Creative accounting is a description of accounting practices that are not considered illegal, but may be somewhat out of the ordinary. Sometimes referred to as Hollywood accounting, earnings management, or cooking the books, the idea behind creative accounting practices is often to emphasize the positive aspects of the company’s financial situation, while downplaying any negative factors. To an extent, accounting irregularities of this type can be misleading to potential investors, and thus are often considered to be unethical, even though the strategy may remain within the letter of the law.
As with most types of misrepresentation, the most effective examples of creative accounting are the ones that tell a portion of the truth, but downplay any elements that could alter the perception that the company wishes to convey to others. For example, a company may play up the fact that it recently experienced significantly increased sales during the last quarter. At the same time, little is said about the fact that expenses increased in proportion to that jump in sales, effectively offsetting that extra sales volume. If those who hear about the increase in sales do not probe a little deeper, the perception is likely to be that the company is now financially stronger, when in fact the business has achieved little to no growth at all.
There are many reasons why a business would make use of creative accounting. One of the more common is to increase the desire for the stock issued by the business. In some countries, this can be accomplished by releasing reports that indicate the officers are receiving bonuses due to increased sales volume, even though that volume did not result in any real increase in profits. At the same time, the business releases additional shares of stock. This sends the message to investors that the company is on the move, and will entice some to execute orders to purchase shares before they are snapped up by other investors. The end result is that the demand for the stock drives up the value of the shares, and benefits the business financially.
In recent years, a number of nations have taken steps to minimize the incidence of creative accounting by implementing regulations that make it more difficult for businesses to cook the books and present a financial position that is does not tell the entire story. The hope is that by doing so, investors will be able to obtain all the data required to make an informed decision about their investment options, and prevent the economy from being adversely affected by misleading financial accounting practices at major corporations. Since there are a number of ways to engage in creative accounting, chances are it will take a number of years to craft regulations that will make those unorthodox accounting processes explicitly illegal.