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CAEA3224 ACCOUNTING THEORY AND PRACTICE

ASSIGNMENT [CREATIVE ACCOUNTING, ETHICS AND

PROFESSIONAL DEVELOMENT] SUBMITTED BY

Kevin Gan Wai Ming CEA120032

Ahmad Faiz Bin Ahmad Faisal CEA12005 Ahmad Norbasyir Bin Zulkifli CEA12006

Nur Fatin Syafiqah Bt Mohd Latif CEA120072 Nuur Syukrika Bt Rodzi CEA120084

LECTURERS:

Dr. Norhayah Binti Zulkifli

Puan Suhaily Binti Shahimi

Date of submission: 18th December 2014

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Table of contents

NO CONTENTS PAGE

1 ABSTRACT 3

2 INTRODUCTION 4

3 TECHNIQUES OF CREATIVE ACCOUNTING 5

4 ETHICAL PERSPECTIVE OF CREATIVE ACCOUNTING

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5 CREATIVE ACCOUNTING AND PROFESSIONAL DEVELOPMENT

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6 ARGUMENTS FOR AND AGAINST CREATIVE ACCOUNTING

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7 CONCLUSION 18

8 REFERENCES 20

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1.0 Abstract

Creative accounting has been one of the most debated issue in the profession of accounting in

this decade. It is legal but unethical. Yet, it is still being adopted everywhere. The aim of this paper is

to study the mutual relationships between creative accounting, ethics as well as it effects to professional

development. In total, there will be six sections in this paper. The first section is where the creative

accounting will be defined. Secondly, the study of techniques of creative accounting. Thirdly, the

discussion of ethical perspective of creative accounting. The question whether creative accounting is

acceptable from the view of ethical perspective will be answered in this section. Fourthly, a study of

how the creative accounting will affect the professional development. Fifthly, the comparisons of the

pros and cons of creative accounting as a whole. Lastly, a summarization of creative accounting, ethics

and professional development to be drawn based on the discussion of this paper.

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2.0 Introduction

By referring to the journal of Creative Accounting: Nature, Incidence and Ethical Issues,

creative accounting Involves the repetitive selection of accounting measurement or reporting rules in

a particular pattern, the effect of which is to report a stream of income with a smaller variation from

trend than would otherwise have appeared. (Copeland, 1968)

Besides, creative accounting can be defined as a practice of accounting, laws and regulations,

known as generally accepted accounting principles (GAAP) (Stice & Stice, 2006, p. 13). Although,

the GAAP is being followed by the persons-in-charge of the preparation of accounts, they are making

good use out of the loopholes of the accounting principles and standards to falsely portray a better

image for the company itself, especially when appealing with the investors. The creative accounting

issue has also been highlighted in the movie The Procedures in 1968. Noted that the practice of

creative accounting is legal however is unethical.

Definitions of creative accounting can be varied as follow:

Is any action on the part of management which affects reported income and which provides

no true economic advantage to the organization and may in fact, in the long-term, be

detrimental. (Merchant and Rockness, 1994)

Involves the repetitive selection of accounting measurement or reporting rules in a particular

pattern, the effect of which is to report a stream of income with a smaller variation from trend

than would otherwise have appeared. (Copeland, 1968)

This paper should give a better understanding to the readers about creative accounting roles in

the industry, the pros and cons of creative accounting, as well as the perspective of creative accounting

from the ethical and professional development view. We may as well see, how creative the accountants

and managers in manipulating the concept to serve its purposes.

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3.0 The Techniques of Creative Accounting

There are many ways creative accounting can manipulate the financial statement. Some of creative

accounting practices are outlined below.

3.1 Off-Balance Sheet Finance

Off-balance sheet financing (OBSF) is a form of financing in which huge capital expenses are

kept off of a companys balance-sheet through different classification ways. This is an effective

technique because auditors would face a hard time to detect it. Companies always use OBSF to keep

their debt to equity and leverage ratio low. By using OBSF, companies are able to show better debt

ratios. Therefore, the companies can loan more money but at the same time still maintain a good debt

ratio required by lenders and put on a good face for investors (Mathews and Perera, 1996). However,

OBSF has a weakness in which it will bring a long term problem of repaying the loan back to the

lender in future. Another example of OBSF is operating leases. The lessee only report the required

rental expense for the use of asset and the asset itself is kept on the lessors balance sheet.

