game
Label
Definition
Aggressive
A forceful and intentional choice and application
Accounting
of accounting principles done in an effort to
achieve desired results, typically higher current
earnings, whether the practices followed are in
accordance with GAAP or not
Earnings
The active manipulation of earnings toward a
management
predetermined target, which may be set by
management, a forecast made by analysts, or an
amount that is consistent with a smoother, more
sustainable earnings stream
Income
A form of earnings management designed to
Smoothing
remove peaks and valleys from a normal earnings
series, including steps to reduce and store
profits during good years for use during slower
years
Fraudulent
Intentional misstatements or omissions of
financial
amounts or disclosures in financial statements,
reporting
done to deceive financial statement users, that are
determined to be
fraudulent by an administrative, civil, or criminal
proceeding
Creative
Any and all steps used to play the financial
accounting
numbers game, including the aggressive choice
practices
and application of accounting principles,
fraudulent financial reporting, and any steps taken
toward earnings management or income
smoothing
Source: The Financial Number Game by Charles W. Mulford &
Eugene E. Comiskey, 2002 (John Wiley & Sons)

II.

OBJECTIVES

Objective of the study is to find out the relationship between

creative accounting and types of industries which adopt
creative accounting to manipulate the financial figures. Types

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of creative accounting mean how many ways creative

accounting may be done and what are the solutions of
creative accounting so that the effect of creative accounting
may be minimized. Relationship between corporate
governance and creative accounting. Ethical behavior of
auditors to reduced the effects of creative accounting.
Who are the parties who will get the benefits of creative
accounting and what is the after effect of creative accounting
on the life of the organization. We have taken various
examples of worldwide companies like Enron, WorldCom
who have used creative accounting and shows different
figures to compete with other companies and their after they
collapsed.
We also try to look on the accounting standard parts
which allow creative accounting and how it should be
modified by the accounting authorities to reduce the effect of
creative accounting because in present scenario, the
accounting standards have some loopholes which provide
alternative methods of accounting e.g. Recognition of
revenue, methods charging for depreciation, recognition of
cost etc.
What are the ethics and responsibility of an independent
auditor and things to be keep in the mind at the time of
auditing by auditors also looked in the study.
We are looking the answer of effect on financial
reporting after making independent board in enterprise to
reduce the impact of the creative accounting.
We also want to try the answer whether it is good or it
brings company into the crisis. These are the some questions
for which we want to search the answer.

III.

REVIEW OF LITERATURE

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. It talks about
type of creative accounting like capitalizing interest, brand
accounting, methods of depreciation, stock valuation, and
accounting standards which prevent the major abuses which
used to occur and has issued a number of regulations in the
form of Financial Reporting Standards.
The main approaches which help accounting reader and
prevent creative approaches by companies are:
FRS 1 Cash Flow Statements
Profit was easy to manipulate according to critics of creative
accounting and therefore Accounting Standard Board
therefore issued FRS 1 which requires most of the companies
to publish cash flow statement. Although there are some
technical problem with it.
FRS 2 Accounting for Subsidiary Undertakings
In the 1980s, there were a number of complex schemes
where companies could bring profit without disclose their
source of income and hide certain liabilities and assets from
its balance sheet by operation of subsidiary style operations.
FRS 2 makes more transparent relationship between a
holding company and its subsidiaries.

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The SIJ Transactions on Industrial, Financial & Business Management (IFBM), Vol. 1, No. 5, November-December 2013

FRS 3 Reporting Financial Performance

This was a significant standard and has transformed the
appearance of the profit and loss account, and also introduced
some new financial statements. Instead of concentrating on
single figure profit Accounting Standard Board considers
companies to disclose information which reflects the various
elements which make profit up.
FRS 4 Capital Instruments
This standard has the objective of ensuring that capital
instruments are shown in financial statements in such a way
that truly reflects the obligation of the issuer. Under this
standard there was a clear definitions as to what must be
shown as a debt, non-equity shares, and equity shares with
clear rules.
FRS 5 Reporting the Substance of Transactions
In the past it has been possible for companies to report
transactions in a way which has been legally correct, but has
obscured the reality of the economic transaction. The
standard attempts to rectify this by setting out definitions and
the appropriate accounting treatments, particularly for
transactions like consignment stocks, sale and repurchase
agreements, and factoring of debts.
Naser (1992) stated that much is written about Creative
accounting and about the various schemes of window
dressing and off-balance sheet financing and very little
information is available how widely such schemes are used
by various companies. He has done a little empirical study to
find the relationship whether creative accounting is related to
the types of companies or industrial classifications, the reason
behind the use of creative accounting, perceived legitimacy,
consequences of the continued use of creative accounting,
and measures to be taken to minimize its use. Because of
much concern topic about creative accounting, it was difficult
to obtain data from companies about their own creative
accounting practices. However, it was felt by researchers that
external auditors ought to represent an alternative source of
creative accounting providing that their client information
will keep secret.
In 1988, they sent copies of questionnaire to auditors and
companies and got 15(out of 22) respondents that had had
experience of auditing companies (7%) never encountered
problem of creative accounting, 73% had found between 1
and 5 examples and 3(20%) had come across more than 5
examples. In this research he finds from his sample that
private companies provided most frequents encountered
examples of creative accounting and interesting was that all
companies appears to make some use of it. Similarly for
industrial classification, the result was that creative
accounting was likely.
Uurelu, Marin, Danail & Loghin (2010) explained that
the ethics in accounting and creativity. They stated that ethics
should be followed by an accountant and creative accounting
is big challenge for them. They talked about National Code of
Ethics for Professional Accountants of Romania.

