Creative Accounting

Creative accounting refers to accounting practices that deviate from (the spirit of ) standard accounting practices. They are characterized by excessive complication and the use of novel ways of characterizing income, assets or liabilities. Sometimes the words "innovative" or "aggressive" are used.

The term is also (used more seriously and disparagingly) to refer to systematic misrepresentation of the true income and assets of business organizations. "Creative accounting" on this scale has led to a number of recent accounting scandals, and many proposals for accounting reform.

Creative accounting is also used by smaller companies for tax saving purposes and large companies for meeting bonuses or shareholders expectations. One commonly accepted incentive for the systemic over-reporting of corporate income was the granting of stock options as part of executive compensation packages. Since stock prices reflect earning reports, stock options could be most profitably exercised when income is exaggerated, and the stock can be sold at an inflated profit.

Companies, following standard accounting guidelines, use loopholes to tweak their earnings numbers here and there just to make the crucial number, earnings per share, look better. Ultimately, the goal for most companies is to smooth out bumps to show steady or consistent high growth.

A company that shows steady growth with few surprises often gets regarded from investors via a high stock price which goes a long way towards keeping the executives’ stock options in the money.

It may be that investors, who have been punishing companies with aggressive a/g by selling their shares, whose behaviour will determine whether firms continue to push the envelope.