Two companies buy the same machine on the same day. One says it will last ten years, the other eight. Both follow the rules, and their profits differ. Now imagine a finance team that picks, every year, the choices that make profit look best. Nothing illegal has happened, yet readers of the accounts are being steered.
This topic is about that grey area: how accounting choices change the numbers, why managers are tempted to use them, and how to spot it.
It covers fair presentation and the true and fair override, why different policies and estimates give different results, creative accounting and earnings management, the opportunities and incentives behind them, overt and covert practices, the red flags that analysts and auditors watch, the usual techniques, big bath accounting, and the ethics. It builds on the International Accounting Standard (IAS) 8 topic.
The next topics move to the standards on revenue, assets and liabilities, where many of these choices arise. The syllabus asks you to evaluate earnings management and creative accounting and their effect on the usefulness of ratios.
In 30 seconds
Fair presentation is usually achieved by following International Financial Reporting Standards (IFRS), but it is not a single “correct” set of figures: different policies and estimates give different results. Creative accounting uses choices, judgements and structuring to give an altered impression of performance or position, often within the rules. Earnings management is a type of it.
It happens where there is opportunity (subjectivity, complexity, weak governance, weak auditors, vague rules) and incentive (income smoothing, targets, share price, loan covenants, bonuses, tax, takeover). Overt practices are disclosed. Covert ones are not and do more harm. Red flags include profit not matching operating cash flow, volatile margins, unusual year-end deals, frequent policy changes and heavy management incentives.
Techniques include premature revenue, aggressive capitalisation, optimistic asset lives, off balance sheet financing and big bath provisions. Revaluing assets can lower gearing and reduce return on capital without any real change in the business.
Key terms in plain English
| Term | What it means |
|---|---|
| Fair presentation | Statements that faithfully show position, performance and cash flows, usually by complying with IFRS |
| True and fair override | Departing from a rule because following it would mislead, with explanation |
| Creative accounting | Using accounting rules in a way that is not in the spirit intended, to produce a desired result |
| Earnings management | Using methods, or changing methods, to influence reported earnings |
| Income smoothing | Making profit look steadier from year to year |
| Window dressing | Making the position at the year end look better than it is during the year |
| Big bath | Taking all the bad news in one bad year so later years look better |
Syllabus check
This topic covers parts of two syllabus areas:
- D2(f) discussing and evaluating earnings management, window dressing and creative accounting and their effect on the usefulness of ratios;
- B1(a) evaluating how different bases of measurement and recognition of assets and liabilities affect reported financial performance;
- the ethical side, which links to Area A, item 2, on professional accountants’ code of ethics.
CAMA 2020 and creative accounting
The Companies and Allied Matters Act 2020 (CAMA 2020) sets safeguards against manipulation.
| Section | What it says | Link to creative accounting |
|---|---|---|
| s. 378 | The statements follow IFRS and give a true and fair view. If the prescribed format does not, the directors add information or depart and explain | The Nigerian form of the true and fair override |
| s. 404(7) | The audit committee checks accounting policies and reviews the effectiveness of the system of accounting and internal control | A check on aggressive policy choices |
| s. 405 | The chief executive officer (CEO) and chief financial officer (CFO) of a company that is not a small company certify responsibility for internal controls, and failure is an offence | Personal accountability of those who report earnings |
| s. 406 | It is an offence to influence, coerce, manipulate or mislead the external auditor so that the statements are materially misleading | Covers pressure on an auditor to accept manipulation |
| s. 407(3) | The auditor has a right of access to books, accounts and vouchers | Lets the auditor test estimates and cut-off |
Fair presentation and why choice exists
IAS 1 (and International Financial Reporting Standard (IFRS) 18 from 2027) requires fair presentation of position, performance and cash flows. In nearly all cases that is achieved by following IFRS. Fair presentation also needs the entity to choose and apply policies under IAS 8, to present relevant, reliable, comparable and understandable information, and to give extra disclosure when the rules are not enough.
Auditors give an opinion on fair presentation and qualify it if it is not achieved.
But there is no single correct set of figures. Alternative policies give different results, and policies are applied using estimates and judgements. A fair presentation can cover a range.
Example: different policies
A company buys plant for ₦100,000 on the first day of year 1 and depreciates it over 10 years. On the first day of year 2 it might revalue the asset to ₦135,000 (a surplus of ₦45,000 over the carrying amount of ₦90,000).
Compared with staying at cost, the revaluation raises equity and so lowers gearing (50.0% to 41.7% in ICAN’s example), but increases depreciation (from ₦10,000 to ₦15,000), so profit and return on capital employed (ROCE) fall (20.0% to 14.6%) and earnings per share (EPS) falls. Nothing real changed in the business.
