Creative accounting definition
/What is Creative Accounting?
Creative accounting involves the use of unorthodox techniques to adjust the reported profit level or financial position of a business. Managers may engage in creative accounting to increase their bonuses, convince a lender to give the firm a loan, or increase its valuation in the event of a sale. Creative accounting can also be used to reduce reported profit levels, typically to avoid paying taxes. Creative accounting techniques are generally acceptable under the relevant accounting framework, but operate in a gray area where reported results are definitely being skewed away from actual results.
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Types of Creative Accounting
There are many creative accounting techniques that can be used to alter an organization’s financial results. Here are several of the more common types:
Alter useful life assumption. A business could extend the useful life assumption for an asset in order to reduce the related periodic depreciation charge. Doing so extends the depreciation expense associated with an asset over a longer period of time.
Alter salvage value assumption. A business could increase the assumed salvage value of an asset in order to reduce the related periodic depreciation charge. Doing so may result in a larger loss when the asset is eventually sold, but this is likely to be in a later reporting period.
Alter reserve amount. A business could reduce the periodic accrual charge for its bad debt reserve. Doing will result in an underfunded reserve that will eventually need to be replenished, but it will increase profits over the short term.
Alter contingent liabilities. A business could defer the recognition of contingent liabilities that may or may not occur. By assuming that these liabilities will not occur, management is delaying their recognition until they actually do occur, probably in a later reporting period.
Incur an excessive “big bath” loss. A business could take a very large one-time charge to its earnings, thereby building up a large reserve that it can use in subsequent periods to absorb any number of expenses. The result is one large false loss in the current period that is exchanged for a long series of artificially high reported profits in future periods.
Example of Creative Accounting
An example of creative accounting occurred at Lehman Brothers, a major U.S. investment bank. It used a technique called "Repo 105" to temporarily remove billions of dollars of liabilities from its balance sheet. These were essentially repurchase agreements, where Lehman would "sell" assets to another party with a promise to repurchase them shortly after—usually within days. However, Lehman classified these as sales instead of loans, allowing the company to reduce its reported leverage and make its financial position look healthier than it actually was at quarter-end.
This maneuver was not illegal in itself, but it was a clear case of creative accounting, as it distorted the company's financial reality without properly disclosing the true nature of the transactions. Ultimately, the practice misled investors and regulators about Lehman's financial health before its collapse in 2008.