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Incidence and ethical issues of creative accounting

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    Many accounting scandal cases (like the scandals in Enron, World, and other firms) in the past few years ad happened with the result of collapse. Most of these scandals were conducted by the senior management Of organizations 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” (Gosh, 201 0, 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 functions 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 f which is to report a stream of income with a smaller variation from trend than would otherwise have appeared’. Griffith (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. Maser (1 993, 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 skillfully 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 resented 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. Motivations of Creative Accounting Numerous scholars have researched on the issue of what motivate the behavior of creative accounting towards the management. Multiform and Comprise (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, favorable 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”.

    Shaffer (2009) analyses internal and external of Astray. 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 DOD 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 (Shaffer, 2009). For this reason of their private interest, directors may manipulate financial figures to et their desire. Letter, Larker and Raja (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 favorable 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 reference of the company and when major capital market transactions are being expected” (Mat, Blake & Odds, 1 999, p. ). 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. Mat, Blake and Odds (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 he managers’ opportunities to obtain benefits from their inside information.

    Dharma and Level (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. Whooper (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 sing 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 (Beauty and Harris, 2001 ). Mistaken and Keelhauls (2000) have researched on the companies in Europe, they identify that the organization tax would be the motivation for managers in the companies to use creative accounting. The above motivations identified are some of the cornrow reasons for creative accounting.

    In general, the main reasons for sing 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 Chipper (1989) identified the most important and basic technique applied by creative accounting is the flexibility in regulation. Accounting regulation permits much flexibility in selecting and applying polices from generally accepted accounting standard (GAP).

    What is the significance of the legibility of GAP? The flexibility of the accounting standard leaves much space for making decisions in certain cases. Thereby, companies in similar positions may generate various consequences by selecting different accounting policies (Multiform & Comprise, 2002, p. 20). One example of flexibility in the choice of the accounting policies is the asset valuation. According to International Accounting Standard (SIS) 1 6, paragraph 29, it permits a selection between carrying nor-I-current assets by applying either cost model or revaluation model.

    As a result, companies may change their accounting policies validly in respect of their necessities. In accordance with Accounting Standards (AS) 1 paragraph 26, if it produces any material effect in the present period or a material effect is reasonably expected in the future period which are caused by changing of accounting policies, this change should be disclosed. When such a change generates a material effect in the current period, the amount by which any provision in the financial reports is affected by such change should also be disclosed to the extent ascertainable.

    The policy changed may be not difficult to identity in the year of change imperatively. However, it will be much difficult to be identified after few years (Chipper, 1989). Therefore, we need to consider the boundaries of creative accounting. Because GAP is a rules-based system (Remit 2008), there is a distinct line for most transactions between which measured for within the boundaries of GAP and those measured for cross the boundaries. “It gets gray in cases where GAP permits a particular accounting method, but that method is abused by an overzealous management”.

    For example, one of the requirements for revenue recognition (SIS 18, 2009) is delivery. A firm ay have fulfilled the delivery requirement, but by adding other contingencies to the sales agreement in the form Of a side letter (open return, postpone payment, other services provided), the revenue in question is effectively not earned. As another example, costs that benefit future periods may be capitalized. But some firms stretch the definition of what constitutes a future benefit and capitalize costs that should have been expensed.

    What these transactions have in common is that other firms in the industry are likely not accounting for them in the same manner. Directors or managers ay use the creative accounting discretionary in entire cases to achieve stable financial position of their companies. Nicholls and Wilson (1988) notice that managers probably determine to rise or lessen the provision of bad debts to obtain their desire result. In addition, the timing of transactions has also provided the managers with opportunities to raise the earnings, hence, give a better result when the profit is in deficiency.

    For example, a company holds an investment at historical cost which can be sold at higher value where operating profit is negative. The company managers are accretions to select the time of selling the investment, thereby, rise up the profit in the statements. Artificial transactions are also identified by Nicholls and Wilson as an effective creative accounting technique which is used to manipulate the figures from balance sheet and to transfer the profit amount between accounting periods. In order to reach this purpose, one or more related transactions are commonly entered with a third obligation party such as a bank.

