Creative Accounting: An Empirical Study on Its Implication

*Dr.ReshmaRajani
**Ms. Saloni Gupta
Abstract
Financial statements should depict the true and fair view of the companies. In todays
competitive environment companies are trying their best to enhance their earnings and create
goodwill and confidence amongst the stakeholders. Companies desire to present the reports with
the profits growing steadily have led to numerous accounting scandals over the past decades
such as Enron, Anglo-Irish Bank, Satyam Computer Services, Lehman Brother, Autonomy
Corp.This reveals that at least some accountants can be extremely creative with their finances
they control.Such practice adversely affects the decision of different users of the financial
statements. Creative accounting has emerged as a new way of manipulating financial statements
of the companies.Certain loopholes in Indian Accounting Standards are facilitating the
companies to indulge in such malfeasance to earn huge profits or save taxes. Account
manipulation attempts to show different financial results than what they actually are. The
research paper consists of the study which has been conducted to identify the different motives of
creative accounting and to find various measures to prevent such malpractice. Our exploratory
study examined and reviewed historical facts and past literature. To address this issue a
questionnaire was administered to 30 respondents. The study revealed that all the respondents
were aware about the creative accounting practice but the detection of creative accounting is
difficult as it is practiced within the framework of accounting system. This problem is not only
confined to India but is present in all the international companies too. The study concludes that
there is need for stronger enforcement and monitoring mechanism for International Financial
Reporting Standards in India. Streamlining the accounting and auditing system and enhancing
the practice of corporate governance appears to be the engines to make the accounting more
objective and transparent.
Keywords- creative accounting, financial statements, manipulation, accounting standards.

*Assistant Professor,Jagran College of Arts, Science & Commerce.Email:reshma_rajani@rediffmail.com

**Assistant Professor, Jagran College of Arts, Science & Commerce. Email:saloni7012@gmail.com

Introduction
Accounting is a business language. Accounting information includes income statement, financial
statement, budgeting, strategic planning, cost analysis, auditing, income tax preparation, cash
flow statement, performance measurements, evaluation, control and preparing managerial reports
for decision making. Accounting helps in communicating these statements, viz. the proprietor,
management, owners, creditors, debtors, bankers, employees, government etc. for forecasting,
planning, comparing and evaluating the earnings capacity and financial position of the business.
Hence, it is necessary that the accounting information must be clear, simple and easy to
understand and analysis and representation consists desirable information that is trustworthy.
However there have been many accounting frauds in the past. In some cases they have reached to
the tune of billions of dollars. In 2002, big accountancy firms like Arthur Anderson, Ernest and
Young, Price Waterhouse Coopers etc. were drag into court or they admitted negligence in their
duties. These companies were held responsible for preventing the publication of bogus financial
reports. Due to their carelessness, their clients were able to publish reports which were
misleading and gave a completely different impression of the clients company financial status.
In the United States of America the impact of Enron collapse was great as it was closely
followed by the bankruptcy of WorldCom Company. Then a series of similar scandals, Ahold
Royal in the Netherlands and Equitable Life insurance company in the UK, all these showed that
this was not just a U.S. phenomenon and the accounting and auditing practices have been widely
condemned (Dana SimonaGherai and Diana ElisabetaBalacin, 2011). Following this scandal and
many more by companies like Adelphia, Tyco International, etc.the Sarbanes Oxley Act was
enacted as a U.S Federal Law in July 2002 to safeguard the investors. In India the need for
corporate governance has been highlighted because of the scams occurring frequently such as
Harshad Mehta Scam(1992), Ketan Parikh Scam(1995), Satyam Scam(2007) etc. RamalingaRaju
the Chairman of Satyam Computers was alleged for funding the accounts of the company cash
and bank balances. Scams like Satyam have decreased investors confidence and have raised
questions on all large companies which were directly and indirectly related with it. This reveals
that at least some accountants can be extremely creative with their finances they control. Such
creativity can include the misdirecting or misuse of funds, understating expenses, overstating
revenues, understating liabilities and overstating corporate asset values, thereby misrepresenting
the financial state of a company. Certain loopholes in Indian Accounting Standards are

facilitating the companies to indulge in such malfeasance. Suchpractice of window dressing can
be referred as creative accounting or innovative accounting. Thus this paper attempts to identify
the different motives behind the practice of creative accounting and providing strong measures in
preventing such malpractice.
Definition and Concept of Creative Accounting
Kamal Naser (1993), offers this definition of creative accounting which presenting an academic
view: creative accounting is the transformation of financial accounting figures from what they
actually are to what preparers desire by taking advantage of the existing rules and/or ignoring
some or all of them.
Creative accounting is the process whereby accountants use their knowledge of accounting
rules to manipulate the figures reported in the accounts of a business (Amat, O. et al., 1999).
Methods of Creative Accounting
Following are the frequently used methods of creative accounting.
Off-Balance Sheet Financing such as deliberately failing to disclose financial liabilities.
Under depreciating fixed assets or changing the method of depreciation.
Income smoothing to reduce sales volatility.
Overstating the business stock or inventory to show higher profits and increasing current
assets.
Businesses that are involved in long term contract can manipulate profits by recognizing
revenue too early.
Window dressing for instance reporting next years financial sales in the current year or
hiding or ignoring current year expenses.
Capitalization of costs such as interest and research and development
At the time of mergers, amalgamation, acquisitions writing off goodwill against reserves.
Pre acquisitions write down and deferred consideration on acquisition.
Brand accounting capitalization of assets.
Contingent liabilities
Currency mismatch between borrowing and deposition.

Thus Creative Accounting is used to present assets and liabilities, income and expenditure in a
complicated way to incur huge profits. The frequency of large scale creative accounting fraud is
seldom, but is carried out with the support of key executives in a company, and may even rely on
the co-operation of officials in other corporation or affiliated companies. The officials present the
assets and liabilities in a very clever way with motive of saving tax money or increasing the
market share value. Creative Accounting can also be used to manipulate the value of publicly
traded companys shares for financial gains.
Literature Review
Creative accounting has been the subject of research, discussion and even controversy in many
countries these years. Much has been written on the topic in recent years. Numerous articles have
appeared looking at the different perspectives of the techniques companies use to 'make
statements what they want them to be' (Jon S. 1998). (Dilip2006) argues that the real incentive of
creative accounting is the conflicts of interest among different interest groups.(Stolowy and
Breton, 2000) suggest three broad objectives for earnings management: minimization of political
costs; minimization of the cost of capital and maximization of managers wealth. (Naser and
Pendlebury, 1992) questioned senior corporate auditors about their experience of creative
accounting. They were able to conclude that a significant proportion of all categories of
companies employ creative accounting techniques to some extent. Many research
studiesexamine a particular aspect or technique of creative accounting. According to
PriceWaterhouse senior partners observation (Conner1986), fraudulent reporting normally
occurs among those above management level in which effective internal control are designed.
Financial statement are commonly used to generate the delusion that company is in better
condition than it actually is by misapplication of the accounting principles to cover the economic
realities. There is a substantial literature on creative accounting, much of it originating in, and
concerned with, the United States. However, the US literature offers valuable insights into
creative accounting in any country with a reasonably highly developed capital market.A recent
comprehensive review of the US literature is provided by (Healy and Wahlen, 1999) there has
been a growth in the volume of literature discussing creative accounting issues.
Objectives of the study
The study aims to achieve the following objectives-

 To find out whether the creative accounting practice affects the financial reporting
system.
To examine the reasons for creative accounting practices.
To provide valuable suggestions to prevent such malpractices.
Research Hypotheses
Based on the above mentioned objectives, the following hypotheses have been formulated Ho.1- Creative accounting practices has no significant effect on the financial reporting
system.
Ho.2-Implementation of International financial reporting standards do not have significant
effect in preventing creative accounting practices.
Research Methodology
The survey method of research design was adopted in this study and non-probability
convenience sampling technique was used. The sample constituted of 30 respondents including
10 professional chartered accountants, 10 CA/CS students and 10 academicians of commerce
department of different colleges in Kanpur. In order to accomplish the purpose of the research a
questionnaire was made with 15 questions. For the response 5 point Likert Scale was used where
1 indicates strongly agree, 2- agree, 3- neutral, 4- disagree, 5- strongly disagree. The data
generated for this study were presented in a table and analyzed using mean scores. The stated
hypotheses were statistically tested using chi-square test.
Research analysis and findings
The hypotheses were tested using the chi-square test. The contingency table is given belowTable 1
Ho.1- Creative accounting practices has no significant effect on the financial reporting
system.
Responses

Observed (O)

Expected

(O-E)

(E)
Strongly Agree

Agree

21

15

225

Neutral

-6

36

Disagree

-6

36

Strongly Disagree

-6

36

30

342

Source- Field Survey

2

Calculation of

Degree of freedom

/E

=342/6

=5-1

=57

=4

ImplicationThe calculated value of

(57) is greater than the tabulated value of

=9.48 at 5% level of

significance. Hence, we reject the null hypothesis (Ho.1) and accept the alternative hypothesis
(H1). This indicates that creative accounting has significant effect on the financial reporting
system.
Table 2
Ho.2- Implementation of International Financial Reporting Standards does not have
significant effect in preventing creative accounting practices.
Responses

