Creative accounting, also known as earnings management or cooking the books, is legal but can be misleading to investors. Companies use it to emphasize positive financial aspects while downplaying negative ones. It can increase share value, but regulations are being implemented to prevent deceptive practices.
Creative accounting is a description of accounting practices that are not considered illegal, but may be somewhat out of the ordinary. Sometimes known 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 minimizing any negative factors. To some extent, accounting irregularities of this type can be misleading to potential investors and are therefore often considered 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 those that tell part of the truth, but downplay anything that might alter the perception the company wants to convey to others. For example, a company may play on the fact that it recently experienced a significant increase in 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 additional sales volume. If those who hear about increased sales don’t do a little more research, the company is likely to be in greater financial strength, when in reality the business has achieved little to no growth.
There are many reasons why a company would make use of creative accounting. One of the most common is to increase the desire for shares issued by the company. In some countries, this can be accomplished by publishing reports that officers are receiving bonuses due to increased sales volume, even though that volume did not result in an actual increase in profit. At the same time, the business releases additional shares. This sends the message to investors that the company is on the move, and will entice some to fill orders to buy shares before other investors do. The end result is that the demand for shares increases the value of the shares and benefits the business financially.
In recent years, several nations have taken steps to minimize the incidence of creative accounting by implementing regulations that make it more difficult for companies to cook the books and present a financial position that doesn’t tell the whole story. The hope is that by doing so, investors will be able to obtain all the data they need to make an informed decision about their investment options and prevent the economy from being negatively affected by deceptive financial accounting practices at large corporations. Since there are multiple ways to engage in creative accounting, it will likely take several years to come up with regulations that make unorthodox accounting processes explicitly illegal.
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