The Prevalence of Creative Accounting in the Corporate World - Essay Example

Creative accounting is “an assembly of techniques, options and freedom...without moving away from laws or accounting requirements, allowing to the managers to change the financial result or the financial statements.” (Balaciu & Pop p. 936). There are four ways in which creative accounting can arise. The first way is when there are alternative accounting policies, and managers can make a choice among these policies. For example, a a manager might be faced with the decision to write off or capitalise research and development costs. The second way is to apply bias to accounting estimates, for instance when asset life must be estimated for depreciation purposes. The third way is by “structuring transations in such a way as to manipulate the results in the financial statements.” An example of this is selling an asset that is artificially depress or boosted. The fourth way that creative accounting can arise is by “timing genuine transactions to as to manipulate accounting.” An example of this is an investment with a cost of f1 million with a market value of f3 million, this profit can be realised in any year of the managers choice. (Oliveras & Amat p. 8). Moreover, hybrid securities can be a source os creative accounting, as these securities combine features of assets and debts, and, although they are better classified as debt than equity, they are often reported as equity on balance sheet, which “creates illusions in financial statements.” (Carlin et al. p. 44). Unfortunately, auditors sometimes allow creative accounting because of the “relevance and reliability...of reported information.” (Rabin p. 67). Governments can also engage in creative accounting, meaning a “measure implying an improvement in the fiscal balance...if it does not imply an improvement in the intertemporal budgetary position of the government sectgor at large.” (Milesi-Ferretti p. 4). However, this is not the focus of this paper, so this will not be more closely examined. This paper will examine the prevalence of creative accounting, according to the four hypotheses iterated in this assignment. The first hypothesis is that the prevalence of creative accounting is a result of the deficiencies in the legal systems for banking and accounting. The second hypothesis is that the prevalence of creative accounting is a result of the lack of autonomy in regulatory and supervisory agencies. The third hypothesis is that the creative accounting is a result of a slow and inefficient judicial system. The fourth and last hypothesis is that creative accounting is the result of managerial greed. The last part of this paper will examine the effect of international standards on creative accounting. Hypothesis #1 – Creative Accounting is a Result of Deficiencies in the Legal Systems for Banking and Accounting The statement that creative accounting in the corporate world is a result of the deficiencies in the legal systems for banking and accounting is a simplistic one. Different countries have different laws regarding banking and accounting, and they have different standards for enforcing these laws. Accounting laws have been somewhat standardized by the advent of the International Financial Report Standards, which was mandatorily adopted on January 1, 2005 by the European Union to resolve the differences between each nations unique accounting rules and regulations, but this has only been mandated in Europe, so other countries presumably still have their own standards. (Smith p. 6). La Porta et al. (1998) demonstrated the differences between countries when it came to both the text of the laws regarding corporations and the enforcement. La Portas (1998) work showed that legal systems are different around the world, and that these differences are both in individual countrys text and enforcement. (La Porta p. ). La Portas study concerned how individual countries handled investors rights, as far as the individual countrys quality of law in this regard and how the law in each country enforced the law. This is an important measurement when dealing with creative accounting, as investors rights are strongly correlated with creative accounting activity. (Leuz et al. p. 1). The reason why this is so is because, when legal systems give investors the rights to discipline insiders, this correspondence with a reduction in insiders concealment of activities, which thus leads to less creative accounting. (Leuz et al. p. 3). Included under the La Portas rubric of investors rights was the quality of the accounting systems in each country. (La Porta p. 6). The study concerned 49 countries, from every continent but Antartica, with the article focusing on the traditions influenced by France, Germany and Scandinavia (La Porta p. 2). The countries focused on were those already developed, and not in transition or socialistic. (La Porta p. 8). Each country had to have at least “five domestic non-financial publicly traded firms with no government ownership in 1993.” (La Porta p. 8). La Porta began with laying out that law in general fits into one of two broad categories – common law, which can trace its roots to England, and civil law, which is Roman based. (La Porta p. 5). Civil law relies upon statutes and codes, and “relies heavily on legal scholars to ascertain and formulate its rules.” (La Porta p. 9). Civil law has three major branches, and they are French, German and Scandinavia laws. (La Porta p. 5). Due to the spread of