The Ethics of Creative Accounting - Assignment Example

 The Ethics of Creative Accounting Abstract In this report, the objectives of financial statement as valid and reliable informative sources regarding an entities’ financial performance and changes in its financial position are critically evaluated. How far the above argument remains valid is debatable given the widespread financial frauds occurring all over the world due to manipulation of financial statements by the reports. Moreover, major implications of adopting IFRS for financial reporting have been discussed. To some extent, the argument of enhanced quality of financial reporting through adopting IFRS can be obtained. However, adopting IFRS itself may not always result in increasing the quality of financial information. In addition to adopting IFRS several relevant changes in the overall economic and institutional framework need to be implemented to achieve the enhanced quality financial reporting. Further, before implementing IFRS fully to all countries, an international consensus taking into account of the country specificities needs to be obtained regarding the treatment of various financial instruments and various accounting procedures .This is needed to implement IFRS without affecting the information provided by the financial statements of enterprises . Objectives of Financial Statements –A Critical Evaluation 1. Introduction Financial Statements of an enterprise are intended to give valuable information about the financial health of the company to its owner investors and lenders (Tracy, 2004).In other words, they are supposed to give information about the financial position, performance and changes in financial position of the enterprise. These are a major source of financial information that helps the users in making decisions about economic activities. Thus according to IASC(1989,paragraph 12), “The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.” On the other hand, it is argued that the preparers of the financial statements can manipulate the financial statements by 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 (Nasar, 1993:2). It may not be illegal in all cases but they are considered as unethical (Amt et al, 1999). This process is called creative accounting. The inappropriate use of creative accounting has resulted into financial statement frauds in many cases, which has been an issue of great concern. The frequent events of creative accounting and scandal have resulted in a loss of confidence among the investors in financial markets all over the world. The creative accounting and frauds have become increasingly common all over the world now. This questions the validity of the statement on the objective of financial statements. However, this issue remains unsettled. In this essay, a critical evaluation is done on the statement regarding the objective of financial statements. 2. Financial Statements and the Treatment of Financial Instruments According to Wang (2007), the four main characteristics of an ideal financial statement are relevance1, reliability2, comparability3 and understandability4. There are two sets of internationally recognized accounting standards, the US GAAP developed by the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) issued by London based International Accounting Standards Board (IASB)(Warren,2005). The convergence of national accounting standards to IFRS is supposed to achieve the benefits of high quality universally comparable financial information and other benefits of globalization (Purvis etal, 1991 Based on IAS 16, the treatment of the investment in plant, property and equipment by a firm under IFRS is discussed. The issues like asset recognition, determination of amounts for them and estimating depreciation allowances in this regard are discussed here. The cost measurement of plant, property and equipment according to this standard is done based on its current transaction date (IASC foundation, 2003). The IAS 17 discusses the specific treatment for leases to be followed under IFRS (IASC Foundation, 2009). Based on this “Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit. Lessees shall recognise finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease”( IASC Foundation, 2009,p 1). Under the existing country specific GAAP, the rental arrangements, lease arrangements and hire arrangements are reported in separate ways in many countries. IFRS demand a single method of accounting for both the leases. The IFRS also demands methods to ban the interest methods of depreciation and amortization (ASB, 2001). There has been widespread concern among many stakeholders about the single accounting method that treating some short-term arrangements separately has many benefits involved that outweigh the costs and hence there may be exclusions for this (EFRAG, 2009). However, EFRAG (2009) has rejected this claim stating that there will be no exclusions for the single accounting methods. All approaches under IFRS are adopted from the point of view of lessee while EFRAG (2009) feels the need to think from a lesser’s view point before implementing new rules or changing existing ones. IAS 23 discusses the treatment of borrowing costs under IFRS (IASC Foundation,). Based on this “Borrowing costs are interest and other costs incurred by an entity in connection with the borrowing of funds”(IASC Foundation ,1984, p1). Based on the revised standard on borrowing costs, “To the extent that borrowing costs relate to the acquisition, construction or production of a qualifying asset, the revised Standard requires that they be capitalised as part of the cost of that asset. All other borrowing costs should be expensed as incurred (Deolitte, 2007, p1). IAS 36 discusses the identification of an asset that is impaired in an entity (IASC Foundation, 1998). Based on this, “An asset is carried at more than its recoverable amount if its carrying amount exceeds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired and the Standard requires the entity to recognise an impairment loss” (IASC Foundation, 1998 p1). IAS 37 discusses the accounting policies regarding contingent assets and liabilities under IFRS. In addition to the issues discussed above, the other issues of concern while adopting IFRS are regarding ownership and control, financial accounting for leases, derecognition, revenue recognition and distinction between debt and equity(UNCTAD, 2006) . To find out the group classification for a particular entity while adopting IFRS, the distinction between control and ownership of that entity needs to be done. Through control of an entity, we mean the power to direct that entity. Ownership means having legal rights for votes, advantages etc. However, the distinction between both is not clear. This is because controlling power of an entity includes having certain legal rights also. Further, ownership can lead to control of an entity also (ASB, 2001).Hence while preparing consolidated financial statements under IFRS, the distinction between control and ownership becomes very difficult. In addition to this, the ownership concentration in different countries varies depending on the level of financial development (Ding etal, 2007). Therefore, preparation of consolidated financial statements under IFRS for various countries may be challenging. The derecognition approach to financial instruments varies in different countries. Hence implementation of IFRS will be challenging and create many practical problems based on the procedures in various countries. It is argued that an agreement between all countries is needed in this regard before implementing IFRS (ASB, 2001). In many countries, the revenue component has not been dealt clearly by any accounting standard. Hence the revenue reported by various industries and businesses are fond to be inconsistent. While adopting the classification of revenue by IFRS, how reliable the same standards are for different sectors and industries is debatable (ASB, 2001).Before reporting revenue under the IFRS, an international agreement is therefore needed. Another major issue is the classification of financial instruments as debt or equity under IFRS. First, the distinction between debt and equity instruments is not very clear in many countries according to the GAAP. In addition to these, the definition of equity under IFRS is little bit stringent. Hence, there is possibility that financial instruments classified, as equity in many countries will come under debt classification on adopting IFRS. This may negatively affect many financial instruments in different sectors. This in turn can affect the information content in financial statements in many countries under IFRS. Thus, one major requirement under the IFRS is that the public companies in European Union provide Fair Value of their financial affairs in their financial statements. The fair value approach is that companies need to measure and report certain assets and liabilities based on the estimates of their exchange prices in a current transaction between knowledgeable unrelated willing parties (Landsman, 2006; Ryan, 2008). However, there are many criticisms regarding reporting losses or profits using fair value approach. One criticism questions the accuracy of estimating fair values without discretion. This occurs when markets are illiquid, then firms need to make adjustments for illiquidity to obtain fair values .In such cases, the fair values are estimated as adjusted market-to-market values or market to model values (Landsman, 2006). Landsman (2006) raises doubts about the reliability of fair value accounting particularly for financial instruments, which do not have active markets like privately placed loans. Ryan (2008) however rejects this criticism stating the need for managers of firms to disclose the information about the reliability of fair value estimates by the FASB. Further, the fair value estimates are re estimated each quarter in order to minimize the probability of error. The problem still exists for financial instruments which do not have active markets since in this case the manager can manipulate or misinterpret figures based on their discretion .Hence how far such estimates are reliable is an area of concern . However, it is argued that compared to the alternative of fair accounting called Amortized Cost Accounting (AMA)5 and mixed attribute accounting6 the fair value can be considered a better option (Ryan, 2008). The second major criticism on fair value accounting approach