3.2 Extraordinary Items

Extraordinary item is an accounting entry that will reflect materially-large cost or materially-

large revenue that is not likely to occur and which does not derive from firms normal line of business.

Due to the broad definitions of extraordinary item, many companies considerably have the discretion

in classifying item as extraordinary. The company may wrongly use of extraordinary item category

to reduce some companys tax income (Naser, 1993). Besides, the company can easily manipulate

their return on equity (ROI) and return on asset (ROA) to get a better net profit after tax. Some firms

use it to make their financial look better or worse than they actually are. The manager tries to

manipulate the financial performance by using extraordinary item regarding of their interests.

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3.3 Income Recognition

Income recognition is one of the famous creative accounting methods. Companies might make

improper revenue recognition. They might accelerate or postpone income recognition in regards of

their companys interest. Accelerating or postponing income recognition is a good tool for the

companies whose earnings are spread over more than two accounting period. An example of improper

revenue recognition is where the company might manipulate revenue figure by posting sales before

they are made or prior to payment such as include recording item shipments as sales. As a result, they

might overstate the companys asset by recognizing the sales revenue.

3.4 New Management and the Big Bath

According to Amat and Blake (1999) Big Bath accounting is a technique where a new

manager takes over responsibility and there is an intention to make provisions to ensure that any losses

appear as the responsibility of the previous manager. Big Bath is a term to show a different between

former negative period and a new positive period. They will incur as many expenses in the present

period, with the result increase in profit in the next financial period. Big Bath is one of the creative

accounting methods because it uses accounting choices for bad motive rather than to show financial

reality.

3.6 Acquisitions

The rule of acquisition is the companies have to attribute fair values to the asset and liabilities

they acquired. The acquisition price is designated as in-process research. The managers have

tendency to overstate the restructuring charges over actual charge, sometimes this is called as cookies

jar. By including provision for future losses, future profit could be protected. It is an arrangement

which make the balance sheet weak while flattering future earnings. As investors pay more intention

to earnings, the declining in balance sheet is being overseen.

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3.0 Ethical Perspective of Creative Accounting

Ethics is about how people ought to act to be moral (Buchholz and Rosenthal 2005, p.314)

by setting a standards of good or bad, or right or wrong (Schermerhorn 2002, p. 146) or permissible

in ones conduct (Buchanan 1998). Meanwhile, business ethics focuses on how we use and should use

traditional ethical views to evaluate how institutions orchestrate human behavior (Dienhart 2000).

People make decision differently in business than at home. The factors that affect the ethical decision

making process in business are wider such as the ethical issue intensity, individual factors and

organizational factors.

Ethics is made up of few elements which are law and professional code of conduct. Some

people believed that if an action is legal then it is right although it is unethical. Rule-based approach

provides an accountant or individuals to operate near to the limit without breaking the rules. On the

other hand, Generally Accepted Accounting Principles (GAAP) leave plenty of wiggle room for

those inclined to dupe unsophisticated investors while remaining within the letter of the law (Kahn

2000). For instance, in the case of computing depreciation, accountants have several methods from

which they may choose such as straight line and declining balance.

According to the survey done by Australia Leung and Cooper (1995) the top three ethical

problems in an organization were conflict of interest, client proposals to manipulate accounts and client

proposals for tax evasion. Agency theory argued for company directors to take care of the interests of

the shareholders. Meanwhile, stakeholder theory argued for wider scope of relationship between the

company not only with the shareholders but also with the societies. Being an ethical organization does

help in sustaining the growth and long run of the organization.

There are three theories of ethics which can used to describe the ethical decisions made in creative

accounting which are teleological theory, deontological theory and ethical relativism theory.

