Literature review on creative accounting:
Fair value measurement on property, plant and equipment and investment property
Table of Contents
As Blake and Lunt (2000, p.375) rightly surmise within their work on accounting standards, the term “creative accounting,” was originally coined by the media, and it was particularly prevalent around the time of the Enron financial disaster. It was partially because of the financial collapses of firms like Enron and the major debate that followed these events, that International Accounting Standards were introduced. Amongst the main objectives of these standards, which were intended to make financial statements easier to understand and provide for more transparency (Alfredson et at 2007, p.6), one of the aims was curtail future opportunities for creative accounting.
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The IASB, when designing these standards started from the premise that corporate business had an obligation to account to investors, creditors and other stakeholder on a regular basis, usually within the annual financial statements, about the “performance, situation and future prospects of that business” (Alfredson et al 2007, p.4), which the focus being on the accuracy of this information. It thus sought to legalise this obligation and, through the standards, ensure that this result was achieved. However, despite the introduction of the standards and regulations, as Mulford and Comiskev (2002), Blake and Lunt (2000) have observed, irregularities in financial statements are still occurring. Many academic and professional observers are of the opinion that the measurements introduced by the IASB is serving to “obscure concrete evidence” in financial statements (Swanson and Miller 1989, p.1).
In particular these concerns are centred around the board’s movement away from historical cost accounting to a system of “fair value” accounting (Alfredson et al 2007, p.48), the introduction of which was against the wishes of many stakeholders (Williams 2006). Fair value is intended to improve the accounting measurements used in financial statements by ensuring that these reflect relevant and current valuations of the business (Blake and Gowthorpe 1998, p.1). However, the argument against fair value, quite apart from the fact that it takes up an inordinate amount of management time (Scott 2003, p.2), is that it provides opportunity for manipulation and misuse and thus increases the potential for creative accounting. This is particularly prevalent in the area of asset valuation.
The intention of this study is to investigate the arguments and debate that continues to surround the concepts and practices of creative accounting and the impact, if any, that “fair value” has had upon this issue. In particular, the study will concentrate upon these elements in relation to their use in the valuation of property, plant and equipment and investment property, which can in many companies, form a major part of their current balance sheet valuation. The objective is to assess and evaluate whether the introduction of the fair value concept has led to the intended improvement of financial reporting in these specific areas of the financial statements, or if creative accounting methods and processes are still being used to circumvent these improvements. It has been decided to conduct this research by using a literature review format.
Before being able to assess the extent to which the concept of “fair value” has impacted upon the reporting accurate values of assets in financial statements and the reduction of the prevalence creative accounting following the introduction of new standards and measurements, if any, it is important to understand the meaning and theories of creative accounting. Furthermore, understanding the reasons why these actions are being taken by so many corporate organisations is of equal relevance.
Within the wealth of literature surrounding accounting and accounting standards, there are a wealth of diverse definitions for the term creative accounting Hey-Cunningham, D (2002). For example, from an academic viewpoint Blake and Lunt (2000, p.375) define it as “that which does not faithfully represent the underlying commercial activity and is therefore not neutral.” Amat et al (1999, p.3) use even stronger terms to define creative ac counting, which they indicate is “a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business.”
As is perhaps to be expected, other stakeholders have been more forthright in their definitions and opinions. A business journalist, Ian Griffiths (quoted in Amat et al 1999, p.3), reveals the media view when he stated, “Every set of published accounts is based on books which have been gently cooked or completely roasted” commenting further that “It is legitimate. It is creative accounting.” An Investment analyst, Terry Smith, interviewed by the same authors (Amat et al 1999), also showed the level of concern felt about creative accounting in this segment of stakeholders. He commented, “We felt that much of the apparent growth in profits which had occurred in the 1980’s was the result of accounting sleight of hand rather that genuine economic growth.”
Acceptance levels and appropriateness in regards to the performance of creative accounting also show similar differences of opinions depending upon which particular stakeholder views are garnered. Whilst many say that manipulation, which is at the foundation of creative accounting, is an inevitability that cannot be addressed, whilst others believe that is the weakness of rules and measurements that allow this practice to continue (Langendijk et al 2003, p.31 and p.350).
