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Uncovering creative accounting: How to detect and prevent misrepresentation in your business
Posted by Grace Townsley
January 10, 2023
Creative accounting is a way of altering the financial records of an organization in order to portray a healthier financial position than actually exists, or to fraudulently steal or siphon off cash by using false financial information.
It can involve techniques like recording profits in an unusual manner or changing the values of certain assets to improve a company’s balance sheet. Creative accounting is also known as “cooking the books.”
Arguably the world’s most infamous creative accounting scandal was the 2001 bankruptcy of Enron. For a more recent example, look no further than the collapse of Sam Bankman-Fried’s FTX.
Not all forms of creative accounting are illegal, but they are all frowned upon
In some countries, any form of creative accounting is illegal and can result in criminal or civil charges. In the U.S. specifically, creative accounting practices are prohibited under the Sarbanes-Oxley Act of 2002.
And creative accounting can even be considered securities fraud if the misleading financial statements are used to manipulate investors, like stockholders or venture capital firms. If a business owner is caught using creative accounting, or if any of their employees used creative accounting with or without the owner’s knowledge, the consequences can be severe.
Fines, criminal sanctions, jail time, the loss of licensure and a loss of the freedom to start future businesses are all possible outcomes of being found guilty of creative accounting. The business may also be subject to civil litigation brought by investors or other parties claiming damages due to the inaccurate financial statements.
Whether the business owner was aware of the creative accounting or not, they may experience significant reputational damage and difficulty obtaining financing in the future.
Why do some businesses engage in creative accounting?
Some businesses engage in creative accounting to get around certain legal requirements or to make their financial statements appear better than they really are. They may use these techniques to hide losses, present their company in a more profitable light or to reduce their taxable income.
In some cases, businesses may also cook their books to avoid financial obligations or to gain an advantage over competitors by presenting themselves as the stronger, better, more favorable choice.
What are some of the most common methods of creative accounting?
1. Off-balance sheet financing:
This technique is used to avoid disclosing certain liabilities on the balance sheet to improve your debt-to-income ratio or hide debt.
2. Revenue recognition:
This involves recognizing revenue before it has actually been earned or received in order to show higher profits or revenues than what is true.
3. Reclassifying expenses:
Expenses can be moved from one account, like the property or utilities account, to the cost of goods sold account. On paper, this reduces the company’s tax liability by distorting actual profit levels.
4. Asset revaluation/writeoffs:
By revaluing assets on the balance sheet, companies can artificially inflate their balances and make their finances appear better than they actually are. They may also write off expenses that weren’t truly necessary to the business’ growth and operations, like the owner buying a luxury car or an executive taking a nonbusiness vacation on the company’s dime.
How is creative accounting detected?
Creative accounting can be detected by independent auditors and other financial institutions who review the accuracy of your business’ financial records. Auditors typically use analytical procedures, review internal controls and compare balance sheets over different periods of time to detect any potential manipulation of figures.
Financial analysts may also identify disparities between projected and actual results, or discrepancies in major accounts on the balance sheet that could suggest creative accounting has occurred.
An example of how an auditor can detect creative accounting is by analyzing the company’s balance sheet over several periods to check for inconsistencies. If a company is falsely inflating revenue or assets, the discrepancies should be apparent in the figures reported on successive balance sheets.
Another way an auditor can detect manipulation is by comparing actual business results to the budgeted results. If they notice any unusual discrepancies that triggered a significant change in the company’s performance and can’t be explained by market factors, that’s a sign that creative accounting has occurred.
Successful businesses avoid creative accounting by following GAAP
The best alternative to creative accounting is following the Generally Accepted Accounting Principles (GAAP) and other applicable laws. Small businesses of every age and stage of growth should strive for complete accuracy in their financial statements, and a strict adherence to legal and ethical standards.
Even if your business is in the early stages of growth, setting clear and firm accounting standards early on ensures you’re ready for the expansion to follow.
Proper accounting isn’t just a best practice. It’s essential for the healthy operation, streamlined management, and long-term growth of your small business.
In addition to taxes, accounting, bookkeeping and CFO services through its FinOps, Escalon’s Essential Business Services include PeopleOps (HR, benefits, recruiting and payroll) and Risk (business insurance). Talk to an expert today.
As a professional copywriter in the finance and B2B space, Grace Townsley offers small business leaders big insights—one precisely chosen word at a time. Let's connect!