A discussion on terms such as creative accounting, sloppy accounting and fraudulent accounting is usually in connection with the presentation of ‘financial report’ for a company (or group of entities) operating a business, so before launching into creative accounting, sloppy accounting and fraudulent accounting, I would like to first address what is a financial report and types of financial reports.
What is a financial report?
Section 295 of the Corporations Act 2001 (Cth) sets out the contents of a financial report, which comprise the following three important documents:
Types of financial reports
Financial reports are typically published by a company and provided to third parties for a particularly period, usually a financial year which for most companies runs from 1 July to 30 June. There are two types of financial reports:
The financial reports ought to disclose within the ‘notes to the financial statements’ and in the ‘directors’ declaration’ whether the financial report is considered a ‘general purpose’ or ‘special purpose’ financial report. Generally speaking,
Some of the public may view an accountant as a person who captures transactions to simply record financial history by following black & white rules. The reality is that accounting is somewhat abstract and there is always more than one way to report history in the financial reports, even when adopting Australian accounting standards because application of Australian accounting standards requires professional judgement.
Irrespective of whether a financial report is considered ‘general purpose’ or ‘special purpose’, the objective of the financial report is to present a ‘true and fair’ view of the financial position and financial performance of the company. There is no prescriptive accounting definition on what ‘true and fair’ means – what is ‘true and fair’ is ultimately a matter for the courts to determine, usually with the assistance of expert evidence, often given by a forensic accountant.
Australian accounting standards provide that if there are ‘material’ misstatements included in the financial reports then the financial reports are likely to be misleading to users relying on the financial reports. Therefore misleading financial reports cannot present a ‘true and fair’ view of company’s financial position and financial performance. Australian accounting standards provide guidance on what is considered ‘material’ for the purposes of avoiding the preparation of misleading financial reports, which is a matter of professional judgment, based on qualitative and quantitative factors.
Now we have talked about financial reports, the presentation on what is included therein will be influenced by, what I characterise as Creative Accounting, Sloppy Accounting and Fraudulent Accounting.
What is Creative Accounting?
Creating Accounting is a bit of loaded term because there is a misconception that it suggests something illegal, fraudulent or misrepresented. This misconception could arise from instances where creative accounting has been noted by financial commentators in connection with a company when fraud is discovered or the company later collapses and enters into liquidation.
Creative accounting is simply an acknowledgement that there may be a range of possible answers i.e. descriptions and numbers included in a financial report) when adopting generally accepted accounting principles (and Australian Accounting Standards provide authoritative guidance when describing generally accepted accounting principles).
It is important to stress that:
Creative accounting techniques
The following are just a few of the many sorts of ways creative accounting can be used with respect to general purpose financial reports (which are audited by an independent auditor):
The scope for creative accounting is significantly greater when it comes to a company which produces special purpose financial reports, particularly if they have not been subject to audit, because the company is not obliged to comply with Australian accounting standards.
What is sloppy accounting?
Slopping accounting only applies to special purpose financial reports which have not been audited and is probably best described in relation to a company’s financial reports where the accounting policies adopted have not been complied with and/or the accounting policies adopted are not appropriate.
Examples of sloppy accounting include the absence of all appropriate year-end accrual adjustments such as:
Unsigned directors’ declarations within a financial report with no accompanying income tax return (or income tax return with no evidence of lodgement of the tax return with the Australian Taxation Office) may reflect a draft version of the financial report which could be subject to sloppy accounting.
Sloppy accounting (by my definition) cannot result in the financial reports being a true and fair representation of the company’s financial position and financial performance.
What is fraudulent accounting?
Fraudulent accounting is a deliberate deception involving the presentation of financial reports that cannot be a true and fair representation of the financial performance a.
While creative accounting (sometimes referred to as ‘window addressing’) are permissible under the law, fraudulent accounting is illegal because the company is claiming the presented financial reports provide a true and fair view of the company’s financial position and financial performance with the knowledge that they are not a true and fair view. This knowledge held by the company is for the purpose of deceiving the users or readers (i.e. third parties to the company) as to the true and fair view of the company’s financial position and financial performance.
There many examples of publicly listed companies (e.g. Enron, being a well documented example) presented financial reports which have been independently audited which have been subsequently found to have prepared fraudulent financial reports. While independent auditors have to consider the possibility of fraudulently prepared financial statements, an independent auditor’s primary role is not to look for fraud and the scope and nature of an audit does not involve reviewing each and every transaction which comprise the financial statements.
How a forensic accountants deals with creative accounting
A forensic accountant must understanding human behaviour and step into the shoes of management and understand the motives of management when preparing financial reports for a company. Management may be highly motivated to want to leave a favourable or unfavourable impression depending on whether it seeks to want to impress or depress a particular reader of the financial reports.
Being too conservative or aggressive can cross the line into fraud if it can be proved that there is a deliberate intention to harm or gain a benefit. However, proving fraud can be quite challenging, particularly where there are numerous conflicting motivating forces at work.
Summary and conclusion
Confusion can arise where creative accounting is pushed to the extremes producing significant financial consequences. In these situations, the lines between creative, accounting and fraudulent accounting can be quite murky. As a forensic accountant working in disputes, one party in the dispute may argue window dressing and the other party argues it is fraud. Unaudited special purpose financial reports present the greatest risk that the information presented may not reflect a true and fair view of the company, however the presentation of independent audited general purpose financial reports, with an unqualified audit opinion, does not mean that a fraud has not been perpetrated on the company or by the company.
 This article does not seek to address the criteria and guidance for companies on whether financial reports should be considered ‘general purpose’ or ‘special purpose’.
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