It is apparent that the media and investors support the latter of these opinions. However, according to a survey conducted by Amat et al (1999, p.13) as part of their research into creative accounting, the auditor profession not only believed that it was inevitable, with 91% of UK respondents believing that it could not be solve, but also over a third were of the opinion that it was a “legitimate business tool.”
As indicated earlier, it is also felt that the introduction of the “fair value” concept as a measurement that would reduce the incidence of creative accounting is criticised as not being capable of fulfilling this role. The consensus is that this concept is expensive to implement, difficult to determine and verify, due mainly to objectivity characteristics, and is therefore easy for the opportunistic organisation to manipulate (Benston 12008, p.103).
Historically, creative accounting methods are used in a number of ways, all of which are designed to influence the financial statements and results produced by commercial organisations. Irrespective of whether these are directed towards the profit and loss account or balance sheet, all of these methods will have the effect of altering, or manipulating, the value of the business.
One popular method is that known as “income smoothing” (Alfredson et al 2007, p.682). The objective of this method is to avoid the appearance of volatile changes in profit growth levels. For example, if a business moves from £1 million profit in one year to £2 million in the next, but it is expected that the third year profits would fall by 25% in comparison to year two, income smoothing may be implemented in this year. The smoothing effect is designed to show a more controlled and sustained level of growth, as can be seen from table 1.
Table 1 Income smoothing
The smoothing process can be achieved in a number of ways. One of the most obvious routes of achieving this situation is by the manipulation of provisions or accruals (Antill and Lee 2005, p.129). In the case described above increasing accruals or reducing debtors would have the desired effect of moving profit from the second year into the third, thus smoothing out the volatile look of the profit curve that previously existed. As some of these provisions are based upon estimations, manipulation is difficult to verify (Alfredson et al 2007, p.682). For example, within the financial statements of financial institutions such as banks, there is a requirement to provide for existing and potential bad debts. As an significant element of the bad debt provision calculation is based upon judgement, which can be biased, it is possible for these figures to be manipulated to show a more favourable position than might in reality be the case.
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Another method of manipulating the financial results is related to earnings management. In this case the management of the business will have a particular target in mind (Mulford and Comiskev 2002, p.15). One target might be to move earnings from one year to another with the specific intent of manipulating the profitability of the business for that particular year. An example of this is given in the research of Amat et al (1999), where they took an existing investment that had a historical cost of £1 million but a current value of £3 million. As the business managers in this situation have the freedom to choose exactly which year they can sell the investment and realise the profit, they have the ability to manipulate the financial statement results by their decision.
Alternatively, sometimes a special “one off” charge may be included within the accounts, which will depress the profits and earnings. For example, if the payment of a lawsuit has been agreed to be completed over a period of years, it is possible that the management will decide to include all of these payments within one year. The management is then able to explain away part of the poor performance as result from this exceptional event. The difficulty is that, upon further examination of some exceptional items in corporate financial statement, it is often difficult to justify them being excluded from normal business operations. Therefore, it could be argued that they are, in effect, simply attempts to “window dress” the figures in an effort to put a more positive view on the results (Stolowy and Beton 2004).
One element of earnings management that has proven popular with corporate management is the “big bath” scenario, which is seen by academics as an opportunistic method of creative accounting (Reidl 2004, p.823). The theory behind the “big bath” is particularly useful when an organisation’s management can foresee that the results for a current year are going to be poor. To limit the impact that this might have upon the future, and effectively to show that this situation will soon be reversed, management will seek to increase these losses. In other words, they will “dump” as much expense as they can into the bad year (hence the term big bath) so that the next years profit show a more significant improvement in the company’s fortunes. Often this method of creative accounting will be used where there has been a change of management during the year. By affecting the big bath method, the new CEO is able to pass the blame for poor results onto the previous management team (Riahi-Belkaoui 2004 p.58). Of course, the manipulated improvement to the following year’s profits will have the benefit of improving the new team’s reputation with investors and other stakeholders.
