Creative accounting is a practice that potentially being undertaken as a result from some individual care more on their own interest and indirectly causes issues arise in ethical dimension of creative accounting. From information perspective, agency theory gives a clear picture on creative accounting scenario. Whereby managers misuse their privileged position in manipulating financial reporting in their own interest which providing superior information content to shareholder. Lack of personal skill or unwillingness to carry out detailed analysis making individual shareholders do not have the clear view on the effect of accounting manipulation give a high possibility in the incidence of creative accounting.
Definition of creative accounting
In the USA, the preferred term of creative accounting is “earnings management”, however in Europe the preferred term is “creative accounting”. Generally, creative accounting is accounting practice that falls outside the regulation and give benefit to certain people. It can be described as a practice with a clear aim to interrupt the financial reporting process which affects reported income to make it looked normal and provides no true economic advantages to relevant parties like shareholders. Concisely, creative accounting is the transformation of financial accounting figures from what they actually are to what users’ desire by taking advantage of the accounting policies which is permitted by accounting standard.
Motivation for creative accounting
There are several motivations have been identified in stimulating the behaviour of creative accounting in the organization. These are proven by various researches being done in the past.
Firstly, the significant motivator for creative accounting is to report a decrease in business income to lower the tax paid. Second, to enable the company’s performance appear better in future, company will maximize the reported loss to make bad loss in that year. This is called ‘big bath’ accounting for the purpose in smoothing the income. Thirdly, to provide positive view on expectations, securities valuation and reduction on risk for analysts in anticipated capital market transactions and maintain firm’s performance in analyst’s expectation.
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Other motivations are to manipulate profit in order to match the reported income to profit forecasts and to distract attention from negative news by boosting company’s profit figure though change in accounting policies. Managers’ motivations in managing earning aim to report a stable growth in profit not only to reduce the perception of variability toward organisation’s earnings, but also are in relation to income measurement. In order to make company faces less risk and gain more benefit in aspect of raising fund, takeover bids as well as prevent takeover by other company.
Creative accounting is needed to maintain or promote the share price and create a good profit growth. To gain benefit from inside knowledge, director of the company engage creative accounting to postpone the release of information to the market. Last but not least, many types of contractual right, obligation and constraints based on the amount reported in the accounts also motivate company to apply creative accounting.
Techniques of creative accounting
Creative accounting is actively applied in six areas. The first area is regulatory flexibility, whereby changes in accounting policy are permitted by accounting regulation. For example, IAS permit carrying non-current asset can be recovered at either revalued amount or depreciated historical cost in asset valuation. Secondly, dearth of regulation by which some accounting treatment might not be fully regulated as there is few mandatory requirements.
The third area is management has large extent of estimation in discretionary areas, such as assumption in bad debts provision. Fourthly, some transactions can be timed as to show the desired appearance in accounts. For example, the manager is free to choose the timing to sell the investment just to increase earning in the accounts. Fifthly, to manipulate balance sheet amounts by using artificial transaction.
Last but not least, by reclassification and presentation of financial amounts through balance sheet manipulation in order to smooth financial ratios and also based on cognitive reference point in financial numbers’ presentation.
Existence of creative accounting
Theoretically, managers’ motivation in creative accounting is acceptable. However, there is various empirical studies have concluded that certain of companies apply a particular techniques of creative accounting to some extent, for example, applied in non-discretionary component of the bad debts provision. Other evidence is classificatory smoothing by using the extraordinary items, such as pensions cost, dividends from unconsolidated subsidiaries, extraordinary charges and credits and research and development costs in manipulating the figure of income in financial statements as it was proven by several researchers.
Merchant found that managers acknowledge manipulative behaviours in accounting information and Black argued non-current asset sales are exploited by manager as creative accounting tools through timing of its transactions since relevant accounting standards are permissive. Creative accounting behaviour is slightly still persisting although regulations are tightened.
Amat reported out of 35 large listed companies especially in Spanish identified that creative accounting behaviour was overt and considered legal. In addition, there are 3 possible indicators of creative accounting: (1) auditor report qualifications, (2) special authorizations from regulatory agencies, and (3) changes in accounting practices.
In Spanish case, the direction of creative accounting was connected to general economic conditions and this somehow affected reported earning and adjusted earning against Spanish listed companies. However, there are some unique features of Spanish accounting environment bring out special attention such as the audit report qualification are ordinary, and creative accounting may be arose from the collusion of the regulatory authorities.
