The Implication of creative accounting on the firms

This project will examine a variety of concepts of creative accounting, as well as the variety of reasons for directors of a company to participate in innovative accounting.

It explores the characteristics and development of creative accounting practices in the environment of ethical considerations.

It also examines the many ways creative accounting is a reality and provides a summary of some research regarding the nature and impact of creative accounting.

The role played by auditors in detecting accounting fraud is discussed, based on evidence from a variety of research studies.

It will then illustrate the data’s source along with the sampling method, as well as the method of data analysis that was selected for this study.

In the end, the paper concludes with an analysis of potential solutions to the accounting issues that are creative.

Chapter 1

Introduction

The manipulation of financial data is referred to by various terms. In the USA the most popular term and the most widely used term is “Earnings management” While in Europe the most frequently used phrase will be “Creative accounting” and this is the one that will be utilized in this research. The term is defined in a variety of ways. It is, however, an accounting process that involves accountants using their knowledge of accounting regulations to alter the numbers included in the books of a company. The definition of the term will be further explored later in this article.

Creative accounting is when managers are involved in altering the accounting figures in order to modify the financial reports. The reason behind this change is either to deceive people about the bad performance of the company or attract new contracts or investments based on numbers in financial statements.

The research will utilize the findings of the previous study on scandals, like Enron to determine if the motives are similar to those stated by the other researchers. Additionally, it will highlight the ways in which managers have used innovative accounting methods to commit fraud.

The remainder of the course is arranged according to the following structure. In chapter 2, the research is examined to determine an exact definition of creative accounting, and examine the motivations that drive creative accounting. In chapter 3, the research method is used to establish the importance of creative accounting in Enron’s Annual reports. In chapter 4, the report will examine the main findings as well as the recommendation and conclusion of the research. In chapter 5, various sources for the research will be discussed such as journals, articles, and other sources.

The rationale behind the study

Numerous fraudulent cases were discovered over the last few years. These scandals were fabricated by managers and directors of the businesses. There are many victims who have suffered due to the mismanagement of their positions, starting with shareholders, progressing to employees, and ending up with society.

While the majority of these companies were examined by auditors from outside but fraud has been discovered within the companies. The reason for this is because auditors only provide reasonable confidence in their assessment of the financial statements, and certain of them have been involved in fraud such as Arthur Andersen.

Many people are unaware of the ways in which a company could utilize creative accounting to manipulate the accounting figures and, consequently, commit fraud.

This paper will examine the ethics and method of creative accounting, presenting examples of how to apply it.

Goals and Objectives:

To comprehend the meaning of creative accounting and definitions of creative accounting.

To look at the different motives or reasons for making use of CA by the company’s management.

To identify and explain the methods of accounting that are creative.

To comprehend the role of auditors as well as their responsibilities in the deducting of CA.

To find out if auditors (both internal and external) are a part of reducing the CA within the company.

To understand the impact on the impact of CA on the economy of the country.

Limitations of the study

The study had succeeded in obtaining an audited financial statement for Enron Corporation for four years that began in 1997 and ended in 2000. But, there was a failure to collect the adjustment report’s figures, excluding debts and income. The missing figures could be vital to include in the process of making a sound judgment. In addition, the time needed to complete this research was a bit small to gather the necessary data needed for this research.

Chapter 2

Literature Review

There are a variety of scholars who have to defined creativity in accounting (CA) with different perspectives. The following are the definitions.

It involves the repeated choice of accounting measures or reporting guidelines in an established pattern and the result is to present the income stream in a manner that has an equidistant trend than it would have otherwise occurred. (Copeland, 1968)

“Is there any action by management that impacts the revenue reported and is not a true benefit to the business and could be end up to cause harm’. (Merchant and Rockness 1994)

“Whereby the real the financial results of a firm is altered by managers to gain personal gain’ (Klein, 2002)

It was observed that even though researchers from various decades have defined CA, however, they have agreed on the core notion of CA which is the use of accounting regulations to alter accounting figures to demonstrate an inaccurate result of a business’s performance.

