Creative Accounting Sample Essay

Creative Accounting

Financial statements are the primary documents that are used by internal and external stakeholders to gain an in-depth understanding of the general financial performance of a company. The financial data extracted from these documents constitute crucial information that influences the decisions of these stakeholders concerning company management and performances. Therefore, the accuracy and reliability of these documents is a crucial factor to considers in order to make appropriate business decisions.  This fact became a point of focus and importance following the collapse of well-established companies like HealthSouth, Enron, and WorldCom in 2001. Its significance is further intensified following the recent financial crises that have resulted in the collapse of many financial institutions around the globe.

To generate transparent, reliable, and timely financial statements, accountants should follow the guiding principles and standards as stipulated in the GAAP and IAS. Despite the existence of strong accounting standards (GAAP and IAS), it sometimes becomes impossible for accountants to create genuine financial statements without manipulating particular aspects of the business. These manipulative behaviors are primarily executed by the accounts who want to influence the decisions of users of these financial statements in favor of their corporations. The complex and unpredictable nature of the continuously changing business landscape makes it impossible to seal all the potential financial loopholes in advance when setting accounting and financial standards. However, Jones (2010) argues that even if the current accounting standards and regulations cannot prevent the financial scheming conducts in advance, they can curb it afterward. The purpose of this paper is to critically evaluate Companies’ use of Creative Accounting in Financial Reporting and examine its effects.

History and definition of creative accounting

Even though the practice of creative accounting has received many publications over the last few decades, there has always been an aspiration to manipulate business figures to create a favorable impression among business leaders. According to BALACIU and Alina (2010), the desire to make business figures more alluring to the public, stakeholders, and investors dated back more than 500 years ago. Luca Paciolo was an Italian mathematician, and early contributors to the field of accounting had developed the tradition of creative accounting in his book De Arithmetica (Balaciu & Alina, 2010) notes that. His records demonstrated that the Venetian trade men during that era had a practice of recording transactions between themselves by double-entry bookkeeping with inked quill-pens in primary and supplementary books. In case of any noticeable inconsistencies in these records, the ink column was periodically brushed over in the books to make the records more illegible. Citing from this example, it is evident that the manipulative behavior of figures in the business landscape is not a new phenomenon and date back five centuries ago.

Fast forward, the concept of account manipulation was brought into the light following the early researches of Copeland (1968). In his research, he defined the act as the ability of bookkeepers to skillfully manipulate their net profiting by either decreasing or increasing net profits or sales of their companies at will. However, Mulford and Comiskey (2005) demonstrated that account manipulation is a broad concept that also includes alterations in balance sheet transactions. Subsequently, the concept of account manipulation was coined into a business term “creative accounting” by a financial and economic journalist in the United King known as Griffiths. Numerous terms have since been coined to define the concept of account manipulation, including earning management in the US, innovative accounting, cosmetic accounting, financial engineering, income smoothing, or window dressing (Amat & Gowthorpe, 2004).

Similarly, several definitions have been coined over the years to describe the concept of creative accounting comprehensively. According to Griffith, creative accounting is the ability of business management teams to manipulate the accounting figures to achieve the desired outcome in their financial statement.  In scholastic sagacity, Pijper (2016) defines creative accounting as the ability of accountants to creatively manipulate figures reported in the accounting books without a break the set accounting standards (GAAP and IAS). Jones (2010) explained it creative exploitation of ambiguities or gaps in accounting rules by accountants in order to depict their preferred picture of financial performance.

Motivations for Creative Accounting

There are several motivations behind the application of creative accounting practices in the commerce landscape. One of the primary incentives for using these techniques is the projected increase in stock prices. Every corporation goes into business intending to increase its value. According to Carmen and Moroi (2019), the ability of a corporation to produce a sustainable and possibly growing stream of earning creates an illusion that the company is performing exceptionally and is likely to have a positive impact on the stock prices. One possible explanation for this phenomenon is that profitable business attracts investors who willingly pay a higher value for stocks because of the corporate earning power and increasing cash flow. The cash flow must either be provided currently or expected to increase soon. Therefore, by applying creative accounting techniques, companies may effortlessly communicate to potential investors that their firms are on a growth trajectory of having higher profit margins, thus attracting higher stock prices (Carmen & Moroi, 2019).