French law, called The French Commercial Code, through Napoleonic invasions in the 1800s, French law is heavily influential in Belgium, the Netherlands, parts of Poland, Italy, the Western regions of Germany, parts of Saharan Africa, Indochina, Oceania, and the French Caribbean. (La Porta p. 9). German Commercial Code is not as widespread as French Commercial Code, but it is still globally influential, being heavily relied upon in Austria, Czechoslovakia, Greece, Hungary, Italy, Switzerland, Yugoslavia, Japan and Korea. (La Porta p. 9). In addition, China has borrowed heavily from the German Code and has, in turn, influenced Taiwan. (La Porta p. 9). Scandinavia law was confined, for the purpose of this article, to include the 4 nordic countries of Denmark, Finland, Sweden and Norway. (La Porta p. 10). The common law countries are those relying upon English law, and include the United States, Canada, Australia, India and many other countries, 18 countries in all. (La Porta p. 10). La Portas broad findings were as follows: Common laws give investors stronger rights than civil laws, and the French civil laws are the weakest of the civil law branches. (La Porta p. 6). Germany and Scandinavia law falls somewhere between French law and common law. (La Porta p. 6). On the other hand, law enforcement is highest in Germany and Scandinavia, Frances law enforcement is the lowest, and the common law countries fall somewhere in between. (La Porta p. 6). Countries may have lax enforcement of laws that are on the books, even if that country has a relatively effective body of law, and the reasons for lax enforcement include weak courts, preferences for private arrangements, outdated laws and business practices evolving to circumvent the law. (Slavova p. 11). Law enforcement was examined in five different measures: “efficiency of the judicial system, rule of law, corruption, risk of expropriation – meaning outright confiscation or forced nationalization – by the government, and likelihood of contract repudiation by the government.” (La Porta p. 25). Also included in this rubric was accounting standards. (La Porta table 5). In examining the La Portas findings, it is important to narrow the findings to those that are relevant for the purposes of determining which countries are more likely to have deficient legal systems that would be responsible for more prevalent creative accounting. This measurement is accounting standards, and the index is created by “examining and rating companies 1990 annual reports on their inclusion or omission of 90 items,” which fell into the 7 categories of general information, income statements, balance sheets, funds flow statement, accounting standards, stock date and special items. (La Porta table 1). It shows that the French Commercial Code countries, consisting of Argentina, Belgium, Brazil, Chile, Colombia, Ecuador, Egypt, France, Greece, Indonesia, Italy, Jordan, Mexico, Netherlands, Peru, Phillippines, Portugal, Spain, Turkey, Uruguay and Venezuela, had the lowest rating on accounting standards, at 51.17. (La Porta table 5). The next lowest are Denmark, Finland, Norway and Sweden, with a 60.93 rating. (La Porta table 5). Then comes German Commercial Code countries, consisting of Austria, Germany, Japan, South Korea, Switzerland and Taiwan, with a rating of 62.67. (La Porta table 5). The highest were the common law countries of Australia, Canada, Hong Kong, India, Ireland, Israel, Kenya, Malaysia, New Zealand, Nigeria, Pakistan, Singapore, South Africa, Sri Lanka, Thailand, United Kingdom, United States and Zimbabwe, with a 69.62 rating. (La Porta table 5). La Portas findings show that the countries that are influenced by the French Commercial Code presumably have the most lax rules regarding accounting practices, if you can extrapolate overall laws protecting investors to laws regarding accounting practices. They also are the most lax in enforcing the laws that they do have, with La Porta specifically tailored his findings to accounting practices, demonstrating that the French Commercial Code countries have the lowest ratings on accounting standards. (La Porta table 5). Germanic and Scandinavia influenced countries are considerably above French countries in ratings on accounting standards, and below Common Law countries on this standard, and they are also below Common Law countries as far as the text of the laws that they have. (La Porta table 5). Therefore, Common Law countries would presumably have the most robust laws regarding accounting practices and the best enforcement of these laws. French origin countries have the worst in these two indices, and Germanic and Scandinavia countries are somewhere in between. Taken as a whole, La Porta shows that one cannot paint all global corporations with the same brush, that brush being the notion that creative accounting is a result of deficiencies in the legal system. In some countries, notably those developed, non-socialistic countries who have adopted the French Commercial Code as their primary legal standard, this may be true. It seems like these countries have lackadaisical enforcement of already lax laws, and this would certainly lead to a greater incident of creative accounting or even outright accounting fraud. But with countries adopting the Common Law, the United Kingdom and United States among them, creative accounting would be less a product of legal deficiencies than it would be a product of some other factor. Germanic Code adopters and Scandinavian origin