    For instance, when the company had made an arrangement to sell a bank an asset and mean to lease back that asset for the entire of its useful life. Under this arrangement of sale and lease back, the price of sale can be beyond or below the current price and compensated for the gap between the raised or lessened rental prices. Grammatical, McNally and Thomas (2001) presented another technique by reclassifying and presenting of accounting figures. In their literature, they noticed that companies may engage in manipulating the balance sheet with the aim to represent and reclassify the liabilities to enhance the liquidity ratios.

    Cognition of the presentation of accounting figures signifies the reference points show a special type of creative accounting. Mistaken and Keelhauls (2000) illustrated that most manipulations in such a way are happened to enhance investors’ perception. They gave an example ‘the idea behind this behavior is that humans may perceive a profit of, say, 301 million as abnormally larger than a profit of 298 million’. In spite of not changing much from 298 million to 301 million, people are always more aware of the latest figure than the earlier one.

    Exchange (2002) have the same perspective. He presented that managers do massage the minor different amount to reach that considerable reference points. Whereas the design of International Accounting Standard SIS) is aim to lower or avoid committing accounting fraud which is caused by the operation of management in a company, SIS, sometimes, provides various methods of polices of an account in financial reports. Although SIS is not mean to produce any bad results, it does play a part in committing fraud.

    All above techniques identified have a common motivation that is to perform financial statements more appeals on the perception of stakeholders. 4. 5 Auditors’ role and their responsibilities After a number of accounting scandals happened in last decades, many people, for example, shareholders or investors have lost faith in the audit companies. They feel uncertain towards the auditors’ responsibilities assigned to the responsibilities of auditing in reducing or even eliminating the accounting fraud and whether or not they took part in committing fraud.

    Individuals debate on the disparity between the actual audit performance and the expectations from auditors. Audit Committee Institute (2007) has presented that auditors should be more aware of the various creative accounting opportunities that exist. This can be achieved by obtaining a thorough understanding of all circumstance around the company that may bring it about the pressure or incentives from inside and outside the many, and thereby, motives the company to engage in inappropriate creative accounting.

    The independent auditors should be constantly vigilant to the possibility of creative accounting and clearly understand the firm’s process to choose or modify their accounting policies, estimates and judgments, in such way, these processes can be assessed. Buena and Humphrey (1995, p. 714) explained the responsibilities of the auditors should involve in evaluating the internal control systems of the firm to detect in a avoidance attitude in the case of creative accounting or the possibilities of committing fraud.

    Donaldson and Palmer (2003) have analyses the collapse Of World and Enron. They investigated the role and responsibility of both firms’ auditors and concluded that they accepted the inappropriate financial reports because of their failure of resistance towards the managers’ pressure. In the other words, the auditors had committed in fraud by this way. Auditors may base on outside resources to confirming information. Nevertheless, if the directors or managers in the firm are intentionally to weaken the function of auditing they can in collusion with the external individuals.

    Therefore, no tater how good auditors they are, they may not be able to keep the stakeholders from such operation at entire situations. 4. 6 Auditors’ role and responsibilities in reducing creative accounting Whereas the above has referred to an auditor can be committed in accounting scandals, inside and outside auditors are also play a significant part in minimizing such fraud as long as the standards of ethics, auditing and accounting have been correctly applied. Abraham (2001) have discussed how can the auditors effectively carry out their responsibilities to reduce or eliminate creative accounting.

    He included there was no relationship between creative accounting and the auditors’ quality as well as the organization scale by using sample collected from NYSE, NASDAQ and AMES. Mat (2008) investigated the role of auditors in elimination of creative accounting behavior by analyzing another sample listed in IBEX 35 index. However, he concluded in the opposite Of the result published by Abraham (2001 Mat (2008) concluded that auditors had played important part in financial market especially on the occasion of elimination of creative accounting behavior.