Another motivation behind the use of creative accounting in companies is to attract higher credits and lower interest rates. Creative accounting helps in improving specific key performance ratios used by creditors to determine the viability of businesses to obtain credit. Cernusca et al. (2016) argue that inflating company assets and understating company liabilities on the balance sheet is one way of improving the crucial performance ratios analyzed by creditors.  Also, to attract proper credits, companies can use creative accounting to conceal their unstable profits that portray as being susceptible to hostile takeover or stock fluctuations (Pijper, 2016). Creditors perceive companies with unstable net returns as less well managed and generally riskier in comparison to companies with stable returns. Furthermore, in certain instances, companies use creative accounting not to appear to be exceptionally profitable but to manage earnings down. However, the usefulness of this account manipulation will pivot on the acknowledgment or recognition of the reduced profit level as being valid by the key players (Pijper, 2016). For instance, during the Gulf War, oil companies applied income decreasing policies to evade the political consequences of a higher profit stemming from increased retail prices.

Techniques of Creative Accounting

There are several methods of creative accounting that companies have used to lure investors and creditors into investing in their businesses. Below are some of the significant creative accounting techniques:

Income Smoothing

According to Copeland (1968), income soothing is the ability of expert accountants to even out a company’s variations in net returns from one period to the next. This form of creative accounting is practiced by most companies in recognition of investors’ willingness to pay more for stocks from companies with steady and predictable cash flow as opposed to stocks from corporations with unsteady and unpredictable income. Investors’ term the volatile cash flow patterns of the later company as a higher risk investment and tend not to invest. Kliestikova, Kovacova, and Kliestik (2018) argue that the practice of income smoothing is not illegal as long as the preparers’ follows generally accepted accounting principles (GAAP). Bhasin (2016) note that expert accountants can use their accounting expertise to manipulate figures reported in accounting books without breaking accounting standards (GAAP and IAS) to ensure the legality of income smoothing.

One of the primary examples of income smoothing techniques is deferring revenue during a successful fiscal year in case the next business year is expected to be unfruitful. Also, the company can delay recognizing its sales during a challenging financial year in anticipation of a better return in the future (Bhasin, 2016). Additionally, a company may engage in deferring the recording of present time operating costs like payment of suppliers and rental fee, to subsequent period to make the current period earning look better.  It is, therefore, sensible why companies engage in some level of creative accounting techniques. However, implementing the income smoothing process requires a consideration of what the Internal Revenue Service IRS permits and total deception.

Overvaluing Assets

During the construction of a balance sheet, accountants put much focus on assets valuation. Like liabilities, assets can be categorized as either current or long-term. Some of the everyday items found in the asset category include intellectual intangibles, inventories, account receivable, and cash and equivalents.

Manipulating inventory

According to Ali, Butt, and Bin (2011), inventory represents an organization’s manufactured goods that are yet to be sold to the final consumers. The value of inventory is usually priced at a wholesale price but sold to the consumers with a markup. If the inventory is sold, its wholesale value is recognized as the cost of goods sold, and the total value is recorded as revenue in the income statement (Ali, Butt & Bin, 2011). Therefore, increasing any inventory value subsequently leads to an understatement of cost of goods sold, and consequently attracts higher cash flow, assuming the sales volume remain constant. With an illusion of higher net income, companies can easily attract investors and creditors.

A typical example of this practice was carried out by Laribee Wire Manufacturing Co. The company under financial difficulties in the late 1980s decided to record an imaginary inventory and carried other inventory at bloated values to create a favorable impression among six different banks. Laribee Wire Manufacturing Co. reported having received more than $3 million in profit, while in the real sense, it had made a massive loss of $6.5 million (Ali, Butt & Bin, 2011). Wire Manufacturing Co. got away with this tactic and managed to receive a loan of $130 million by using its inventory as collateral.

Provision for Doubtful Accounts

Account receivables are considered as current assets in the balance sheet. Therefore, corporations that employ accrual accounting can record the anticipated revenue in their account receivables immediately sales are made. Thus, during the process of recording anticipated sales on account receivable, accountants often have the opportunity to manipulate figures in the balance sheet. That is, when they want to create a favorable impression to investors, they can increase the company profits by acknowledging that there will be a deficient level of non-payment for goods and services already sold.

