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Discuss the claim that creative accounting is just manipulation for short term gains and for the purpose of deception, thus every avenue that restricts its use should be pursued.
The word creative accounting was first used in 1986 Mel Book film "The producer", but the concept has been in reality for over 500 years. In the book written by Italian mathematician Luca Pacioli in 1494, he laid down some fundamental on creative accounting. It has been responsible for the numbers of high profile companies collapse around the United States and in other part of the globe between the 1930s and 1940s (citation). Recently in early 2000, the spectacular collapse of Enron and WorldCom have used creative accounting to manipulate the figures to compete with other companies. Accountants effectively used the judicial status of proceedings on the balance sheet to cover their economic means (citation).
The concept of creative accounting has always been seen as a malignant and a negative act (use and abuse. The accuracy and reliability of the financial statements are essential for the stakeholders of the houses in order to make appropriate determinations. But as soon as we hear about creative accounting, the image of its manipulation, dishonesty and deception in financial comes into our minds (citation). However, Creative accounting may be the colorful representation of a company’s assets, financial obligations and income. It is basically done to attract investors. The example of "the half glass of water" may be forced to explain the concept. If a glass is filled with water to its half volume, and so instead of saying "it is half empty", the creative accountants would prefer to say "it is half full"(cite from webpage). According to Kamal Naser, Creative accounting refers to the use of accounting knowledge to see the reported figures, while remaining within the sound ability of accounting rules and laws, so that instead of showing the actual performance or position of the fellowship, they consider what the management wants to tell the stakeholder (cite from Brij).
The aim of this research essay is to provide the effect of creative accounting for the business of the company. It will also explain the techniques used by managers or corporate to manipulate their account to show the desired result for their personal short term goals and role of corporate governance in it. Moreover, this essay will also identify the professional and ethical limits on the illicit use of creative accounting.
Creative accounting is used by businesses for their short term profit. Many companies are running their businesses in the market on edge with other investors. In this era of tough competition and sinking profits, managers tend to apply the concept of creative accounting in their businesses to achieve their short term time horizons and opportunistic investing. Of course, many businesses need to manage both short-term and long-term scopes. In such a world of goods and services, a approach of making a series of sequential short-term investments and commitments can be economically justifiable.
The recent global financial crisis has advised that the trend of short-term profit seeking has had a huge impact on the financial industry, along with other industries. The recent case relating the mortgage-banking desk at Citigroup is an ideal way to explain the terminology of 'short termism' which tells that the collapsed time horizon of both business decision makers and investors, not only harm an enterprise’s reputation and value, but also invites individual and institutional corruption.
Creative accounting has substantially increased because companies and businesses are constrained by a lot of forms of constructive rights, obligation and constraints based on account or report. There are a lot of reason for why creative accounting took place: to get increase investors confidence, ability to report stable earnings and psychological expectations due to changes in anticipated income, positive effects of income smoothing on expectation, on securities valuation and risk reduction, tax motivation, executive compensation tied to income measurement, change in accounting method or due to ways companies designed their accounting policies (cite from out).
The main problem which occurs in the businesses are the leading people who really only focus on their short-term and short-sighted profit. When these people observe the accounting as a necessary evil and a tool with which they could play and modify with accounting that can lead to harm for the company's future. This approach creates a new sort of accounting, which is called in accounting practices, creative. It is an imaginary concept because their primary goal is to fulfil the ideas of the owners which plays a decisive role and is known as deceptive accounting.
Creative accounting gives the managers or corporate governance the power to adjust or misrepresent the companies underlying financial performance, making more difficult for an investor or financial analyst to assess the performance of the firm and to compare between different companies. For this particular reason, creative accounting is a deceiving practice which conflicts with the basic aim of accounting regulation transforming the exercise of standard setting in a redundant feature on one hand and on the other hand providing an unfair advantage to companies that are able to successfully practice this deceiving exercise.
In the application of accounting methods, managerial judgements used to report firm performance is not considered to be manipulative until this particular judgment is used with the intent to manipulate reported results. This is related also to the fact that managers may focus on short-term personal incentives such as maximizing salaries, bonuses, and other short-term compensations, rather than focus on the long term economic success of the firm. All those doubts appear where a separation of the ownership from the control of a corporation exists and in this respect the conflict that arises is described by the Agency theory.
Agency theory is one of the main factors why the manager's or corporate use creative accounting. Agency theory can help us provide a solid structure for the understanding of creative accounting. According to the Agency Theory, the firm is considered to be a legal fiction that serves as a focus for complex process that is characterized by conflicting features of the objectives of individuals (cite). The conflicts are mainly related to sharing the economic resources and the lack of confidence, these conflicts between the shareholders and managers being considered in the literature to be the root of creative accounting. It is this particular theory which had implemented in the area of manipulation of accounts, the idea that managers are not neutral in presenting accounting financial statements. The other view which is closely related to Agency Theory and the way it has gained more advocates is related to the fact that managers provide information through the channel of disclosure in order to achieve their own goals. In this context the disclosure strategies are regarded as opportunistic (Cite).
According to Sweeney reports presented in 1994, Companies which are near to a violation of debt covenants are more likely to use creative accounting for making income increasing accounting policy changes than others. Income smoothing has also resulted from management felt-need to neutralize environment uncertainty and dampen the wide fluctuations in the firm’s operating performance subject an intermittent cycle of good and bad times. The technique of income smoothing may hide long-term changes in the gains (important). Spohr also added that given the public firm’s clearer separation of ownership and management, the strongest identified motives for income smoothing was bonus plan and job security motive (cite from out).
