Investors have the responsibility of checking out all of the accounting on-goings of a company before they decide to invest in it. Hence it is also important to know about the functionalities of “creative accounting”, as it is being called now. This is a branch of accounts that deals in manipulating accounts in a way that will provide different financial results than what is truthful. Managers of reputed firms get into such malpractices because they ae compelled by the economic reasons to show that they are ahead of the game. But the long term effects of this kind of a practice are very harmful to all involved. Below are a few reason of why creative accounting is resorted to in the first place:
Share price manipulation
It is often seen that to increase the price of the shares and hence the value of the firm, incorrect or distorted figures of accounts revenue generated are published. These inflated figures gain popularity and shows strong financial stability which in turn draws investors to buy more shares of the firm. Although it may work on a short term basis, if revenue is shown to be more than it is, it means that the company’s capacity to handle short term capital is hampered. This firm will have to have more focus on its short term capital because the revenue generated would not match up to the expenses due to increase in the various interest groups. It is fraud and has criminal prosecutions but affects the company’s reputation and goodwill even if it has not closed for business eventually.
Key managers’ compensation
Usually the key managers of the company are paid according to the accounting position of the company. They get shares as bonuses or their incentives depend on worth of the company. This is an added motivation for key personnel managers to try to manipulate the incoming numbers. This occurs especially to cover up a bad revenue patch. The accounting is also interfered with when there are debts to be raised from banks. It is important to show a strong financial backing and this is one route taken to achieve the purpose.
Shareholders vote of confidence
Although shareholders do not participate in the management of the company, they are interested in the accounting numbers. They have the power to replace the board if the company has not been managed well. This hence becomes a motive for accounting manipulation.