Explain The Meaning Of Creative Accounting

1. Explain the meaning of “creative accounting” and “earnings management”

Creative Accounting

Creative accounting is an accounting practices that may follow the standards of accounting but is certainly deviated from those rules of standards. They were done by excessive use of complicated method and use of many novel ways of characterizing income, assets and liabilities with the intention to influence the reader towards how the doer would like them to understand. Creative accounting is also called cooking the books.

Earnings management

Earnings management is a strategy used by management to deliberately manipulate company’s earnings so that the figures match a predetermine target. Earnings management take advantages of the application of accounting

Parfet (2000) came up with the idea that there are two types of earnings management, “good” and “bad” and it appears that there is a correlation between bad earnings management and failure of companies.

i. Describe the “good” and the “bad sides” of earnings management.

The good side of earnings management relates to efficient contracting. When a contract contains strict or incomplete terms on a manager, earnings management may provide flexibility, as long as there are no self-interest motivations by the manager. Earnings management is good as long as it does not violate any rules or law or any of the Generally Accepted Accounting Principles.

The bad side of earnings management is that it reduces the reliability of the financial statements. This is because, earnings management are done by the drive of many factors, for example: bonus, political, taxation and many more. These factors lead to bad earnings management done by managers, thus reflecting the financial statements sometimes to be untrue. Earnings of a company are manipulated to show a strong position of the company to blur the investors. ii. Discuss how Enron crossed the line from “good” to “bad” earnings management until the company collapsed on December

SPEs will be created, and outside investor will come in with the supply of external capital and share of risk. With SPE, companies may finance a large project without jeopardizing entire firm. As for Enron, SPE were used to fund or manage risks associated with assets such as the acquisition of gas reserves from producers. As for financial reporting purposes, rules set by GAAP state that SPEs are a separate entity from the sponsor,( Healy and Palepu). This means, SPEs assets and liabilities no need to be disclosed in the sponsor’s statement of financial position. The use of SPE can be seen as a good form of earnings management, as risk can be transferred to SPE and external investor, rather than Enron to bear all the risk by itself. SPEs are used by Enron to replace potential liabilities with assets such as promissory notes issued to itself by its own SPEs, and increase earnings through income generated by SPEs. This kind of earnings management is deemed to be legal as it adhere to the GAAP. The elimination of the need to disclose SPE’s assets and liabilities in the Statement of Financial Position of Enron enables Enron to report higher earnings, as some of the problematic assets and liabilities are transferred to