Nature, Incidence and Ethical Issues involved with creative accounting

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The nature and occurrence of creative accounting practices within the framework of ethical considerations was discussed in this paper. In this paper, definitions of creative accounting, possible reasons for directors to involve in creative accounting, how creative accounting can be attempted and summarizes of empirical research based on nature and occurrence of creative accounting was discussed to gain more understanding of creative accounting.

In addition, ethical issues of creative accounting and evidence from empirical research about creative accounting were also discussed. In the conclusion part, solutions for creative accounting problem were suggested.

DEFINITIONS OF CREATIVE ACCOUNTING

Barnea and others (1976) defined creative accounting as the intentional dampening of variations about earnings level considered to be regular for firms. Merchant and Rockness (1994) defined creative accounting as action of management which influence reported income and do not give true economic advantage to company and may be detrimental in the long-term.

Copeland (1968) defined creative accounting as the recurring selection of accounting practices to report income with a smaller fluctuation from trend. In conclusion, creative accounting involves a makeover of financial accounts using accounting practices allowed by accounting rules.

MOTIVATION FOR CREATIVE ACCOUNTING

Management has different motive in doing creative accounting. Several research studies have been conducted to investigate management motivation towards creative accounting. Obviously, tax is one of the important motivators identified in different research studies.

Another motivation for creative accounting is to report stable earnings, which known as income smoothing too, especially in countries with highly conservative accounting systems. In contrast, 'big bath' accounting is applied where loss in current year is maximized so that reports in future years appear better.

Managements go for creative accounting when there are anticipated capital market transactions, and when there is a difference between the expectation and real performance. In such situation, managements may manipulate the profits to meet current targets. At the same time, a company may have an income-boosting accounting policy through creative accounting to divert attention of others from unwanted news.

Research studies also indicated that the motivation for creative accounting included the manager compensation, the desire to maintain firm's underlying economic income, and the nature of a firm, whether it is owner-controlled or management-controlled.

In addition, creative accounting is used by management to maintain or boost the share price by reducing the apparent levels of information to the outsiders. Therefore, it is easier for the company to raise capital from new issuance of shares, offer own shares in takeover bids, and defend against takeover by other companies. Management can have advantage in insider dealing of own company shares through creative accounting too.

TECHNIQUE OF CREATIVE ACCOUNTING

Basically, creative accounting can be realized through six potential areas. Each potential area is listed and explained below.

Regulatory Flexibility

There is always a choice of policy in accounting regulation, for example, the method for asset valuation.

According to Schipper (1989), changes in accounting policy may be easily identified in the year of change, but difficult to be discerned afterward.

Dearth of Regulation

Accounting regulation is not fully covered all areas or aspects in accounting.

Scope for Managerial Judgment

Management has authority for judgment in discretionary areas.

Timing of Transactions

Account transactions can be manipulated and recorded at the desired time by management to achieve certain objectives.

Use of Artificial Transactions

Artificial transactions created with an obliging third party to control balance sheet amounts and transfer profits between accounting periods.

Reclassification and Presentation of Financial Numbers

Organizations may reclassify liabilities on balance sheets to alter reported liquidity and leverage ratios. (Gramlich et al., 2001)

The manipulation of financial figures is to achieve significant reference points.

EXISTENCE OF CREATIVE ACCOUNTING

Proving the existence of creative accounting is far more different and complicated than discussing it. However, over these years, numerous research studies which examined creative accounting have come to the conclusion that supports its existence.

Creative accounting behavior identified by Amat and others (2003) was relatively obvious based on the Spanish listed companies. In this study, there are three possible indicators of creative accounting:

Auditor report qualifications

Special authorizations from regulatory agencies to adopt non-standard policy.

Changes in accounting policy from one year to another

Analysis of financial statements is an important step in this study to identify all creative accounting behaviors. The observation also show that the analyst' reports in Spain fail to include the existence of audit report qualifications and special authorizations of creative accounting practices. This research result shows that some elements of creative accounting practices are usual.

THE ETHICAL PERSPECTIVE

Companies desire to show the report with the profit grow steadily. This report is done by having stipulation for liabilities and opposing assets value during good years so that the reported profit can be improved in bad years. The purpose of this method is to evaluate the sources generate in following years and prevent unachievable expectations. However, the investors have the right to be informed on the violation of trading provisions and the effects of income smoothing in profit trend.

Revsine (1991) considers the main function of accounting is to supervise the contracts between managers and groups who provide the finance so that the market mechanisms function efficiently and able to pinpoint the possibilities in creative accounting. The text about the ethics of bias in the accounting policy regarding on creative accounting is evaluate at both 'macro' level of accounting regulator and 'micro' level in the management of individual.

Ruland (1984) differentiated the deontological view and teleological view which deontological view is where the moral rules apply actual actions whereas teleological view is action should be evaluated on the moral worth of outcome. However, Revsine (1991) tends to perceive deontological view in public sector and teleological view in private sector. Ruland (1984) also talk about difference between 'positive' responsibility and 'negative' responsibility. 'Positive' responsibility is the responsibility to exhibit unbiased account while 'negative' responsibility is the managers' responsibility for the state of affairs which they fail to avoid. Compare with 'duty to act' which requires engaging with consequences to be attained by creative accounting, Ruland thinks that 'duty to refrain' that involve preventing the bias inherent in creative accounting is more critical because of the three issues which are relentlessness, certainty of outcome and responsibility.

Creative accounting seems morally doubtful for those professional accountants. According to Price Waterhouse senior partner's observation (Conner1986:78), fraudulent reporting normally occurs among those above management level in which effective internal control are designed. Financial statement are commonly used to generate the delusion that company is in better condition than it actually is by misapplication of the accounting principles to cover the economic realities.

Fischer and Rosenzweig (1995) and Merchant and Rockness (1994) discovered that accountants are favorable in violating the accounting rules while students are favorable in manipulating the transactions. The reasons are accountants may obtain rule-based approach to ethics and think that the violating of accounting rules is under their job scope which ethical judgment demanded.

Merchant and Rockness discovered that motivation of management impact the accountants' attitudes to creative accounting. This motivation was to advance the company. Accountants and managers who protest the creative accounting might face the risk of ruining their reputation. Schilit (1997) reports case where the accountant's employer, food wholesaler who capitalizes the slotting expense and amortize it for ten years. The accountant noticed that the employer was against the accounting treatment. Therefore, he notified the auditors to force the company expense but amortize the slotting. The company unable to pursue the auditors approves the capitalization of slotting costs. Later, the accountant was set off for the reason contrast with the employer judgment. To avoid having the same fate with that accountant, there are some suggestions such as verify the acceptability of the accounting method and do not interrupt something which is legal to avoid offense. In addition, the accountant should present legal method to attain favorable outcome to the management and mistreatment should report to the appropriate supervisor.

SOLUTIONS

We can see that creative accounting is a fraudulent and unwanted practice in general. In this section we will be discussing on some actions that can help minimize creative accounting practices. Below are some of the solutions:

Reduce range of accounting methods choice by reducing permitted accounting methods or by clearly specify conditions to use each method. Be consistent in methods usage also helps.

Control misuse of judgment. Draft regulations to minimize the use of judgment and be consistent.

Artificial transactions can be deal with by applying the substance over form concept.

Limit the timing of real transactions by regular revaluations of items in accounts.

Besides change in accounting rules, governance codes and ethical standards must also be enforced properly in the business world. Regulation without proper enforcement is useless in preventing individuals from practicing misleading reporting.

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