The company's directors may keep on using an income-boosting accounting policy change in place to keep all the distraction attention news away. An example of income smoothing could be a alter in accounting method, Which helped K-Mart's boosted their quarterly profit figure of $160 million, by a happy coincidence distracting attention from the company slipping back from being the largest retailer in the USA to the number two slot.(cite from important)
Accounting ethics are concerned issues regarding right and wrong in the practice of accounting. Ethics developments tend to focus on educational areas on discussions related to conditional application according to the situation. In this respect, individuals tend not to absolutes the professional life and to judge every situation based on what they have to gain more. In business life this damage is equal to getting success, achieving the goals, by all means (creative).
In the present competitive markets, companies generally like to prefer a steady trend of growth in profit rather than showing fluctuating earning or gains. The principle of steady profits could be accomplished by creating unwanted elevated provisions for values of assets and liabilities in the profit earning years, so that these provisions could be reduced and thereby improve in the year with bad earning. The supporter of the creative approach thinks that it is a measure against the 'short-termism' of judging an investment on the basis of the annual earning achieved in the next years. It also helps to avoid higher expectation among the investor’s mind that even in the good years the organization in not able to produce good financial position as required. There has a significant amount of debate around to say that if the conditions on the company’s position are in fact volatile, then the investor has a legal right to know about it and income smoothing might again cover the change in long term profits trend.
In 1991 Revsine said that the problem in relation to both managers and shareholders and argues that each can draw benefits from loose accounting standards that provide managers with latitude in timing the reporting of income (Revsine). He added by saying that he thinks that the prime role of accounting is as a mechanism for monitoring contracts between managers and other groups providing finance; market mechanisms will operate efficiently, identifying the prospect of accounting manipulation and reflecting this appropriately in pricing and contracting decisions.
Revsine appears to take a teleological view of accounting in the private sector, allowing managers to choose between the alternatives permitted in 'loose' standards to achieve their desired end, but to take a deontological view of accounting in the public sector where he calls for tighter standards to prevent such manipulation. We might ask whether the presence or absence of market discipline justifies such ethical inconsistency. Ruland also discusses the distinction between a 'positive' responsibility, which here would be the duty to present unbiased accounts, and a 'negative' responsibility where managers would be responsible for states of affairs they fail to prevent. As we have seen, Ruland gives priority to the 'positive'. Within Revsine's framework, where all outcomes are deemed to be impounded in the process of contracting and price-setting, the distinction is not acknowledged. The 'duty to refrain' would imply avoiding the bias inherent in creative accounting while the 'duty to act' would involve pursuing the consequences to be achieved by creative accounting(creative accountin123).
In order to contribute to ethical developments, the accounting curriculum in higher education must focus not only on teaching students technical skills (Frank, Ofobike and Gradisher, 2010) such as how to perform accounting estimations, or interpretations of, accounting rules and accounting theory but also into explaining the role of ethics in accounting profession and the economic consequences of the lack of ethics. We tend to believe that the role of ethics and morality in the accounting profession has been largely ignored from the curriculum and this could have been resulted in the increasing documented of accounting scandals during the past decade.
When fraudulent reporting occurs, it frequently is perpetrated at levels of management above those for which internal control systems are designed to be effective. It often involves using the financial statements to create an illusion that the entity is healthier and more prosperous than it actually is. This illusion sometimes is accomplished by masking economic realities through intentional misapplication of accounting principles.
Recommendation/ Restriction 500
It is not completely possible to reduce the impact of creative accounting completely because of involvement of managers and auditors and slow work of regularities bodies. But it can be reduced to some extent by credible accounting in which it is stated that the impact of creative and fraudulent accounting can be reduced by streamlining the accounting and auditing system and more effective corporate governance(BRIJ).
There are several ways to put restriction on the negative aspect of creative accounting. Firstly, the firm's financial report governance plays a vital role in improving the quality of financial reports. It allows the shareholders to choose the independent directors who keeps an close eye on the activities of mangers. these reports are the true indicators of the firm's state and gives a clear vision about company to investors. Also, there should be independent auditors who are free from management's pressure and can function to provide a high quality reports to the shareholders and stakeholders. Moreover, in order to deliver the accurate financial reports, auditors need to follow their code of ethics. It reminds them that in spite of every manipulation, auditors need to check each transactions and query the managers if there is any suspicion. An auditor should be confident and up to date about the knowledge of existing laws and regulations. Auditors should make conditions on which companies have stop follow the same method of accounting in bad year, which they had used in good years.
Secondly, introducing forensic accounting for white collar fraud detection and fraud prevention may help to prevent it by dealing with complex financial matter, incomplete record, deception, lawyers, agencies and legal system (deolite.com). Reducing the alternative choices of accounting treatment in accounting standards. Furthermore, enhancing the quality of corporate governance to minimize asymmetrical information and to ensure compliance with mandated reporting requirement.
Sarbanes-Oxley Act which required a substantial change in vision of company's board to have a majority of their directors independently. The independence of the board of directors is associated with the protecting the interests of shareholders and election of top management.
• Enforcing strong regulation, and
Creative accounting offers a formidable challenge to the accounting profession. The problem is an international one, with accounting policy choice being a particular problem in the Anglo-American tradition and transaction manipulation a particular problem in the continental European tradition. There is a wide variety of motivations for managers to engage in creative accounting. The justification for creative accounting put forward in the 'positive accounting theory' tradition is:
In conflict with mainstream thinking on ethics.
Particularly relevant to the USA, where there is a well-developed stock market and a focus on detailed accounting regulation rather than broad principles, and is considerably less
elevant in other countries.
Accountants who accept the ethical challenge that creative accounting raises need to be aware of the scope for both abuse of accounting policy choice and manipulation of transactions. New Zealand offers an example of a country where a well-designed framework of accounting regulation has curbed creative accounting.(Important)