countries would be somewhere in between these two standards, in that their accounting standards are in the middle, so the prevalence of creative accounting in these countries would presumably be less than in France origin countries and more than in Common Law countries, all other factors being equal. Indeed, the studies done by Leuz et al. (2002) bear this out. They measured earning management across the same clusters that La Porta delineated. The United States and the United Kingdom was one cluster, and they were identified as countries with “large stock markets, dispersed ownership, strong investor rights and legal enforcement. The next cluster was Germany and Sweden, who were defined as “insider economies with less developed stock markets, concentrated ownership, weak investor rights, but strong legal enforcement.” The final cluster was Italy and India, who were “insider economies with weak legal enforcement.” (Leuz et al. At 3). Similar to what I theorized, they found that “outsider economies with strong enforcement” displayed the lowest earnings management and “insider economies with weak enforcement” displayed the highest level of earnings management. However, these studies were conducted before the European Union adoption of the International Financial Reporting Standards (IFRS), which changed the standards in European Countries and homogenized accounting practices. Therefore, La Portas data is outdated, but beneficial to establish a benchmark for the European and other countries who have adopted these standards to deal with corporate accounting. The IFRS will be discussed in greater detail later in this paper. Hypothesis #2 – the Prevalence of Creative Accounting is a Result of Inadequacies in the Autonomy of Government Regulation and Supervision Bodies The next theory that will be discussed is the theory that the prevalence of creative accounting is tied to how autonomous government regulation and supervision bodies are. The definition of autonomy is “not controlled by outside forces” (Wordnet), and, after reviewing the literature regarding creative accounting, there is some truth to this statement. Accounting is regulated in most countries by two different means – local laws and accounting regulations, which take the form of standards. (Gowthorp & Amat p. 4). These standards are closely governed by the International Accounting Standards Committee (IASC), as well as the IFRS. (Gowthorp & Amat p. 4). The IASC and IFRS promulgated international standards for countries to adhere to. In 2001, the IASC became the International Accounting Standards Board, or IASB, which was responsible for issuing the IFRS. (Gowthorp & Amat p. 5). Accounting regulation is important because it “affects the allocation of economic resources, and so it has potentially wide-ranging effects upon social welfare and the balance of economic power between parties with often competing interests.” (Gowthorp & Amat p. 6). Gowthorpe and Amat examined the prevalence of macro-manipulation, which is defined by them as lobbying to alter accounting regulations. (Gowthorp & Amat p. 3). They also examined the prevalence of micro-manipulation, which is where preparers ignore accounting rules or misapply them. (Gowthorp & Amat p. 8). The macro-manipulation examined by Gowthorp & Amat concerned two different aspects of accounting – pooling, or merger accounting, which is where “pooling of interests generally produces combined statements that show the combination in much better light than under the alternative method of acquisition accounting”; and the classification of goodwill, which represents the difference between what a business is actually worth and what the value of its net assets are. (Gowthorp & Amat, pp. 12-13). The FASB, which is the US accounting regulator, proposed that pooling be outlawed. (Gowthorp & Amat p. 13). The reasons that the FASB wanted this practice outlawed is because the groups of companies could not easily be compared, too many regulatory resources are used for this type of accounting, and genuine pooling is rarely used. (Gowthorp & Amat, p. 12) As this move would negatively affect earnings per share and return on equity, corporate America was dismayed at this proposal and Cisco, a software corporation and lobbyist against FASB, lobbied against pooling being outlawed. However, FASB was only able to get pooling outlawed if it made a major concession regarding goodwill. (Gowthorp & Amat p. 13). Goodwill, as stated above is the difference between the worth of a business and the worth of its net assets. For instance, a small law firm might have net assets of less than f3,000 – the value of its printer, copier, office furniture, computers, art work, etc. But that same law firm might be worth considerably more, if it has a large clientele with much value. Its actual worth might be more like f30,000 or more. The difference between these two numbers is goodwill. Other examples of goodwill include intangible assets, such as patents and licencing agreements. (Finch “Intangible Assets” p. 2). There are two ways of valuing good will. One way would be to amortise it, which would depress reported profits. (Gowthorp & Amat p. 13). The other way to treat it would be to not amortise it, but test it regularly for impairment – ie, test to see if its value had reduced. (Gowthorp & Amat p. 13). The FASB wanted to treat goodwill as an asset that is amortised to 20 years, but it ended up taking a non-amortisation approach to goodwill. This gives corporations