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3.1. National Code of Ethics for Professional Accountants

It is divided into three parts. Part A establishing the
fundamental of principles of professional ethics for
professional accountants and also provide conceptual
framework for applying these principles.
Part B and Part C illustrates how the conceptual
framework should be applied in specific situations where Part
A is not applicable code recognizes that accounting.
Profession objectives are established to meet the highest
levels of performance and meet the public interest.
Achieving these goals involves meeting four basic
requirements:
Credibility: Throughout society there is need for
credibility in information and information systems.
Professionalism: There is a need for customers,
employers and other stakeholders can be clearly
identified those accounting professionals.
Service Quality: It requires ensuring that all services
obtained from the professional accountant are
carried to the highest standard of performance.
Confidence: Professionals accountants service users
must be able to feel confident that there is a
framework of professionals ethics governing the
provision of these activities.
Creative accounting is termed as synonym on for
deceptive accounting.
According to him ethical behavior of a person in
accounting depends on:
Moral Sensitivity: Which could be described as how
the subject comprehends the ethical dimensions of a
situation. In accounting, one can feel that a practice
can affects some people adversely or favorably. But
there are also some sentiments of greed, selfsufficiency than those related to good behavior.
Moral Judgment: Moral judgment or capacity to
judge which alternatives are ethically acceptable and
which are not. In accounting, objectivity, open
mindedness insight and perspicacity can be
considered as integrated within practical wisdom.
Moral Motivation: Moral Motivation understood as
willingness to take the moral course of action,
placing moral values above the other values and
taking personal responsibility for moral outcomes. It
plays a crucial role in selecting the right action and
in executing it.
Moral virtues or permanent attitudes and interior
strength formal behavior: among these virtues, those
which have special relevance to accounting are
truthfulness, honestly, loyalty, trustworthiness,
fairness, integrity, service to the common good,
gratitude and benevolence.
Courage,
perseverance,
competence,
diligence,
professional will help to defeat inner resistance to act as one
should.
Practical wisdom has been said, provides capacity to
perceive the right means for each virtue

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Stolowy & Breton (2000) described that creative

accounting is a concept dealt by professions particularly by
journalist and academics to a lesser extent.
i.
Creative Accounting in a professional perspective:
creative accounting is an expression that has been
mainly
developed
by
practitioners
and
commentators (journalist) of the market. The
motivation which they understood is what investors
want to see, than what actually was to mislead them.
ii.
Creative Accounting in an Academic Perspective:
creative accounting also entered in academic
literature, in the U.K. under the label of window
dressing. Manipulations of such amplitude are hardy
market anomaly. The behaviors of market
participants are different than the efficient market
hypothesis. The drama was that functional market
hypothesis work better where manipulations was
widely spread and have been dramatic effects on the
understanding of risk and return potential of the
firms.
iii.
Creative Accounting and Creativity: creative
accounting, as it is dealt with in a perspective,
almost nothing to do with creativity. It is more likely
to relate with accounting alternative than creativity.
However, there is on situation when accounting will have
been Creative. When a legal, economic or financial
innovation occurs without any existing accounting standard
to regulate it.
Smith (1998) classified accounting firms as structured,
intermediate or unstructured in terms of their audit
methodologies. Using US data at a time when the Big 8
accounting firms still predominated, he classified 22 auditing
firms. The number of accounting income increasing policy
changes was higher for structured auditors and massively
lower for unstructured auditors.
Smith also 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 ),
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.
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Out of above 12 techniques, those seven numbered as: 1,

2, 4, 8, 9, 10, and 11 having a cleared income effect.
Accounting policy change with an income effect is less
clearly attributable to an auditor effect in U.K. study than his
earlier Australian study.
Blake & Salas (1996) explained that creative accounting
is seen as widespread in the U.K. and undermines the
credibility as a disease.
During 1990s, 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 can not be solved completely and in U.K.
95% thinks so. They also compared Anglo American with
continental European.
Mati et al., (2012) described creative disclosure as a
feature of creative accounting. It is also known as impression
management in literature. It can be found in corporate annual
report under forms of distortion of narratives of numerical
and graph manipulation. They gave importance to theoretical
framework than empirical study because interpretation of
empirical analysis is impossible without theoretical guidance.
Creative presentation must be regarded as a complex
mechanism that includes motives for engaging in
manipulation of accounts, types of information disclosed and
types of manipulation strictly connected to presentation of
information.
There are two types of information disclosed:
(i) Verbal information and
(ii) Numerical information
They are considered to be a part of following strategies
which regard manipulations connected to presentation of
financial information as follows the summarize form of
strategies includes:
Using a creative accounting manner to make the text
difficult to read;
Using persuasive language that comprises only
positive words and emphasizes positive financial
performance;
Using creative accounting visual manipulation in the
way information is presented with the scope of
attracting the attention from other items that are
important but in the same time are not flattering for
the financial performance presented.
Using performance comparison that involves
choosing the benchmark that portrays current
financial performance in the best possible light.
They were explaining about the positive language
used to report the financial information to
stakeholders, which make them difficult to

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understand the language used in reporting and they

invest money in bad investment. This type of
manipulation is known in the literature also under
the name of Positive Bias .
They also explained about Polly Anna Principle
(concept introduced by Hildebrandt & Synder, 1988)
managers used to present financial performance of
the firm in the best light possible using only positive
words.