Another example of creative accounting is apparent in the methods used by corporations to move items off balance sheet, particularly in the case of debt and financing (Pierce-Brown and Steele 1999, p.159). For example, where corporations sell property portfolios through a process of sale and leaseback, profits can be enhanced by manipulating the value of the portfolio. The downside of this process is that increases the rental amount but, the advantages are that this is spread over a number of years and, in addition, the increased values will have an immediate positive effect upon the current value of the business. In addition, companies are also afforded the ability through these processes to violate and circumvent debt covenants (Mulford and Comiskev 2002, p.91). As Pierce-Brown and Steele (1999, p.162) suggest, all it requires to achieve this situation is a change in the accounting policies put in place for the organisation.
In a number of creative accounting methods described within this section, particularly those relating to fixed assets, the key element of the method is its reliance upon judgement. If corporations therefore wish to manipulate their results in any of these ways therefore, all they have to do is ensure that the judgement secured is biased in the direction they require (Alfredson et al 2007, p.259). With auditors, actuaries and other experts having differing standards by which they would estimate valuations, for example some would be more cautious than others, influencing financial results in a particular direction is not impossible to achieve.
One of the concerns that have been expressed following the change to fair value is that, rather than reducing the opportunity for manipulation and creative accounting that previously existed, in certain areas this measurement has increased the potential. This is particularly seen to be the case in terms of business assets (Antill and Lee (2005) and Stolowy and Breton (2004)). For example, as with other areas of manipulation, the ability to be able to choose between some elements of asset valuations being based upon the historical cost basis, or using the fair value method of revaluation, this area can also be seen to have the potential of being influenced by biased judgements.
We have seen that the main result achieved from using the various methods of creative accounting is to change the revenue, earnings and value of the business, but the real question is for what purpose is being employed? In other words, which stakeholders does it benefit or disadvantage? The answer to these questions, as the literature being reviewed has indicated, the purpose of creative accounting has different objectives for each segment of stakeholders (Blake and Lunt 2000).
Firstly, many academic have concentrated upon the effect and benefit that creative accounting might have for the one group of stakeholders who are closest to the corporate operations, which would be the management team. The salaries, bonuses and other rewards for most CEO’s and senior management are linked to the performance of the business and, if these performance levels are not reached, the rewards will not be forthcoming. However, there is no negative impact on salaries related to the amount by which targets are missed, for example, whether the results are £1 million of £5 million below target salaries will remain the same. Therefore, if the CEO believes that in a particular year the business will not reach the required target, it is to his or her advantage to shift earnings from that year into the next in order to enhance and improve the potential size of future rewards (Investopedia 2008).
Furthermore, as has already been indicated in the previous section, management earnings manipulation is also a useful tool in enhancing the reputation of the management team itself. In addition to the benefits available to a new CEO and team as outlined, it is also possible that the same process will be used by management teams exiting the business to improve their attraction to future employees (Riahi-Belkaoui 2004). In other words it is being used for self interest purposes by the management (Scott 2003, p.91).
Wealth transfer is another popular reason for manipulation (Stolowy and Breton 2004). This is especially prevalent where there is a group situation with a number of subsidiary companies involved, where it is not difficult to manipulate the accounts by moving earnings or assets from one of the businesses to another. Such a scenario might be seen as favourable where part of the corporate assets, in terms of one of the group corporations, might be being groomed for possible takeover or flotation. Furthermore, in the case of a multinational, this method of Creative accounting is useful in transferring wealth from a business located in one country to that operating in another national location. In this case it can be helpful in combating political pressure that might be being exerted to transfer wealth away from the corporation (Pierce-Brown and Steele 1999, p.161).
Further evidence of manipulation for political purposes was examined in the work of Stolowy and Breton (2000, p.13). In this case they looked at this mode of creative accounting as related to corporations within the oil industry. What they found was that, during periods such as the Gulf War, which resulted in increased retail prices of fuel, these corporations adopted accounting policies that were designed to reduce their revenue. The purpose of this exercise was to limit the potential “political consequences” that might result from their organisations being seen to make higher profits during this period.