an effective way to manage their earnings, or to creatively account. The reason for the FASBs concession regarding goodwill is because it needed this concession to be able to outlaw pooling. (Gowthorp & Amat p. 14). This anecdotally shows the influence of lobbying on the accounting regulatory agency. The agency is supposed to be an independent body who promulgates rules that are for the best interest of everybody to follow. Unfortunately, they were influenced by lobbyists and forced by Congress (who introduced a bill to curtail FASBs ability to eliminate the pooling method of accounting) (Gowthorp & Amat p. 14) to adopt the goodwill method that will encourage corporate creative accounting so that it could eliminate pooling, which would have been another method of creative accounting. Closely related to macro-manipulation is micro-manipulation, which basically means ignoring regulations that you dont like. (Gowthorp & Amat p. 15). This was a problem in Spain, where supervisors allowed companies to adopt accounting policies that were in contravention to the current accounting regulations. (Gowthorp & Amat p. 17). The way that these concessions were made was through lobbying. (Gowthorp & Amat p. 17). Micro-manipulation shows how regulatory agencies are sometimes not only not autonomous, but basically toothless. It also shows the lack of autonomy of supervision bodies, as these bodies bend to the lobbyist, instead of staying independent. Regulatory agencies can be manipulated by lobbyists who convince supervisors to ignore the regulations. That they can be so easily undermined shows the lack of autonomy, as it is clearly being controlled by outside influences. The practice of macro and micro manipulation show that regulatory agencies and supervision bodies are not always autonomous, but can be influenced by lobbyists and forced into adopting rules by legislative bodies that threaten bills that further erode the autonomy of these bodies. The rules that are adopted in these environments are usually rules that allow corporations to more easily practice creative accounting, so, based upon the anecdotal evidence presented above, I would agree with the statement that the inadequacies in the autonomy of governmental regulation and supervision bodies contributes to the prevalence of creative accounting. Hypothesis #3 – The Prevalence of Creative Accounting is due to the practical difficulties in enforcing legal and ethical rules due to the slow functioning of the judicial system This is a more difficult question to answer, as not a lot is written about this aspect in the literature. However, the data that was extrapolated from La Porta et al. (1996) can be used to evaluate this statement. This is because one of the aspects studied by La Port et al. concerned the efficiency of each countrys judicial system. To review, La Porta et al. found that the common law countries that were of English origin had the best rating of accounting standards, a high degree of enforcement of rules protecting investors and a good set of laws regarding investor protection. German and Scandinavia origin countries had good accounting standards, the highest degree of rules enforcement and good set of laws regarding investor protection, but not as good as the Common Law countries of English origin. French origin countries had a poor set of laws regarding investor protection, poor enforcement of laws in this area and poor accounting standards. Based upon this, it was theorized that Common Law countries would experience less creative accounting than Germany or Scandinavia countries, and French countries would experience the most creative accounting of these countries, a theory that was borne out by the studies done by Leuz et al. Using this framework, we can look at La Portas findings regarding judicial efficiency and see if they correlate with the prevalence of creative accounting. The findings were that the French countries had the lowest rate of judicial efficiency, with a 6.56 rating. The Common Law countries of English origin had the next lowest rate, at 8.15, followed by German countries at 8.54 and Scandinavia countries at 10. (La Porta table 5). What this tells us is that the efficiency of the judicial systems does not necessarily correlate with the prevalence of creative accounting. It seems to correlate in the French systems, as the French countries have the most creative accounting of the cluster countries, and also have the most inefficient judicial system. However, the second most inefficient judicial system is that of the Common Law countries, which has shown to have the least creative accounting problems of the cluster countries. By far the most efficient judicial system is that of the Scandinavia cluster, and they are only middle of the road as far as the prevalence of creative accounting. I therefore do not entirely agree with the hypothesis that an inefficient judicial system is responsible for the prevalence of creative accounting. Hypothesis #4 – The Prevalence of Creative Accounting is a result of Personal Greed of Top Management and Owners This hypothesis, like the first hypothesis, is simplistic and does not tell the entire story. Yes, there are greedy managers and owners who “cook the books” for their own gain – and they are known as white collar criminals. (Green pp. 506-507). However, there are many motivations for creative accounting, and most of them do not have anything to do with personal gain. Some of the motivations for creative