Creative Accounting and Earnings Management - Essay Example

?THE OF THE MODULE IS ADVANCED FINANCIAL REPORTING Table of Contents Creative Accounting and Earnings Management 3 Introduction 3 Key Elements of Creative Accounting 4 Motivation for creative accounting 5 Evidences of Practice of Creative Accounting 7 Effectiveness of Accounting Standards to prevent Creative Accounting 9 Conclusion 12 References 15 Bibliography 19 Creative Accounting and Earnings Management Introduction Financial statements are prepared by managers of a company or enterprise to represent the true and fair view of the affairs of the company. They are then used by the shareholders and other users of financial statements for the decision making process. It is a very critical part of financial accounting because it provides information for the users of financial statements to interpret and come to a conclusion about the performance of the company. Creative accounting practices are such malpractices in accounting which may be legal and in accordance with the existing accounting standards but may not be in line with the true spirits of the rules laid down under accounting standards. In other words, when financial statements are prepared by the relevant managers of a company that is inconsistent with the purpose or intention of the existing accounting standards, then it is said to be a practice of creative accounting. The managers do so by taking advantage of the flexibilities available in the letter of the rules in accounting standards practices (Lee, 2007, p.215). Earnings management is a term which acts as a substitute for creative accounting. Trying to manipulate the earnings which are reported by the managers of a company, by taking help of some specific accounting process, is termed as earnings management. The company does so to influence its earnings in a short term horizon (Akers, Giacomino & Bellovary, 2007). Earnings management makes use of accrual accounting. However, the main issue regarding this is that, it is very difficult to differentiate between regular accrual accounting and earnings management (Bissessur, 20008, p.53). Now, since management has discretion in earnings management, it can lead to fraudulent activities like wrong representation of data in the financial statements. Accounting standard boards have been striving hard to combat the creative accounting practices followed by the companies. The accounting standards are revised often to help fill its loopholes. More and more regulatory measures are taken to keep a track on how the financial information is reported by the firms. These measures taken are proving quite effective in preventing current creative accounting practices, but the question is whether it will be able to stop these malpractices completely or not. It is indeed very difficult to put an end to creative accounting in future (Keupp, 2002, p.1). Key Elements of Creative Accounting It is not very easy to precisely define creative accounting. Still, three elements can be regarded as key elements of creative accounting. They are: a. Flexibility: Accounting is always associated with flexibilities present in it. While accounting, one can use their discretion to choose their own preferred way of recording sales or turnover of the company, the method of depreciation to be used by the company, the method of valuation of inventory, etc. This type of flexibility helps the managers of a company to represent the true and fair view of the company’s affairs and its earnings in the financial statements. However, in practice the case may be quite different. These flexibilities in the hands of managers can be used by them to present the company’s performance in a more favourable way than what it is in reality. These methods can be applied by staying within the regulatory framework. b. Account Management: Accounting policies can be utilized by the managers of a company to accomplish the objectives of the management of the company and may not fulfil the essential requirements of the users. It can thus be used as a tool that can be managed and not as a means to provide true and fair view of the company. c. Interests of Managers: In theory, accounting information should provide relevant information to the users which can be used by them for various decision making process. Whereas in practice, creative accounting is more for the interest of managers rather than for the benefit of its users (Jones, 2007, p.285-286). Motivation for creative accounting We all know that creative accounting practices leading to misrepresentation of information in financial statements is not ethical. Everyone should prevent the use of creative accounting. However, there are some strong reasons which guide and force the managers to resort to such practices in a company. Many factors lead to the motivation of managers to the practice of creative accounting. The managers of a company resort to following creative accounting practices either to manage and maintain their position or to increase the earnings of the company (Shah, Butt & Tariq., 2011, p.532). Some of these motivating factors are given below: a. Income Smoothing: Most of the companies are inclined to the fact that it is always better to show a steady growth pattern in earnings, rather than showing inconsistent profit figures, which shows many rise and fall of profits. This method is known as income smoothing (Tucker & Zarowin, 2006, p.254). This is done by creating abnormally high provisions for liabilities when the company is performing well and then using these provisions to report better profits in lean years. b. Personal Gain: Managers are motivated to present profits to their desired level when additional bonuses are associated with attainment of certain profit level. c. Following the Trend: The managers can be attracted towards using creative accounting if they find that most of the other business entities in the same sector are resorting to such means. d. Tax Avoidance: It may be possible to avoid tax by inflating the expenses or deflating the incomes in the financial statements (Gowthorpe, 2006, p.443). e. Additional need of Financing: Business concerns often need additional funds for investment, which they wish to have by borrowing at lower interest rates. Now, the lenders will lend money to the company at lower rates only in the case of lower risk perceived by them. Managers of the company then get motivated to use the practices of creative accounting like minimising bad debts, overstating values of assets and income and understating values of liabilities. f. Change in accounting policy to boost income: A change in accounting policy is sometimes adopted by companies to divert the attention of potential investors from some unwanted news about the company. These policy changes are favourable to the companies because they show a striking increase in earnings of the company, thereby diverting the attention of the investors from some other news which is against the company performance (Amat, Blake & Dowds, 1999). g. Boosting Shareholders Confidence: Income smoothing, as discussed earlier can help maintaining a steady growth of share prices of a company. Thereby, helps keeping the faith and confidence of the shareholders of the company, which may subsequently assist in raising more share capital for the company. h. Indirect Personal Gain: Association of the managers with a company having strong records of profit can help the managers to gain reputation in the market. The manager may not be rewarded in a short run, but in long run the manager is supposed to get benefited. i. Profit matching future forecasts: Certain accounting policies are followed by companies which enable them to match the future earnings with the previously forecasted profit figures. It does so by staying within the accounting regulation framework. During product sales, these companies record a large amount of profit that is set aside to be realized in future years. It does so with the purview that those profits will be covered to provide costs related to customer support, or to provide potential upgrade of the product, etc. This is a very conservative approach of accounting policy which implies that it is very easy to forecast the future profits of the company (Amat & Gowthorpe, n.d, p.5-6). j. Job Security: Managers and others who are responsible for preparing the financial statements may be motivated to use creative accounting in order to show good profit results that can help them secure their position in the company (Jones, 2011, p.34). k. Cover up Fraud: Companies at times take help of creative accounting practices to cover up for their fraudulent activities within the company. l. Meeting the Agreements: Sometimes the managers are motivated to use creative accounting in presenting financial figure that have been agreed upon with some lenders previously. This is a common practice when the company is in danger of failing to meet the agreed requirements set by the lenders to the company (Gowthorpe, 2008, p. 463). Evidences of Practice of Creative Accounting There have been many instances of use of creative accounting in different business entities. Creative accounting often leads to fraudulent activities and they do not happen in a vacuum. Many different parties are involved in these practices who are interested to resort to such creative accounting methodologies for their own interests. These parties include managers, regulators, auditors, shareholders, merchant bankers, etc. Creative accounting is more likely happening when a company is passing through hard times financially (Jones, 2011, p.22). Some of these evidences of creative accounting leading to fraudulent activities by companies are mentioned below: (i) The Downfall of ENRON: ENRON was one of the leading companies in USA and was well known for its innovation and aggressive approach towards market. It filed its bankruptcy in the year 2001. The reason behind this huge debacle of ENRON was its use of creative accounting leading to malpractices in its accounting policies. ENRON was able to cover up for their losses for many years by not mentioning many of it’s off the book transaction which were suffering loss (Barreveld, 2002, p.136). The shareholders and investors of the company were unaware of those facts and the share prices continued to build up. The auditors and other regulators did not look into this matter in details and ultimately resulted in the fall of ENRON (Santa Clara University, 2002). (ii) Parmalat Scandal: It is also sometimes known as Europe’s Enron (Columbia Business Law Review, 2005). Paramlat was an Italian based company. It was considered to be one of the largest dairy companies in Europe. It went to bankruptcy in the year 2003. The company was involved in very fast market expanding approach. It followed creative accounting practices by having cash balances mentioned in the balance sheet of the company which were already gone and no longer existed in reality (Enriques & Volpin, n.d, p.6-7). It was also involved in hiding debts which were not mentioned in their financial statements. (iii) Waste Management Scandal: Waste Management Inc. is a US based company. It deals with businesses like waste management, environmental services, etc. in USA. It was involved in a fraud resulting from creative accounting practices. It under mentioned its depreciation expenses by a huge amount in its financial statements, leading to a large inflated profit figure, helping in their personal cause (Wall Street Journal, 2002). (iv) WorldCom: WorldCom was another US based company which was alleged of fraudulent accounting practices. It was one of the largest telecommunications company and is a part of the Verizon Communications Group today. It is now called as MCI. Inc. Huge debt and their corporate culture were the reasons behind their malpractices. WorldCom misrepresented their profit figures to an amount equalling $9 billion taking help of creative accounting practices (Dartmouth, n.d.). (v) Qwest Communications: Qwest Communications was involved in an accounting scandal in the year 2002. It restored to creative accounting practices by inflating its profit figure. This was done with the help of revenues that were generated from an improper accounting procedure of long term deals (Badawi, 2008). These were some instances of corporate fraud that results due to creative accounting practices. Other such cases include companies like, Tyco International, Health South Corporation, Bernard L. Madoff, AIG, Satyam Computer Services, etc. Effectiveness of Accounting Standards to prevent Creative Accounting Financial and management accounting is a very important part of any business organization. The users of financial statements of a company like shareholders, investors, creditors, etc are very much dependent on them to come to a conclusion about the performance of the company. So it is a must that these financial statements should reflect a true and fair view about the company affairs. Also these financial reports should have consistency in the way they are presented to the outsiders of the company and must follow the same pattern across all industries and organizations. In order to regulate this process of reporting financial information, the International Accounting Standards Board (IASB) lays down various accounting standards that are to be strictly adhered to by the companies while preparing financial statements. Accounting standards contain list of various