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This project will explore several definitions of creative accounting and the range of reasons for a company's directors to engage in creative accounting.
It explores the nature and occurrence of creative accounting practices within the context of ethical considerations.
In addition, it considers the various ways in which creative accounting can be found and summarizes some empirical research on the nature and incidence of creative accounting.
The role of the auditors in deduction creative accounting is discussed, drawing evidence from several empirical studies.
Then, it will illustrate the source of data, the sampling method and the data analysis technique that has been chosen for this research.
Finally, the paper concludes with the analysis of possible solutions for the creative accounting problem.
Manipulation of financial information is known by several terms. In USA the preferred term and widely used is "Earnings management" whereas in Europe the favored term is "Creative Accounting" and also this term will be used in this study. The term can be defined in different ways. However, primarily it is 'a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business'. Further definition will be explored later in this paper.
Creative accounting occurs when managers involve in changing the accounting figures to alter financial reporting. The motive behind the alteration is either to mislead stakeholders about the poor performance of a company or attract new contract and investment that depend on figures in statements.
This research will apply the previous study in some scandal cases, such as Enron to find out whether it has same motive as mentioned by other authors. In addition, it will show the way in which managers have used creative accounting to committed fraud.
The rest of study is organized as follows. In chapter 2 the literature is reviewed to pinpoint certain definition of creative accounting and explore the motives behind creative accounting. In chapter 3 the research method is employed to identify the relevance of creative accounting to Enron annual reports. In chapter 4 the paper will discuss major finding, recommendation and conclusion of the study. In chapter 5 different sources of the study will be listed including articles, journals and so on.
- Rationale of study:
- Aims and Objectives:
Many fraudulent cases had been found in the past few years. These scandals had been made by directors and managers of the organizations. There are numerous victims who suffered from misuse of the position starting from shareholders, going towards employees and end up with societies.
Although most of these organizations have been audited by external auditors, the fraud has been occurred within the firms. This is because the auditors give only a reasonable assurance of their view on the financial statements and even some of them involved in fraud like Arthur Andersen.
There are many people who are still not aware of how the company may use creative accounting in manipulate the accounting figure and hence committed fraud.
This paper will explore the ethic and the way of using creative accounting providing with practical example.
- To understand the meaning and explore definitions of creative accounting.
- To explore several reasons or motives of the using CA by company's managers.
- To list and explain the techniques of creative accounting.
- To understand the role of auditors and responsibilities in deduction of CA.
- To identify whether the auditors (both external and internal) play role in minimizing the CA in corporation.
There are various scholars who defined creative accounting (CA) in different views. These are as follows.
- 'Involves the repetitive selection of accounting measurement or reporting rules in a particular pattern, the effect of which is to report a stream of income with a smaller variation from trend than would otherwise have appeared'. (Copeland, 1968)
- 'Is any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may in fact, in the long-term, be detrimental'. (Merchant and Rockness, 1994)
- 'Whereby the true financial performance of a company is distorted by managers for private gains'
It has noticed that although scholars from different decades had defined the CA, they agree the basic concept of CA which is use knowledge of accounting rules to manipulate accounting figure to show the faulty result of the organization performance.
- The reasons and motivations of creative accounting
- Techniques of creative accounting
- The role of auditors and their responsibilities
- The role of auditors in minimizing the CA in the firm
Various authors have studied about the issue of management motivation towards creative accounting.
Shafren (2009) concluded based on his analysis of Satyam Company that the stakeholders are interesting on company's financial statements because there are mean to show how the firm is performed and its position in market. Therefore, managers try depicting these figures in such way to send positive indicator to the investors. The investors always attracted if annual statement is superb. Thus, to express this view mangers aim to modify the statement by means of tricks of CA. In other hand, the directors also have their own reasons as their bonuses may decide in proportion with the profit they made or reported. Lttner et al (1997) have also agreed that when the manger bonuses and stock options are depend on the company performance there is likely that the manager modify the figures upward to get the desired result.
Dharan and Lev (1993) Showed in their study of 'The valuation consequence of accounting charges' that an organization used CA when its share price started to fall following the increase in share price which it reported previously. This reason arises when company face great pressure from a variety of obligations and constraints based on amounts reported in statements. For example: based on survey of US bank managers, they found that when a new bank manager hold responsible for an entity there is inspiration to adjust loan provision so he makes sure that any losses occurred by previous manager can be covered from this provision.
According to Beatty and Harris (2001) mangers may manipulate the accounting figures in such way to reduce the burden of tax levies or to allow them to pay lowest possible income taxes by providing that the cost involved is less than the income tax benefit. Niskanen and Keloharju (2000) agreed in their research of 'earning cosmetics in a tax-driven accounting environment: evidence from Finnish public firms' which is based on European companies that the corporate tax could be the reason for CA used by managers of the company.
These are some of common motives for CA. However, the most noticeable motives are modifying the accounting figures to show positive indicator to investors and downward the firm income for tax purpose. Therefore, stakeholders should at least to be aware of these two areas.