The motivations and reasons behind accounting innovation

Numerous authors have examined the subject of motivational factors for managers toward creative accounting. There are numerous reasons. One of them was mentioned by

Shafren (2009) stated from his study of Satyam Company that the stakeholders are interested in the financial statements of the company since they are ways to display how the company is performing and how it is performing in the market. Thus, managers try to portray the figures in a way that they can send a positive message to investors. Investors are always drawn to when their annual statements are excellent. Therefore, in order to convey this belief, managers attempt to alter the statements by using tricks of CA. On the other hand, directors may have their own reasons for their bonuses can be decided according to the profits they earned or disclosed. Lttner and colleagues (1997) have confirmed that when a manager’s bonuses and stock options depend on the performance of the company, it is a chance that the director will adjust the numbers upwards in order to achieve the desired results.

Another reason was identified another reason was mentioned by the author’s other authors such as Dharan, in addition to Lev (1993) in 1993. demonstrated the study “The impact of accounting charges on valuation the fact that an organization opted to use CA when its share price began to decline following a rise in the price of shares that it had previously reported. This happens when companies have to contend with numerous constraints and obligations that are based on the amount that is reported in the statements. For instance, based on surveys conducted by US managers of banks, the researchers found when a new manager of a bank has responsibility for an organization it is a good idea to alter his loan provisions so that he makes sure that any losses incurred by previous managers can be protected by the provision.

However, Beatty Harris and Harris (2001) stated managers can manipulate accounting numbers in a way to lessen the tax burden or allow them to pay the least amount of tax on income by ensuring that the amount of tax incurred is less than the tax benefits. Niskanen, as well as Keloharju (2000), were in agreement in their research on earning cosmetics within an accounting environment driven by tax evidence from Finnish public companies, which is basing their research on European companies. They concluded that the corporate tax may be the main reason behind CA being utilized by the management of the business.

There are many common reasons for CA. The most obvious reasons for CA are changing the accounting data to provide an investment-friendly indicator and to reduce the income of the firm to meet tax requirements. So, all stakeholders need at a minimum be aware of these two aspects. If there were more independent directors on the board, then there would be less motivation, or it is possible to eliminate it. The best method to eliminate this kind of procedure is to not be aware of the methods by which it could have been observed, but rather to nominate additional independent directors.

Creative accounting techniques

Largay (2002) published in an essay “Lessons learned from Enron In spite of the strict regulations that exist in certain countries such as the USA The accounting regulations allow for a lot of flexibility. The possibilities for CA and its techniques could be discovered in specific areas.

One of the methods that are used in CA according to Schipper (1989) was the flexibility in the regulation. In his article entitled ‘Commentary on the use of creative accounting’, that the accounting regulations offers a lot of flexibility when selecting any of the policies established by the International Accounting Standard Board, for instance, it permits non-current assets to be appraised either at the historical cost or at an amount that is revalued. Therefore, if the management decides to alter the policies of the business, it could make sense to deduct the cost during the year of the changes, however, it can be difficult to determine the exact value in the following years. Another factor is the lack of regulations found in all countries. AS it is evident on the ground in Romania and Spain where there are a few required requirements for stock option or recognition of pension obligations.

CA may also be seen to be the discretionary role held by the management. It could be utilized in certain items to gain

stability in the financial situation. This is been stated in McNichols as well as Wilson (1988) in 1988. a manager could decide to increase or reduce the number of bad debts to achieve the desired result. The timing of certain transactions also gives managers an opportunity to boost the amount of revenue and provide an appearance that the net profit isn’t sufficient. For example, a company might have an investment in the historical cost that could be sold at the current price (i.e. at a higher amount) when operating profit is negative. The third method that the author mentions is the use of artificial transactions which can be used to manipulate the account balances or transfer the profit amount between the accounting period. This can be accomplished by entering relevant transactions through the help of a third party, such as banks. Imagine an arrangement was agreed with a bank to lease the asset back to the bank and then lease back the asset for the duration of its lifespan. The agreement consists of selling the asset for a lower or more than an uncontrolled deal, and the amount of compensation comes from the difference in the rental cost.

The other method was described by Gramlich and colleagues (2001) in the article that they stated that companies might attempt to alter their balance sheets in order to alter the classification of liabilities in order to improve the liquidity ratio. This type of manipulation is done to improve the perception of investors. While there isn’t much distinction between the 298 million figures and the 301 million investors were able to perceive the most recent number as more significant than the previous one.

The International Accounting Standard had been developed to help reduce or completely eliminate the fraud in accounting that is committed by the managers of the business. However, in some instances, IAS can be a factor in making fraud by offering different methods for handling the financial statements of an item. Each of these methods has one purpose, which is that it creates FS more appealing from the perspective of the stakeholders.