recording and reporting accounting rules that are to be followed by every organization. Accounting standards are continuously being upgraded to prevent practices of creative accounting worldwide. Now since these accounting standards are meant for all types of business as a whole, wide scopes are available and contain flexibility that can be interpreted and applied while reporting financial information (Davis, Miksiewicz, Nitta, Rothenberger & Scalera, 2011, p.9). IASB have taken various steps to curb the practice of creative accounting. Yet different loopholes present in the accounting standards are being used by the managers of the company to record and report the financial information in their own designed ways. These lacunas are being continuously upgraded by the IASB. Some of the recent developments of IASB to curb creative accounting are as follows: a. Previously the provision for ‘Extraordinary Items’ was effectively used by the companies to exclude certain items from being included in the profit and loss account to minimize its effect on the operating profit. Later, this category of ‘extraordinary item’ was removed from the accounting standards and the companies cannot restore to such malpractices now (Gowthorpe & Blake, 1998, p.28). b. The creative accounting practice of using the technique of income smoothing, as discussed earlier, is now prevented through changes in accounting standards where there is a limitation on keeping provisions for liabilities. c. The disclosure requirements of various items are now more stringent and must be in compliance with the set accounting standards. d. The International Financial Reporting Standards (IFRS) that has been set up recently under the Conceptual Framework has brought a considerable change in the presentation of financial statements. This helps in providing more useful financial information for the users. Financial statements now portray financial information that gives a more cohesive picture of the organization by showing a more clear relationship between each items indicated there. A company’s future cash flows are now easily predictable with the information being presented and it is not that aggregated as before. The users can now more easily identify and assess about the financial flexibility of the company (Benzacar, 2009, p.29). e. IAS 19, which deals with employee benefits have been successfully revised by IASB and further improvements have also been recommended. It now gives a clear picture about the present and future financial position of a company. f. IASB have also made certain changes for the improvement of fair-value accounting procedures. It now requires a company to provide additional disclosures with respect to the judgements used by the management regarding the fair-value measurement. Likewise, many other changes have been made in the accounting standards and IASB is fighting it hard to prevent creative accounting and earnings management practices. These improvement measures taken by IASB are proving quite effective too, but the question is whether it is enough or is there something than can still be done in this regard. Conclusion Creative accounting is an appalling challenge to the profession of accounting. It is a problem which is not centred to certain specific countries but all the nations of the world. The managers of the companies are motivated to the use of creative accounting practices in financial reporting of the company in many ways as discussed earlier. It is not true that creative accounting is always bad and many arguments in favour of it are quite evident, but managers are often attracted towards using it for their personal gains (Amat, Blake & Dowds, 1999). With the changes in accounting policies being adopted by a company, it creates both a favourable and unfavourable view about the company. So it can be quite misleading for the investors and shareholders of the company. Hence stricter rules must be employed to curb the available choices of accounting policies (Oliveras and Amat, n.d, p.14). IASB has been fighting it hard against creative accounting practices, but a lot has to be done still. Creative accounting practices are still prevalent worldwide and it is a challenge for IASB to put a stop on these practices. The following recommendations can serve for the purpose of effectively combating creative accounting. 1. The options of choosing an accounting method should be more limited to reduce flexibilities in the hands of the managers of the company. 2. IFRS that has been set up recently, should be effective globally and every country should comply with it, in order to come under the same platform of following the same accounting principles. 3. Moreover, the accounting standards should set out financial reporting requirements which involve less subjective decisions to be taken by the managers of the companies. Improper use of judgement by the mangers while reporting about the financial information of a company can be lessened by reducing the scope of judgement or by giving stress on consistency of accounting policy used by a company. That would not allow any company to change their accounting policy as and when they wish to do so. 4. ‘Substance over form’ can be used as a concept which will enable to curb down practice of using artificial transactions. Managerial scope to use the flexibility in timing of reporting genuine transactions can be prevented if IASB sets regulations which require more frequent and regular revaluation of accounting items. This will help detect profit or losses on change in valuation of those items each year as and when they occur. 5. The role of auditors should be more intensified to identify malpractices in financial accounting methods. Auditors must be independent of any influence by the company directors. 6. There should be limitations on extraordinary transactions in business (Amat, Blake & Oliveras, n.d, p.6-8). 7. True and fair view principle of accounting must be given the highest priority while preparing financial statements of any company (Moldovan, Achim & Avram, 2010, p.60). 8. The regulatory framework needs to be stricter on imposing greater penalties for companies which are found guilty of non-compliance of the accounting standards. References Akers, M. D, Giacomino, D. E. & Bellovary, J. L. (2007). Earnings Management and Its Implications. [Online]. Available at: http://www.nysscpa.org/cpajournal/2007/807/essentials/p64.htm. [Accessed on March 9, 2012]. Amat, O, Blake, J. & Dowds, J. (1999). The Ethics of Creative Accounting. [Pdf]. Available at: http://www.econ.upf.edu/docs/papers/downloads/349.pdf. [Accessed on: March 9, 2012]. Amat, O, Blake, J. & Oliveras, E. (no date). 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