Figure 1: Creative Disclosure Framework

The creative visual manipulation disclosed information

to influence decision, using creative visual effects to
underline a part of the corporate report or an item in order to
make it more oblivious to users (e.g. figures, font, style, size
of the letters or numbers, color etc.)
To create a strong visual effect the ordering of the items
location is also important like first part of the corporate
reports can be chosen and those items which minimize the
favorable direction last parts of corporate reports to be
chosen.
As stated above information disclosed can be either
verbal or numerical. The particular creative presentation is
related to numerical which can be either inside numerical
information the lowest prior, period comparative benchmark
earnings number can be chosen to report in this respect the
highest year-on-year increase in earnings.
In external numerical information can be constructed
from the lowest competitors in a cross section analysis of
industry performance.
Rabin (2005) described about auditors attitude towards
creative accounting and ethical behavior of auditors.
Auditors ethical judgment is formed by the provisions of the
code, organizational policies governing ethics and individuals
own moral agency. Ethical judgment is fundamental to
auditors in forming opinion whether financial statement fairly
present the financial position, result of operations and cash
flows of an entity and it is distinct from compliance with
statements of GAAP Accruals are preferred method for
manipulation accounting information because they are
difficult to trace directly management can manipulate the
timing of the reorganization of a transaction. The three
dimensions of auditors evaluation of the quality of financial
reporting contained in the scenarios reporting practices
(understandability, relevance and reliability) are:
Firstly, this finding seems to supports that quality
assurance has come to be regarded as that the ethical

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principles section of the code has little impact on professional

practice modeled in the formative mode.
This research article provides insights into the attitudes
of auditors when they assess creative accounting practices
and secondly, identified that relevance and reliability are
more important than understandability in assessing the
quality of financial information.
Thirdly, the findings of this study was that auditors
perceive that meeting analysis and management targets, the
maximization of remuneration and a lack of corporate
governance are factors that influence the use of aggressive
accounting by management.
However, auditors attitude towards creative accounting
were not associated with the existence of these factors and in
the last point, research model find negative relationship
between experience and auditors attitudes towards creative
accounting, indicating that the more experienced an auditor
is, the less likely it is that he/she will agree with
managements creative accounting choices.
Cosmin (2010) described the various techniques used by
the managers to get desired results.
A census (not exhaustive) of the techniques used in
creative accounting:
1. Tangible assets: subjective depreciation of assets
creates proper field of creative accounting of
management estimates that recoverable value is
lower than net accounting assets are considered
impaired for difference. The result will be affected
by recording a depreciation expenses.
2. Goodwill: Goodwill increases by underestimation of
assets purchases capitalization and depreciation of
goodwill during its useful life have influence on the
outcome of further coming year.
3. Depreciation: Option for depreciation method has
impact on the profit and loss during useful economic
life of an asset. Thus, a different method of
depreciation has different impact on outcome. An
option on different useful life leads to different
expenditure.
4. Inventories: The inventory provides sufficient
opportunities
of
creative
accounting
and
subjectivism. The under estimation or over
estimation of stock finally has an impact not only on
the financial statement of current year but also on
the following year.
5. Provisions for liabilities and charges: A practice
provision (increase and decrease thereof) is an
effective tool for leveling outcome. Establishment
of provisions in those years where the profit results
lead to decrease, while the resumption of the
provisions in the income year in which the registers
deficit increase leads to the result.
6. Construction contracts: Choosing between the two
methods of accounting for construction contracts has
the following impact on the profit and loss: - Under
the completed contracts, the result will be
recognized after the completion of contract, while in

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method based on percentage of definitive result will

be staggered over time, throughout the progress of
the contract switching from one method to another
method also impact on profit and loss account.
Mechanisms that have an impact on the balance sheet
will be listed in the following table:
Table 2: Creative Accounting that Impact on the Balance Sheet
Elements
Mechanisms
Impact on balance sheet
Tangible
Lease-back: the sale of
- Improvement revolving
assets
fixed assets, followed
fund;
by taking them in the
- Improve cash.
Immediate location.
Tangible
Revaluation of tangible
- Increased asset value
assets
Assets
(increase in depreciation
and equity
expenses)
- Increased equity
Minority
Inserting in equity,
- Change indebtedness and
Interests
debt, or between the
equity.
two alternatives.
Loans
In substance defeasance - Reduced rate
arrangement by which
indebtedness;
the transferred assets to
- Increase rate financial
a trust, which
autonomy;
incorporates the same
- Increase financial
time and management
profitability.
of debt.
Customer
Discounting of ticket
Reducing the need for
Claims
Orders
working
capital;
- Increased Treasury
Assignment of claims
Slight decrease of working
from a pool of
capital
(from the difference
between price and
value of transaction);
- Decreased need for
working capital
- Increased Treasury
Source: Cosmin, L. I. (2010). A census of creative accounting techniques.
Romanian economic business review, 5, 4-1 , 104-108.

