Creative accounting consists of accounting practices that follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.
A primary benefit of public accounting statements is that they allow investors to compare the financial health of competing companies. However, when firms indulge in creative accounting they often distort the value of the information that their financials provide. Creative accounting can be used to manage earnings or to keep debt off the balance sheet, for example. Pressure to meet short-term expectations of Wall Street or year-end financial targets may be a cause of creative accounting activity by the C-suite. The CFO of a software company may take a portion of revenues that should be recorded as a liability on the balance sheet and recognize it as earned in the current period to reach a certain revenue goal. A CFO of a manufacturing company could delay the recording of current period expenses to a subsequent period to make current period earnings look better. If a gray area in accounting is found, it may be exploited.
Often, executive compensation is at stake. If creative accounting is a slippery slope to fraudulent accounting, Enron Corporation would be the poster child. Creative accounting designed to manipulate numbers and thus enrich select individuals at the company devolved into the outright illegal handling of the books and reporting to the public. The result is well known.
Charlie Munger, Warren Buffett's business partner, once said, "Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history's great advances."