Largay (2002) wrote in his article of 'Lessons from Enron' regardless of the high regulation exist in some countries like USA, the accounting environment afford great flexibility. The potential way for CA and the techniques can be found in certain areas.
One of the techniques which can be used in CA as mentioned by Schipper (1989) is flexibility in regulation. He added in the article of 'Commentary on creative accounting' that accounting regulation provides a great flexibility in choosing any policies that are set by International Accounting Standard Board, for example it allows the non-current assets to be valued either at historical cost or at revalued amount. Thus, if management decide to change policies of the company it may easy to deduct in the year of change but it is much difficult to be identified after sometimes probably after few years. Another point is the lake of regulation in some area existing in almost every country. AS it can be seen in Romania and Spain where there are few mandatory requirements for stock option and recognition of pension liabilities.
CA can also be finding as the discretionary position of the management that may used in some items to obtain stability in financial position. This had explained by McNichols and Wilson (1988) that manager may decide to increase or decrease the provision of bad debts to adjust the desire result. The timing of some transactions also offers mangers the opportunity to increase the revenue and give an impression result when net profit is not adequate. For instance, company has an investment in historical cost which can be sold at current value (i.e. at higher value) where operating profit is showing an adverse figure. The third technique mentioned by the author is the artificial transactions that are usually use to manipulate balance sheet amount or to move the profit figure between accounting periods. This can be achieved by entering the related transactions with third party like a bank. Suppose an arrangement had made with bank to sell the asset to bank and lease back the same asset for the entire of its useful life. The arrangement consists of selling the asset at lower or higher value than in an uncontrolled transaction and the compensation is from the difference of rental price.
Gramlich et al (2001) said that firms may attempt to manipulate balance sheet in order to change the liabilities classification to improve liquidity ratio. Most of time this manipulation is occurred to improve the investors perception. Although there is not much difference between 298 million and 301 million, investors perceived the latest amount more than the earlier one.
The International Accounting Standard had been created to reduce or even eliminate the accounting fraud that is occurred by the management of the organization. However, sometimes IAS unintentionally plays role in committing fraud by providing different ways of treatment of an item in financial statements. All of the techniques have one motive which is to makes FS more attractive on the view of stakeholders.
After many alleged scandal cases occurred in last decade, many individuals, such as shareholders have lost confidence on the audit firms. They are wondering the responsibility of the auditors in deduction the fraud and whether they played key role in committing fraud.
According to Audit Committee Institute (2007) auditors should be aware of all circumstances that lead the firm to face a pressure from both within and outside the organization and thus, encouragement firm to involve in inappropriate earnings management (creative accounting). The independent audit should be often alert of the possibility occurrence of CA and should deeply understanding the company's processes in modifying accounting policies, estimates and judgments in order to assess these processes.
Donaldson and Palmer (2003) were mentioned in conference the role that auditors played in accounting scandals of Enron and WorldCom. The auditors failed to resist pressure faced by the manager and therefore, accept the misleading financial statements i.e. they involved in fraud. Auditing may depend on external sources to verifying data. However, if the employees of the company have an intention to defeat the auditing function, they can cooperate with individuals outside the company, so even the best auditors will be unable to protect investors from such conduct at all cases.
It had mentioned above how the auditors were involved in corporate scandal. However, internal and external auditors are also play role in at least to minimize these scandals when the audit standards, accounting standards and ethical code of conduct have been properly used.
Ebrahim (2001) had mentioned in his study of 'Auditing Quality, Auditor Tenure, Client Importance, and Earnings Management: An Additional Evidence' how the quality of auditors can be effective on earnings management or CA behavior. He used sample that listed in NASDAQ, NYSE and AMEX. The data was collected for 9 to 11 years. The sample included only the firms with fiscal year ended i.e. December 31. He found that the quality of auditor and the firm size had no relation with creative accounting.
Amat et al (2008) argued in their empirical study of 'Earnings management and audit adjustments: An empirical study of IBEX 35 constituents" the view of Ebrahim (2001). The sample of the study was collected from IBEX 35 index (Spain). It had collected a sample size of 42 companies for period between 1997 and 2004. The study attempted to explore the role of auditors in prevention of the creative accounting practice. As the result, this study had supported the significant role of auditors in financial market particularly in the prevention of CA practice.
Internal auditor's proactive role. Companies are expanding their internal auditing staff to help curtail earnings management and to comply with the requirements of the Sarbanes-Oxley Act. Not only do internal auditors seek out the unethical practices, but their presence alone is a preventive measure. Auditors have many tools available to detect unethical practices. Trend analysis searches for unusual variations in revenues and expenses, and cutoff testing (carefully monitoring purchases and sales close to the year's end) is invaluable for finding year-end distortions. The author advises internal auditors to review accruals and restructuring costs, since these have been a source of problems in the past, and to report any evidence of earnings management promptly to the board's audit committee. The auditor's effectiveness as a watchdog depends on having a direct line of reporting to the board and carefully documenting any suspicious practices.