Auditors’ role and the responsibilities they have

In the wake of numerous scandal-related allegations that were reported in the last decade many people like shareholders, have lost faith in the audit companies. They’re pondering the responsibility of auditors in deducting from the fraud, and if they were the primary factor in the fraud.

According to the Audit Committee Institute (2007), auditors must be aware of any situations that cause the company to be subjected to pressure from outside and within the company and consequently encourage the company to engage in faulty management of earnings (creative accounting). Auditors independent of the firm must be aware of the possibility of CA and must be able to comprehend the business’s procedures for changing the accounting policy, estimations, and judgments to evaluate the effectiveness of these procedures.

Donaldson as well as Palmer (2003) Palmer and Donaldson (2003) presented at the conference the roles auditors played in accounting scandals like Enron as well as WorldCom. The auditors were unable to resist pressure from management and, consequently, accept the fraudulent accounts i.e. they were involved in fraud. Auditing can rely on outside sources to verify the accuracy of data. However, if employees of the business are determined to thwart the auditing process or collaborate with outsiders outside the company, which means that even the most skilled auditors won’t be able to safeguard investors from such actions in all instances.

Auditors’ role in reducing the CA within the company

As mentioned previously, auditors were implicated in corporate scandals. But, both external and internal auditors play an important role in at the very least lessening the impact of these scandals when accounting standards, audit standards, and ethics codes are correctly applied.

Ebrahim (2001) has mentioned in his research on Auditor Quality and Auditor Tenure, Client importance as well as Earnings Management: A Supplementary Evidence’, how the qualities of auditors could have a positive impact in influencing earnings management and CA behavior. He utilized a sample that was is listed on NASDAQ, NYSE, and AMEX. The data was gathered for between 9 and 11 years. The sample was limited to companies with their fiscal year ending i.e. December 31. He concluded that the reputation of the auditor and firm size was not related to innovative accounting.

Amat et al (2008) presented in their study of “Earnings management as well as audit adjustment: A comparative analysis of IBEX 35’s constituents” the perspective that of Ebrahim (2001). The study’s sample was gathered from the IBEX 35 index (Spain). It collected a sample of 42 firms for the time periods between 1997 and 2004. The study sought to understand the importance of auditors in the prevention of fraudulent accounting practices. This study has confirmed the important auditing role played by auditors in the financial markets, particularly in the preventative aspects of CA practice.

Clikeman (2003) stated in his journal entitled Auditor’s of Alert to Earnings Management’ that the external auditors aren’t just the ones who spot the CA practice, but also the internal auditors have also the responsibility and obligation of the prevention of this kind of practice as well as to conform to diverse requirements of standards and Acts like Auditing standards as well as Sarbanes-Oxley Acts. Internal auditors have numerous tools to aid in identifying unethical practices. The trend analysis can point to the unusual variances in revenues as well as expenses and cutoff tests that allow monitoring of the purchase and sales in the financial statements of the business at the end of the year. These are just a few of the tools that are available to auditors to identify any irregularities and report them to the Board.

Director is the person who can spot fraud in the start since the position he holds gives him to have access to all aspects of the company. So, the government, as well as the regulatory authorities, should strengthen the rules of boards of directors as well as management groups instead than solely focusing on the responsibility of the auditor. While there are numerous regulations that govern the auditing of auditors and their work efficiently There have been numerous recent corporate scandals. This suggests that there are some shortcomings in these standards and rules.

The implications of CA for the economy of the nation

Everyone is concerned about CA including analysts as well as regularities and the government because of its effects not just on the company as well but on the nation’s economy. Studies in the past have revealed that CA can have a negative impact on the entire economy particularly when it causes major corporate scandals. One of the latest articles of this kind was written published by Hugh (2009).

Hugh (2009) described in his piece titled “Creative Accounting and Italy’s Growing Unemployment Issue in detail how the CA had a negative impact on the Italian economy. He highlighted two types of unemployment benefits offered in Italy. There are the Ordinary Redundancy Funds, which is used in times of uncertainty such as market crisis or The Extraordinary Redundancy Fund that is accessible in the event of bankruptcy. In order to benefit from this plan, businesses are committing fraud through sending employees home in accordance with redundancy procedures, and then formally re-employment, and paying them at the table. This will permit companies to pay only 70% of the wage and the rest is provided by state governments. This leads to an Italian underground economy accounting for around 15 percent of GDP of State institutions i.e. 300 billion annually. Companies could benefit from the help, but they’re causing distortions to the market and threatening the development of more productive businesses.

