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Creative accounting
Euphemism referring to unethical accounting practices

Creative accounting is a euphemism for accounting practices that comply with the letter but not the spirit of standard accounting practices, often involving questionable accounting ethics to distort financial results in favor of the preparers. It involves complex methods to misrepresent income, assets, or liabilities and is sometimes called "cooking the books." Creative accounting has contributed to major accounting scandals and often blurs the line with outright fraud. The term gained popularity after reports of irregularities at Enron and Worldcom during the stock market downturn of 2002. It was first coined in the 1968 film The Producers by Mel Brooks, also known as Hollywood accounting.

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Motivations behind creative accounting

The underlining purpose for creative accounting is to "present [a] business in the best possible light" typically by manipulating recorded profits or costs.4 Company managers who participate in creative accounting can have a variety of situational motivations for doing so, including:

  • Market and stockholder expectations of profits
  • Personal incentives
  • Bonus-related pay
  • Benefits from shares and share options
  • Job security
  • Personal satisfaction
  • Cover-up fraud
  • Tax management
  • Management buyouts
  • Debt covenant
  • Manager's self-interest
  • Mergers and acquisitions

Types/examples of creative accounting schemes

Earnings management

Main article: Earnings management

Creative accounting can be used to manage earnings.5 Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence contractual outcomes that depend on reported accounting numbers.6

Hollywood accounting

Main article: Hollywood accounting

Practiced by some Hollywood film studios, creative accounting can be used to conceal earnings of a film to distort the profit participation promised to certain participants of the film's earnings. Essentially, participants in the gross revenue of the film stay unaffected but profit participants are presented with a deflated or negative number on profitability, leading to less or no payments to them following a film's success. Famous examples of deceiving good faith profit participants involve Darth Vader actor David Prowse (with $729M adjusted gross earnings on Return of the Jedi)7 and Forrest Gump novel writer Winston Groom (with $661M gross theatrical revenue)8—both of whom have been paid $0 on their profit participation due to the films "being in the red".910

Tobashi schemes

Main article: Tobashi scheme

This form of creative accounting—now considered a criminal offense in Japan, where it originated—involves the sale, swap or other form of temporary trade of a liability of one company with another company within the holding's portfolio, often solely created to conceal losses of the first firm. These schemes were popular in the 1980s in Japan before the government instituted harsher civil laws and eventually criminalized the practice. The Enron scandal revealed that Enron had extensively made use of sub-corporations to offload debts and hide its true losses in a Tobashi fashion.

Lehman Brothers' Repo 105 scheme

Main article: Repo 105

Lehman Brothers utilized repurchase agreements to bolster profitability reports with their Repo 105 scheme under the watch of the accounting firm Ernst & Young. The scheme consisted of mis-reporting a repurchase agreement (a promise to re-buy a liability or asset after selling it) as a sale, and timing it exactly in a way that half of the transaction was completed before a profitability reporting deadline, half after—hence bolstering profitability numbers on paper. Public prosecutors in New York filed suit against EY for allowing the "accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehman's true liquidity condition".11

Enron had done exactly the same about 10 years earlier; in their case, Merrill Lynch aided Enron in bolstering profitability close to earnings periods by willfully entering repurchase agreements to buy Nigerian barges from Enron, only for Enron to buy them back a few months later. The U.S. Securities and Exchange Commission (SEC) filed charges and convicted multiple Merrill Lynch executives of aiding the fraud.12

Currency swap concealment of Greek debt by Goldman Sachs

See also: Goldman Sachs § Involvement in the European sovereign debt crisis

In 2001–2002, Goldman Sachs aided the government of Greece after its admission to the Eurozone to better its deficit numbers by conducting large currency swaps. These transactions, totaling more than 2.3 billion Euros,13 were technically loans but concealed as currency swaps in order to circumvent Maastricht Treaty rules on member nations deficit limits and allowed Greece to "hide" an effective 1 billion euro loan.14 After Goldman Sachs had engineered the financial instrument and sold it to the Greeks—simply shifting the liabilities in the future and defrauding investors and the European Union, the investment bank's president Gary Cohn pitched Athens another deal. After Greece refused the second deal, the firm sold its Greek swaps to the Greek national bank and made sure its Short and Long positions towards Greece were in balance—so that a potential Greek default would not affect Goldman Sachs.15

