Creative accounting or reasonable estimate

There’s a lot of mythology that surrounds the idea of creative accounting. Part of it stems from the misconception that the profits for the year, or the financial position at the balance sheet date, are identifiable sets of numbers. Creative accounting is seen as distortion of these for some nefarious purpose, such as misleading investors.

The reality is much more difficult. Neither the profit for a particular period nor the financial position at any date can ever be known with certainty, until a company has ceased to exist and (as the liquidation of Lehman Brothers in Europe demonstrates) possibly not for some years after that.

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Accountants in discussion.

The problem is this: when an accountant sets out to draw up a profit and loss account and balance sheet (statement of financial position), there are many definite numbers, but there are also, in any large business, a number of unknowns. The accountant has to make estimates about these, or may even have to ignore some altogether because they are too difficult to measure.

To borrow from Dick Cheney, there are the ‘known unknowns’ – transactions that were incomplete at the end of a period for which you want to measure profit, and long-lived assets whose cost must be allocated against profits as the asset is used but whose precise future use is unknown. Business cycles do not necessarily have anything to do with the financial reporting year, and the accountant has to make estimates of what will happen in the future.

There are also the ‘unknown unknowns’ – things that may become apparent in the future and have been caused by past actions but which the accountant does not know about yet. This could be the employee whose health has been affected by their work, or a product that turns out to injure people when they have used it for a year or two.

The level of certainty with which the accountant can measure these things varies from one type of business to another, as also does the extent to which the business works in an environment where there are many unknowns, but it is sure that any set of financial statements includes, and is to an extent shaped by, estimates. Thus far, we have not been talking about creative accounting.

Where the mythology and the misunderstandings arise, is that it is in the nature of an estimate that it cannot be verified. Different accountants, armed with the same basic information, would make different estimates, each one perfectly valid. In a worldwide group there will be hundreds of individual companies, each with its own estimates, which all impact upon group profit. In closing the annual accounts, decisions have to be made about these.

As long as the final decisions are within appropriate accounting rules and reflect the economic reality as perceived by management, this is not creative accounting, this is normal business practice. Management must not undervalue the business (that would not be appropriate behaviour towards existing shareholders) nor must they overvalue it (that could lead to wrong investment decisions).

Where creative accounting, or management manipulation of profits, starts is when the estimates do not coincide with a reasonable view of economic reality. Of course, this is extraordinarily subjective, and almost impossible for the outsider to assess. Even if the outsider has a different view of the same economic reality, the test is always this: was management’s view reasonable from their perspective?

Creative accounting can also be a question of wilfully misinterpreting the accounting rules – this was certainly one of the problems with Enron, which misused accounting rules to exclude from its group accounts some activities that should have been included and which would have radically changed investors’ perceptions.

Can companies get away with creative accounting? In the end, the answer is probably not. Real cashflows and actual transactions are the bedrock of the financial statements and it becomes impossible to conceal a mismatch between this economic reality and the financial statements. The problem is that many investors may have lost money by then, and as in the Enron case, investors then lose confidence both in financial reporting and the capital markets. This can take years to put right.

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