Other researchers like Bernoth as well as Wolff (2006) had discovered in their research on “Fool the Market,” Creative Accounting’ that the CA raises the risk-free rate. They utilized the model of portfolios with five interest differentials and altered it to study the impact of CA on spreads of bond yields between nations. The modification process for the model continued in the assumption that the government could use CA in order to render the analysis of the financial situation of the country hard to monitor. The researchers found that when a country makes public its financial information it is likely that the CA can increase costs of borrowing dramatically (if it becomes public) particularly since the market isn’t sure to what extent the CA exists.

However, Sopelsa (2010) warned in his article “US Creative Accounting may repeat Greece’s tragedy that the US might have the same problems similar to Greece’s massive debt if the country does not manage its spending and address its structural deficit. This is because of the involvement in CA for many years by the USA similar to the one which occurred in Greece. The US government could not include the Federal Reserve and government-sponsored entities like Fannie Mae in its financial statements. This meant that the ratio of GDP to debt has risen to 85 percent and is likely to 100 percent in the next two years. Therefore, the situation will be worsened if it was to go to foreign loans. The government will have to enforce strict budget control, change social security, address the health care expenses and reform the taxation to increase revenue.

The CA could lead to an economic balloon in countries such as the US as was been mentioned in Sopelsa (2010). Instead of blaming audit firms or companies who were in trouble (involved in scandals), the government must be concerned about the reasons why this is taking place. Some governments are aware of the issues is happening in the neighboring or distant nation, but they don’t recognize the issues within their own country. They knew about the risks of the CA and therefore, they need to figure out a way to stop any future fraud.

Chapter 3

Methodology

This article is limited to secondary data been gathered from various sources, such as journals (weekly and monthly) as well as magazines, newspapers financial reports, and more.

It reviewed a number of literature that were gathered from various sources (as previously mentioned).

In this chapter, selection, analysis of data, and presentation of data will be examined.

Data collection

The researcher confirmed a major accounting scandal in the last decade, including Enron, Freddie Mac, Halliburton, Merrill Lynch, and the recent instance of Bernard L. Madoff hedge funds’. These were random selections from several instances. Then, lastly, among the alleged frauds, one sample was selected which is Enron Corporation.

The financial information of Enron was gathered in its reports for the year 1997 to 2000 (see the appendix).

3.2 Analysis and presentation of data

The Enron Corporation US Energy Company was founded in 1932. It became a company group in 1979. It employed about 22,000 people across more than 40 countries around the world.

It was ranked in the Fortune 500 as the seventh-largest company in operation in America and the sixth-largest energy corporation and the top company in the fields of communication, paper, and pulp around the globe with revenue that exceeds 100 billion dollars.

In the latter part of the year 2001 Enron was forced to open the chapter 11 bankruptcy protection due to disclosure of fraud, and then being accused of fraud by creditors and investors to assert their rights. It was among the biggest bankruptcy trials in US time.

As per Holmes (2006), Kenneth Lay (CEO of Enron) utilized creative accounting to change reports which enabled the company to create artificial shortages by increasing prices by 10 times.

In this article, financial ratios will be utilized to show the importance of CA on annual reports of the company. It will also be studied over a period of 4 years, from 1997 until 2000.

Enron’s net income is expected to be cut in 1997, 1998 1999, as well as 2000, by $96 million in total, $113 million, $250 million, and $132 million, respectively.

It was also discovered that the long-term debt of companies must be added to the debt which was reported earlier. At the end of the year 1997, these additional debts should be added to make the total $14103 million. The additional amount of $561 million and $685 million must be added in 1999 and 1998 to reflect the current long-term debts of the business. The company must also include the sum which was set at $628 million in 2000 to correct its debt figure. These balances can be viewed in the following manner:

These were the most significant aspects that needed adjustments (there were other adjustments that weren’t taken into consideration when analyzing this report). The next step is to show the effect on certain ratios through these changes.

The gap between the amounts reported isn’t that different from the balance of adjustment but it is significant after adding these disparities over the years. In addition, these figures are information that is only available at the time of publication. Additional adjustments are required to balance for other items, and the gap will continue to grow between the adjustment and reporting balance.