Proposals on limiting the creative accounting techniques:

First is the reducing the number of permitted
accounting methods or specifying which method
should be used in given circumstances,
Trading links will be considered as a whole
(substance over form),
Encourage to regular review (revaluation of assets)
Creating arbitration institution,
Auditors should to intensify their efforts to identify
the possible manipulation of information supplied by
the financial statements.
Matis et al., (2009) explained taking Romanian example
How cash is a king and Creative accounting impact profit and
loss account and balance sheet but cannot impact on cash
flow statement because it is a lot harder to manipulate
because you can raise value or minimize value but you cannot
make the money pops. So, it is not surprising that the scope
for creative accounting is here quietly restricted but not
impossible. In Romanian, managers have begun to look
deeply into cash flow hedging opportunities techniques. As

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well as the creative accounting techniques, applied to cash

flow reporting hedging techniques have an influence on
future cash-flow, affecting the result in specific ways.
Cash flow hedging is focus on two main areas: Foreign
Exchange and Interest risk management.
As far as foreign exchange hedging instruments and
concerned the interest is increasing.
One of the simplest hedging instruments is a forward
agreement, based on foreign exchange rate.
According it IAS 7, the amounts are to be included in
cash flow report are actual amount paid or received.
Therefore, the rates at settlement/payment data are used. The
exchange difference is relevant in calculating the amounts
paid or received. Unrealized foreign currency differences are
not cash flows and will be excluded from cash flow
statement.
In other area for cash flow hedging area is reserved for
interest risk management. A simple and used method is IRSInterest Rate Swap that has the effect foe the company of
transforming a variable into a constant.
Based on fundamental research and both the discussion
with experts in the field from Romania, we narrowed this vast
area of creative accounting regarding cash flow at the
following presented in Table 3:
Areas
Lack of
honesty
regarding
accounts
payable

Non
operating
cash

Capitalization
of expenses
that are
questionable

Table 3: Creative Cash Flow Areas

Creative cash flow
A company has written a check for one of its
suppliers and while the check is in the mail this
particular cash manipulating company will not
deduct the accounts payable with honesty and puts
those amounts in the operating cash flow as cash
on hand.
Another way for a company to boost its cash flow
image is related to delay in writing all their checks.
Non-operating cash is usually money which has
nothing to do with business (e.g. money from
securities trading). To include this particular non
operating cash it would only distort the true cash
flow performance of the company's business
activities. They should be dealt with separately.
The ultimate goal is to distort the operating cash
flow.
Not all of capitalizations of expenses are
questionable.
The
capitalization
became
questionable if the expenses are regular production
expenses, which are part of the operating cash
flow performance of the company. If the regular
operating expenses are capitalized, they are
recorded not as regular production expenses but as
negative cash flows from investment activities.
While it is true that the total of these figures operating cash flow and investing cash flow remain the same, the operating cash flow boosted
than that of companies that deducted their
expenses in a timely fashion. Basically, companies
engaging in this practice of capitalizing operating
expenses are merely juggling an expense out of

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Selling
Accounts
Receivable

one column and into another for the purpose of

being perceived as a company with strong core
operating cash flow. The ultimate goal is to pop up
the operating cash flow.
This is also called securitizing. The agency buying
the accounts receivable pays the company a certain
amount of money, and the company passes off to
this agency the entitlement to receive the money
that customers owe. The company therefore
secures the cash from their outstanding receivables
sooner than the customers pay for it. The time
between sales and collection is shortened, but the
company actually receives less money than if it
had just waited for the customers to pay. So, it
really doesn't make sense for the company to sell
its receivables just to receive the cash a little
sooner - unless it is having cash troubles, and has a
reason to cover up a negative performance in the
operating cash flow column. This can distort the
operating cash flow from negative one to a much
boosted one.

Source: Matis, D., Vladu, A. B., & Negrea, L. (2009). Cash-flow reporting
between potential creative accounting techniques and hedging opportunities
case study romania. Annales Universitatis Apulensis Series Oeconomica,
11(1), 140-153.

Elisabeta & Beattrice (2010) talking about agency theory

in the field of creative accounting, which relates to the
conflicts of interests between users of accountancy
information.
An agency relationship comes into existence when one
party, known as the principal, entrusts management of their
assets to another party, known as agent, who has competence
and knowledge inaccessible to the principal. The most
common form of agency is that in which a manager operates
on behalf or a shareholder.

From this point of view in the life of an enterprise. We

can identify two categories of actors having a special position
[Feleaga, 2006].
On one side, the shareholders, who have rights after
the creditors, suppliers, employees etc. they take the
financial risk justifying the appropriation on a part
of the years profit and from the case of the entity
closing down,
On the other side, the leaders because they have
privileged information, taking into account the
position held in the enterprise and, therefore are
tempted to take advantage by allowing themselves
considerable advantages or generally by, directing
the entity towards a direction which is useful for
them.
The conflict of interest among different interest group is
the real cause of creative accounting. Managing shareholders
interest is to pay less tax and dividends. Investor-shareholder
wants to get more dividend and capital gains. Countrys tax
authorities like to collect more and more taxes. Employees
want to get better salary and higher share in profit. But
creative accounting puts one group or two groups to
advantageous position at the expense of others.
The IASCs framework for preparation and financial
statement, envisaged by the IASB. Presents the following
categories of users: current on potential investors, employees,
creditors, suppliers and other commercial creditors, client,
government and governmental institutions and the general
public. They may be divided into internal and external users.
Internal users are principally management personnel
within the company. They have responsibility to release
information and external users come into other categories.

Firm

Market

Investors
- Actual
- Potential
(Including
Shareholders,
Funders and
buy side
Analysts)

Intermediaries
- Stockbrokers
- Underwriters
-sell side analysts
- Auditors

- Managers
- Employees

Society

- State
- Local government

Other Stakeholders
- Trade unions
- Customers
- Suppliers
- Etc.

