Creative Accounting Nature Incidence And Ethical Issues Accounting Essay

Published:

1. INTRODUCTION

This article was written by Oriol Amat and Catherine Gowthorpe which was filed in Journal of Economic Literature Classification. This paper focuses on the nature and incidence of creative accounting practices in the context of ethical consideration. Agency theory and information asymmetry between management and stakeholders are being introduced to provide concrete explanation for the creative accounting behavior. It starts off with the definition of creative accounting, follows by potential and incentives for a company's directors to engage in creative accounting. Besides, the authors also discuss the techniques of creative accounting and its existence was proved by the evidence from a few empirical studies. Lastly, the authors touch on creative accounting from the ethical perspectives and conclude this paper with some possible solutions.

2. DEFINITION OF CREATIVE ACCOUNTING

According to the authors, the USA prefers to use the term of 'Earning Management' while for Europe countries, the preferred term is 'Creative Accounting'. The authors are using the term of 'Creative Accounting' in this paper because some accounting manipulations involve primarily balance sheet rather than earnings management.

Lady using a tablet
Lady using a tablet

Professional

Essay Writers

Lady Using Tablet

Get your grade
or your money back

using our Essay Writing Service!

Essay Writing Service

There are several definitions of creative accounting as shown below:

Barnea et al (1976) stated that creative accounting is the deliberate dampening of fluctuation about some level of earnings considered to be normal for the firm.

Schipper (1989) said that 'creative accounting' is similar to 'disclosure management', 'in the sense of a purposeful intervention in the financial reporting process.'

According to the authors, they consider the creative accounting mentioned in this paper involves a transformation of financial accounts using accounting choices, estimations and other practices allowed by the accounting regulation.

3. MOTIVATION FOR CREATIVE ACCOUNTING

There are various studies that examined the issue of management motivation towards creative accounting behavior. As mentioned by Niskanen and Keloharju (2000), tax is a significant motivator. Imposition of tax levies are based on the income. The anticipated income has a positive relationship with the psychological expectation. The higher the psychological expectation they aim for, the higher the anticipated income.

Some countries may apply conservative accounting system and this will affect high level of provisions to accumulate. For the big bath accounting, the company makes a bad loss in order to maximize the reported loss in the year .They also hope that the future years will appear to be better.

The motivation for creative accounting is the gap between the actual performance and the firm expectation when there is a significant capital market transaction anticipated. The variance will lead to manipulation of profit to tie in to forecasts. According to high conservative accounting policy, this means that future earnings are easy to predict as it follows the trend each year. Creative accounting is the income-boosting accounting policy that changes in hand in order to distract attention from unwelcome news. For instance, when companies sell products, the large part of the profit is deferred to future years in order to cover potential upgrade and customer support costs.

Next motivation is the manipulations earning motives and the executive compensation which is linked to income. Manager's motives are to reduce the perception of variability underlying economic earnings of the firm. For instance, they observe the difference in motivation between managers in owner-controlled and management-controlled firms.

Besides, the motivation for creative accounting will help to maintain or boost the share price by both reducing the superficial levels of borrowing, and hence make the company less expose to risk and create a good profit trend. By issuance of new shares, offering the share in takeover bids, and resisting takeover by other companies will help to raise capital of the company.

It can also use creative accounting to delay the release of information to the market and hence give more opportunity for the insider of the company. The insiders of the company have the ability to know about the information of share before the share publishes to the public.

4. TECHNIQUES OF CREATIVE ACCOUNTING

The potential creative accounting has found in six principal areas: regulatory flexibility, a dearth of regulation, a scope for managerial judgments in respect of assumptions about the future, the timing of some transactions, the use of artificial transactions and finally the reclassification and presentation of financial numbers.

Lady using a tablet
Lady using a tablet

Comprehensive

Writing Services

Lady Using Tablet

Plagiarism-free
Always on Time

Marked to Standard

Order Now

The first technique is the regulatory flexibility. The accounting regulation allows people to choose policy. For instance, the company can make choices in respect of asset valuation. International Accounting Standards can make choices by carrying non-current assets at either revalued amount or depreciated historical cost.

The second technique is about limitation of accounting regulation in some area. There is some area that is not fully regulated. There are a few mandatory requirements in respect of accounting for stock options. Besides, the creative accounting does not follow accounting regulation when recognizing and measuring pension liabilities and certain aspects of accounting for financial instruments.

The third technique is about the discretionary areas. For instance, examine the discretionary and non-discretionary elements of the bad debts provision.

Besides, having a good timing for some transactions can impress the account. For instance, a business with an investment at historic cost can be easily sold for higher sales price than its current value. The managers can choose which year he wants to sell the investment in order to maximize profit.

Next, the artificial transactions can be entered to manipulate balance sheet amounts and profit between accounting periods. For instance, an arrangement to sell an asset to a bank follows by the lease of the asset back for the rest of its useful life. The sale price under the sale and leaseback can be artificial and the difference can be compensated by the increased and reduced rental.

The last technique is reclassification and presentation of financial numbers. The firm may want to have a good reported liquidity and leverage rate by manipulating the balance sheet figures and reclassify the liabilities. For instance, a human may perceive a profit of 301 million to be better than the normal profit that he usually receives which is 298 million. Hence, they indicate that some minor massaging of figures do take place in order to reach 301 million.