Parmalat's mis-accounted credit-linked notes

See also: Parmalat § Financial fraud (2002–2005)

Italian dairy giant Parmalat employed a number of creative accounting and wire fraud schemes before 2003 that lead to the largest bankruptcy in European history.16 It sold itself Credit-linked notes with the help of Merrill Lynch through a Cayman Islands special-purpose entity and over-accounted for their value on the balance sheet. It also forged a $3.9Bn check from Bank of America.17 The publicly listed company stated to investors that it had about $2Bn in liabilities (this figure was accepted by its auditors Deloitte and Grant Thornton International), but once audited more vigorously during the bankruptcy proceedings, it was discovered that the company's debt turned out to actually be $14.5Bn.18 This massive debt was largely caused by failed operations in Latin America and increasingly complex financial instruments used to mask debt—such as Parmalat "billing itself" through a subsidiary called Epicurum.19 It was also discovered that its CEO Calisto Tanzi had ordered the creation of shell accounts and diverted 900M Euros worth into his private travel company.20

Offshoring and tax avoidance

See also: Offshore financial centre, Offshore Leaks, and Tax avoidance

In order to avoid taxes on profits, multinational corporations often make use of offshore subsidiaries in order to employ a creative accounting technique known as "Minimum-Profit Accounting". The subsidiary is created in a tax haven—often just as a shell company—then charges large fees to the primary corporation, effectively minimizing or wholly wiping out the profit of the main corporation. Within most of the European Union and the United States, this practice is legal and often executed in sight or with explicit approval of tax regulators.21

Nike, Inc. used this method by selling its Swoosh logo to a Bermuda-based special-purpose entity subsidiary for a nominal amount, and then went on to "charge itself" licensing fees that Nike Inc. had to pay to the subsidiary in order to use its own brand in Europe. The Dutch tax authorities accepted this siphoning structure, but did not publish the private agreement they had with Nike.22 The licensing fees totaled $3.86Bn over the course of three years and were discovered due to an unrelated U.S.-based lawsuit as well as the Paradise Papers.23 In 2014, the Bermuda deal with Dutch authorities expired, and Nike moved the profits to another offshore subsidiary, a Netherlands-based Limited Liability Partnership (CV, short for Commanditaire Vennootschap, generally known as a Kommanditgesellschaft). Through a Dutch tax loophole, CV's owned by individuals that are residing in the Netherlands are tax-free. Exploiting this structure saved Nike more than $1Bn in taxes annually and reduced its global tax rate to 13.1%; the company is currently being pursued for billions of dollars of back taxes in litigation by multiple governments for this multinational tax avoidance.24

A number of business documentaries ( 72 ) center around financial scandals and securities fraud that involved creative accounting practices:

See also

Further reading

References

  1. Jones, Michael, ed. (2012). Creative Accounting, Fraud and International Accounting Standards. John Wiley. doi:10.1002/9781119208907. ISBN 978-0-470-05765-0. 978-0-470-05765-0 ↩

  2. Jones, Michael, ed. (2012). Creative Accounting, Fraud and International Accounting Standards. John Wiley. doi:10.1002/9781119208907. ISBN 978-0-470-05765-0. 978-0-470-05765-0 ↩

  3. The Producers – From the Current – The Criterion Collection http://www.criterion.com/current/posts/918-the-producers ↩

  4. "Creative accounting – Motives, techniques and possibilities of prevention". ResearchGate. Retrieved 2020-07-05. https://www.researchgate.net/publication/330202220 ↩

  5. "Creative Accounting". Investopedia. Retrieved 14 January 2014. http://www.investopedia.com/terms/c/creative-accounting.asp ↩

  6. Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365–383. ↩

  7. "Star Wars Movies at the Box Office". Box Office Mojo. Retrieved 2019-09-23. https://www.boxofficemojo.com/franchises/chart/?id=starwars.htm ↩

  8. "'Gump' a Smash but Still in the Red, Paramount Says: Movies: Writer, who is due to get 3% of net profits, hires lawyer to question the studio's accounting practices". Los Angeles Times. 1995-05-24. Retrieved 2019-09-23. https://www.latimes.com/archives/la-xpm-1995-05-24-mn-5473-story.html ↩

