Many will likely consider ways to mitigate the impact of the announced law on additional profit tax (excess profit) going into public discussion on their company. However, it must always be kept in mind that the line between what is permissible within the frameworks of creative accounting and what is impermissible, manipulative, is very thin and must not be crossed.

In the current situation, when the law on additional profit tax for a certain group of business entities based on the income they will generate in 2022 is in preparation and public discussion, most of these business entities will certainly carefully consider how to optimize their balance sheet and reduce the tax base within what the law allows, thereby avoiding additional taxation. It must be known here that the boundary between what is permissible within the frameworks of creativity and what is impermissible – manipulative is not based solely on the application of the legal framework but largely on ethics. Laws and other acts are not omnipotent and practically all-encompassing, and if we want to present our balance sheet positions fairly, they cannot and are not the only support.

The definition of the goal and the method of maintaining accounting records and preparing financial statements is ‘to present key data about the financial-accounting operations of a particular company in a realistic, truthful, and fair manner.’ This is expected by all stakeholders of the company (founders-owners, managers, employees, customers and suppliers, investors and creditors, the budget, and the local community), who are also users of information from financial and other related reports, which are in constant search for useful and accurate information that is not the result of various manipulations from different interests and perspectives.

Managerial Accounting

Creative accounting, when viewed from the perspective of the needs of internal users, is interpreted through the concept of ‘managerial accounting’ in order to realistically and objectively present results, highlight all essential aspects, and create prerequisites for decisions about changes that eliminate obstacles and introduce improvements.

When viewed from the perspective of public disclosure of financial and other related reports, primarily for the needs of external users, there is an insistence on presenting the actual financial position and business results within the accounting regulatory framework, considering several possible more or less related goals, so that: trust is maintained and investor interest is developed, rights to bonuses are achieved and confirmed, preparations are made for takeovers or defenses against hostile takeovers, and the payment of profit tax is postponed for the next period, thereby improving liquidity.

In practice, creative accounting (‘romantic’ definition: imaginative use of accounting numbers) often turns into what is called manipulative accounting. This involves procedures that intentionally present falsified financial statements with the aim of deceiving the public. The maneuvering space is partly found in accounting standards, which are often unclear and very complex, and estimates are subjective.

The risks of possible manipulations progressively increase due to a lack of agile and competent management, independent oversight, and internal controls, especially excessive pressure to achieve short-term profits (now and immediately) instead of long-term sustainable and stable operations, and when decision-making is dominated by an individual or a small group. Protection against manipulations is partly achieved through transparent accounting policies, continuous development of competencies in the field of entrepreneurship economics, and the use of adequate analytical techniques and tools appropriate to the informational potentials of double-entry bookkeeping.

‘The ‘Sad’ and ‘Happy’ Report

Hypothetically, entrepreneurs would be happiest if they could prepare two reports at the end of the year, one ‘sad’ for supervisory institutions in which tax obligations are determined (the lower the profit, creating a tax shield using legally permitted ‘silent reserves’), and the other ‘happy’ for most other stakeholders (customers, suppliers, creditors,…) with the best possible profitability indicators (creating hidden losses), activities, liquidity, and indebtedness.

However, this is only hypothetical. The annual financial report is only one single report, so entrepreneurs and decision-makers, considering goals and priorities (bonuses and dividends, interest and credit rates, company value, tax payments, liquidity…) opt for the application of legally permitted, unfortunately sometimes also impermissible and fortunately relatively easily visible, techniques and tools to achieve them.

How Results Are Beautified

In an effort to beautify business results and financial indicators, revenues are prematurely recognized (for services that will only be realized in future periods, for deliveries that the customer has not yet accepted and confirmed, for deliveries that the customer is not obliged to pay until the testing period and/or trial work has passed) and are overestimated (commission and consignment sales, sales to intermediaries, neglecting recourse rights).

In the same intent, in manufacturing companies (including the production of intangible assets, software, etc.), in the cost accounting of inventories and production (which unjustifiably includes and defers too many costs), current period costs are reduced and profit margins are increased or losses are reduced. In the case of a need to present results as worse, the reverse procedures are applied.