It is evident that the main change was in the return on the capital share that had risen to 2.6 percent on the balance between 1998 and 1999 (look at the table above).

The gearing ratio was excessive, particularly in 1997. This was a sign that the company was carrying excessive debt. The level of debt decreased dramatically in 1999, dropping to 65% following the adjustment which might have given the company some hope to solve the issue but the level of gearing had risen from 70% to 70% by 2000. This explains why Enron employed CA in order to conceal the truth about what was happening within the business.

3.3 Data presentation

The chart below is an illustration of the affection from this CA on the balance of the company’s account.

3.4 Finding

It was believed that following adjustments to the income and long-term debts there was a significant change in the capital return as well as net profit. However, there were additional numbers that needed to be adjusted, so the adoration will be higher. Thus, it was able to deceive the public by making them believe that the company was in good financial standing and was an investment worth their money however, it was actually in debt and was suffering.

It was among the companies that used to use the CA practice. Other companies also use the CA like “Duke Energy”. In the end, there was a huge negative impact on the sector, which then devastating effects on the US.

The accounting fraud has been employed by Enron had a negative impact on investors more than the manipulations that had been shown previously because some fraudulent figures weren’t included in this report.

Chapter 4

Conclusion and Recommendation

4.1 Conclusion

Numerous accounting scandals involving corporations were reported in the 1980s. One of the early scandals was the Australian “Nugan Hand” Banks and the latest scandal that involved “Lehman Brothers” and “Golden Sachs”. However, there will be many accounting scandals be faced around the globe if we don’t attempt to improve the processes to stop the CA.

The article had addressed a variety of aspects of innovative accounting. It explained the reasons why directors of the company have involved the CA in order to perpetrate fraud. The most popular reason is the one has mentioned in Dharan as well as Lev (1993) as stated that a company is looking to increase the value of its shares.

The paper explained a few of the strategies of CA that can be employed by companies, such as changes in accounting procedures adjustments to the provision of bad debts, adjustments in the figures in the accounting period, and more.

It also talked about the role of auditors, particularly external auditors, in the event of corporate scandals, and ways to identify the possibility of fraud. It also described the role of auditors in minimizing the chance of CA through disciplinary action in accordance with auditing standards and other rules. Auditors’ qualifications are an important aspect of detecting fraud.

The review of literature cautioned about the impact of CA on the economic system. It discovered that in some instances CAs CA increased the interest rate, and could result in massive debt burdens for countries that exercise CA similar to what occurred in the US. Furthermore, it will have an impact on GDP as in the cases like Italy.

The methodology, it discussed sampling and the place from which the data was gathered. Then, it had analyzed the annual reports from Enron Corporation from the year 1997 until 2000. The results of the company which reported differed from the ones after adjustment. In the end, it provided a fake report to shareholders.

4.2 Recommendation

There were many issues that occurred as a result of the CA Some of them were discussed in this article and others were still being debated by others. Some blame the auditors while others say it’s the government’s responsibility. There are however many individuals engaged in CA. To address the issues of this method the researcher offered diverse suggestions from various points of view. These suggestions can be found below.

From an investor’s perspective, investors are able to take certain actions to lessen the chance of CA. Investors should not rely solely on the financial statements of the company in deciding if the company is a good investment. They should also seek an independent professional opinion, as there are times when the F.S was fabricated with a material error.

The investors must diversify their investment portfolios and not put all of their eggs in the same basket. While it’s difficult to eliminate risk completely, investors can lessen the risk by spreading their risk across many different businesses or investing in different countries, so that when there is a loss in one business resulting from the method the investors will benefit in another. So, investors are able to earn profit by maximizing their return, regardless of the negative investments which are included in the portfolio.

From a business’s viewpoint, it is important to appoint more directors who are independent to manage public interest, thereby avoiding the issue of personal interests. This will result in more transparent reportage of the business situation. If there’s an unfortunate event they’ll deal with the issue in a responsible manner instead of implementing unwelcome practices.

They must also establish an audit committee qualified with extensive experience and integrity to identify serious errors that may be made in the F.S. Furthermore the audit committee should adopt all the necessary measures to stop the fraud.

In the view of the government viewpoint, it must choose appropriate standards and enforce severe penalties against those who break the regulations. Furthermore, even though certain countries aren’t permitting the auditor company to offer multiple services but there are certain governments that allow the company to provide diverse services to clients. This is not permitted in every country.

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