Creative accounting, which many be known by other terms such as earnings management, income smoothing or aggressive accounting, refers to accounting practices that portray a business’s financial situation as either better or worse than the actual circumstances. While legal in a technical sense -- the practices do not violate generally accepted accounting principles (GAAP) -- creative accounting proves ethically questionable. The fallout from the revelation of creative accounting practices, which some consider fraud, can damage a business’s reputation and provides a strong reason to prevent it in the first place.
Segregating functions offers a simple method of control that helps prevent creative accounting. For example, the business can employ an internal bookkeeper to manage daily transactions, but use a CPA to review banking transactions and prepare a financial statement each month. A similar approach, applicable in larger organizations, calls for reviews of financial statements by members of different departments to make it more difficult for any one individual or small group to artificially change the numbers.
Ethical lapses, such as the use of creative accounting practices, often stem from a business culture where management or executives do not emphasize or demonstrate ethical behavior. The failure to demonstrate ethical behaviors sends the unmistakable message that any ethics code set out by the business serves only as PR. Business owners, executives and managers that make ethical choices, such as honest discussions with customers when things go wrong, set a model of behavior that employees often prove willing to follow.
Formal policies and penalties against creative accounting serve a three-fold purpose. On one level, they put new employees on explicit notice that a business does not condone such practices. Formal policies and penalties serve as a mechanism for correcting the behavior of employees that disregard the policy with some form of punishment short of firings. If an employee did not believe in the authenticity of the prohibition on creative accounting, for example, direct reprimands solidify the business’s position on the matter. Formal policies and penalties also provide grounds for letting an employee go, should he persist in creative accounting practices after receiving less severe punishments.
External audits do not entirely prevent unauthorized creative accounting, but external auditors with extensive experience often prove more capable of detecting creative accounting, according to a research study in the February 2013 issue of the International Journal of Business and Management. Even if auditors do not always spot creative accounting, external audits as a standard practice often serve as a psychological deterrent. The threat of detection reduces perceived opportunity, one of the triggers for fraudulent behavior.