Figure 2: Players in the Field of Accounts Manipulation

Source: Stolowy, H., & Breton, G. (2004). Accounts Manipulation: A Literature Review and Proposed. Review of Accounting and Finance, 5-92

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The investors can be divided into four sub-groups: real

and potential shareholders and the real and potential
stakeholders.
Managers may or may not believe in market efficiency.
In case they do not, they can under to manipulate the number
to reduce the cost of capital and to satisfy demand of external
existing shareholders, to increase their own remuneration, to
decrease the overall risk of firm, or to avoid violating the debt
covenant or incurring political capital costs.
Table 4: Potential Gains and Losses in/from Manipulating Accounts
Players
Gains
Losses
Managers
Reducing the cost of capital
The job and
Keeping their job
reputation
Managing their remuneration
Respect the debts covenants
Official examination
Minimization of income tax
Gain tax advantages
Improve relations with
creditors, employees and
investors
Avoid political costs
Existing
Increase the market value of
Wealth transfer to
shareholders their bonds
the actual
Controlling employees claims Shareholders
Existing
Increase the market value of
Wealth transfer to
bondholders their bonds
the actual
Controlling employees claims Shareholders
Employees
Keeping their jobs
Their job from an
Increase the remuneration
unexpected
Bankruptcy
Suppliers
Keeping their client
Some money
following an
unexpected
bankruptcy
Clients
Continuous services
Services
Warranty respected
interrupted
Warranties not
honored
State
Tax to collect
No more tax to
Jobs for people
collect
Unemployed
people to
provide for
Bankers
Repayment of the loan
Some money
following an
unexpected
bankruptcy
Society
Keeping the job
Jobs lost and
Production of wealth
resources wasted
Source: Stolowy, H., & Breton, G. (2004). Accounts Manipulation:
A Literature Review and Proposed. Review of Accounting and
Finance, 5-92

Shah et al., (2011) tried to give answer that why do

managers do creative accounting and how they become
successful in performing such practices in the presence of
stringent rules and procedures. They also tried to explore
whether creative accounting practice is good or bring crisis in
the companies and link of corporate governance with creative
accounting. Many world examples given like Enron which
show higher profit than actual and then collapse. The role of
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debit and credit has also explained in which playing with

different items like assets, expenses or liabilities which
creates creative accounting and increase or decrease profits
according to their wants.
Corporate governance can play role to reduce the risks of
investors and show true and fair view of financial reporting.
There are some choices in current accounting rules under
International accounting standards and U.S. GAAP that allow
managers some choice in determining methods of
measurement and criteria for recognition of various financial
reporting elements.
Financial report should be audited by an independent to
reduce the information risk and to enhance perceived
integrity.
The audit committee of the board comprising of
independent non-executive role to prevent misuse of creative
accounting techniques and observance of ethical standards in
financial reporting. It was explained that 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.
Table 5: Rewards of the Managing Profits (Earnings Management)
& Financial Position
The Objectives & Benefits Companies
Category
Trying To Achieve
Share-Price Effect
Higher Share Price
Reduce Share Price Volatility
Increase Firm Value
Lower Cost of Equity Capital
Increased Value of Stock Options
Borrowing Cost
Effects

Improve Credit Rating

Lower Borrowing Costs
Relaxed or Less Stringent Financial
Covenants

Management
Performance
Evaluation Effects

Increased Bonuses based on Profits/ Share

Price

Political Cost Effects

Decreased Regulations
Avoidance of Higher Taxes
Source: The Financial Number Game by Charles W. Mulford &
Eugene E. Comiskey, 2002 (John Wiley & Sons)

Fierov has explained creative accounting in context of

joint stock company that how they show fiction statement
than reality to take a loan they show higher value of assets,
low profit again at the time of paying tax to the government
and again profit increases at the end of the year when
information is to be given to shareholders.
Creativity in the accounting comes at a time when it
should reach to the public in the form of true background,
figures and results. This transforms the actual financial
statements to those which the owner would like to achieve as
positive and favorable results of the company. It is the
shareholder and director who are responsible for the accuracy
of accounts. But the paradox remains with the fact that the
expert must to find out the accounting and tax levers to fix
situation when the enterprise gets into trouble through its

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creativity. It was also explained that whatever reason

whatever is creative accounting will always be reflected in
financial indicators and ultimately at the company solvency,
because not everything which looks like a profit is really a
profit. The truth is even that at the moment of artificially
overestimation of financial ratios of the company could fall
into solvency, bankruptcy, insolvency etc.
Creative accounting could be restricted at so-called
harmonization of financial reporting and by application of
mandatory IFRS (International Financial Reporting
Standards) IAS, which are international guidelines for
accounting also preparation and presentation of financial
statement published by the International Accounting Standard
Board (IASB).
Teodora & Nicolae (2009) has taken 110 samples to
explain the level in which financial accounting professional
comply with the professional ethics standards.
Based on results of survey they found managers do not
agree with the statement that financial-accounting
innovation and creativity is fraud. In their first hypothesis
testing questioned and they found based on survey results that
the financial accounting creativity and innovation is a wellappreciated performance. Survey results are also explaining
why creativity and innovation is used by companies and they
found the answers by their survey was that they want to get
additional financial resources, the desire to avoid legislative
ambiguities and tried to explain answer why companies do
not use creativity and innovation wasCorrectness, fear, existence and internal and financial
auditors, stakeholders.
Anonymous (1997) has explained what are the economic
incentives of creative accounting. Choice of creative
accounting is not causes because of performance but the
specific characteristics of the company. The relevant
economic variable gearing, size and earning volatility are
measurable and give predictable results. As more as a geared
a company the greater its use of creative policies to increase
its reported earnings. Larger organisation and those in
monopolistic, or more regulated, industries also have an
economic incentives to employ creative accounting.
Companies with economic power because of their bigger
market size tend to reduced or smoothed profit to avoid the
attention of monopoly authorities or costly lobbying by other
groups with a political agenda. Companies in the water
industries, hotels and leisure and brewing employ more
creative accounting techniques than companies in the
electricity and financial service industry which employ fewer.
Companys auditor also play a role to determine the
extent of creative accounting use in the company. Research
done and found that in big firms also auditors allow
creativity. The link between variables such as gearing, size
and earnings volatility and accounting policy choices occurs
because imperfection in capital markets create a real
incentives for companies to adopt creative accounting.
Park (1958) kept different approaches to explain the
types of thought necessary for developing accounting ideas

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principle. What are the thought process in creative accounting

and how we organise our thinking.
Creative thinking is necessary for measuring enterprise
financial position and operating performance and providing
information geared to managerial decision making. Mere
technical advancement cannot fill the bill. The impetus for
creative development must come in greater measure from
thinking generated within the intellectual circle of our own
profession. Must create receptiveness for the innovations and
should anticipate the demand for each new informational
device and its supporting rationale and educate the users of
financial information to their future needs
Nurturing open minded attitude need creative
accountancy research in accountancy. Office and factory are
laboratory of accountant. The general theory and technique of
accountancy will achieve its brillion future through directed
creative effort.
To accomplishment of objectives stated above involves
applying scientific method, eliminating logical fallacies and
using operational approaches to creativity to solve
accountancies problem and for expanding perimeter of its
theory.
Moldovan et al., (2010) focused on how information
provided by accounting effects external users, and mainly on
how and why distorted information gets outside of the
organisation into the hands of unsuspecting users. It was also
explained there is a inverse casual relationship between true
and fair view principal and creative accounting.
True and Fair cannot be defined easily. Definition
given by some authors to this concept, first true and fair,
nether of which are easy to define and secondly there are
those who explain true and fair view in terms of generally
accepted accounting principles rather than accepting the
concept as an independent quality.
True and fair view through financial reports respect both
word of law and its spirit. It is acknowledge that true and fair
view expresses the responsibility of company management
and auditors to show the correct financial position of the
company.
In the anglo-sexon accounting system this principle is
valued more than any principles. As using more set of
accounting policies overriding for true and fair view which
provides accounting choices for different methods. The
chances of creative accounting increases. But it depends on
intention. If intention is not bad it will give true and fair view
of accounting information.
3.2. Professional Ethics in Creative Accounting
Creative accounting is a challenge for the accounting
profession. In practice, the situation in which under the
pressures of the management, the accounting professional
applies a certain accounting treatment provided by the laws
and regulations which show different image of the
organisation than true and fair one, which are countless. The
accounting professional is forced to balance ethics,
accounting principles and their job.

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It also tries to answer whether creative accounting is

fraud? But it said creative accounting technique can be called
aggressive accounting but it is not a fraud because it is not
against the law.
A poor corporate governance is leading factor together
with a weak internal control and a lack of honesty and
transparency in presenting the companys performance which
allows creative accounting to crawl in.
For the solution of creative accounting cash flow
statement is suggested because it is not easy to manipulate
accounting in cash flow than accural base system. Forensic
accounting should be taught to the students to know the
dangers of getting involved and how to detect the application
of such techniques.
Gherai & Balaciu (2011) has taken examples of
accounting scandals that have left traces in the history due to
their strong impact like the Enron phenomenon, Paramalat,
Worldcom, Xerox, Xerox, Ahold Royal, or Equitable Life
bankruptcy are few examples.
Enron, WorldCom which were collapsed in year 2002
used accounting techniques to show manipulated accounts
which decrease the confidence in financial reporting, audit
reports and regulations governing the professional
accountancy. To improve old rules and setup new stream
lines were supported by all countries effected by the
bankruptcy crisis.
Thus the law Sarbanes-Oxley from 2002 is one of the
reforms that have repercussions throughout the world by
adopting the standards belonging to foreign trade companies
in U.S. market and determination of other countries to study
its provisions and act on his own benefit. Many countries
made law related to corporate governance like New Zealand
and Australia.
Companies show different depreciation method, life of
assets, residual value of assets to fluctuate the earnings.
Mangers have role to shows fluctuating profits which puts
firms into financial crisis after showing profits and growth in
beginning year then they collapsed. To exclude creative
accounting from balance sheet auditors and management
have to play a big role and provide true & fair view by
financial reporting. It is not possible to eliminate creative
accounting completely.
Vladu & Mati (2010) tried to explain the topic of
creative accounting and corporate governance in the context
of internal demand for manipulative behavior which
emanates from the contracting value of earning management
in the principal-agent relationship between shareholders and
mangers poor corporate governance causes manipulating
accounting practices.
The topic of information asymmetry is also discussed
since no approaching regarding creative accounting omits it.
In which one party has better information than other party in
the context of managers and shareholders where manager has
more information than shareholders in an enterprise.
Information asymmetry work in context of capital market.
The CFO and board of company know more than the