Finally, and perhaps the most important reason for creative accounting methods, it is the impact that these changes have upon current and potential investors that is often the focus of these actions. Most academic and professional researchers and observers, including Tweedie and Whittington (1990), Antill and Lee (2006), Barker (2001) amongst others, see this purpose as being the prime objective of creative accounting.
Manipulating revenues and balance sheet items, as well as earnings management are intended to present the corporation to the investor in a good and positive light, encouraging them to make and/or retain the investment (Stolowy and Breton 2000, p.10). These methods can also be used to have a positive impact upon investors decision making indicators, such as the P/E ratio (Barker 2001, p.2) and cash flow statements (Mulford and Comiskev 2002, p.354).
One of the adverse problems of this manipulation process is that it also has an effect upon the “accounting for risk” (Babbel et al 2003, p.16) and this can affect a whole industry. A typical example of this happening in practice can be witnessed in the current credit crunch (2008). There are those who argue that the effects of this event were exaggerated because of the financial institutions propensity for manipulating bad debts. It can be argued therefore that, whatever the immediate benefits are of creative accounting, and irrespective of which stakeholders receive those benefits, at some future stage there is likely to be witnessed an adverse reaction that will eliminate the short-term benefits. Furthermore, as the current bank crisis has indicated, the potential losses from this future reaction can threaten the continued existence of the corporation.
The international financial reporting standards, as indicated previously, were designed to reduce creative accounting. Two areas which were singled out for particular attention within this situation were the accounting standards to be used for the valuation of property, plant and equipment and investment property as these were seen as areas of the financial statements that have a significant influence upon the value of a corporation (IASB 2008).
There have been a number of measurements used in the past to arrive at a realistic value for these assets. The most commonly used was the historical cost method. This method used the initial cost of the asset as a starting point and then, as it was used within the business, depreciated that asset over what was considered its useful life, often using what was known as the direct line method of depreciation or amortisation. Foe example, if a particular item of equipment cost £10,000 and its life expectancy within the firm was set at 5 years, that asset would depreciate at £2,000 per annum. However, as Mulford and Comiskev (2002, p.321) rightly observe, the drawback to this system is that it often does not “correlate with assets whose value did not diminish predictably over time.” In the case of the £10,000 item used above, it might be that, at the end of its useful life to the company it was sold for £2,500, which means that, if this is received at the end of the useful life period, profits for the business for that year were enhanced by this amount. The argument against this system is that during the course of the previous four years the true value of the asset was not being reflected in the financial statements and this had an adverse effect on the value of the firm (Blake and Lunt 2000).
Another method of measurement that was used within some financial accounting environments was replacement value (Lindsell 2005). This method takes the cost of replacement as its marker for valuation rather than the historical price paid. It also relies upon the current value of the used equipment to provide a calculation of the difference. Using the example of the £10,000 asset as an example, if the replacement cost was £11,000 and the amount receivable should the used asset be sold is £9,000, there is a difference of £2,000 to be accounted for. This differential would effectively replace the depreciation reserve used within the historical cost method and was deemed by some to be more appropriate in that it reflected known values (Bens and Heltzer 2004). The only risk element in using this method is taking into account the judgement on the sale of the used asset.
A further method of measurement was introduced that relied upon exit value. The basic concept of this method was that it used the sales value of the corporation’s assets (Barker 2001, p.87). The calculation of this value might for example, be used in the case of the business being acquired by another or its value upon failure. The difficulty with both of these situations is that unless either situation was imminent, judgements and estimations had to be used to assess these values. One issue that arose with exit value, particularly in respect of the valuation of assets such as property, was the inclination to undervalue the asset for tax reasons (Mulford and Comiskev 2002, p.131). Others have referred to the asset sale element of this measurement as the net realisable value (NRV). This takes into account the market for the asset, the maximum return likely to be achieved, then deducts the cost of transportation and other ancillary disposal costs before arriving at the NRV value (Van Ziji and Whittington 2006, p.3).