Undervaluing Liabilities

Another crucial technique that accountants use to practice creative accounting in the business landscape is to undervalue corporation liabilities on the balance sheet. Understating any form of company expenses is crucial in boosting the bottom line profit. The following are some of the techniques used in this category:

Masking Contingent Liabilities

According to Balaciu and Alina (2010), contingent liabilities are liabilities that a corporation can accrue and are contingent upon the outcome of an unpredictable future event. These liabilities are reported at the footnote on the financial statements if the contingency is possibly to occur, and the sum of liability can sensibly be estimated. Kliestikova, Kovacova and Kliestik (2018 ) note that a company contingent liability can be an anticipating law suit from a competing firm for violation patent right, pension obligation, or warranty obligation. Accountants can innovatively account for these liabilities either downplaying their materiality or underestimating them.  Underestimating contingent liabilities subsequently increases the company’s net income and shareholder’s equity. Bhasin (2016) notes that underestimation or downplaying contingent liabilities by corporation accountants is a violation of the GAAP and IFRS standards and regulation that requires firms to accurately record their contingent liabilities with full disclosure, prudence, and materiality.

Other Creative Accounting Techniques

“Big Bath” Accounting

According to Cernusca et al. (2016) big bath is an accounting practice where a company’s management team knowingly manipulate its income statements to make its poor net returns look much more worst than it really is, so that future  net returns look better. This practice is often implemented in a bad financial year that is characterized by significantly reduced sales and increased liability, and performance artificially inflated in the following year. There are several techniques that company CEO can use to carry out bid bath: delaying the realization of revenue, taking write-offs, or prepaying expenses (Cernusca et al., 2016).

Using Cookie Jar Reserves

According to Pijper (2016) cooking jar reserves are saving from companies previous quarters that are used by companies to inflate or maintain net income in the subsequent quarters. Like smoothing income, the intent of using cookie jar reserves in reporting net profit is to create an impression among investor that the company is on a steady growth trajectory thus attracting higher stock prices. Using cookie jar reserve to normalize financial statements is considered unethical and illegal because it potentially mislead investors into believing that the company is doing great while it is recording loses in almost every quarter. As Mulford and Comiskey (2005) states this technique includes making unrealistic estimation of the more common liabilities like warranty cost, loan losses, or sales returns. The recorded accruals are then stashed in cookie jars during good times and retrieved during tough economic times.

Abuse of Materiality Concept

According to Mulford and Comiskey (2005) material concept is accounting principle that allows trivial matters to be disregarded from financial statement while all material items to be disclosed. Therefore, abuse of materiality concept involves an intentional documentation of errors in revenues, expenses, equity, within the defined percentage limit. Companies engaging in this practice often defend their actions by arguing that the effect on net on the net income is too insignificant to influence investors’ decisions (Amat & Gowthorpe, 2004).

Getting Creative with the Income Statement

It consist of the practice of recording a dissimilar level of earning power by using the layout of the income statement instead of using the normal format in which transactions are recorded. For instance, corporations may label a recurring expenditure as nonrecurring or record nonrecurring revenue as a recurring revenue “other revenue” (Amat & Gowthorpe (2004).

Problems with Cash-flow Reporting

Cash-flow reporting presents company executives with other loopholes to use in communicating higher earning power to indicate a sustainable and consistent cash flow. A corporation’s ability to earn more profits from sales of its products and services is much greater when it has steady cash flow. Therefore, a company can classify financing inflow as operating item, or operating expenditure as a financing or investing item.  Jones (2010) argues that even though the following process may not potentially alter the total change in cash, it still increases cash flow from operations.

Other Important Issue to Address

If creative accounting is believed to be stemming from the presence of loopholes in the accounting standards (GAAP and IAS) maybe one of the principle roles belongs the setters in decreasing the possible negative effect of account manipulation. Milesi-Ferretti (2004) notes that the primary strengths of the currently practiced accounting standards (GAAP and IAS) is their ability to clear define and explain relevant accounting items which can help in preventing the  abuse of accounting principles that are fundamental to creative accounting. Milesi-Ferretti (2004) further acknowledges that the IAS are constantly being reviewed to keep up with the emerging trends of creative accounting and views creative accounting as the primary drivers to the formation and expansion of IAS.

Even though this point of view is correct, it would be more important for standard setters’ to intensify the careful definition and clear clarification qualities of the standard. It is impractical to completely seal all the loopholes being exploited by accounts to practice creative accounting. However, it would be practical to reduce at least the negative impact of creative accounting by strictly implementing the accounting standards, decreasing managers’ flexibility in deciding among different accounting methods, and giving more importance to ethical considerations of accounting practice.


