What’s the difference?: Creative Accounting vs Fraud

If you were born before 2000, living in the US and are studying business majors, you might have heard accounting scandals like Enron or WorldCom. You might not know exactly what they are about, but I’m sure their names have crossed your ears at least once. They are two of the biggest accounting frauds in the US history in the last few decades (I will cover these frauds stories another day).

But, before that, I want to introduce you to a ‘might be’ new concept to you, which is….. (drum rolls pleasee)… Creative Accounting.

The name ‘Creative’ Accounting might mislead you into thinking that it is something positive. But, if you are a junior investor who had just started learning investing like me, you might want to take an extra look before putting your whole 401K into companies’ stocks. This is due to the fact that Creative Accounting is designed to serve the company’s interests instead of us, the users. It is supposed to move around the regulatory system, exploiting loopholes around accounting rules and policies to boost the company’s performances, sometimes more than what they are actually worth.

Exhibit 1. Creative Accounting vs Fraud in the U.S.

There are two types of definition of Creative Accounting (Exhibit 1 and 2):

• Wider definition in the US, that does include Fraud.

• Narrower definition in the UK and most of Europe, that does not include Fraud. UK and most European countries see Creative Accounting as distinct from Fraud. Even though Creative Accounting is not designed to support the interests of the users of financial statements, it is still working within the regulatory framework. It is not illegal, but per se… it is still unethical. Sort of like: Fraud is bad-bad, and Creative Accounting is bad-meh, as the sole purpose of accounting is to present true and fair view of the company, so the shareholders can make an informed economic decision to buy or sell or hold shares.

Exhibit 2. Creative Accounting vs Fraud in the U.K. and Europe

(Personally, I like the UK and Europe definition a bit more than the US, as it provides more context and characteristics to each word).

In my next several posts, we will also come to learn that there are a lot more of creative accounting cases than we would imagine previously. Companies will use Creative Accounting practices to cover up their shortfalls in poorer years and try to ‘save’ the company by smoothing their profits/losses with the expectation that they would make higher profits in the next year. For some of these companies, they are able to dispense their profits/losses to the next few years, ultimately saving the company.

However, for some of the unfortunate others, the financial result is worse in the next few years and they are trapped to indulge in more extensive techniques. Eventually, it starts to lead them to the slippery slope of false accounting and fraud.

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“… fraud comprises both the use of deception to obtain an unjust or illegal financial advantage and intentional misrepresentations affecting the financial statements by one or more individuals among management, employees, or third parties. Fraud may involve:

• Falsification or alteration of accounting records or other documents.

• Misappropriation of assets or theft.

• Suppression or omission of the effects of transactions from records or documents.

• Recording of transactions without substance.

• Intentional misapplication of accounting policies.

• Willful misrepresentation of transactions or of an entity’s state of affairs.

Auditing Standards Board, Statement of Auditing Standards, SAS 110 (1995)

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