accounting include the need for shareholders and workers to be confident in the corporation, and this confidence is borne through stable earnings; psychological gain that relates to the increase or decrease anticipated income; tax incentives; current losses are maximized so that future years will appear better; income smoothing has positive effects on securities valuation and risk reduction; to smooth gaps between actual performance and analysts expectations; a need to match reported earnings to profit forecasts; the need to make future earnings easier to predict; the need to distract the public from bad news about the corporation; and the need to help maintain or boost share price by making the corporation appear less subject to risk, thus raising capital and insulating the company from takeover bids. (Amat & Gowthorp pp. 5-6). Other reasons for creative accounting is because corporations are under so much pressure to not be labeled unreliable, and a need to have smooth earnings so that bonuses can be better assured. (Yu p. 8). In short, the main motivations for creative accounting has to do with protecting the company, as opposed to personal gain of any one person. I therefore disagree with the hypothesis that a major reason for creative accounting is the personal greed of top managers and owners. International Financial Reporting Standards and Their Effect on Creative Accounting Practices The European Union mandated, on January 1, 2005, the adoption of the International Financial Reporting Standards (IFRS), which is a “single global set of accounting standards.” (Chen et al. p. 2). The IFRS represents high quality accounting standards. However, the studies that were done had mixed results as far as the effect on accounting practices. Ahmed et al. found that corporations in the European Union actually increased income smoothing in the period after the adoption of the IFRS. (Ahmed et al. p. 1). Their sample in their study consisted of 1,600 firms from 21 countries who adopted the IFRS in 2005. (Ahmed et al. p. 3). They compared these corporations to benchmark corporations, 2,000 in all, from 17 different countries, who did not adopt the IFRS during this same period of time. The study found that, in the pre-adoption period, that the IFRS firms had “less income smoothing, more conservative accruals, and more timely loss recognition” than the benchmark non-IFRS firms. (Ahmed et al. p. 3). After the adoption of the IFRS “income smoothing increased, accrual conservativism decreased, timeliness of loss recognition decreased, and timeliness of gain recognition increased for IFRS firms relative to benchmark firms.” (Ahmed et. al p. 3). Similarly, Chen et al., found that the implementation of the IFRS led to greater income smoothing and delayed recognition of large losses in their study of corporations from 15 EU member states. (Chen et al. p. 10). However, they also found that there was “less of managing earnings towards a target, a lower magnitude of absolute discretionary accruals, and higher accruals quality.” (Chen et al. p. 10). These are all signs that creative accounting has decreased, at least in those respects. Meanwhile, Finch (2008) discovered that, in measuring goodwill and its impairment after the adaptation of IFRS left substantial room for improvement, as “required disclosures were frequently omitted, or suggested that the technical requirements of the IFRS goodwill impairment testing process had not been complied with.” (Finch p. 1). What these studies show is that, in certain respects, creative accounting actually increased after the implementation of the IFRS. The reason for this is that the IFRS is principle-based, as opposed to rules-based, so managers have more discretion and flexibility in implementing IFRS. (Ahmed et al. p. 6). Since managers prefer smoother earnings, they are more likely to take advantage of this greater flexibility and discretion to increase income smoothing. (Ahmed et al. p. 6). Since these studies show a mixed bag, as far as whether or not creative accounting decreased after the implementation of IFRS, I do not whole-heartedly agree with the statement that these current standards have improved the situation. CONCLUSION Creative accounting is a problem in corporations. It gives a false picture of the health of an organization, and can lead to distrust. However, it is not necessarily a result of deficiencies in the legal system, nor necessarily because of inefficiencies in the judicial system, nor necessarily because of the greed of managers and owners. There is, however, some anecdotal evidence that a lack of autonomy in regulatory agencies might lead to creative accounting. The mandatory adoption of the IFRS did not completely solve the problem of creative accounting either, as some measures of creative accounting, most notably income-smoothing, actually increased after this event. Therefore, it seems that creative accounting is here to stay, at least for the time being. BIBLIOGRAPHY Ahmed, A., Neel, M. & Wang, D. 2009, The Effects of Mandatory Adoption of International Financial Reporting Standards on Smoothness, Conservatism and Timeliness of Accounting Earnings, pp. 1-26, Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1502909 Amat, O. & Gowthorpe, C. 2004, Creative Accounting: Nature, Incidence and Ethical Issues, UPF Working Paper No. 749, pp. 1-45. Balaciu, D. & Pop, C.M. Is Creative Accounting a Form of Manipulation? pp. 935-940. 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