    Clansman (2003) illustrated both the outside ND inside auditors must responsible for preventing creative accounting behavior. Both of them should be alert to perceive the creative accounting behavior and to be in accordance with the variety of the provision of auditing standards. He mentioned that there are numerous ways provided to help the insider auditors in detecting unmoral behavior. These ways include the tendency analysis to discover the abnormal difference between earnings and costs.

    In addition, they can use the cut off test to monitor sales and purchases in profit and loss statements of the firm for the year end. These re two examples of the measurements that the auditors can apply to perceive any suspect items and report to the top of the organization. Generally, directors may be the ones who should perceive fraudulent items at the first place because they are in positions which can enter into the detail of the firms’ business. Therefore, the policies of the top management should be improved by either the government or the regulators instead of only focus on the role and responsibility of auditing.

    In spite of various regulations have provided to enable the auditors to process their tasks efficiently, there are till numerous company fraudulent cases in recent. This implies that those standards and regulations still exist deficiencies and need further improvement. Regulations In order to prevent the opportunities for creative accounting practices, accounting regulators may consider the probability of conducting the variety of situations audibly which permit the use of creative accounting.

    Cabana (1992, p. 1 1 5) identified the opportunities of creative accounting practice can be reduced by constantly developing a conceptual framework according to the work performed by ACE. The purpose of financial data will be clearly resented and the priority clearly established. Gab;s (1991, p, 19) noticed that the directions to create accounting policies not only influence the setting of accounting standards but they also produce provisions to be used by professionals.

    In this way, they are allowed deeply knowledge of the accounting rules, which supports the analytical ways towards the complicated items and provides basic professional views about the accounting behavior. The use of creative accounting in the case of selecting accounting techniques can be minimized by limiting the available accounting terms or thoroughly detailing the circumstances and scope in which a technique could be used. In this way, it can also contribute to obtain accordance in the selection and application of accounting techniques.

    Mat, Blake and Oliver’s (deed) gave the example of the accounting terms of Spain, illustrated that the terms of accounting policies could be altered if it is presented in the accounts of annual financial statements and the influence of the difference is eligible in the outcome Of the firm. If it is limited in the alteration Of accounting terms, when a firm selects a term, the same term would have to be applied in afterwards because that term attains the picture which is required for that financial year. The possibility of directors or managers inappropriately using their own views to reach their desire can be reduced by the following two ways.

    First, regulators may design accounting norms which reduce the possibility of using directors’ own opinions subjectively. For instance, accountants in UK were inclined to employ the abnormal item in the income statement account to involve accounts in order to avoid the actual margin. The Accounting Standard Board in UK dealt with method to abolish the criteria of abnormal accounts. The second way has been discussed in the above which is to enhance the auditors’ role and responsibilities in identifying misleading information.

    Auditors must make evaluation if the creative accounting existed in the financial statements when processing their audit report. Mat, Blake and Oliver’s (deed) observed that concept of “substance over form” can be cited to reduce the possibilities of artificial transactions. In this way, the accounting essence will be determined by the economic essence rather than legal form of the transactions. For instance, “linked transactions would be accounted as a whole”. The occurrence of subnormal transaction of non-current asset may be decided by the management of a firm.

    In entire cases, the extent of its application can be minimized by employing organized and constant evaluation of the non-current assets. Therefore, the variance of value in the surplus or deficit would be recognized in the accounts of financial statements in every single year as long as transactions are actually accounted for instead Of appearing only the year when assets are sold. 4. 7 The implication of Creative Accounting on economy Nowadays, individuals (such investors, government and regulators) are more ware of creative accounting because of it not only affect the company but also have great influence on economy of its country.

    Many scholars have noticed that creative accounting impact negatively on the overall of the economy in its country particularly where it result in huge organization scandals. Hugh (2009) investigated in how has creative accounting impacted on the economy in Italy. He presented organizations acquired advantages speculatively by applying unemployment policies such as the Ordinary Redundancy Funds (ROOF) and the Extraordinary Redundancy Fund (REFER) in Italy. ROOF may be used in unexpected cases. For instance, where there is market crisis, REFER can be applied in event of company collapse.