Example: different estimates
Two companies buy the same plant for ₦100,000. Company A estimates a 10-year life and a residual value of ₦20,000, so annual depreciation is ₦8,000. Company B estimates 8 years and no residual value, so depreciation is ₦12,500. This can happen in the normal course with no intention to mislead, but it reduces comparability and gives room to manipulate.
The true and fair override
Where applying a standard would be misleading, a departure may be permitted. The entity must explain why compliance would mislead and give enough information to calculate the adjustments needed to comply. The override is controversial: some see it as a loophole, and some legal systems do not recognise it. Section 378 of CAMA 2020 gives a similar power in Nigeria.
How IFRS reduces the problem
- Removing choices of policy.
- Rules on selecting policies (IAS 8).
- Disclosure of judgements, estimates and sources of uncertainty, and of significant policies.
- Firmer guidance on fair value (IFRS 13).
Disclosure does not ensure comparability, but lets users see the effect of differences.
Creative accounting and earnings management
Creative accounting is the use of aggressive or questionable techniques to produce a desired result, within the rules but not in the spirit in which they were written. It is not necessarily illegal, but it can cross into fraud. Earnings management is an attempt by management to influence reported earnings by using specific methods or changing them, such as deferring or accelerating income and expense.
Aggressive earnings management misleads stakeholders, and at the extreme it is a crime.
The spectrum, from most to least legitimate
- Normal policy choice within the rules, such as first in, first out (FIFO) or average cost for inventory.
- Reasonable estimation, such as asset lives.
- Judgement on classification of a cost, such as expensing or capitalising.
- Systematic selection of legitimate choices to push perception in one direction.
- Systematic selection at the margin of the rules, to alter perception materially.
- Artificial transactions to create material misrepresentation.
- Fraud.
Opportunity
- Subjectivity: more room for judgement.
- Complexity: hard to regulate precisely.
- Weak corporate governance: poor control over directors.
- Insufficiently independent auditors: under management pressure.
- Imprecise regulation: no clear benchmark to challenge.
- Inadequate sources of information: no evidence to challenge estimates.
- Inadequate penalties.
Incentives
- Income smoothing: a steady growth trend looks better than volatility.
- Achieving forecasts already announced.
- Profit enhancement to improve short-term perception.
- Share price, which may rise with earnings.
- Accounting-based contracts, such as loan covenants on gearing or interest cover, and profit-related pay.
- Director incentives: bonuses on EPS, share options, job security.
- Tax: lower profit to reduce tax, though the tax authority must also be convinced.
- Regulated industries: lower profit to influence a regulator.
- Internal accounting: moving profit between divisions or subsidiaries.
- Losses: pressure to improve results.
- Commercial pressures: a takeover bid or raising finance.
Risk is greatest where opportunity and incentive occur together, and professional scepticism should be strongest where directors benefit personally.
Overt and covert practices, and sustainability
- Overt practices change profit or position but are disclosed, for example not depreciating assets, capitalising development costs, significant provisioning, or changing depreciation policy. Informed investors can see through them.
- Covert practices are not disclosed, for example timing of revenue on complex long-term deals, overhead allocation, and many decisions to capitalise or expense. They are hard for outsiders to spot, so the effect on share price can be larger and shareholders may be mispriced.
Some practices can be sustained (income smoothing at a normal level of profit, off balance sheet financing). Others cannot, because they only move profit between years: capitalising expenses (the later years bear the amortisation) and bringing revenue forward (future profit is lower).
Consequences. Even where disclosed, markets may not be efficient, accounting-based contracts may be affected, and complex transactions may not be understood. Revelations of manipulation cause share prices to fall, and also reduce trust in reported earnings generally. A covenant on gearing or interest cover can be avoided by boosting equity or earnings, which helps shareholders but harms lenders.
Red flags
| Area | Warning sign |
|---|---|
| Cash flows | Operating cash flow consistently below reported operating profit |
| Profit and tax | Reported profit far above taxable profit without explanation |
| Acquisitions | Many acquisitions give room for fair value and provision games |
| Trends | Unusual year-end transactions; revenue and EPS growth out of line; swings between conservative and aggressive; provisions that move opposite to profit |
| Ratios | Old inventory and receivables; falling gross margin with rising net margin; inventory and receivables growing faster than sales; gearing changes |
| Policies | Minimum disclosure; changes in policy and estimates poorly explained |
| Management | Past estimates proved unreliable; always meeting forecasts; no profit warnings; interim results out of line with year end |
| Incentives and culture | Pay tied to reported earnings; takeover or other pressure |
| Audit and related parties | Unexpected audit qualification; material related party transactions involving directors |
No single flag proves manipulation. When several occur together, the auditor should be put “on inquiry”.