Observed (O)

Expected (E)

(O-E)

Strongly Agree

Agree

15

81

Neutral

-2

Disagree

-3

Strongly Disagree

-6

36

30

134

Source- Field Survey

2

Calculation of
=134/6
=22.33

/E

Degree of freedom
=5-1
=4

ImplicationThe calculated value of

(22.3) is greater than the tabulated value of

=9.48. Hence, we reject

the null hypothesis (Ho.2) and accept the alternative hypothesis (H2). This indicates that
Implementation of International Financial Reporting Standards have significant effect in
preventing creative accounting practices.
Table 3
Factors motivating the creative accounting practices (where 1- highest and 5-lowest score)
Factors for rating

Mean

Weighted
Average mean

a. Encourage investors to buy company stocks

2.47

2.26

b. Increase firms market value of shares

1.70

1.51

c. Avoid taxes

2.07

1.86

d. Easy availability of finances at low interest rates.

3.57

3.25

4.46

4.08

Healthy managerial performance

Source: Field survey
Implication-

In the Table 3, the mean and weighted average mean of various motives were calculated to find
out the main aim behind creative accounting. As the highest score is 1 and lowest is 5, the mean
score which is near to 1 is the highest rated option. Hence, it is clear from the table that the key
objective of creative accounting is to increase the firms market value of shares in market (with
the mean score of 1.70) following with the practice to avoid taxes (2.07). Attracting new
investors and retain the existing ones(2.47) also motivated companies to practice window
dressing. Easy availability of finance at low rate of interest (3.57) has been rated fourth and
healthy managerial performance (4.46) rated as the last drive to practice creative accounting.
Major findings of the study
In present scenario only 43% of the respondents agreed that the financial statements
depict the true and fair view of the companies and 60% of the respondents agreed that
creative accounting practice cannot be easily identified.

 All the respondents strongly agreed that independent auditors appointed should follow
the auditing standards.
73% of the respondents strongly agreed that public company should review the internal
financial reports time to time and enforce control to prevent losses.
70% of the respondents strongly agreed that financial reports must be certified by CEOs
and CFOs.
50% of the respondents strongly agreed that several legal and criminal penalties should
be imposed who indulge in such malpractices.
50% of the respondents strongly agreed and 40% agreed that familial relationship among
the leaders of the company and board of directors puts the company at creative
accounting risks.
40% of the respondents strongly agreed and 47% of the respondents agreed that the
financial players (CA/CS/Auditors/Accountants) have significant role in cooking the
books of accounts.
53% of the respondents agreed that companies practice of corporate governance.
Only 20% of the respondents agreed that the financial players follow ethical accounting.
Recommendations
The following suggestions can be made in line with the above findings The government should provide adequate environment for business so that the
entrepreneurs do not indulge in fraudulent practices.
There should be more than one auditor in the company and that should be rotated
periodically so that informal relationships do not affect the authenticity of the financial
statements.
Role of independent directors should be enhanced.
The financial statements of the companies entering the Indian market through mergers,
acquisitions or any other mode should be checked by two or more independent auditors
under the government supervision.
Transactions which are changed in special circumstances should be closely examined.
Rewarding and motivating employees in disclosing any manipulation going in the
company.

 Encouraging the new generation of accounting professionals to be honest and ethical in

their behaviour and accounting both.
Conclusion
Creative accounting has posed severe challenge to the accounting profession. The problem is not
only confined to India but is present in all the international companies too. The study concludes
that there is need for stronger enforcement and monitoring mechanism for International Financial
Reporting Standards in India. Streamlining the accounting and auditing system and enhancing
the practice of corporate governance appears to be the engines to make the accounting more
objective and transparent.
References

Amat,O et al., 1999, The Ethics of Creative Accounting, Journal of Economic

Literature Classification.

Conner, 1986, Enhancing public confidence in the accounting profession, Journal of

Accountancy.

Dana, S.G and Diana, E.B, 2011, From Creative Accounting Practices and Enron
Phenomenon to the Current Financial Crisis.

Dilip, K.S, 2006, Creative Accounting in Bangladesh and Global Perspectives.

Healy, P.M and Wahlem, J.M, 1999, A review of the Creative Accounting literature and
its Implication for Standards Setting, Accounting Horizon.

Hervey Stolowy and Gaeton Breton, 2003, Account Manipulation: A literature review
and proposed Conceptual Framework.

Jon, S, 1998, Why do companies use Creative Accounting?

Naser, K, 1993, Creative Financial Accounting: Its Nature and Use, HemelHempstead.

Naser, K and Pendlebury, M, 1992, A note on the use of Creative Accounting, British
Accounting Review.