Accounting and Society: Creative Accounting in Australia - Literature review Example

Creative Accounting in Australia Student’s Name: Instructor’s Name: Subject: Date: Table of Contents Table of Contents 2 Creative Accounting in Australia 3 Introduction 3 Literature Review 4 Creative Accounting 4 Reasons for Creative Accounting 6 Ethical Perspective of Manipulative Accounting 7 Unexpected Announcements by the Big Four Banks 10 Regulation of Financial Accounting in Australia 13 Conclusion 14 Bibliography 14 Creative Accounting in Australia Introduction The Australian banking industry is largely dominated by four main banks; Australian and New Zealand Banking Corporation limited (ANZ), National Australia Banking Corporation (NAB), Commonwealth Bank of Australia (CBA), and Westpac Banking Corporation (WBC). The big four banks have in the last few years been accused hit headlines for the wrong reasons for having been accused of creative accounting or manipulative accounting. Hence, these banks have struggled over the time to keep an image of their business activities’ success and legitimacy although there not a single bank among the four which have ever managed to keep out form the financial controversy for the past decade. In this regard, this research paper focuses on explaining the role of the aforementioned banks in criticism against their management’s manipulative accounting. In the interest of this research paper, an overview of the Australian banking system since its deregulation in the early 1979 with subsequent institution of stringent regulatory mechanisms are also focussed. In this respect of this research paper, creative accounting can be explained from two perspectives; first is the macro-manipulation which entails the unnecessary influence by the management of a particular company on policy makers/ regulators to produce regulations favourable to their own interest. Second is the micromanipulation and it entails the manipulation of financial statements i.e. accounting figures, to produce biased view of entity’s financial performance and position. The two kinds of manipulation are attempts of committing creative accounting by the preparers (accountants) of financial statements. Besides, the accountants, there is always, collusion with the financial auditors to certify such manipulated financial statements as representing the true and fair view of the company. In this regard, there is therefore adoption and implementation of International Accounting Standards and enactment of relevant legal acts e.g. Australian Commercial Code to govern financial reporting. This research paper first elaborates on what is creative accounting and the various form of nomenclature applied in parts of the world such as USA, Europe, and Australia. In the second part, the paper explains the reasons usually cited for engaging in manipulative accounting. This is followed by the ethical perspectives of creative accounting which is then succeeded by an overview of unexpected financial announcements of the big four Australian banks that raised suspicion in the 1990s. In the following section, an overview of financial reporting regulatory framework in Australia in focussed. Literature Review Creative Accounting Financial statements are usually used by various stakeholders to evaluate the performance of a particular company in general or its management in particular and hence make the relevant economic decisions. Upon the release of such financial statements, a user who encompasses government authorities, shareholders, potential investors, and government authorities assumes them to be reliable and fit for their purpose. It is in this regard therefore that that accounting regulations/standards are implemented to ensure that financial information produced is consistent and in conformity with set rules to make it reliable for the aforementioned users (Herve & Gaetan 2004). Nevertheless, communication among entities and shareholders may be consciously distorted by the conduct of financial accountants who are majorly involved in preparing the financial statements to suit their needs or to deceive the users. Such interference is committed by altering the content of financial statements and such kind of distortion is usually referred to as ‘earnings management’ or ‘creative accounting’ (Diana et al., 2009). Catherine and Oriol (2009) in their article argue that creative accounting has developed over the years and geographically in terms of its nomenclature and its practices’ complexity. The authors have noted that ‘earnings management’ is the preferred term in the United States whereas in most of the European countries ‘creative accounting’ is usually applied. Other terms describing the same include earning smoothing, income smoothing, accounting cosmetics, or cosmetic accounting, accounting crafts of craft accounting. However, in Australia creative accounting is referred to as feral accounting, manipulative accounting, or fudging (Diana et al., 2009). One of the methods employed by the management is macro-manipulation which involves the efforts by the management accounting to influence creation/modification of accounting standards which suits their needs by influencing the process of policy making. On the other