5. EXISTENCE OF CREATIVE ACCOUNTING

Researchers stated that the existence of certain techniques will result in creative accounting. McNichols and Wilson (1988) imitate the non-random elements of the bad debts provision to identify the discretionary element of accrual.

Barnea at al. (1976) negotiated the category of smoothing with the implication of particular elements.

Dempsey et al. (1993) indicated that managers have a tendency to report particular gains on the income statement and particular losses on the retained earnings statement.

Dascher and Malcom (1970) examined the information of 52 firms in the chemical industry sector which is relevant to four income smoothing criteria including pension costs, dividends from unmerged subsidiaries, particular charges and credits and cost of research and development.

Healy and Wahlen (1999) granted some findings about "compelling evidence" of income smoothing with accruals in banks and insurers.

Merchant (1990) investigated about management control of accounting information by using questionnaire data and interview in two companies.

Black et al. (1998) inquired into the sales of non-current asset as creative accounting tools where the related accounting specification approved will probably develop the creative accounting with time.

Amat et al. (2003) exposed a study about 35 Spanish larger listed companies that managed earnings during the three financial years 1999-2001. The objective of this study is to obtain the possible criteria for evaluating creative accounting. They are qualification of auditor's report, special authorizations from regulation authority to use non-standard policy, and changes in accounting policy.

1999

2000

2001

% of companies that managed earnings

40%

45.7%

25.7%

Number of companies

14

16

9

Reported earnings > Adjusted earnings

5

11

7

Reported earnings < Adjusted earnings

9

5

2

Source: Amat et al (2003)

Table 1: Number of Spanish larger listed companies (out of 35) that managed earnings during the period 1999-2001.

From Table 1 above, the reported earning is smaller than the adjusted earning in year 2000 and 2001 due to the decline of economy in Spanish compared to year 1999. It shows that there is a relationship between the economy situation and the trend of creative accounting. People tend to report more when there is an economy downturn and vice-versa.

Nevertheless, there are some abnormal criteria for the Spanish accounting circumstances. First, company usually can get the qualifications of audit report. Second, there is conspiring between company and rules authorities.

Lady using a tablet
Lady using a tablet

This Essay is

a Student's Work

Lady Using Tablet

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Examples of our work

However, the Spanish' report did not state about the presence of the audit report qualifications, special authorizations and any evidence of creative accounting performances. According to Dechow and Skinner (2000), they dispute the significant data of creative accounting because some investors may trust the superficial data as their knowledge are only restricted to the analysis of the data.

6. THE ETHICAL PERSPECTIVE

"Macro-manipulation" refers to the lobbying action by financial statements preparers in persuading the regulators to produce more favorable terms in according to their interest. On the other hand, "micro-manipulation" illustrates the management of accounting numbers at the entity level which results in an unfair view. The latter kind of creative accounting is given more discussion in this paper.

Revsine (1991) argues that both managers and shareholders can benefit from creative accounting. Managers are able to maximize their compensation by influencing the company's reported earnings. Shareholders also enjoy advantages of "smooth income" in the form of good shares price as the results of reducing the obvious volatility of earning and other management action such as attempting to avoid default on loan agreements.

Merchant and Rockness (1994) give an opinion that accountants are more serious of abuse of accounting rules than of manipulation of transactions. Two potential rationales are discussed by Fischer and Rosenzweig. Firstly, accountants may show less concern on the impact on users of the accounting figures, instead, they may apply the rule-based approach to ethics. Secondly, accountants also may not see their responsibility in the manipulation of transactions which they always think it is the domain of management and thus not subject to the same ethical code. In this case, accountants may only see abuse of accounting rules as falling within their domain. Besides, these researchers also come across that creative accounting based on self-interest of management may attract more disapproval compared to a motivation of theirs which is to promote the company.

However, accountants or managers may ruin their reputation and subsequently affect their career path if there is failure to take a stand against creative accounting particularly when they come to proposed accounting method which is in fact unacceptable. They are facing the same pressure as any other whistleblower. Therefore, Hamilton (1991) offers some suggestions to these people in order to cope with the above mentioned problem. The very first step for an accountant or especially a manager to do is to verify his or her suspicious about fraudulent things, as some accounting practices which look illegal are legal in fact. Next, look for alternative ways to reach the desired results and then recommend these as an alternative option to the management. If the management is still insisting on their way, a report should be made to the appropriate monitoring body.

7. SOLUTIONS

Creative accounting practice is seen as fraudulent and undesirable. The researchers have analyzed several procedures which can be taken to lessen the scope for creative accounting practices.

First, reduce the choice of accounting methods by limiting the permitted accounting methods or specifying conditions in which method should be adopted. Consistency in using the accounting methods is emphasized. Second, outline rules that lessen the use of judgment. Auditors' role is also important in identifying fraudulent estimates. Third, implement the concept of 'substance over form' to deal with artificial transactions. Next, revaluate items in the accounts regularly to identify gains or losses on value changes in the accounts as they occur each year.

Besides changes in accounting regulation, ethical standards and governance codes in the corporate world must be enforced thoroughly.

8. ADDITIONAL INFORMATION

Amat et al. (1999) have investigated and found that there has been reduction in the use of creative accounting practices based on the interviews they have conducted in New Zealand with Big Six and five other firms. Reasons for reduction include new regulatory framework and directors' own responses.