    Firms acquire benefits from that proposal by deceiving various circumstances in methods like dismissing employees from the company according to the process of redundancy and employing them back under the table (Hugh, 2009). The company benefit from this way by paying much less salary and leave the burden of large employees’ salary to the government, therefore, result in shadow economy in Italy around fifteen per cent of the total GAP. A company may benefit a lot in such way. Nonetheless, it is harmful to the market and economy of a country and obstructing the firms and the country from being more productivity in the future (Hugh, 2009).

    Gospels (2010) noticed that America might be confronted with a large amount of liabilities if there is no effective control on their expenditure as well as dealing with its loss. This could be to blame for the commitment in creative accounting in America. Effective measures haven’t taken by the American government to guard Federal Reserve and Government Sponsored Entities (SSE). Consequently, total liabilities took eighty five per cent of total GAP and were forecasted to grow up continuously in the following years.

    Thereby, the condition of American market and economy may be further into recession if it seeks for loan from other countries. In order to produce more income, the government may have to enhance controlling on budget, health care spending public security and tax system. The application of creative accounting could boost economic bubble in a country. Government should have concerned the reason of this situation and how has it occurred rather than imputing it all to the audit firm or the organizations which had been fell into scandals.

    As informed the disadvantages of creative accounting, government should have o come up with strategies in order to minimize or even eliminate the fraud at the first place thereafter. Various issues had taken place due to the use of creative accounting, some of them have explained in the research and the remaining has been presented by others. Some individuals are taking auditing into task while some are considering it is what the governments should be responsible for. Nevertheless, numerous individuals have played role in the creative accounting.

    In order to conquer these issues caused by the creative accounting practices, this research will give some suggestions from different stands. In respect of the consideration of investors who explore the worthiest investments, they should also look for secondary opinion from professionals rather than only depending on the financial reports of a firm to make their decisions for the reason of some possible misleading information is included in the financial statements. Investors should try’ growing diversity in their investment portfolio instead of keeping all their funds in one or few baskets.

    Whereas it is hard to avoid risk completely, the level of the risk can be reduced by secured from diversifying investments into various firms. If one investment makes a loss over a certain period in a firm, other investments may obtain profit over the same period in other firms. In such way, it helps to reduce the overall losses of their investment portfolio. In respect of the consideration of the firms, they should enhance the independence of the board by giving directors or managers independent appointment to look after the public benefits in the organizations.

    In this way, it would help keeping the directors from conducting their personnel benefits and creating more ethical behavior in the entire environment of the organization especially in establishing true and air performance Of the organization. Firms should also employ professional audit committee with good ethical behavior as well as rich experience to help detecting the misleading information which may occur in the financial statements. The audit committee should also assist in creating a climate of discipline and controlling thus minimizing or even eliminate the possibility for fraud.

    In respect of the consideration of the government, it should make effort to choose appropriate and suitable accounting rules and establish relevant punishment against those who are in violation of rules. Moreover, he government should prevent the audit firms from providing the variety of services to its clients. 4. 8 Conclusion -? Section 2 This research has discussed the variety of issues in respect of creative accounting. It have identified why the management of a firm engage in creative accounting to produce fraud.

    The general motivation is when firms want to window dress their actual performance to meet with their internal target and the stakeholders’ expectations. This research has discussed some of the most popular creative accounting techniques that firms applied to achieve their objectives. These technique uses include the flexibility in selection of policies from accounting standards, artificial transaction, reclassification of accounting figures and some more.

    This research has also explained what are the role of the auditors as well as the scope of what they are responsible for in the accounting scandals occurred companies and how to perceive the possibilities of fraud commitments. Furthermore, it has illustrated the role of auditors take part in reducing the risks of creative accounting by constantly acting up to the auditing standards and regulation. It has concluded the auditors have played significant part in perception of frauds.

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