Experienced managers, seasoned fighters for bonuses, with plenty of matches under their belts in which they have faced the ambitions or stinginess of owners, know that at the end of the year they can legally operationally beautify results: by temporarily halting procurement, improving collections through promotional discounts for quick payments, postponing the write-off of old assets, promotional sales under special conditions (rebates, payment deadlines…), selling long-term assets (one-time increase in other income). The author’s note on the last paragraph of the previous sentence: it is a pity that positions of extraordinary income and expenses (mostly one-time items) have been abolished in public reports under the pressure of particular interests of large capital and investors, which was very useful for better understanding how companies actually operate in their core activities.

And When to Reduce

Large (mostly international) conglomerates, aiming to reduce tax obligations and improve liquidity, use the possibilities of internal invoicing (between members of the conglomerate) for various intellectual and similar services, subtly interpreting and applying transfer pricing models (market, cost, and negotiated methods) and thus directing profits to locations with lower tax rates.

In smaller companies (where an individual or a small group dominates the ownership and management structure), personal consumption costs (entertainment, travel, household expenses…) can be hidden in costs; interest rates on loans from members of the company are applied as high as possible, depreciation rates are adjusted to the needs of results rather than corresponding to technical-technological processes and market conditions; costs of provisions (for severance pay, for potential costs in warranty periods and legal disputes); as well as costs of value adjustments of current assets (receivables from customers, inventories…).

Potential Frauds

The costs of external (cooperative) services are a particular area of interest when it comes to using tax shields or when potential frauds involve asset alienation or siphoning money from the company. Service invoices are inflated to transfer money to suppliers, money is paid to owners with profit tax payments, and then the money is shared among participants in the fraud. These types of fraud can be relatively easily forensically detected by checking suspicious invoices compared to market prices for such services. Companies that have collected falsified invoices usually have high profits paid to owners or unusual payments for services to private individuals. There is no strong motive for siphoning money from private companies if it is regular business, given that the profit tax rate is not high compared to other contributions.

However, when a company gets into trouble, it is possible to commit fraud by using false invoices and transferring money to private accounts to siphon cash from the company, leaving unpaid obligations after which the company is ‘pushed’ into ‘bankruptcy’ or insolvency to avoid paying obligations.

Value of Long-term Assets

Recognition and measurement (initial, subsequent) of the value of long-term assets, given extensive standards, allow for significant manipulations: by including/excluding costs at initial presentation (HSFI/MRS, which affects period costs), unrealistic estimates and changes in the useful life of assets, inadequate fair value assessments, deferring the activation of fixed assets, incorrect estimates of residual (salvage) value (liquidation value, sales after write-off).

When the revaluation of assets constitutes a majority of the assets, it raises questions about the credibility of such a balance sheet and the reality of the financial report. The most common goal of aggressive revaluation is to create an image of lower indebtedness as it increases the position of total capital, thereby reducing the share of liabilities in the liabilities.

Off-balance Sheet Records

Sometimes, in observing accounting records and financial statements, it is overlooked that off-balance sheet records are also accounting records that form an integral part of the general ledger and journal and are realized by applying the principles of double-entry bookkeeping. They encompass business transactions that at the moment of occurrence do not have a direct impact on changes in any position stated in the balance sheet, and represent control information in assessing financial risks and financial strength. It is essential that these records can, through the actions of future events, take on characteristics that affect balance sheet positions (guarantees, returnable packaging, third-party assets in lease…) or are deleted upon expiration of the usage period or as a result of their actions.

Inconsistencies Are Recognized!

When all of the above is read, one might conclude that anything is possible, that it is not a problem to act without consequences when creating business reports and presenting results according to that old ‘slightly’ adapted (reversed) in modern times ‘that the end justifies the means.’ However, it is not at all like that.

Double-entry bookkeeping, another invention of the Croatian mind (Benedikt Kotruljević, ‘Della mercatura et del mercante perfetto’, 1458.), and the tools and techniques of economic analytics that process data from accounting records and reports, enable those who know and wish to refine and apply that knowledge in practice to notice deviations from assumptions (continuity, consistency, occurrence of business events) and principles (prudence, substance over form, significance, individual assessment, temporal connection). To recognize inconsistencies and errors and based on that to act on their discovery and elimination, timely warning interested parties and thus make the economy safer, more stable, more successful, and sustainable in the long term.