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3.1 Teleological theory

The term teleological is a Greek word referring to goal. This teleological theory is a

consequentialist approach also known as utilitarianism which based the moral judgment on the

outcomes of a certain action. The moral judgment in these theories is thus based on the intended

outcomes (Ruland 1984), the aims or the goals of a certain action. This theory looks at the ends rather

than the means. Utilitarianism theory holds a principle where the greatest amount of benefits are for

the greatest amount of people. Hence, cost-benefit analysis in accounting is considered similar to

utilitarianism but in a smaller scope.

In the context of creative accounting, a creative accountant would definitely consider the

reactions of financial statement users before adopting the creative accounting techniques such as

income smoothing and introduction of extraordinary items. The pressure from the management and

clients to manipulate the accounts would affect the ethical decisions of accountants. The consequences

of not following order would definitely cost them to lose their job. Ethical egoism is one of the extreme

form of teleological ethics. An egoist will choose decision that will which benefits himself or herself

to the greatest extent. In the other words, an egoist is known as selfish. Accountants might see the

abuse of accounting rules as falling within their domain and therefore demanding their ethical

judgment, while the manipulation of transactions falls within the domain of management and so is not

subject to the same ethical code (Merchant and Rockness 1994).

3.2 Deontological theory

This theory is based on the Greek word for duty, where a duty for a situation is being deduced

by looking at the desirability of principles. Deontological is a non-consequentialist theory. The

decision made is not based on the desirability of the consequences but based the moral judgment on

the underlying principles of the decision-makers motivation. It is not because we like the

consequences they produce so the action is right or wrong but because the underlying principles are

morally right.

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People are likely to be in ethical dilemma if they apply the deontological theory compared to

teleological which has clear cut answer to an issue by weighing the advantages to the disadvantages.

For instance, an accountant can just listen to the order of his or her manager to manipulate the income

statement since by doing so, he or she would not lose job as from the perspective of utilitarianism.

However, if the accountant is an ethical person who holds strongly to the five fundamental principles

of professional accountants that conducting a fraud is totally wrong as it will blinded the users of

income statement from the true disclosure, then he or she would definitely encounters an ethical

dilemma. Possibly, the accountants will not follow the order of their superior.

3.3 Ethical relativism theory

Ethical relativism is the view that there are no universal moral rules. What is morally good in

one context may be morally bad in another. There is no rational way of determining whether an action

is morally right or wrong because different societies have different ethical beliefs unless by asking the

people of this or that society believe it is morally right or wrong. In other words, relativists argued that

there are no ethical standards that are absolutely true and that apply or should be applied to the

companies and people of the societies.

Relativism believes that something is morally right for the people or companies in one

particular society if it accords with their moral standards and vice versa. For instance, the people of

certain Arab societies hold that business bribery is morally acceptable, although the Americans believe

it is immoral. The ethical relativist will conclude that, although it is wrong for an American

multinational to bribe in America, it is not wrong for Arabs or their companies to bribe in their own

society. One of the factors that affect ethical decision making is the organizational factor. If the culture

in the organization allows for creative accounting to be practiced then there would have no issues of

unethical conduct arises as the organization culture believed it is morally right to do so.

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4.0 Creative Accounting and Professional Development

Professional development in the scope of accounting is define as a process of improving and

increasing capabilities of an accountant through the learning and training opportunities in the

workplace, influenced by the spirit to learn and work with competent. Professional development also

helps to build and maintain morale of the employees, and is thought to attract higher quality employee

to an organization. The purpose of the professional development on scope of accounting is to provide

a broad range of programs and services designed to sustain and enhance the skills of members and

financial professionals.

It is important for us to uphold the principles and values of the social group that we are in.

Reputation takes times to be built while to save back a tarnished reputation takes double or maybe

triple the initial times. Same goes to the professional accountants as well, accounting being categorized

as a professional profession implied that community see the accounting as a trustable and integrity

profession. If professional accountants involved in frauds or negative activities, surely it will affect the

professional development of accountants. The publics will not trust the profession anymore. Therefore,

it is important to have standards or guidelines in every professional body to regulate the behaviors of

its members for them to act align with the rest.

