Creative accounting is used to overstate a business’ assets or understate its liabilities. The result of creative accounting can be a misleading picture of a business’ financial condition. It is relatively easy to spot creative accounting if you know where to look. This article will show you how.
Businesses that engage in creative accounting often seek to enhance their earnings power or to create the appearance of them being in a strong financial condition. Companies use accounting scandals to aid them in obtaining credit at lower interest rates. Accounts receivables can be used to detect creative accounting. They can be used to boost earnings on their own. If an accounting balance sheet item seems to have grown at a pace quicker than that of an income statement item, creative accounting may have been used.
Inventory An inventory represents the value of goods manufactured, but yet to be sold. When the manufactured goods are sold, the value of the sale is, as would be expected, transferred to the income statement. This means that when a company overstates the inventory value, the cost of goods sold will become understated and an artificially higher net income will result. This is assuming that the actual inventory and sales remain at a constant amount. Overvalued inventory It is possible to detect overvalued inventory by seeking out telling trends, including inventory increasing at a faster rate than sales, falls in inventory turnover, inventory increasing quicker than total assets and decreasing cost of sales as a percentage of total sales. Unusual or unexpected variations in these figures may be suggestive of potential inventory creative accounting.
Pension obligations are easy to manipulate as the liabilities occur in the future and estimations can only be used to account for them in the short-term period. Companies can devise aggressive estimations in order to enhance short-term earnings and create the illusion that they are in a strong financial position.
Contingent liabilities are obligations dependent on future events. Warranty obligations may be considered amongst the many contingent liabilities a company may face. Companies can use creative accounting by underestimating the materiality of these liabilities. Creative accounting of this kind can be detected by carefully analysing a company's footnotes, which may contain information relating to these obligations.