is that when future cash flows have a skewed distribution, then there is possibility that expected cash flows and most possible future cash flows can be very different. In this case, fair values can tend more towards most likely future cash flows .Therefore, the fair value estimates may not be reliable(Landsman,2006).However, Ryan (2008) shows that this is not a case to worry. This is because, in this case, the magnitudes of the revisions of fair estimates in the direction of most likely future cash flows and expected cash flows will cancel each other. Hence, the mean value of the unexpected change in fair value estimates will be zero. Though there are major criticisms regarding the reliability of fair value estimates and on the reliability of private information provided by the managers on the accuracy of fair value estimates, it is widely required by the GAAP and the IFRS. This is because it can be considered as the best option when compared with the alternatives. Another major issue is regarding the flexibility option to depart from the standard GAAP rules in special circumstances according to the true and fair view /fair view. When the existing rules are not good enough to provide quality financial reports then this provision is useful. However, there are disadvantages also with respect to this flexibility that the financial reports may not be universally comparable .In addition, this provision to depart from the existing rules give the managers more discretionary power .How they are using this power remains a debatable issue(Livne and McNichols, 2009). Sometimes they can use this power to manipulate or misinterpret figures, which is called creative accounting. The next section discusses creative accounting in detail. 3. Creative Accounting The aim of GAAP is that all companies need to follow same set of rules in their financial statements and accounting treatment (Warren, 2005). When the companies manipulate the financial statements for their own personal interests, it will lead to creative accounting in most cases. According to Mulford (2002), the main motivations for creative accounting can be classified into the categories share price effects, borrowing cost effects, bonus plan effects and political cost effects. The companies may manipulate the figures in such a way that share prices tend to higher or lower than what they are for their own interests. These interests include showing investors that the companies have high earning power or showing government that it has low profit for getting government assistance. The tendency to manipulate for showing high share prices will lead to lower corporate borrowing costs also. Moreover, the employees manipulate figures to maximize the bonuses they receive. The political cost effects include manipulating figures to show that the companies have low earnings to avoid high taxation. In addition to these, the flexibility option to depart from the standard GAAP rules in special circumstances according to the true and fair view can sometimes lead to creative accounting. The true and fair value approach is that companies need to measure and report certain assets and liabilities based on the estimates of their exchange prices in a current transaction between knowledgeable unrelated willing parties (Landsman, 2006; Ryan, 2008). In special cases, the true and fair presentation provides flexibility to depart from the standard accounting rules provided by the GAAP (Livne and McNichols, 2009). When the existing rules are not good enough to provide quality financial reports then this provision is useful. However, this provision to depart from the existing rules gives the managers more discretionary power. Sometimes they can use this power to manipulate or misinterpret figures leading to creative accounting (Livne and McNichols, 2009).However, the costs associated with the misuse of the flexibility will be very high so that the managers will not take unnecessary advantage of this option. In the firms where the management itself enforces a self-serving contract, these costs will not be barriers to the managers to abuse the flexibility option. In such cases, it can lead to creative accounting. The empirical evidence by Livne and McNichols (2009) for UK public companies from 1998-2002 shows that the departure from GAAP principles is more frequent when the costs to avoid them are less .This is the case when the principle has less authoritative support. In addition to these, another types of effects called income-smoothing effects and big bath accounting have been cited in many studies (Amat and Gowthorpe, 2004).The former effect arises due to the confidence of the shareholders in the management that is able to report stable earnings and psychological expectations relating to increases or decreases in anticipated income. The later effect occurs where a company making a bad loss seeks to maximise the reported loss in that year so that future years will appear better (Amat and Gowthorpe, 2004). According to Largay (2002), Mulford and Comiskey (2002) and Amat and Gowthorpe(2004) the creative accounting can be found in six areas regulatory flexibility, a dearth of regulation, a scope for managerial judgement in respect of assumptions about the future, the