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shareholders and other users about the profitability of the

company.
Five theories have provided the theoretical underpinning
for research opportunistic behavior in the area of corporate
governance.
Which are:
Agency theory
Legitimacy theory
Institutional theory
Signaling theory and
Stake holder theory
Describing different aspect in association with
managerial opportunistic behavior.
There are two different patterns through which
companies are financed and both of them affecting
accounting earning the companies are related to the corporate
governance model that prevails in a particular country. If
corporate governance model is the shareholder model if
countries belongs to the Anglo-American accounting model.
Capital market has a great role in financing companies in the
context and as consequences great importance will be put on
information available to share holders. Companies are
dominated by equity shares and there is a great separation
between managers and owners and as consequences
information exists and incentives to manipulate accounting
information are considered to be strong.
If a country belonging to euro-continental accounting
model, then the corporate governance model that is reflected
in this context is the stakeholder model and great emphasis is
placed on the information presented to the creditors (e.g.
Banks).
Five basic subjects are covered by the OECD Principles
of Corporate Governance as following:
Protection of the rights of shareholders;
Equitable treatment of all shareholders comprising
full disclosure of material information and also the
prohibition of abusive self-dealing and insider
trading;
Equitable treatment of all stakeholders as established
by law and encouragement of cooperation between
company and stakeholders;
Timely and accurate disclosure and transparency
with respect to matters material to company
performance, ownership and governance;
Strategic guidance of the company and effective
monitoring of its management by the board of
directors as well as the boards accountability to the
company and its shareholders ensured by the
corporate governance framework.
Healy & Wahlen (1999) described about how standard
setters should decide or make accounting standards to reduce
the possibility of earning management. Information about the
company is provided by the financial reporting which should
show the true and fair view of company but managers
manipulate the financial numbers than actual due to their
personnel interest like to increase their management

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compensation, to provide low salary to employees, to pay less

dividends to the shareholders.
Standard add value if they enable financial statement to
show difference between the relevances and reliability of
accounting information under alternative standards.
The chairman of SEC, Arthur Levitt, express worried
over earning management and its impact on resource
allocation. Some creative accounting techniques noticed like
pre-mature revenue recognisation, cookies jar reserves, and
write-offs of purchased in-process R&D are threatening the
credibility of financial reporting. In this article, reviewers
want to find the answer of a central question for standard
setters and regulators, therefore, is to decide how much
judgement to allow management to exercise in financial
reporting.
The standard setters are likely to be interested in
evidence on:
a. The magnitude and frequency of any earning
management,
b. Specific accruals and accounting method used to
manage earnings,
c. Motives for earning management and
d. Any resource allocation effects in the economy.
Much of the academic research on earning management
is of only limited value to standard setters and regulations.
Earning management occurs due to various reasons,
including influence market perception, to increase
management compensation, to reduce the likelihood of
violating lending agreements and to avoid regulations.
Balaciu et al., (2009) has done short review of creative
accounting topics and its development to know about what
are the motivations for creative accounting literature and
solution to this creative accounting term. They tried to
correlate creative accounting with different interest area like
bankruptcies, audit, governance, financial market, the public
sector and quality of financial reporting to prevent creative
accounting by taking various articles from scientific data
source like Science Direct, Emerald, Repec, Google Scholar
etc.
Amat et al., (1999) perceived the various methods of
creative accounting can be considered to fall in four
categories:
i.
There are different options to choose accounting
methods sometimes like in many countries for
example; a company is allowed to choose between a
policy of writing off Research and Development
expenditure as it occurs and amortizing it over the
life of the related project. A company can therefore
choose that accounting will give them preferred
image.
ii.
Some entries in accounting involve an unavoidable
degree of estimation, judgment and prediction. In
some cases for example, in estimating life of an
asset for calculating depreciation, these estimates are
normally made inside the business and the creative
accountant has opportunity to err on the side of
caution or optimum in deciding estimate.
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iii.

Artificial transactions can be entered for the purpose

of manipulate balance sheets amount and increase
profits between accounting periods, which is
achieved by two or more related transactions with an
obliging third party, normally a bank.
iv.
Genuine transactions can also be timed so as to give
the desired impressions in accounts.
Following are the methods which can be used to tackle
each of these approaches by accounting regulations who wish
to curb creative accounting:
i.
Choice of accounting methods can be reduced by
reducing the number of permitted accounting
methods or by specifying the circumstances in
which each method can be used.
ii.
Abuse of judgment can be curbed in two ways. One
is to draft the rules that minimize the use of
judgment and second is apply consistency so that if
one country applies one method which suits in one
year also applies the same in unfavorable year.
iii.
Artificial transactions can be tackled by invoking the
concept of substance over form where by
accounting substance determines by economic
substance rather than legal form of transactions.
iv.
The timing of genuine transactions is clearly a
matter for the discreation of management. However,
the scope to use this can be limited by requiring
regular regulations 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
3.3. Reasons for Creative Accounting
Following are the reasons for the directors of listed
companies to manipulate the accountants are as follows:
Income Smoothing, company prefers to show steady
growth in profit rather than fluctuating high or low.
So, companies charged provision for liabilities
against assets to reduce profits in good year.
A variant on income smoothing is to manipulate
profit to tie in to forecasts.
Company directors may keep an income boosting
alternative in hand to avoid unfavorable news.
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 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 company.
Manager can use creative accounting to delay
release of information for the market, thereby
release of information for the market, thereby
enhancing their opportunity to benefit from inside
knowledge if the directors engage in insider
dealing in their company.
The position taken by Ruland (1984) and compare it to
Revsines analysis on following notes:

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Moral rules apply to actual action and the

teleological view that an action should be judged on
the basis of the moral worth of the outcome.
Positive responsibility, which here would be the
duty to present a negative and unbiased accounts
where managers are responsible for state of affairs
they fail to prevent.
Duty to refrain would imply avoiding the bias
inherent in creative accounting while the duty to
act would involve pursuing the consequences to be
achieved by creative accounting. There had been
many ethical surveys done in Spain and U.K. to
decide about the ethical value of accountant which
showed Spain thinks creative accounting less
dangerous than U.K
Shah (1996) examined the process of creative
compliance in case of complex convertible securities issued
by U.K. listed companies between years 1987-1990. There
was an active dialectic of creativity in designing these types
of instruments. A thift from avoidance to rules to avoidance
again.
Lawyers, accountants and bankers all were involved in
creative compliance.
During 1987-1990 convertible securities attracted a lot
attention from financial engineers. At that time there was no
laws or standards of accounting for the treatment of
convertibles so, no rule stated whether it is taken as equity
outset or coupon rate is charged to profit and loss account. It
was this gap in rules which provided creative accounting.
Than again one more such instrument premium convertible
bond comes into existence. One of the difficulties of
analysing the process of creative compliance is the potential
sensitivity of data collection as one of the most obvious
sources of evidence.
It exposed closed co-operation between various groups
of professionals-lawyers, accountants and bankers- in the
development of the scheme. Companies were willing to
subscribe this scheme at significant cost and for a while,
successful creative compliance was attained, regulators were
slow to respond and when they did make pronouncement,
companies once again circumvarented the rules with the help
of various professionals. Auditors compromised their
positions as quasi-regulators and permitted companies to
circumvent best practice. Close exposure also exposed the
involvement of lawyers in the designing of these instruments,
suggesting that creative compliance schemes requires direct
co-operation from professionals who are familiar with the
existing regulations and can provide the necessary credibility
to the new schemes. Small groups of professionals were also
involved in designing and execution of scheme perceived
commercial benefits that they went on market them to new
potential clients with the hope of enhancing their profits.

IV.

CONCLUSION

After reviewing different articles from different scientific

data source like Science Direct, Google scholar, Jstore and
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Emerald etc we can say that creative accounting is biggest

problem in showing financial reporting disclosed by the
companies which is affected by different incentives perceived
by the different interest groups in the company like mangers
want to show higher profit to increase their compensation, to
increase market price of share of the company and show low
profit so that they can deny the demand of increase in salaries
and incentives of the worker and have to pay low taxes to the
government.
Creative accounting is not a fraud but it takes the
benefits of loopholes in the accounting standards and
regulations. It cannot be said fraud because it works within
the framework of law. It takes advantage of multiple options
available in accounting standard to show the transactions like
different methods of depreciation method and estimating
useful life of the assets, different options available in revenue
recognition as well as loss recognition, different methods are
available in valuing stock inventory whether use lifo or fifo
method for valuation of inventory. Managers use that method
which increases their benefits in that year and shows higher
profit.

V.

RECOMMENDATION

For improving financial reporting quality and to increase the

faith of investors in companys financial report corporate
governance can play a big role in which independent
directors can be chosen by the shareholders which works
upon the mangers activities and keep eyes on managers
activities. Because financial reporting is true indicators
companys operating activities and should provide true
information to shareholders about the companys state of
affairs. So that investors can take decision to invest in
company or not. In that area, independent auditors can be
employed to check the state of affairs of the company and
give true and quality information to the share holders and
stakeholders like creditors bank etc. they should work
without any pressure of the management.
Ethics of auditors is also explained in which it was
discussed that auditors have some ethics to the society and
mangers have also some ethics to not show the manipulated
figures but to show true and fair view of the company.
Mangers should take responsibility of bad position of the
company. Auditors should provide good information to
shareholders and check all the transactions and can ask from
the managers any suspicious account or dubious transactions.
They should provide quality and competent service to their
customers. An auditor should be confident, good knowledge
of existing law and regulations and he should be updated.
In the solution part of the creative accounting regularities
body should make law which reduces the chances of
alternative accounting methods. They should make the
provisions of that if one company chose one method in good
year it should choose same method in unfavorable year also.
In the end we can say that it is not possible to reduce the
impact of creative accounting completely because of
involvement of mangers and auditors and slow work of

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regularities bodies. We can work towards to reduce the

impact of creative accounting to some extent by credible
accounting in which it is to be stated that the impact of
creative and fraudulent accounting can be reduced by
streamlining the accounting and auditing system and more
effective corporate governance.
In India creative and fraudulent accounting can be
reduced by:
Introducing forensic accounting for white collar
fraud detection and fraud prevention;
Reducing the alternative choices of accounting
treatment in accounting standards;
Enhancing the quality of corporate governance;
Amending Companies Act;
Enforcing strong regulation, and
Increasing the effectiveness of audit.

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Brijesh Yadav. I have done my M.com from

Department of Commerce, Delhi School of
Economics, Delhi University in year 2012. I
am also pursuing in M.Phil from Department
of Commerce, Delhi School of Economics,
Delhi University in Accounting area. I am
also Assistant Professor in Department of
commerce, Shaheed Bhagat Singh College,
Delhi University from last 1 year. My interest
area is Accounting, Finance and Taxation which have been very
important area in commerce.

2013 | Published by The Standard International Journals (The SIJ)

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