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Creative accounting is aeuphemism referring toaccounting practices that may follow the letter of the rules ofstandard accounting practices, but deviate from the spirit of those rules with questionableaccounting ethics—specifically distorting results in favor of the "preparers", or the firm that hired the accountant.[1] They are characterized by excessive complication and the use of novel ways of characterizing income, assets, orliabilities, and the intent to influence readers towards the interpretations desired by the authors. The terms "innovative" or "aggressive" are also sometimes used. Another common synonym is "cooking the books". Creative accounting is oftentimes used in tandem with outright financialfraud (includingsecurities fraud), and lines between the two are blurred. Creative accounting practices have been known since ancient times and appear world-wide in various forms.[1]
"Every company in the country is fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since theTrojan horse. ... In fact this deception is all in perfectly good taste. It is totally legitimate. It is creative accounting."
The term as generally understood refers to systematic misrepresentation of the trueincome andassets of corporations or other organizations. "Creative accounting" has been at the root of a number ofaccounting scandals, and many proposals foraccounting reform—usually centering on an updated analysis ofcapital andfactors of production that would correctly reflect how value is added.
Newspaper and television journalists have hypothesized that thestock market downturn of 2002 was precipitated by reports of "accounting irregularities" atEnron,Worldcom, and other firms in theUnited States. According to criticDavid Ehrenstein, the term "creative accounting" was first used in 1968 in the filmThe Producers byMel Brooks, where it is also known asHollywood accounting.[3]
The underlining purpose for creative accounting is to "present [a] business in the best possible light" typically by manipulating recorded profits or costs.[4] Company managers who participate in creative accounting can have a variety of situational motivations for doing so, including:
Creative accounting can be used to manage earnings.[5] Earnings management occurs whenmanagers use judgment infinancial reporting and in structuring transactions to alter financial reports to either mislead somestakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers.[6]
Practiced by some Hollywood film studios, creative accounting can be used to conceal earnings of a film to distort the profit participation promised to certain participants of the film's earnings. Essentially, participants in the gross revenue of the film stay unaffected but profit participants are presented with a deflated or negative number on profitability, leading to less or no payments to them following a film's success. Famous examples of deceivinggood faith profit participants involveDarth Vader actorDavid Prowse (with $729M adjusted gross earnings onReturn of the Jedi)[7] andForrest Gump novel writerWinston Groom (with $661M gross theatrical revenue)[8]—both of whom have been paid $0 on their profit participation due to the films "being in the red".[9][8]
This form of creative accounting—now considered a criminal offense in Japan, where it originated—involves the sale, swap or other form of temporary trade of a liability of one company with another company within the holding's portfolio, often solely created to conceal losses of the first firm. These schemes were popular in the 1980s in Japan before the government instituted harsher civil laws and eventually criminalized the practice. TheEnron scandal revealed thatEnron had extensively made use of sub-corporations to offload debts and hide its true losses in a Tobashi fashion.
Lehman Brothers utilizedrepurchase agreements to bolster profitability reports with theirRepo 105 scheme under the watch of the accounting firmErnst & Young. The scheme consisted of mis-reporting a repurchase agreement (a promise to re-buy a liability or asset after selling it) as a sale, and timing it exactly in a way that half of the transaction was completed before a profitability reporting deadline, half after—hence bolstering profitability numbers on paper. Public prosecutors in New York filed suit against EY for allowing the "accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehman's true liquidity condition".[10]
Enron had done exactly the same about 10 years earlier; in their case,Merrill Lynch aided Enron in bolstering profitability close to earnings periods by willfully entering repurchase agreements tobuy Nigerian barges from Enron, only for Enron to buy them back a few months later. TheU.S. Securities and Exchange Commission (SEC) filed charges and convicted multiple Merrill Lynch executives of aiding the fraud.[11]
In 2001–2002,Goldman Sachs aided the government ofGreece after its admission to the Eurozone to better its deficit numbers by conducting largecurrency swaps. These transactions, totaling more than 2.3 billion Euros,[12] were technicallyloans but concealed as currency swaps in order to circumventMaastricht Treaty rules on member nations deficit limits and allowed Greece to "hide" an effective 1 billion euro loan.[13] After Goldman Sachs had engineered the financial instrument and sold it to the Greeks—simply shifting the liabilities in the future and defrauding investors and theEuropean Union, the investment bank's presidentGary Cohn pitched Athens another deal. After Greece refused the second deal, the firm sold its Greek swaps to the Greek national bank and made sure itsShort andLong positions towards Greece were in balance—so that a potential Greek default would not affect Goldman Sachs.[14]
Italian dairy giantParmalat employed a number of creative accounting and wire fraud schemes before 2003 that lead to the largest bankruptcy in European history.[15] It sold itselfCredit-linked notes with the help ofMerrill Lynch through aCayman Islandsspecial-purpose entity and over-accounted for their value on the balance sheet. It also forged a $3.9Bn check fromBank of America.[16] The publicly listed company stated to investors that it had about $2Bn in liabilities (this figure was accepted by its auditorsDeloitte andGrant Thornton International), but once audited more vigorously during the bankruptcy proceedings, it was discovered that the company's debt turned out to actually be $14.5Bn.[17] This massive debt was largely caused by failed operations in Latin America and increasingly complex financial instruments used to mask debt—such as Parmalat "billing itself" through a subsidiary called Epicurum.[18] It was also discovered that its CEOCalisto Tanzi had ordered the creation of shell accounts and diverted 900M Euros worth into his private travel company.[17]
In order to avoid taxes on profits, multinational corporations often make use ofoffshoresubsidiaries in order to employ a creative accounting technique known as "Minimum-Profit Accounting". The subsidiary is created in atax haven—often just as a shell company—then charges large fees to the primary corporation, effectively minimizing or wholly wiping out the profit of the main corporation. Within most parts of theEuropean Union and theUnited States, this practice is perfectly legal and often executed in plain sight or with explicit approval of tax regulators.[19]
Nike, Inc. famously employed offshoring by selling itsSwoosh logo to aBermuda-basedspecial-purpose entity subsidiary for a nominal amount, and then went on to "charge itself" licensing fees that Nike Inc. had to pay to the subsidiary in order to use its own brand in Europe. The Dutch tax authorities were aware of and approved of this siphoning structure, but did not publish the private agreement they had with Nike.[20] The licensing fees totaled $3.86Bn over the course of 3 years and were discovered due to an unrelated U.S.-based lawsuit as well as theParadise Papers.[21] In 2014, the Bermuda deal with Dutch authorities expired, and Nike shifted the profits to another offshore subsidiary, aNetherlands-based Limited Liability Partnership (CV, short forCommanditaire Vennootschap, generally known as aKommanditgesellschaft). Through a Dutch tax loophole, CV's owned by individuals that are residing in the Netherlands are tax-free. Exploiting this structure saved Nike more than $1Bn in taxes annually and reduced its global tax rate to 13.1%; the company is currently being pursued for billions of dollars worth ofback taxes in litigation by multiple governments for this multinationaltax avoidance.[22]
A number ofbusiness documentaries ( 72 ) center around financial scandals andsecurities fraud that involved creative accounting practices:
