Audit Committees in the Reduction of Creative Accounting Practices - Literature review Example

Institution : xxxxxxxxxxx Title : xxxxxxxxxxx Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2012 Introduction Audit committees are very significant in the process of financial reporting in any organization. An audit committee is an independent body that is charged with the role of scrutinizing and reporting the company’s financial progress. The members of the committee are usually drawn from the board of directors and are answerable to the board of governors. In the wake of serious financial reporting scandals that have been witnessed in the recent years, the role of the audit committee has attracted a great deal of attention. Research indicates that in many of the high profile corporate scandals creative accounting was a major contributory factor. Creative accounting refers to accounting practices that comply with regulations of accounting standards however in real sense they diverge from the same standards. Creative accounting can be performed on the balance sheet and off the balance sheet. The practice can also be described as a process where accountants apply their accounting knowledge to maneuver or manipulate reported figures. This particular paper seeks to evaluate the role of audit committee in mitigating the practice of creative accounting. The role of audit committees in reducing creative accounting practices Audit committees improve the quality of financial information directly and indirectly. They directly improve the quality of information by overseeing the process of financial reporting and indirectly oversee the internal management and external auditing (Owolabi & Dada, 2011). Regardless of their impact on the quality of information, audit committees do improve public confidence in matters relating to financial reporting. The adaptation of accounting practices that are considered the best in the market do always assist audit committees to improve the confidence of the public. Therefore, audit committees have a role of improving public confidence through provision of quality information. The direct and indirect improvement of information quality assist audit committees in reducing creative accounting practices. Idowu & Louche (2010) argue that audit committees can only improve the quality of information if the committee members are independent. The Committee members should not have any relationship with the company. Audit committees are expected to have no employment, personal and business relationships with the company. Contemporary best practices and regulation suggest that members of the audit committee need to have particular personal characteristics. According to UK Corporate Governance Code all members of the audit committee need to be financial experts. The members of the audit committee are therefore expected to have some knowledge and experience in accounting or finance so as to perform their role effectively (The UK Corporate Governance Code, 2010). The accounting or finance knowledge always assists audit committees in detecting any creative accounting practices within the organization. The Audit committee therefore is generally expected to provide a quick warning signal to the company so as to protect it from unforeseen financial crisis and also to protect the company from any intentional attempts by management to ignore problems from auditors (Mulford, & Comiskey, 2002). Another main responsibility of an audit committee is to strengthen the quality of financial information and maintain investor confidence regarding the financial markets and the quality of financial reporting. The degree of the quality of financial information will largely depend on how well the audit committees are reducing creative accounting practices. Provision of strong and reliable financial information enables investors to easily identify any manipulation of the books of accounts. Therefore, as stated earlier, audit committees have a responsibility of directly improving the quality of information by overseeing the process of financial reporting. They also have an indirect responsibility of supervising internal management and external auditing. The responsibility of Audit committee to improve information quality and strengthening of controls normally causes investors to have a lot of confidence on matters relating to quality of financial reporting and operation of financial markets (Wearing & Wearing, 2005). In order to improve the quality of information, the audit committee should be provided with information regarding other GAAP methods that do always result into various accounting outcomes. They are also expected to be supplied with figures that outline these variations (Naciri, 2008). The information received assist audit committee in identifying and disclosing any creative accounting practices when presenting the company’s financial statements. Therefore, when presenting the company’s financial statement, the committee is expected to provide good reasons for accepting the auditor’s and management’s recommendations. The audit committee has a role of ensuring all analyst and press reports regarding the company’s accounting and disclosures are assessed. Management and auditors are normally given a chance to respond to any audit committee’s negative comments. The audit committees have a responsibility of determining if the response is genuine so as to change the recommendations on the financial statement. The recommendations on financial statements do always make auditors and management to effectively execute their obligations, thus minimizing any creative accounting practices (Naciri, 2008). Overvaluation of assets is a form of creative accounting normally done by accountants in various ways. Accountants can overvalue the company’s assets through provision for doubtful accounts. In the process of provision for doubtful accounts, accountants can use accounts receivables to inflate the company’s earnings. However, it is the role of audit committee to use the same accounts receivables to detect the presence of premature or made-up revenues (Saudagaran, 2009). The audit committee has a duty of identifying the period at which the reserves for doubtful accounts were not enough by relating the accounts receivables with net incomes and revenues. In situation where items in the balance sheet are growing at faster rate than items in the income statement, it is the responsibility of audit committee to investigate whether or not the provision for doubtful accounts is sufficient. Overvaluation of assets can also be done through inventory manipulation (Marnet, 2008). The audit committee has a duty of detecting any kind of inventory manipulation. Inventory in organizations represents the value of all unsold manufactured commodities. The value of sold inventory commodities is normally transferred to income statement as cost of commodities sold. Assuming the levels of real inventory and sales remain constant, accountants normally demonstrate creative accounting practices by overstating the values of inventories. This, in most cases, results to understated costs of commodities sold. The financial statement therefore will depict a higher net income for the company which is not true. It is the role of audit committee to detect this kind of manipulation and report it to the board of directors, shareholders and other stakeholders of an organization (Carmichael, & Whittington, 2007). A good example of inventory manipulation occurred in Brammer Industrial Services. The company recorded unrealistic inventory and intentionally overvalued some of its inventories. The company recorded assets that were for rental purposes as inventory within the current assets section. The accurate classification would require the company to classify the assets for rental as fixed assets but not as inventory .If audit committee was involved in determining the financial progress of Brammer Industrial Services this kind of creative accounting practice would have been detected. Audit committees therefore have a role of detecting if the company’s inventories are being manipulated or not. The committees are able to detect inventory overvaluation by looking at the rate at which inventory is increasing. The trends that normally raise suspension are when inventory exceeds sales, inventory turnover is low and when inventory is increasing at a higher rate than total assets (Wearing & Wearing, 2005). The responsibility of audit committee relates to overseeing external auditing. Most regulation bodies such as Sarbanes-Oxley (SOX) argue that external auditors are answerable to audit committees. The audit committees are directly responsible for appointment and compensation of auditors. Audit committees do always ensure that credible auditors are appointed so as to reduce creative accounting practices. The practices are usually common among incredible auditors. Apart from appointment and compensation, audit committees are expected to oversee the work of auditors. Their duty is to ensure that auditors execute their work effectively by exposing all the relevant information to the public. Audit committees have a responsibility of resolving disagreements regarding financial reporting among management and the auditor. They are also expected to pre-approve every non-audit services that accounting firm need to provide. The role of audit committee therefore is to review adjustments that are noted or proposed by the auditors of the company. This involves carrying out discussions with external auditors so as to get information concerning any sort of manipulation of numbers that might have been identified by the external auditors, thus reducing creative accounting practices (Purpura, 2007). The importance of audit committees in minimizing creative accounting practices was outlined when passed SOX in 2002. Apart from SOX suggesting for independency of audit committees, it established the requirements by statute. According to SOX section 301, the audit committees need to execute their role over financial reporting process by selecting, monitoring and compensating independent auditors, implementing procedures that handles complaints regarding accounting, internal control and auditing and finally by implementing procedures for submitting concerns regarding questionable auditing and accounting issues. This type of governance structure normally safeguards the integrity of process of reporting by protecting external auditor for probable management pressure. Jones (2011) argues that effective audit committees do always execute their duties according to SOX section 301 so as to reduce creative accounting practices. It is also the responsibility of audit committees to hold several meetings with management and auditors so as to reduce creative accounting practices. Jones (2011).highlights that he current frauds and continuous increase in number of earnings restatements displays the endless need for improving controls within the process of financial reporting. Audit committees therefore need to effectively execute their role of controlling management and auditors so as to reduce any creative accounting practices within the organization. Different from worker’s fraud, management fraud has less likelihood of being identified by low-level controls due to management override. Audit committees should use high level controls so as to eliminate management frauds and thus reducing creative accounting practices. Majority of internal control systems cannot be considered to be effective restraint to management fraud. Therefore, as stated in SOX section 301, it is the responsibility of an independent audit committee to assist in eliminating management fraud and increase integrity in financial reporting (Jones, 2011). McKesson and Robbins fraud case in the U.S is an essential case that explains the importance of audit committee in controlling management fraud. In the case, the corrupt management claimed that inventory existed. However, it was discovered later that the claim was bogus, thus forcing the company to conduct on-site inventory inspections. After the inspection, in 1972, the need for audit committee was called for by SEC ( Securities Exchange Commission ). The committee was expected to reduce creative accounting practices by eliminating management fraud within the organization. In order to achieve this, SEC encouraged establishment of audit committees that are composed of independent directors. It was believed that the threatening creative accounting practices can be effectively controlled by independent audit committees. This reasoning therefore made Blue Ribbon Committee (BRC) to recommend that organizations need to establish independent audit committees that entails at least three members that are financially literate and one member who is a financial expert. BRC also suggested that audit committees need to adopt an official charter that openly outlines the roles of audit committee in internal control practices (Harrast & Mason-Olsen, 2009). Audit committees also have a role of determining if an organization is manipulating the actual performance of its joint ventures or subsidiaries. Accountants do always manipulate the actual performance of joint ventures or subsidiaries so as to overvalue the company’s assets. The loophole for practicing this kind of creative accounting is normally created when public companies that develop huge investments in different businesses are allowed to account for investment under consolidated or equity methods. This, however, normally depends on the ability of the companies to control subsidiary. Investments, under the equity method, are normally recorded at a cost and later adjusted to depict the dividends received and the share of net loss or profit (Naciri, 2008). This is usually reported on the balance sheet and income statement. The equity method does not control the kind of information investors are able to access. For instance, an organization can exaggerate interest coverage so as to alter the leverage ratios of subsidiary. Investors therefore should be careful and make use of audit committees particularly when organizations use the equity method in area where they seem to control the subsidiary (Naciri, 2008). Detection of liabilities undervaluation is another responsibility of audit committees. As a way of detecting liabilities undervaluation, audit committees always have a responsibility of determining whether pension obligations and contingent liabilities have been manipulated. Public companies normally find it easier to manipulate pension obligations since the liabilities are usually experienced in future. Even though pension liabilities do occur in future, companies are expected to generate their estimations so as to record them in the books of accounts. However, most companies do always use this as an opportunity of making aggressive estimations so as to improve the short term earnings and develop a false impression of the financial stability. Therefore, in order to identify and reduce this practice of creative accounting, it is essential for companies to effectively handle the pension accounts. It is the responsibility of audit committees to ensure that companies use proper ways of controlling pension accounts. Audit committees normally advocate the use of discount rate. Depending on obligation’s size, the increase in discount rate can greatly minimize pension obligation (Carmichael, & Whittington, 2007). Undervaluation of liabilities can also be attained through application of pension accounting. Many companies do use pension accounting in manipulation of short-term earnings. This is usually done through alteration of net benefit cost or the expected return on pension plan assets and on the income statement. Even though estimates need to be roughly similar to discount rate, companies do always make aggressive estimates which will in turn affects the income statement. Enhancing expected return on plan assets will in most cases minimize the pension expense in income statement and increase net income. It is therefore the responsibility of audit committee to identify this kind of creative accounting and report it to the board of directors, shareholders and other interested groups (Saudagaran, 2009). Contingent liabilities refer to obligations that rely on future activities to verify the existence of an obligation, the amount of money owed and the payee or the date payable. For instance, a warranty liability or forecasted litigation loss can be considered a contingent liability. As a way of undervaluing liabilities, companies can creatively record these obligations. The creative recording of contingent liabilities is usually done by underestimating their materiality. Failure to provide reasonable estimation and recording of contingent liabilities that are more likely to occur will result into undervaluation of liabilities and overvaluation of company’s net income or equity of shareholders. It is therefore the responsibility of audit committee to careful read the footnotes of the company that have information about contingent liabilities so as to detect and reduce any creative accounting practices. This assists investors to eliminate the problem of liabilities undervaluation (Carmichael, & Whittington, 2007). In general it can be stated that audit committees play a great role in ensuring that book keepers do not manipulate financial statements. According to Amat (2004), one of the outstanding attributes of creative accounting is the manipulation of accounting numbers .This sort of manipulation is sometimes practiced within the outlined accounting standards and law, however it is usually against the motive of providing a fair and true picture of the company’s financial position. The manipulation of accounting numbers further results to structuring of transactions in a manner that allows the production of accounting results that are creatively preferred by the accountants. Kammerer (2009) provides a case in point of Enron scandal whereby questionable manipulations of accounting numbers were done through accounting adjustments. Enron accountants had adapted a culture of creative accounting whereby attempts were made to manipulate numbers in every financial quarter to a close variance between the targeted incomes and the actual results, in order to provide a nonexistent financial position of the company. Enron’s audit committee did not identify the areas of manipulation of numbers due to the fact that they rarely met to discuss the company’s financial position. Such practices therefore led the collapse of the company. An effective audit committee is therefore vital in the elimination of manipulation of numbers as one of the practices of creative accounting (Kammerer, 2009). Amat (2004) highlights that; a fundamental role of the audit committee is to make a review of financial outcomes or results on annual, semi-annual and quarterly basis. Amat (2004) argues that reviewing financial results of an organization at different intervals facilitates the identification of any sort of number manipulations that may have occurred in the books of accounting. Amat (2004) reveals that a lot of manipulation of numbers done through creative accounting occurs in the balance sheet. As a way of manipulating the balance sheet, companies can use creative accounting to underestimate company’s liabilities and overestimate its assets. It is therefore the role of audit committee to identify and disclose this accounting malpractice to the board of directors and shareholders. Conclusion and identified areas for further research From the discussion, it is clear that audit committees play great roles in reducing creative accounting practices. Improvement of information quality is the main responsibility of audit committees. Audit committees improve the quality of information by overseeing the process of financial reporting and indirectly oversee the internal management and external auditing. Another main responsibility of an audit committee is to strengthen the quality of financial information and maintain investor confidence regarding the financial markets and the quality of financial reporting. Audit committees do also play a great role in ensuring that book keepers do not manipulate financial statements. They have a duty of detecting any kind of inventory, assets and liabilities manipulation. Audit committees have a duty of identifying the period at which the reserves for doubtful accounts were not enough by relating the accounts receivables with net incomes and revenues. They also have a responsibility of detecting any sort of inventory overvaluation and liabilities undervaluation. The recommended areas for further research are the roles of board of directors and other stakeholders of the company in reducing creative accounting, how accounting systems can be implemented so as to minimize any possibility of practicing creative accounting and determining if audit committee is the most effective instrument for corporate governance. References Amat, O, 2004, Creative accounting: nature, incidence and ethical issues, Oxford Brookes University. Carmichael, D. R, & Whittington, R, 2007, Accountants' Handbook: Financial accounting regulations and organizations, John Wiley and Sons. The UK Corporate Governance Code ,2010, the audit committee Harrast, S. A, & Mason-Olsen, L, 2009, Can Audit Committees Prevent Management Fraud? Idowu, S, & Louche, C, 2010, Theory and Practice of Corporate Social Responsibility, Springer. Jones, M, 2011, Creative Accounting, Fraud and International Accounting Scandals, John Wiley and Sons. Kammerer, M, 2009, Creative Accounting, the Enron Case and Its Impact on Corporate Governance, GRIN Verlag. Marnet, O,2008, Behaviour and Rationality in Corporate Governance, Routledge. Monks, G. R, & Minow, N, 2011, Corporate Governance, John Wiley and Sons. Mulford, W. C, & Comiskey, E, 2002, The financial numbers game: detecting creative accounting practices, John Wiley and Sons. Naciri, A, 2008, Corporate governance around the world, Routledge. Purpura, P, 2007, Security and Loss Prevention: An Introduction, Butterworth-Heinemann. Owolabi, S. A, & Dada, S. O., 2011, Audit Committtee: An Instrument of Effective Corporate Governance Saudagaran, M, 2009, International Accounting: A User Perspective, CCH. Wearing, B, & Wearing, R, 2005, Cases in corporate governance, SAGE. Read More