timing of some transactions, the use of artificial transactions and the reclassification and presentation of financial numbers. In the first case, creative accounting may occur de to the flexibility in the choice of policy. In the second case, it may be due to the lack of regulation in some areas as in the case of accounting for stock options in Spain. In the third case, it will be due to the freedom for mangers to estimate in discretionary areas. In the fourth case, it may be due to the flexibility in choosing the timing for genuine transactions given to the managers. In the fifth case, creative accounting will be due to the entry of artificial transactions. In the sixth case, the creative accounting takes place to reach significant reference points (Niskanen and Keloharju, 2000; van Caneghem, 2002). Regarding the ethical issues involved in the creative accounting, many studies have been done. Leung and Cooper (1995) for a survey of 1500 accountants in Australia found that in a survey of 1500 accountants the three ethical problems cited most frequently were conflict of interest, client proposals to manipulate accounts and client proposals for tax evasion. Two surveys of attitudes to creative accounting in the USA both highlight a difference in accountants’ attitudes to creative accounting depending on whether it arises from abuse of accounting rules or from the manipulation of transactions. In as study by Amat et al (1999) on creative accounting in Spain, the role of true and fair view as a solution rather than a cause for the creative accounting problem has been emphasized. For this, the study suggests methods like reducing accounting choices for same transaction, reducing the area allowed for subjective evaluations, reducing artificial transactions through true and fair view, strengthening ethical code etc. Wang (2007) in his case study on the Xerox scandal in USA using questionnaire-based research obtained that this scandal had serious implications and it showed the major flaws in the contemporary US market. The study suggested financial reforms and penalties as possible solutions to reduce such scandals. The study reveals the role of efficient auditors, effective corporate governance, independence of board of members and directors, more influence for the shareholders on the management etc in preventing such scandals. Creative accounting is a serious problem, which has major implications for the business community, the accounting profession and a country’s economy. The main causes and the techniques for the creative accounting need to be examined carefully to suggest methods to prevent the problem. However, the review shows that the attitude of the auditors vary in different nations regarding the usage of creative accounting techniques. Further, the true and fair view can be both part of the solution if not applied efficiently and can be a solution to the problem if managed effectively. 5. Conclusion In this essay, the objectives of financial statements and achievement of the objectives are critically evaluated. On the one hand, it is argued that financial statements are useful and reliable reports to the investors regarding an entity’s financial performance and changes in its financial position. However, how far the above argument remains valid is debatable given the widespread financial frauds occurring all over the world due to manipulation of financial statements by the reports. Moreover, major implications of adopting IFRS for financial reporting have been discussed. On the one hand, there are increasing pressures for various countries to adopt the internationally accepted IFRS. This is supposed to enhance the quality of financial information and to obtain international uniformity in financial reporting. On the other hand, there are widespread criticisms against adopting IFRS in various countries. The critics argue that there are cross-country cultural differences, which are reflected, in country specific financial statements. The IFRS is set by account setting bodies that have their own vested political interests. Hence, the country specific preferences and interests of local public are ignored while implementing IFRS. Then there is great chance that financial statements need not provide an objective and rich information on the financial health of a company. To some extent, the argument of enhanced quality of financial reporting through adopting IFRS can be obtained. However, adopting IFRS itself may not always result in increasing the quality of financial information. Studies have shown that the broad institutional and legal framework in which the enterprise works play a major role in affecting the quality of financial information (Soderstorm etal,2007).Hence in addition to adopting IFRS several relevant changes in the overall economic and institutional framework need to be implemented to achieve the enhanced quality financial reporting. Further, before implementing IFRS fully to all countries, an international consensus taking into account of the country specificities needs to be obtained regarding the treatment of various financial instruments and various accounting procedures .This is needed to implement IFRS without affecting the information provided by the financial statements of enterprises. References Amat,O, John Blake and Jack Dowdes(1999 a): “The Ethics of Creative Accounting”, Economics Working Paper 349, Department of Economics and Business, Universitat Pompeu Fabra. Amat, O, John Blake and Oliveras, E (1999 b): “The Struggle against Creative Accounting: Is 'True and Fair View’ Part of the Problem or Part of the Solution?”