There are five fundamental principles of code of ethics for professional accountants which are

integrity, objectivity, professional competence and due care; and professional behaviors. Breach of

code of ethic may be cause by lack of independence, conflict of interest, insider trading and fraud.

Although, there is guidelines code from IFAC, some practitioners are still willing to sacrifice for their

own interest and purposes (FEE, 2009). Lack of independence among accounting practitioners is a

main cause to many corporate scandals around the world.

The principle of integrity explained about the obligation of all professional accountants to be

honest and straightforward in their business relationships. It also emphasizes on truthfulness and fair

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dealing with all transaction occurred in the company. All transactions must be approved with the right

procedure and had been authorized by the right person on its. Breach of it will resulting in heavy

punishments. For instance, Tyco executives were sentenced up to 25 years in prison after stealing by

manipulating the figures in financial statement of the company. In the case of professional accountants,

they should not make the misleading statement and materially false the report or communication of

information. An accountant also must expertise on the preparation of financial statement to prevent the

information furnished recklessly. The information provided should be clear and not contained in any

confusion that may be convicted. Creative accounting also should be avoided because it can challenges

the integrity of the professional accountants.

Objectivity discussed about an obligation of all professional accountants not to sacrifice their

professional and business judgment because of own interest and the undue influence of others. For

example, objectivity of Arthur Anderson who was the external auditor of Enron was impaired.

Anderson helped Enron cheated on its financial statements with overstated Enron profits 20 per cent

of it's earning for the 4 years, to prevent the loss of his important clients. Relationships that unduly

influence the professional judgment of the professional accountant should be avoided. In addition,

objectivity principles also can be explained further with the auditing aspects. Internal auditor is an

employee in a company and depends on management for salary and remuneration. So, he or she might

be biased in favor of management. For example, internal auditor does not report to the audit committee

when he or she discovered fraud because management threatened them to keep silent. Internal auditor

who afraid to lose their job in the company or being offers a high bonus may just follow the

management favor.

Professional competence and due care describes the obligations of professional accountants on

maintaining professional knowledge and skills at the level required. This is to ensure that employers

or clients receive competent professional service in their organization. While providing professional

services, an accountant should act diligently and technically with the applicable technic and

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professional standards based on their expertise and regulations to show due care. Apart from that,

maintenance and attainment of professional competence are also important. Competence can be

clarified in many definitions such as a performance at workplace, applied what you already learned

and a focus on output rather than input (Brown & McCartney, 1994). Ethical competence also

distinguish between simply having skills and expertise, and having a true sense of professionalism,

(Parn, 2007).

Lastly, the principle of professional behaviour explained about the obligation of professional

accountants to comply with regulations and relevant laws, and also avoid any behaviour that may bring

discredit to the profession. This also includes give all relevant information to third party, which as the

result gives negative effects the reputation of the accounting profession. Professional accountants

should be truthful and honest. They should show good manners in accordance with those holding

positions as a professional accountant. As an example, an accountant cannot make exaggerated claims

for the services. All the claims, should under consideration from the business and the accountant

qualifications. Also, an accountant cannot critics and makes comparisons to the work of others.

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5.0 Arguments for and against creative accounting

There are pros and cons from the introduction of creative accounting into a company. It is

called as creative because the owners of the company are using their imagination to provide a clever

idea or creative attitude that does not based on accountants or tax laws in preparing financial

statement. It is also known as a process whereby accountants use their accounting knowledge to

manipulate the figures reported in the accounts of a business (Amat, Blake, & Dowds, 1999).

Significantly, it does not break any laws. However, it must be stressed out that creative accounting is

not always bad (Mathews and Perera, 1996).

5.1 Arguments for creative accounting

a) Maintain or increase the share price

A positive share price growth implies a good image of a particular company. A stable and

higher share price are one of the objectives in every company because it will helps the company to

raise new capital from the issuance of new shares and in takeover attempts. In order to meet this

objective, the financial statement would have to look profitable. If not, the management can adopt

creative accounting by manipulating financial data such as decreasing the apparent levels of debt to

lower risk and increase the appearance of profit . This include recording the expenses as investments

and loans as profit. Consequently, debt level will decreases and showing the appearance of a good

profit trend. Whereby, a good profit will raise demands for shares and the higher demand of shares

that subsequently will increase the share price.

b) To gain a greater amount of loan

Every borrower will only lend their money to company that has high probability to payback

their money. Generally, the company must own a good debt ratio and good appearance profit.