Creative accounting behaviours can be identified by having thoughtful analysis of financial statement or observed by reasonably well- informed user of financial statement. But, how clearness the users of statement observe creative accounting is questionable. As in Spanish, analysts fail to report the existence of creative accounting. Anyway, value of information content in financial statement is concerned even though financial statements give adequate information enable users to adjust for creative accounting as certain investors rely on reported earning numbers in income statement.
Ethical perspective of creative accounting
There are some ethical issues concerning the exercise of creative accounting. Revsine stated that loopholes in accounting standards provide manager some spaces in the sense of manipulate the timing in income reporting. In his opinion, accounting is a tool to supervise contracts between managers and financial groups, identify possibility of accounting manipulation and how properly it reflected in pricing and contracting decisions. Ethics of bias in choosing accounting policy which implied in creative accounting can be seen through accounting regulators and management level.
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There are 2 views of accounting (deontological and teleological) which viewed differently by Revsine and Ruland. From Ruland’s perspective, deontological view is the moral applied to actual action and teleological view is actions should be judged based on the result of such action. Whereas from Revsine perspective, teleological view of accounting is employed in private sector which permit manager to use ‘loose’ standard to achieve what they want and deontological view is about strict standard in preventing accounting manipulation in public sector. In addition, Ruland has also differentiated positive responsibility and negative responsibility. From accounting perspective, positive responsibility refers to present an account free from bias. Meanwhile, negative responsibility refers to managers would be liable for actions done by others, which they fail to avoid. Compared to “duty to act”, Ruland has stressed on “duty to refrain”, which means avoid the inherent bias in creative accounting. Its importance can be looked into 3 issues, which are relentlessness, certainty of result and responsibility.
Professional accountant regards creative accountings are ethically doubted. Conner stated that managers tend to misapply accounting principles to give better appearance in financial statement to investors. Conflict of interest, client requests to alter account and for tax evasion are the most frequent ethical issues. Accountants’ attitudes toward creative accounting depend on whether it is arisen from misuse of accounting principle and manipulation of transactions. Merchant and Rockness found that accountants more critic in misuse of accounting principles as accountants duty is on rule-based and it falls within their expertise. Failure to act ethically may damage the reputation as an accountant unless he or she reports the abuse to the appropriate party. Slotting is not an acceptable accounting treatment in company practices.
There are some action can be taken by accounting regulators in order to restrain creative accounting:
Decrease allowable accounting method or fix method used in different condition so that scope for choosing accounting method can be narrow downed. Companies should also be consistent in using method chosen by them.
Some rules should be established to reduce the abuse of judgement. For instance, International Accounting Standards presently have almost removed the “extraordinary item” from operating profit. Also, companies should be consistent in applying accounting policy to restrain the abuse of judgement.
Implementation of “Substance over form” can decrease artificial transaction and this can make linked transaction become one as whole.
To restrict the use of timing of genuine transaction, item in account should be regularly revaluated. The increase or decrease in value should be stated in the account each year the revaluation occurs. International Accounting Standards also tends to value item at fair value rather than historical cost.
Besides alteration in accounting regulations, ethical standards and governance codes must be properly executed to avoid individuals from performing creative accounting.
Comparison with other author on the article presented
From the study done by Dilip and Eno in ‘Creative Accounting in Bangladesh And Global Perspectives’ found that the cause of creative accounting is the conflicts of interest among different interest groups. For example, managing shareholders want to pay less tax and dividends. Investor-shareholders are interested to get more dividends and capital gains. Country’s tax authorities would like to collect more and more taxes. Employees are interested to get better salary and higher profit share.
Dilip and Eno also reported that creative accounting may arise under 3 different financial market conditions:
Depending on the financial market evaluation of the company’s future prospects, company keep changes its shares to attract investors to contribute to such shares either at par or at a premium.
Aim to show a desirable picture of its financial conditions when the company whose shares are already listed in a stock exchange.
Based on inflated profits through overvaluation of assets, undervaluation of liabilities and change in systems of stock valuation that promote the image of company in a short time, company having its shares listed in the stock exchange may declare and pay high dividends.
Both of them examines creative accounting in Bangladesh scenario, they found out many of the company prospectuses published in Bangladesh are based on creative accounting. An expert opinion survey also done by them and result showed that although it is not clear for how long, creative accounting has been clearly practice in Bangladesh. Creative accounting not only being practiced in Bangladesh but it seems to be widespread globally in developed countries such as UK, USA as well as Australia. And the case of Enron is the most broadly known case of creative accounting in USA.
Dilip and Eno also suggested that the code of professional ethics should be strictly overemphasized. Accounting education is needed as well as the responsible of instructor to instill moral values of integrity, honesty and sincerity into student’s character as it is critical to modern society, the business world and the accounting profession.
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