. UPF Economics Working Paper 363. Amat O and Catherine Gowthorpe (2004): “Creative Accounting: Nature, Incidence and Ethical Issues”, UPF Economics Working Paper 749 Australian Prudential Regulation Authority (2004): “Adoption of International Financial Reporting Standards. Prudential Implications. Overview “ Paper 3rd November 2004. Australian Government (2006) “A review of the policy of sector-neutral accounting standard-setting in Australia”, Financial Reporting Council. ASB(2001):Inside Track Barton, A. (1999), ‘Public and Private Sector Accounting – the Non-identical Twins’, Australian Accounting Review, vol.9, no.1, pp. 22-31. Clarke,F, G, Dean and K Oliver(2003) “Corporate Collapse: Regulatory, Accounting and Ethnical Failure” , second edition, USA: Cambridge University Press. Deolitte (2007): “IAS Plus”, http://www.iasplus.com/iasplus/0704ias23.pdf, Accessed April 5 2010. Ding Y, Hope Ole-Kristian, , Jeanjean Thomas and Stolowy, Hervé(2007). “Differences between Domestic Accounting Standards and IAS: Measurement, Determinants and Implications” (March 3, 2006). Rotman School of Management Working Paper No. 07-04 EFRAG (2009 “EFRAG’s Comment Letter on the IASB/FASB Discussion Paper Leases”, United Kingdom: IASS. FRC(2005): “The Implications of New Accounting and Auditing Standards for the True and Fair View and Auditors Responsibilities”, London, United Kingdom. HIH Royal Commission (2003) “HIH Royal Commission, Final Report”, Canberra, Government of Australia. Hung, M and Subramanyam, K.(2007). “Financial Statement Effects of Adopting International Acconting Standards: the Case of Germany”. Review of Accounting Studies, Forthcoming. Available at SSRN: http://ssrn.com/abstract=622921 International Accounting Standards Board(2007). “A guide through International Financial Reporting Standards (IFRSs) 2007 : including the full text of the Standards and Interpretations and accompanying documents issued by the International Accounting Standards Board as at 1 January 2007 ; with extensive cross-references and other annotations”, London, United Kingdom : International Accounting Standards Committee Foundation. IASC Foundation Education (1984): “IAS23 Borrowing Costs”, http://www.iasb.org/NR/rdonlyres/189CA297-4D7E-4826-80BC-35876874AD44/0/IAS23.pdf, Accessed April 5 2010. IASC Foundation(1998): “IAS 36 Impairment of Assets”, http://www.iasb.org/NR/rdonlyres/A288C781-7D39-4988-BA71-9AB77A263BA0/0/IAS36.pdf, Accessed April 5 2010. IASC Foundation Education (2009): “1AS 17 leases”,: http://www.iasb.org/NR/rdonlyres/B8ABE9AA-8F5B-4301-866E-ED2D423504E7/0/IAS17.pdf, Accessed April 5 2010. IASC Foundation Education (2003): “International Accounting Standard 16 (IAS 16), Property, Plant and Equipment” https://www.cgapdnet.org/Non_VerifiableProducts/ArticlePublication/IFRS_E/IAS_16.pdf, Accessed April 5 2010. KPMG(2008): “IFRS Briefing Sheet”, United Kingdom Landsman W R(2006) : “Fair value accounting for financial instruments: some implications for bank regulation”.BIS Working Paper No 209 Livne, Gilad and McNichols, Maureen F.(2009), “An Empirical Investigation of the True and Fair Override”, Journal of Business, Finance and Accounting,pp1-30. Merchant, K.A.: 1990 “The effects of financial controls on data manipulation and management myopia”, Accounting, Organizations and Society, Vol. 15, No. 4, pp.297-313. Merchant, K.A. and Rockness, J.: 1994 “The ethics of managing earnings: an empirical investigation”, Journal of Accounting and Public Policy, 13, pp.79-94. Mulford, C. W and Coniskey, E. E. (1951): “The Financial Numbers Game: Detecting Creative Accounting Practices”, New York: Wiley. Naser, K. (1993): “Creative Financial Accounting: Its Nature and Use”, Hemel Hempstead, Prentice Hall. Purvis,S., Gerson H and Diamond M(1991) :”The IASC and its Comparability Project: Prerequisites for Success”, Accounting Horizons,5,25-44. Ryan S(2008) ; “Fair Vale Accounting: Understanding the Issues raised by the Credit Crunch”, White Paper prepared for the CII, NewYork:CII. Smith, T. (1992) “Accounting for growth”, Londres: Century Business. Soderstrom, Naomi S. and Sun, Kevin Jilin(2007): “IFRS Adoption and Accounting Quality: A Review”. European Accounting Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1008416 Tracy J A(2004); “How to read a financial report : wringing vital signs out of the numbers”. New York [u.a.] : Wiley. UNCTAD(2006). “International accounting and reporting issues: Review 2006”, New York : United Nations Publication. Van Caneghem, T (2002): “Creative accounting induced by cognitive reference points”, British Accounting Review, 34, pp.167-78. Wang C (2007): “A Close Examination on Creative Accounting from Theoretical, Practical and Subjective Perspectives”, UK: University of Nottingham Warren, K. (2005), “Converting to International Accounting Standards”, Chartered Accountants Journal’, July 2005, pp. 18-21. Read More