Common techniques
| Area | Examples |
|---|---|
| Timing of expenses | Under-provisioning in poor years and over-provisioning in good years; aggressive capitalisation; optimistic asset lives; accelerating expenses in good years |
| Revenue recognition | Recognising before it is earned; recording out-of-period revenue; recognising before goods move; cut-off errors; percentage-of-completion estimates |
| Reserves and exceptional items | Manipulating reserves; timing exceptional gains to offset exceptional losses |
| Off balance sheet financing | Structuring a finance lease to look like an operating lease |
Reducing profit on purpose: big bath accounting
Managers do not always want higher profit. If results will be poor anyway, they may make them worse: writing down assets and creating provisions, so that later years have lower costs and the provisions can be released back to profit. A new chief executive might do this to blame the predecessor.
For example, a ₦1 million restructuring provision created in year 1 (loss increases from ₦2,000,000 to ₦3,000,000) and released in year 2 turns an original loss of ₦1,000,000 into break-even. Rules limit this: IAS 37 bars a restructuring provision until there is a detailed formal plan and a valid expectation in those affected, and it requires measurement at each reporting date. Still, any rule that allows different amounts or different timing can be used creatively.
Performance measures and ethics
Earnings before interest, tax, depreciation and amortisation (EBITDA) is popular because it removes financing, tax and non-cash charges that rest on estimates. Its weakness is that IFRS does not define it, so companies choose what to include, and comparison suffers. In IFRS 18, an EBITDA-type figure used in public communications is a management-defined performance measure, so it must be reconciled to an IFRS subtotal.
Earnings management is ethically doubtful even within the rules, because the intent is to influence stakeholders’ decisions. The accountant who will get a bonus if targets are met faces a self-interest threat, and a manager’s reminder of that bonus may be an intimidation threat. On the other side, not manipulating earnings builds reliability, encourages prudence, sets an example, and keeps management focused on cash.
The profession’s code of ethics, not only the letter of the law, is the safeguard.
The rules in more depth
Why disclosure does not cure everything
If a company changes its depreciation policy and says so, users can adjust. If it moves a sale across the year end and says nothing, they cannot. That is why covert practices are more serious.
Why ratios move
A booked sale raises profit and so ROCE and EPS, and the extra net assets lower gearing. Capitalising a cost lifts profit and assets, and so ROCE and EPS, now at the expense of later years. Removing a liability raises profit and lowers liabilities at once.
Why a pattern matters more than one item
One optimistic estimate may be honest. A string of choices that all push profit in the same direction in the year the bonus target was close suggests intent.
Worked example: the effect of a window-dressed sale
Scenario. Draft accounts of Bright Plc show profit before interest and tax (PBIT) of ₦60 million, interest of ₦10 million and profit after tax of ₦50 million (tax ignored for simplicity). Capital employed is ₦400 million (equity ₦320 million, loans ₦80 million) and there are 10 million shares. Just before the year end the finance director records an extra sale of ₦40 million (cost ₦20 million) to a friendly customer, to be reversed in January. The figures are illustrative. Show the effect.
- Before:
ROCE = 60 ÷ 400 = 15.0%.
EPS = 50 ÷ 10 = ₦5.0.
Gearing = 80 ÷ 400 = 20.0%. - The extra sale: receivables up ₦40m, inventory down ₦20m, so net assets and profit up ₦20m.
- After: PBIT = ₦80m. Profit after tax = ₦70m. Equity = ₦340m. Capital employed = ₦420m.
- ROCE = 80 ÷ 420 = 19.0%.
EPS = 70 ÷ 10 = ₦7.0.
Gearing = 80 ÷ 420 = 19.0%. - Assessment. ROCE and EPS rise, gearing falls, with no real change in the business. This is window dressing through premature revenue. Red flags would be a year-end spike in sales, receivables rising faster than sales and a reversal after year end.
- Safeguards. The auditor tests cut-off (s. 407(3) of CAMA 2020), the audit committee reviews the policy (s. 404(7)), and the CEO and CFO answer for the controls (s. 405).
How to score full marks
- Define creative accounting precisely: within the rules, but not in their spirit. Say that it is not necessarily illegal.
- Pair opportunity with incentive. Examiners reward the idea that risk is highest when both exist.
- Calculate the effect on ratios when numbers are given: ROCE, EPS, gearing, gross margin. State the direction and the reason.