Companies will also need loan to expand their businesses and in financing the day-to-day operations.

Usually, a new organization (not the new established company) will need a lot of money to start or

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improve their business. Therefore, by using one mode of creative accounting, Off-Balance Sheet

Finance (OBSF), the company may gain a greater amount of loan from borrower. This is because of

the true financial position of the company in relations to its debt is distorted as it does not disclose

certain information in report. With that, companies are able to appear with appropriate debt ratio that

required by borrower in order to borrow more money (Mathews and Perera, 1996). As a result, not

everything that looks like profit is really a profit after the implementation of creative accounting.

c) To meet the internal expectations of company

A manager is responsible for managing company towards achieving the objectives and

company's expectations that has been made. Internal expectations can be categorized into various parts.

For instance, a forecast to get higher target on sales, profit and share price. These forecast will give

pressure to company that has poor performance and at the end, would push the manager to implement

the creative accounting. Creative accounting is legal for the manager to adopt however it is unethical

as there will be a gap between the actual performance of the firm and analysts expectations.

Managers have to make sure the accounts came out as expected in order to secure their job. An

example of creative accounting techniques that likely to be use was timing of a sales transaction. To

illustrate, if a company own a building that worth RM150,000 at historic costs, which is the book value

amount on the financial statements, and that building now has a current market value of RM800,000,

manager can freely choose whether to sell it now or not. Certainly, if company performance has

reached the forecast performance of the company, the best accounting option for company is not sell

the investment now. According to Hooper (1999), because of the discretionary nature of accounting,

it will always involve choices.

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d) To meet the external expectations of company

Besides, manager also responsible for managing company towards achieving the company

external expectations according to agency and stakeholder theory. For instance, the external parties are

shareholders, employees, customers, suppliers and societies. Shareholders expect for their wealth

maximization. Customers expect a long term survival of the company for their interest. While for

suppliers, they want assurance of payment and long term relationship with the company. Therefore,

whenever the company is not performing, the manager will instruct their accountants to use creative

accounting techniques in order to meet the stakeholders expectations.

Moreover, a company has the option of deciding on an accounting method "that gives their

preferred image" (Amat and Blakee et. al, 1999). This fact really helps manager bring the company

toward achieving their goals. However, because of scare from losing their job the staffs may easily be

placed in difficult ethical situation. As according to Kahn (2000, p. 91), staff have been fired for

questioning inappropriate accounting practices.

5.2 Arguments against creative accounting

Not all managers agree with the implementation of creative accounting techniques in their

company. Some of them may think that it is not ethical. Whereby, it happens because of insufficient

personal skill, irresponsibility and unwillingness to involve in detailed analysis (Breton and Taffler,

1995).

a) Blindfold the investors

Basically, investors invest in a company because of the growth prospect and the positive

financial performance of the company. However, noted that the company is not providing a true and

fair view of its performance. Adoption of creative accounting lead to manipulation of financial

statement. Apparently, the company is not gaining profit although the financial statement showed

profit. Hence, investors are being fooled by the false representation from the management of company.

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The practices of creative accounting make the information from financial statements become

unreliable and none useful anymore for investors to use it for the purpose of decision making.

