Creative accounting refers to accounting rules being bent, or questionable accounting judgments being applied in the preparation of financial statements. The term is used as an innuendo for poor accounting behavior in organizations of all sizes.
Shareholders, managers, and wider civil society as a whole are all users of financial statements – they use them to be informed about the activity of an organization. The tax authority would like to see a company’s profit before tax, a labor union would be interested in the total wage cost of the firm compared to the prior year, and potential investors would like to track growth in revenues.
When creative accounting is applied, this can distort the picture shown to users of the accounts and can be considered financial statement fraud. False accounting is actually a criminal offense, as defined in the Theft Act 1968.
Why do people account creatively?
Accountants rarely employ creative accounting for the thrill or enjoyment of exercising power and control over the financial reporting of an institution. It is usually driven by pressure exerted on the accountants by senior management who wish to hit a specific financial target (or to not exceed a previous target by too much margin).
This pressure can be explicit or exerted indirectly on the accounting team, resulting in the accountants looking for any levers within their grasp that they could use to impact a reported result. This might include reassessing the valuation of large, judgemental provisions, or failing to accrue for a cost that has yet to be presented to the organization as an invoice, but which has certainly been incurred.
When does creative accounting become fraudulent?
Creative accounting becomes fraudulent the moment it has a material impact on the financial statements. Given that creative accounting is used purposefully to impact the result, in practice, creative accounting is virtually always fraudulent. If it had no material effect then why would an accountant bother to employ it in the first place?
What should you do if you see creative accounting?
The correct thing to do in these cases is to report the fraudulent accounting to your line manager or in some cases the Board of Directors or an independent whistleblowing hotline. You should be afforded some protection as a whistleblower within an organization but this has not been the case in reality. Some companies behave in a hostile manner towards whistleblowers.