- Give red flags by group, not a random list: cash, trends, ratios, policies, management, incentives, audit.
- For ethics, name the threats (self-interest, intimidation) and the principles (integrity, objectivity, professional behaviour).
- Balance the answer: some choice is legitimate, and the line is a matter of degree and intent.
Common mistakes in the exam
- Calling all creative accounting illegal.
- Giving incentives without opportunities, or the reverse.
- Saying revaluing an asset improves every ratio. It lowers gearing but usually lowers ROCE and EPS.
- Forgetting that capitalising expenses and early revenue only move profit between years.
- Ignoring the cash flow check.
- Writing about manipulation to raise profit only, and forgetting big bath accounting.
- Treating EBITDA as an IFRS-defined measure.
Quick revision
- Creative accounting: within the rules, against the spirit. Earnings management is a type.
- Spectrum: policy choice, estimation, classification, systematic selection, marginal, artificial transactions, fraud.
- Opportunity: subjectivity, complexity, weak governance, weak auditors, vague rules, little information, weak penalties.
- Incentives: smoothing, forecasts, share price, covenants, bonuses, tax, regulation, takeover.
- Overt (disclosed) and covert (not disclosed). Sustainable and unsustainable.
- Red flags: cash gap, tax gap, trends, ratios, policies, management, incentives, audit.
- Big bath: bad news in one year, release later.
- CAMA 2020: ss. 378, 404(7), 405, 406, 407(3).
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. Creative accounting is best described as:
- Always illegal fraud
- Using accounting choices within the rules to produce a desired result, not in the spirit of the rules
- Following IFRS exactly
- Auditing the accounts
Show the answer
B. It is not necessarily illegal but can cross into fraud.
Question 2. The risk of creative accounting is greatest when:
- There is opportunity only
- There is incentive only
- Opportunity and incentive occur together
- There is neither
Show the answer
C. Both elements are needed.
Question 3. Which of the following is an incentive for earnings management?
- A bonus based on earnings per share
- Strong governance
- Precise regulation
- Independent auditors
Show the answer
A. The others reduce opportunity.
Question 4. Practices that change profit but are disclosed are called:
- Covert
- Overt
- Fraudulent
- Statutory
Show the answer
B. Covert practices are not disclosed.
Question 5. Which of the following is a red flag?
- Operating cash flow consistently below reported operating profit
- Operating cash flow close to profit
- Consistent policies
- Early audit sign-off
Show the answer
A. A persistent gap needs explanation.
Question 6. Revaluing a depreciable asset upwards usually:
- Raises ROCE and lowers gearing
- Lowers gearing and lowers ROCE
- Raises both
- Changes nothing
Show the answer
B. Equity rises, but so does depreciation.
Question 7. Big bath accounting means:
- Cleaning the office
- Recognising all the bad news in one year so later years look better
- Paying a large dividend
- Refinancing debt
Show the answer
B. Provisions made now can be released later.
Question 8. A sale of ₦40m (cost ₦20m) is recorded before the year end and reversed after it. The effect on profit in the year is:
- ₦20m higher
- ₦40m higher
- ₦20m lower
- Nil
Show the answer
A. The profit on the sale is ₦20m.
Question 9. EBITDA is:
- Defined by IFRS 18 as a mandatory subtotal
- Not defined by IFRS, so companies choose what to include
- Always audited
- A tax measure
Show the answer
B. In IFRS 18 it may be a management-defined performance measure.
Question 10. Which section of CAMA 2020 makes it an offence to influence, coerce, manipulate or mislead the external auditor?
- Section 406
- Section 394
- Section 402
- Section 413
Show the answer
A. Section 405 covers the CEO and CFO certification.
Written questions
Question 11 (10 marks). (a) Define creative accounting and explain why it is not necessarily illegal. (3 marks) (b) State four circumstances that give the opportunity for creative accounting. (4 marks) (c) State three incentives for creative accounting. (3 marks)
Question 12 (20 marks). (a) Describe the spectrum of creative accounting practices from most to least legitimate. (5 marks) (b) Distinguish overt and covert creative accounting and explain why covert practices are more harmful. (5 marks) (c) State five red flags that an analyst or auditor would look for.
(5 marks) (d) Draft accounts of Bright Plc show PBIT ₦60m, interest ₦10m, profit after tax ₦50m, capital employed ₦400m (equity ₦320m, loans ₦80m) and 10m shares. A year-end sale of ₦40m (cost ₦20m) is recorded and reversed in January. Calculate ROCE, EPS and gearing before and after the sale and comment. (5 marks)
Question 13 (10 marks). Bonny Camp Plc has a new managing director who considers EBITDA the key measure and suggests that reported profit and EBITDA can be managed to show strong results. The financial controller will receive a large bonus if targets are met. (a) Explain, from an investor’s view, the benefits and shortfalls of reporting EBITDA.
