The nature, incidence and ethical issues of creative accounting

6 June 2016

Creative accounting is also called “Earnings management” which is known as the manipulation of financial information. The term can be defined in many ways. Initially we define it as ‘a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business’ (Naser, 1993, p.59). Creative accounting, at root, is the origin of numerous accounting frauds.

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Many accounting scandal cases (like the scandals in Enron, WorldCom, and other firms) in the past few years had happened with the result of collapse. Most of these scandals were conducted by the senior management of organisations and many victims include the employees, shareholders as well as the society had been suffered from these fraudulent cases. Therefore, it draws our attention to why and how a company may use the creative accounting to commit its so-called “window dressing” (Ghosh, 2010, p.2).

This research will explore the nature, incidence and techniques of creative accounting as well as how it works. This research will first review the previous literatures to find out the certain definitions of creative accounting by various authors. Then it will look into what motivate people to commit creative accounting and techniques applied to commit creative accounting. The next is looking into the measures and responsibilities of detecting and combat creative accounting. In the rest we will discuss the key findings, recommendations and conclusion of this research. 1.2 Literature Review

There are various views of the definition of creative accounting by different scholars. Copeland (1968) defines it ‘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’. Griffiths (1986:1) presents his point of view that: “Every company in the country is fiddling its profits.

Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed in order to protect the guilty. It is the biggest con trick since the Trojan horse. . . In fact this deception is all in perfectly good taste. It is totally legitimate.

It is creative accounting.” Naser (1993, p. 59) defines creative accounting as “the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing rules and/or ignoring some or all of them”. It is the procedures of playing the financial numbers by skilfully applying the accounting standards and the selection of measurement and disclosure choices to achieve the financial performance which a company expected. Klein (2002) illustrates ‘Whereby the true financial performance of a company is distorted by managers for private gains’.

The above series of definition presented by various authors who although from different decades, their basic perspective towards creative accounting reach consensus. They agree that the primary concept of creative accounting is ‘a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business’.

1.3 Motivations of Creative Accounting

Numerous scholars have researched on the issue of what motivate the behaviour of creative accounting towards the management. Mulford and Comiskey (2002) identified various positive effects the managers would receive from manipulating figures.

They show that “the rewards may be any of the following: lower corporate borrowing costs as a result of an improved credit rating, favourable effect on share prices, political gains, and/or incentive compensation plans involving stock option or profit-sharing for top management and key employees which are tied to income measurement”. Shafren (2009) analysed internal and external of Satyam. He illustrates that shareholders are more aware of the financial reports of this company because financial reports present how well the company operates and its performance in the market.

Therefore, managers or directors mean to depict good performance and position by manipulating figures hence in such way the stakeholders will be shown positive indicators from the financial statements. By this way, investors will more likely to be attracted and given confidence with this superb financial report. This can be achieved by modifying the figures in the statements using the tricks of creative accounting. In addition, how many bonuses directors will receive in a year may base on the percentage of the profit reported (Shafren, 2009). For this reason of their private interest, directors may manipulate financial figures to meet their desire. Lttner, Larcker and Rajan (1997) have the same perspective.

They illustrate that when the directors or managers private interest (such as stock options and bonuses) is rely on the performance of the company, they are more likely to use creative accounting to manipulate the figures in order to achieve their favourable results. Another motivation of creative accounting is the positive effect that the income smoothing brings to the valuation of security and reduces the risk for the analyst. “Where management observes a gap between analysts’ expectation and the actual performance of the company and when major capital market transactions are being expected” (Amat, Blake & Dowds, 1999, p. 7).

Therefore, directors or managers manipulate financial figures to match with the figures they expected. Fox (1997) researched the company of Microsoft to look into how their accounting rules are designed to tie in the actual profits to forecasted profits. He identified that a considerable high proportion of the firm’s profit made by selling products was deferred to the following years with the aim to cover the potential upgrades and other costs.

Amat, Blake and Dowds (1999) suggest another motivation of creative accounting is related to the share price of a company. They illustrate “companies raise capital from new share issues, offer their own shares in takeover bids, and resist takeover by other companies”. Therefore, directors or managers try to lessen borrowing and create the performance of a positive earnings trend in such way to maintain or boost the share price of the company.

Where the managers participate in conducting shares of their firm, creative accounting may be used to postpone releasing the information for market. Hence, in such way, it would enhance the managers’ opportunities to obtain benefits from their inside information. Dharan and Lev (1993) have noticed that companies are likely to use creative accounting when their share prices start to drop comparing to the share prices which they have reported previously.

This is for the reason of huge stress produced by the various obligations as well as constraints depended on the value stated in the reports. Hepworth (1953) reported in his work the existence of tax levies on the basis of income and confidence by the stakeholders and employees in management is also an important reason of using creative accounting. Directors or managers my apply the creative accounting to help lessen the pressure of tax levies in such way to pay lower possible taxes of income as long as the involving cost provided is not more than the income tax benefit (Beatty and Harris, 2001).

Niskanen and Keloharju (2000) have researched on the companies in Europe, they identify that the organisation tax would be the motivation for managers in the companies to use creative accounting. The above motivations identified are some of the common reasons for creative accounting. In general, the main reasons for using creative accounting are because of the gaps between the actual performance of companies and their internal targets and stakeholders’ expectations, desire of tax benefits and providing income smoothing. Thereby, stakeholders should be more aware of these areas. 4.4 Techniques of creative accounting

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