hand, micro-manipulation is the most possible and common in wide range of organizations. This entails the alteration of accounting disclosures by accountants to deceive the users of financial statements. In the above types of manipulative accounting, the major reason inside the mind of accountants is presenting financial statements that suit their self interests. Besides, some have a genuine perception in their scope of economic reality is more preferable form all points of view. Although, as earlier mentioned, they distort financial information in order to meet their own individual needs (Catherine & Oriol 2009). Reasons for Creative Accounting The debate around manipulative accounting majors largely on the impact on decision-making process of investors. In this regard, there are a number of reasons which are cited as to why the financial accountant or manager or the entire management of a company may conspire to manipulate the financial statements of a company (Oriol et al., 1999). The first reason is income smoothening in which entities ‘prefer to report steady trend of growth in profit rather than to’ show inconsistent profits characterised by rapid rise and falls (Oriol et al., 1999, p. 3). In such instance the entities make unjustifiable provisions for liabilities/loans and against asset values in favourable years in order to reduce these provisions, thus modifying the reported profits in unfavourable years. Some of the proponents of this approach it a good technique against ‘short-termism’ of evaluating an investment based on earnings realised in the immediate subsequent years. On the other hand, income smoothing puts under control a high raise and fall in expectations in favourable years that the entity is not capable of delivering what is needed subsequently. Nevertheless, arguments against this approach establishes that income smoothing conceals long term changes in earnings trend and in case business conditions of an entity are actually volatile, then investors have the right to be informed. Secondly, as opposed to income smoothing, another probable reason is to alter profits so that they correspond to forecasted figures. Some of the banks are accused of designing their accounting policies within normal accounting rules so that they match reported earnings to profit forecasts. In such a case, such accounting policies are highly conservative and perfectly respectable in that it becomes easy to forecast future earnings. Thirdly, manipulative accounting facilitates in boosting or maintains a company’s share price by reducing the apparent levels of borrowing thus making an entity to appear lees vulnerable to financial risk. This can also be done by creating an impression of a favourable earnings’ trend. Such moves may go on in facilitating an entity to raise capital from issuance of new shares, offering their own share in takeover bids, and resisting takeover by other companies. The fourth probable reason for the management to engage in creative accounting is that if they get involved in ‘insider dealing’ of their company’s share, they can apply manipulative accounting in delaying the release of market financial information. In such a case, they improve their chances of benefiting from inside knowledge. Ethical Perspective of Manipulative Accounting Some managers have out rightly defended themselves by arguing a few misrepresentation hypotheses to defend the act of manipulative accounting. Thus, they bring into focus the question of positive accounting theory and agency theory (Oriol et al., 1999). In this regard, the author inter-relates this problem with both the shareholders and management and goes on further to argues that each party benefits from having ‘loose’ accounting standards which provide the management with latitude in timing their reporting of earnings. Shareholders are said to benefit from creative accounting in that the management can manipulate accounting data to smoothen their income since this may reduce the anticipated earnings volatility and thus increase their share value. Besides, default on loan agreements action can benefit the shareholders (Oriol et al., 1999). Generally, the implicit views perceived by most of the people is that; the main role of accounting is to provide a mechanism through which it is possible to monitor contracts between the entity’s management and other groups that provide finance. Secondly, the other general perception is that market mechanisms continues to operate efficiently while reflecting this accordingly in contracting and pricing decisions (Oriol et al., 1999). Fraudulent financial reporting as is referred to in Australia, is generally committed at management levels above those for which internal control systems are created and expected to be affective. The illusion created by this manipulative accounting is aimed at masking the financial reality via deliberate misapplication of the accounting standards/principles. In a research study by Oriol et al. (1999) in Australia, manipulative accounting was found to be dominant especially in the banking industry and researchers identified three ethical problems amongst 1500 financial accountants; the conflict of interest, client’s proposal to both manipulate accounts and evade tax as