The concept of creative accounting has attracted mixed reaction from practitioners and academicians. Some scholars and practitioners’ view creative accounting as an unethical and unlawful act while another equal proportion argue that the practice is ethical and legal because it only exploits the flexibility of accountings standards. Whichever way we decided to view this practice, it is important to acknowledge that it plays a pivotal role in massive accounting scandals that have recently hit the global business landscape. Furthermore, the practice of engaging in creative accounting stems from different factors other than accounting standard loopholes and motivation of firms to appeal to outside investors.

Milesi-Ferretti (2004) asserts that the practice of creative accounting results from the insufficiency in the legal framework for banking and accounting, difficulties in enforcing the legal and ethical rules due to slow functioning of the judicial systems, and inadequacies in the independence of governmental regulation and supervision bodies. The following are some of recommendations that should be implemented to curb the growing incidences of creative accounting.

  1. GAAP standards should be subjected to IAS and SAS standards to ensure the provision of comprehensive and effective rules and regulations of accounting practice within the business landscape to foretell the practice of creative accounting within organizations.
  2. Operators of accounts and those performing accounting duties should strictly embrace and adhere to global financial reporting standards like the international financial reporting standards (IFRS).
  3. There should be greater emphasis on enforcement of code of corporate governance and ethics. Regulatory bodies should effectively enforce changes in accounting regulations and ethical standard government code to prevent corporations from using deceptive reporting practices of creative accounting.
  4. External auditors should honestly carry their duty in identifying and reporting dishonest entries in the financial statements.
  5. Regulatory bodies should come up with rules and regulations that minimize the use of judgement prediction and estimations in the treatment of specific entries like extra ordinary item in financial reporting.


Creative according have recently hit the air waves following numerous accounting scandals around the globe. This paper comprehensively explored some of the critical creative accounting techniques, including Income Smoothing, Manipulating inventory, “Big Bath” Accounting, and Abuse of Materiality Concept. Generally, creative accounting has created formidable challenges in the accounting practice especially when carried to extreme negativity. Extreme creative accounting practices have often cast aspersion on the credibility of accounting standards and principles. As a result, there has been a rise in the need for close scrutiny of the potential abuses of accounting standards among corporations. Therefore, the effect of creative accounting on stakeholders as a whole should not be ignored and given much consideration than it is currently getting.




Ali Shah, S. Z., Butt, S. A., & Bin Tariq, D. (2011). Use or abuse of creative accounting techniques. International Journal of Trade, Economics and Finance2(6).

Amat, O., & Gowthorpe, C. (2004). Creative accounting: nature, incidence and ethical issues.

BALACIU Diana, Alina Beattrice Vladu (2010), “Creative Accounting – Players And Their Gains and Loses”, Annals of Faculty of Economics, Vol.: 1, issue: 2, pp. 813-819

Bhasin, M. L. (2016). Survey of Creative Accounting Practices: An Empirical Study. Wulfenia Journal KLAGENFURT23(1), 143-162.

Carmen, V. Ã., & Moroi, C. (2019). The Determining Factors of Creative Accounting. Ovidius University Annals, Economic Sciences Series19(2), 927-933.

Cernusca, L., David, D., Nicolaescu, C., & Gomoi, B. C. (2016). Empirical study on the creative accounting phenomenon. Studia Universitatis “Vasile Goldis” Arad–Economics Series26(2), 63-87.

COPELAND, Ronald M. (1968), “Income Smoothing”, Journal of Accounting Research, Vol. 6, pp. 101-116

Jones, M. J. (2010). Creative accounting, fraud and international accounting scandals. John Wiley & Sons.

Kliestikova, J., Kovacova, M., & Kliestik, T. (2018, April). Hiding the bankruptcy through creative accounting. In Proceedings of International Academic Conferences (No. 7508682). International Institute of Social and Economic Sciences.

Milesi-Ferretti, G. M. (2004). Good, bad or ugly? On the effects of fiscal rules with creative accounting. Journal of Public Economics88(1-2), 377-394.

Mulford, C. W., & Comiskey, E. E. (2005). The financial numbers game: detecting creative accounting practices. John Wiley & Sons.

Pijper, T. (2016). Creative accounting: The effectiveness of financial reporting in the UK. Springer.

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