(5 marks) (b) Comment on the nature and incentives of earnings management and whether it is ethically acceptable. (5 marks)
Model answers
Show the model answer to Question 11
(a) Definition (3 marks). Creative accounting is the use of aggressive or questionable accounting techniques to produce a desired result, following the rules in letter but not in the spirit intended. (2) It is not necessarily illegal because it uses choices and judgements the rules allow, though it can cross into fraud. (1)
(b) Opportunities (4 marks, any four at 1). Subjectivity. Complexity. Inadequate corporate governance. Insufficiently independent auditors. Imprecise regulations. Inadequate sources of information. Inadequate penalties.
(c) Incentives (3 marks, any three at 1). Income smoothing. Achieving forecasts. Raising share price. Accounting-based contracts such as loan covenants. Director bonuses and options. Tax. Takeover or fundraising pressure.
Show the model answer to Question 12
(a) Spectrum (5 marks). Normal policy choice within the rules. (0.5) Reasonable estimation and judgement. (0.5) Judgement on classification, such as expensing or capitalising. (1) Systematic selection of legitimate choices to push perception in one direction. (1) Systematic selection at the margin of the rules to alter perception materially. (1) Artificial transactions to create misrepresentation. (0.5) Fraudulent activities. (0.5)
(b) Overt and covert (5 marks). Overt practices change profit or position but are disclosed, such as not depreciating assets or capitalising development costs. (1.5) Covert practices are not disclosed, such as timing of revenue on complex deals or overhead allocation. (1.5) Covert practices are more harmful because outsiders cannot tell manipulation from real improvement, so shares may be mispriced and shareholders may suffer undue loss. (2)
(c) Red flags (5 marks, any five at 1). Operating cash flow out of line with profit. Reported profit out of line with taxable profit. Many acquisitions. Unusual year-end transactions or trends. Old inventory and receivables, or inventory and receivables growing faster than sales. Changes in policy and estimates poorly explained. Management whose estimates proved unreliable. Pay tied to earnings. Unexpected audit qualification. Material related party transactions.
(d) Bright Plc (5 marks).
- Before.
ROCE = 60 ÷ 400 = 15.0%. - EPS = ₦5.0.
- Gearing = 80 ÷ 400 = 20.0%. (1.5)
- After: PBIT ₦80m, profit ₦70m, equity ₦340m, capital employed ₦420m.
- ROCE = 19.0%.
- EPS = ₦7.0.
- Gearing = 19.0%. (2.5)
- Comment: profit, ROCE and EPS rise and gearing falls with no real change in the business, which is window dressing by premature revenue. (1)
Show the model answer to Question 13
(a) EBITDA (5 marks). Benefits:
- it removes depreciation and amortisation, which rest on subjective estimates and are non-cash
- it removes interest, which reflects financing decisions, and tax, which management does not control
- so it is said to show the effect of management’s operating decisions
(2.5) Shortfalls: it is not defined in IFRS, so companies can choose what to include, which makes it open to manipulation and weakens comparison over time and between companies. (2.5)
(b) Earnings management (5 marks). It means using judgement and structuring transactions to give a misleadingly good picture, commonly to meet a target. (1.5) Incentives include bonuses, share price, targets and job security. (1) Even within generally accepted accounting principles (GAAP) it is unethical if the intent is to deceive stakeholders. (1) The controller faces a self-interest threat from the bonus, and the managing director’s reminder may be an intimidation threat.
(1) It cannot be sustained and goes against the duty not to mislead stakeholders, so the code of ethics should guide the response. (0.5)
Pathfinder on creative accounting and earnings management
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The CFO wanted to spread a past service cost to make profits “more stable and attractive to investors”, which is income smoothing. The marking guide gives 4 marks for the IAS 19 treatment, 4 for the ethical issues under the ICAN Code and 4 for the effect on users. The incentives, ethics and red flag sections of this topic give you the language for the second and third parts.
Revise first: Creative accounting and earnings management
These questions ask how an accounting treatment changes ratios and what a reader should investigate further. The worked example shows how to calculate the effect of a manipulation on ROCE, EPS and gearing and what to say about it.
Revise first: Worked example: the effect of a window-dressed sale
Source: ICAN Pathfinder, Strategic Business Reporting. Diets covered: May Diet, 2026 and November Diet, 2025.
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