illustrated in the figure below. Figure 2. The three ethical problems in Australia Source: Oriol, A, John, B & Jack, D 1999, ‘The Ethics of Creative Accounting’, Journal of Economic Literature classification. M41. P.1 -17 From the diagram above, it is clearly evident that manipulative accounting is rampant in Australia as it was ranked high above tax evasion amongst ethical issues for Australian accounting practitioners. In the same note on ethical perspective, a multiple survey conducted to asses the Australian banking industry, majority of Australian banks were found to be most disappointing. ANZ bank which is the third-largest retail bank was rated by the public and in particular investors and customers as the most satisfactory with a rating of 74.7 % ahead of the others. Subsequently, the commonwealth bank of Australia was found to be the most suspicious in its business practices and thus the worst performer with a rating of 62.9 %. On the other hand, Westpac bank was rated the poorest with a score of 62.7%. In another research study on the big four Australian banks by a United States research group, Forrester, ANZ was described as the ‘best of bad bunch’ among the other banks. This survey was conducted in the year 2006 and some of the criticisms against the Australian banks were levelled against lack of effective internal control mechanisms, design flaws, and creative accounting (n.a 2006). As aforementioned in the above section on unexpected financial announcements, the boom and bust cycles in the Australian banking sector with particular interest on the financial losses which were released by the four major, there was no hint by the management in there would have any looming trouble. In this case the financial reporting rules and regulations which were applied by the management are depicted as being objective. It is for that reason that it was largely seen that the big four Australian banks practiced micro-manipulation form of creative accounting. Unexpected Announcements by the Big Four Banks Deo et al. (2007) in their article have taken a closer look at 10 years immediately preceding the National Australian Banking Corporation’s surprise announcement on January 2004, in which the other four major banks in Australia announced unprecedented expenses and/or looses. An illustration of this is shown in the table below. Figure 2. Financial losses of Australian banks in the year 1991-1992 Source: Deo, H, Irvine, HJ & Abraham, A 2007, ‘The legitimizing power of regulation for Australian banks: An institutional approach Some of the shocking announcements were made by these banks in the early 1990s and mostly related to devaluation of property as well as lack of Australian banks’ recognition that they were massively underprovided in regard to bad debts. In 2002, the National Australian Bank was with regard to Homeside mortgage division whereas in subsequent year form instance in 2004 concerned the forex trading losses. Nonna (2007) concurs with Deo et al. (2007) that the publication of financial losses was followed by annual reports in which earning figures were radically affected. This is what Nonna (2007) attributes may have been the result of micro-manipulation by the banks’ management. In the last decade of the 20th century, the big four banks in Australia had unending problems with both doubtful and bad debt provisions, and in particular WBC, CBA, and ANZ were worst hit. In one case, ANZ released a profit figure of $ 267 million in the year 1991 after accounting for doubtful and bad debts of about $ 1037 million. In the subsequent year, 1992, the same bank released a financial report depicting loss of up to $ 579 million being the result of huge doubtful and bad debt provisions of up to $ 1600 million. In an annual report to the ANZ shareholders in the year 1992 that charge on provision, as the management claimed was attributed to the Australia’s recession since the early 1930s. This resulted in devaluation of assets that were affected severely and the report depicted the charge was to be reduced in subsequent years and hence the bank regain its profitability path. Subsequently, Deo et al. (2007) goes on to comment that commonwealth bank reported $ 883 million profit after provisioning for doubtful and bad debts of up to $ 1026 million. In the same note, the bank’s debt problems worsened more with provisions reaching up to $ 843 million. For instance, in the year 1992, the banks profit, $ 409 million, became far much less than that of the year 1991. In this case, the management, in the banks annual financial report, described the year to be a difficult characterized by weakened economic stability. On the other hand, WBC also experienced financial hurdles during the years with provisions of its doubtful and bad debts. The bank reported $ 476 million profit in the year 1991 after provisioning for $ 1119 million. As it indicated in the financial report, conditions worsened in the year 1992 with a record loss of $ 1562 million being result of $ 2802 million provision for doubtful and bad debts. In the annual financial report, the management argued that the expense of 1992 was inclusive of particular provisions pertaining to diminutions in asset value which resulted form the changed