  9. "Why Do All Hollywood Movies Lose Money?". Priceonomics. 30 July 2013. Retrieved 2019-09-23. http://priceonomics.com/why-do-all-hollywood-movies-lose-money/ ↩

  10. "'Gump' a Smash but Still in the Red, Paramount Says: Movies: Writer, who is due to get 3% of net profits, hires lawyer to question the studio's accounting practices". Los Angeles Times. 1995-05-24. Retrieved 2019-09-23. https://www.latimes.com/archives/la-xpm-1995-05-24-mn-5473-story.html ↩

  11. "Attorney General Cuomo Sues Ernst & Young For Assisting Lehman Brothers In Financial Fraud | New York State Attorney General". ag.ny.gov. 21 December 2010. Retrieved 2019-09-23. https://ag.ny.gov/press-release/2010/attorney-general-cuomo-sues-ernst-young-assisting-lehman-brothers-financial-fraud ↩

  12. "SEC Charges Merrill Lynch, Four Merrill Lynch Executives with Aiding and Abetting Enron Accounting Fraud". www.sec.gov. Retrieved 2019-09-28. https://www.sec.gov/news/press/2003-32.htm ↩

  13. "Goldman Sachs details 2001 Greek derivative trades". Reuters. 2010-02-22. Retrieved 2019-09-23. https://www.reuters.com/article/goldman-sachs-greece-derivatives-idUSLDE61L1KH20100222 ↩

  14. Balzli, Beat (2010-02-08). "Greek Debt Crisis: How Goldman Sachs Helped Greece to Mask its True Debt". Spiegel Online. Retrieved 2019-09-23. https://www.spiegel.de/international/europe/greek-debt-crisis-how-goldman-sachs-helped-greece-to-mask-its-true-debt-a-676634.html ↩

  15. "Goldman Sachs Shorted Greek Debt After It Arranged Those Shady Swaps". Business Insider. Retrieved 2019-09-23. https://www.businessinsider.com/goldman-sachs-shorted-greek-debt-after-it-arranged-those-shady-swaps-2010-2 ↩

  16. "Europe's biggest bankruptcy remembered". www.europeanceo.com. Retrieved 2019-09-29. https://www.europeanceo.com/finance/europes-biggest-bankruptcy-remembered/ ↩

  17. Goldstein, Steve. "Parmalat: A disaster, but no Enron". MarketWatch. Retrieved 2019-09-29. https://www.marketwatch.com/story/parmalat-a-disaster-but-no-enron ↩

  18. Tran, Mark; agencies (2004-02-17). "Police net widens on Parmalat family". The Guardian. ISSN 0261-3077. Retrieved 2019-09-29. https://www.theguardian.com/business/2004/feb/17/corporatefraud.parmalat ↩

  19. Teall, John L. (2014-02-25). Governance and the Market for Corporate Control. Routledge. ISBN 978-1-317-83471-7. 978-1-317-83471-7 ↩

  20. Tran, Mark; agencies (2004-02-17). "Police net widens on Parmalat family". The Guardian. ISSN 0261-3077. Retrieved 2019-09-29. https://www.theguardian.com/business/2004/feb/17/corporatefraud.parmalat ↩

  21. "Nike's Sweetheart Dutch Tax Deal Ignored 'Economic Reality,' EU Says". ICIJ. 8 July 2019. Retrieved 2019-09-30. https://www.icij.org/investigations/paradise-papers/nikes-sweetheart-dutch-tax-deal-ignored-economic-reality-eu-says/ ↩

  22. "Nike's Sweetheart Dutch Tax Deal Ignored 'Economic Reality,' EU Says". ICIJ. 8 July 2019. Retrieved 2019-09-30. https://www.icij.org/investigations/paradise-papers/nikes-sweetheart-dutch-tax-deal-ignored-economic-reality-eu-says/ ↩

  23. "Nike Stays Ahead Of The Regulators". ICIJ. 6 November 2017. Retrieved 2019-09-30. https://www.icij.org/investigations/paradise-papers/swoosh-owner-nike-stays-ahead-of-the-regulator-icij/ ↩

  24. Hopkins, Nick; Bowers, Simon (2017-11-06). "Revealed: how Nike stays one step ahead of the taxman". The Guardian. ISSN 0261-3077. Retrieved 2019-09-30. https://www.theguardian.com/news/2017/nov/06/nike-tax-paradise-papers ↩