In the real world situation, investors will find a company that clearly void the implementation

of creative accounting practices to invest. Nonetheless, it illustrates that its fruitless to invest

elsewhere in the world as the practice of creative accounting seems to be happening everywhere. Also,

Kraus (1999: p. 1) said, Dont believe any figures you get as there are unseen risk. This is the follow-

up of the worldwide spread of this creative accounting practice in companies.

b) Effect the integrity of the profession

Fraud in reporting usually occurs among those above management level. According to Jones

(2011, p. 21), the concept of creative accounting has developed over time under the pressure of users,

such as managers, accountant, auditors, regulators, shareholders, and others. This situation will bring

a negative perception about the professions. Till some accounting practices that are legal to use

becomes suspicious by outsiders. Financial statement has to be transparent from any erroneous

activities. When creative accounting is used to create fraud, it will dampen the reputation of

professional accountants that prepared it. Consequently, it will creates a bad perception towards the

accounting profession. As a professional accountant, there is a duty to act professionally in order to

uphold the image of the profession. Reputation takes years to build while a tarnished reputation will

take double effort of building the initial reputation.

c) Effect the long run of business

The practices of creative accounting do give a benefit to business. However, it also effect the

long run of business. Norgard (1987) argued that many companies use creative accounting methods to

maintain their profits or minimize their losses. On top of that, an accountant did some changes to their

debit and credit entries which is no longer showing a true and fair view representations.

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At first, auditor may fail to detect it. Somehow, when the same things always happen to the

company, this unethical practice will be detected and the company may be banned by many

stakeholders. Here David Brown, a Canadian corporate regulator make a comparison between

companies that applies creative accounting to athletes on steroids. Athletes that took steroids not

allowed to involve race and banned from competing again in a period. Then he said, a similar

punishment should be applies to company that practiced creative accounting to misrepresent their

company.

d) Vibrant demand for creative compliant.

Can creative accounting ever be stopped? It is a big question. However, the answer is probably

not. Creative accounting practices has become a part of business nature because it is the best way and

easy way to set up a desired value and to attract stakeholders. Good ethical not be considered when

profit maximization is main priority of companys objective.

Moreover, Griffiths also mentioned that there is nothing to eliminate creative accounting when

the imposition of standards seems more sophisticated forms of financial manipulation. Due to that, it

is not impossible that vibrant demand for creative compliance will happen. In the end, there will be a

creative accounting arms race. So, all stakeholders must be aware in making any decision. Lastly,

deeply said by Austin Mitchell, manipulative accounting could be a name for creative accounting since

it has more in common with the massage parlour than the creativity of the literary salon.

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6.0 CONCLUSION

In conclusion, one may think accounting is a clear-cut issue, but creative accounting sure is not.

However, creative accounting is not genuine illegal, but on the other hand, it is not widely promoted.

Managers and accountants may employ creative accounting or do it by themselves for the best interest

of the firm. Although they must follow generally accepted accounting principles (GAAP) while

completing financial statements, still, there is loopholes in the framework that allowed for

manipulations of certain items in financial statements.

It is impossible to impose similar standards in this world because of several reasons such as the

status of the country, the size of the businesses and the nature of the business operations. Hence, many

techniques were introduced and practiced by the accountants for the earning management. Next,

creative accounting is deemed as legal as long as it does not lead to fraud but from the ethics

perspective it is an unethical act. There are many ethical theories to support the arguments for and

against the implementation of creative accounting. No fines or punishments could be enforced on

someone as long as it is still legally right. Noted that, an action is deemed ethical or not is based on

the ethical theory that he held.

A bad sprout in a family will destroy the image or reputation of the family members as a

generalization. Same goes to the profession of accountants as well. Professional accountants accused

of misleading the users of financial statement and being convicted with frauds will leave a bad

impression to the community regarding the profession. Working in a professional field required the

practitioners to obey the standards and regulations that have been set. As for the case of professional

accountants, it is stated in one of the fundamental principles which is personal behavior where an

accountant has to comply with relevant laws and regulations and should avoid any action that discredits

the profession.

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Should creative accounting practice be totally restricted? This is a point to be pondered on.

There are pros and cons of creative accounting. However, it is hard to come to a consensus whether it

is completely bad because different parties have different point of view. For instances, from the

perspective of the company, they may think that creative accounting is necessary to drive their

performance and might as well make it as a culture of the organization. On the other hand, from the

perspective of the stakeholders, the investors to be precise, they are strongly against creative

accounting as it denied them a truth picture of the companys performance. Hence, the practice of

creative accounting is debatable and further research and study have to be done.

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