valuation policy as a consequence of rapid fall in the property market. In the same note, Deo et al. (2007) writes that in the year 2003, NAB released a financial report stating a profit of $ 3955 million after tax but in the following years, the bank reported a foreign currency trading loses of $ 180 million that ultimately grew up to $ 360 million. This was claimed to be a consequence of illegitimate practices of various forex traders and preparers (financial accountants) of financial statements who took advantage of lack of proper internal controls within the bank’s systems. Nonna (2007) writes that instead of the malpractices being exposed by the bank internals control systems. The suspicious behaviour was released by NAB ‘whistle-blower’. In these instances, the public’s perception and/view on the probability of bank’s management being involved in manipulative accounting became high. These shocking revelations impacted heavily on the four major Australian banks being held on suspicion considering the fact that they control Australian banking industry to an extent of 70% . Nevertheless, Deo et al. (2007) notes that majority of Australian public regard the four major banks the best investment vehicles and that they are capable surviving any shocking revelation whatsoever. Consequently, it is in such high public and government suspicion of malpractices that there were a few inquiries which were launched by authorities. In particular, Deo et al. (2007) writes that Australia Prudential Regulatory Authority (APRA) made recommendation that Australia banking industry was not complying with effective banking supervision requirements. The APRA inquiry into NAB’s foreign currency trading losses was therefore an investigation into the banking practices in the Australian context. Besides, investigation by the bank itself on some of its practices revealed that there was poor level of transparency among the financial management/ accountants. In this regard, there were resignations by several bank directors in particular the CEO who was accused of lacking to provide proper financial management guidance (Deo et al., 2007). Regulation of Financial Accounting in Australia In Australia, there have been persistent efforts to institute a robust regulatory framework upon which Australia banks are required to present their financial statements. This came into being after various conducting three banking inquires to establish the practices of the four major banks. The creation of regulatory systems and control bodies have gone ahead to institute rules and regulations against which the financial reporting of various banks are evaluated to establish their compliance. The Australia corporations Act of 2001 as well as regulatory bodies for instance the Australian Securities and Investments Commission (ASIC), the Australian Accounting Standards Board, APRA and the Australian Stock Exchange (ASX) are involved in instituting regulatory procedures so as to improve financial reporting (Deo et al., 2007). Furthermore, the authors argues that there has enactment and enforcement of stringent measures in the banking industry in the recent past which are aimed at improving corporate disclosure and governance. This has majorly emanated from public pressure and government authorities so that an appreciable level of financial accountability can be attained in the banking sector. In complying with the regulatory procedures, banks are therefore capable of portraying a good public image and restore confidence among various stakeholders in the truthiness and fairness of their financial reports. Conclusion It is evident that creative accounting can be applied by the management to portray a misleading image of an organization. Although, it might not be possible to commit macro-manipulative accounting, majority of the management exercise micro-manipulative accounting. This is what majority of the public perceived to have been happening the early 1990s in the Australian banking industry. For that reason there need to have a proper regulatory framework to oversee governance in various financial institutions especially in the banking sector. Bibliography Catherine, G & Oriol, A 2009, ‘Creative accounting: some ethical issues of macro- and micromanipulation’, Journal of Economic Literature classification, M41. pp. 1-22. Deo, H, Irvine, HJ & Abraham, A 2007, ‘The legitimizing power of regulation for Australian banks: An institutional approach’ viewed 22 December 2010 . Diana, B, Victoria, B & Alina, BV 2009, ‘A brief review of creative accounting literature and its consequences in practice’, Annales Universitatis Apulensis Series Oeconomica, vol. 11, no. 1, pp. 170-183. Herve, S. & Gaetan, B 2004, ‘Accounts manipulation: A literature review and proposed conceptual framework’, Review of Accounting & Finance, vol. 3, no. 1, pp. 64-69. n.a 2006, ‘Australian banks disappoint in multiple surveys’, Bank Marketing International. p. 5 Nonna Martinov-Bennie 2007, ‘What we might learn about fraud and corporate governance from NAB's 'annus horribilis’’, Australian Accounting Review, vol. 17, no. 3, pp. 85-90. Oriol, A, John, B & Jack, D 1999, ‘The Ethics of Creative Accounting’, Journal of Economic Literature classification. M41. P.1 -17. Read More