Prior to the settlement on fair value as being the most appropriate measurements, one measure that most academics thought would be favoured by the “Standard setters” was the deprival value approach (Van Ziji and Whittington 2006, p.3.). The intention of this process was to determine the cost of the asset based upon the removal effect that it would have upon the business, in other words what cost would the business incur if it was deprived of that asset. As indicated, many academics thought this method would produce the accurate results. However, the professionals were not of the same opinion (Van Ziji and Whittington 2006) and, through the process of consultation and lobbying it was their voice that one the day. One has to wonder whether to threat to manipulation and creative accounting had any influence upon the decisions made by professionals.
Fair value was the concept introduced with the introduction of the IASB standards and measurements. The intention of fair value is to ensure that the financial statements produced by a corporation are a true representation of the physical values that could be achieved for the business assets and liabilities should these be liquidated at the date those statements were submitted. In this respect it differs from the historical cost method in that the most important statement under fair value is the balance sheet rather than the profit and loss account (Penman 2007, p. 8-9). Similarly, it favours realism rather than the conservative approach that was apparent in some of the previous methods (Swanson and Miller 1989, p.93). As most academics and professional observers are agreed, fair value has now become the most popular choice of all the available methods used within financial reporting statements (Stolowy and Breton 2000, Bens and Heltzer 2004, Staff team 2004 and Blake and Lunt 2000). However, one of its main disadvantages is its subjectivity. Those opposed to this method argue that “subjective valuations do not work when account objective values are what is needed” (Penman 2007, p.14).
Although some believe that fair value has a use for investors (Schroeder et al 2005, p.310), there are others that argue the “lack of verifiability of the inputs necessary to implement such a system potentially adds noise and bias over and above the more traditional historical cost estimates” (Bens and Heltzer 2004, p.2). Even the fact that, in appropriate instances, the fair value still allows corporations to use the historical cost approach, as is the case with some asset valuations, rather than reducing the concerns over this method, it is felt that the mixed measurement can do more harm to values (Swanson and Miller 1989, p.90 and p.160).
One of the major elements of the subjective argument is that fair values relies upon expert judgements and opinions, and that bias or error could lead to increased “volatility in financial statements” (Barth 2006, p.323) and also reduce the ability to be able to compare results across a specific industry or range of industries (Staff team 2004). As Antill and Lee (2005, p.67), the fact that fair value is reliant in most cases to expert opinion and natural bias means that the estimations included within the financial statements may differ from the actual values received for the assets, a position that will not be realised until the sale has taken place. Therefore, from the literature reviewed it is true to say that, irrespective of its increasing popularity, issues remain to be addressed in respect of the fair value method (Alfredson et al 2007, p.48). As Barker (2001, p.148) indicates, although the intention of this process is either to ensure there is a genuine relationship between the asset and the profitability of the corporation or, by indicating an overpayment eliminate its value, the current concerns relating to judgement and verification of values brings the practical implementation of these objectives into question.
In its introductory framework document to the IFRS standards, the IASB (2001) identified the four main characteristics of quality to be exhibited within financial statements as being “understandability, relevance reliability and comparability.” It further identified that the elements of the statements to be concentrated upon were: –
- An asset is a resource controlled by the entity because of past events and from which future economic benefits are expected to flow to the entity.
- A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
- Equity is the residual interest in the assets of the entity after deducting all its liabilities.
in relation to the balance sheet and, in terms of the profit and loss account ” The elements of income and expenses are defined as follows:”
- Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
- Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence’s of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
In the early editions of the standards, references and definitions of the “fair value” method of measurement to be used were sparse. However, following consultations (IASB 2007 a and 2007 b), efforts were made to address this situation. This resulted in the creation of the following fair value definition:
That fair value is “the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction” (Van Ziji and Whittington 2006, p.6).
The previous lack of guidance available was seen as a flaw in the standards (Alfedson et al 2007, p.7). This, together with the fact that the ISAB gave in to pressure from American corporations to give up on many of the changes that would have affected the asset of goodwill (Weil 2000 and Mard and Hitchner 2007), did not endear the system and standards to any experts, as continuing criticism from all sides has evidenced (Lee 2006). Both prior to and since the definition of fair value being introduced there has been
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