THE IMPACT OF CREATIVE ACCOUNTING ON FINANCIAL AUDIT

Abstract

The information supplied by the financial statements based on creative accounting presents a large number of characteristics: the usefulness of information in the decision making process, the relevance (pertinence), reliability (objectivity or credibility), opportunity (meeting deadlines), predictive value, retrospective value, verifiability, neutrality, fidelity, prudence, continuity, importance, balance between cost and benefits, complete character (completeness), the absence of misleading elements, intelligibility, comparability. Detecting creative accounting influences on financial statements is the role of the financial auditor who can correct these deviations.

Headnote

Abstract

The information supplied by the financial statements based on creative accounting presents a large number of characteristics: the usefulness of information in the decision making process, the relevance (pertinence), reliability (objectivity or credibility), opportunity (meeting deadlines), predictive value, retrospective value, verifiability, neutrality, fidelity, prudence, continuity, importance, balance between cost and benefits, complete character (completeness), the absence of misleading elements, intelligibility, comparability. Detecting creative accounting influences on financial statements is the role of the financial auditor who can correct these deviations.

Keywords: creative accounting, accounting norms, annual financial situations, reality, financial audit

JEL Classification: M41

Introduction

The concept of creative accounting was introduced by the Anglo - Saxons. It is a consequence of economic, legal and social development as well as the pressure of information users who want to promote a certain image of a company to third parties.

The existence of numerous accounting methods offers a certain leeway for interpretation and for the implementation of these methods in the accounting activities. Therefore, without undermining the norm and requirements of accounting, creative accounting offers the possibility to present more favorable results.

The phenomenon of creative accounting can be understood as the alteration of economic reality of an entity through techniques, options, lack of restraints allowed by the legal norms.

The term of creative accounting has its roots in the United Kingdom, but it has been used in specialized literature under forms such as imaginative accounting, intentional accounting, accounting engineering.

Some characteristics of creative accounting are:

- Creative accounting does not involve breaking the law;

- Creative accounting is designed to approach the legal, economic and financial innovations in a way that offers favorable solutions for the parties involved b y taking advantage of the legal and professional breaches and gaps;

- The techniques and practices of creative accounting result in an alteration of reality so that it fulfills certain purposes.

There are a number of factors that can stimulate creative accounting namely:

- The cost resulting from conflicts of interests; If the managers' remunerations are calculated according to the financial statements, they might be tempted to resort to those accounting procedures that allow these remunerations at a high level;

-The managers' lack of competence; In this case creative accounting can be ''the beginning of the end'' because the managers' who lack competence focus their attention on private arrangements and therefore neglect the informational system and the financial ratios;

- The weak spots in accounting; The absence of a standard requires managers' to develop a set of principles and accounting practices for every scenario encountered;

- The approach of the users of financial information; Because of the excessive focus given to the results of the companies, they are encouraged to ''improve'' their performance in order to satisfy the requirements of the users;

- The influence of fiscal rules; The aspects of fiscal matter overrule those of economic matter when it comes to interpreting economic events and transactions.

This type of practice is not considered illegal. They respect the legal limits as well as the accounting rules up to date.

After analyzing the above we can certainly state that even though creative accounting was meant to aid in the interpretation of legal, economic and financial innovations for which there are no accounting solutions it is often used in order to manipulate the numbers in the annual accounts without breaking the law.

The motivation of creative accounting

As far as the reasons that influence the managers' to use creative accounting we can name:

- The cost resulted from conflict of interests. When managers are paid according to the financial statements they will be tempted to use different techniques to maintain their earnings as high as possible;

- The lack of competence of managers. When managers do not obtain satisfying results they choose creative accounting to cover it up. British researcher J. Argenti was the first to make the connection between creative accounting practices used for covering up the lack of competence of managers and the downfall of business stating that using these methods is only a delay of the end of the company.

- Times of crisis. It is easily understood that in times of crisis companies can have difficulties, making their managers want to hide the true state of their finances to project a better image;

- Globalization of entities. Because it is at the core of the globalization of entities, the free circulation of capitals on the financial markets motivates managers to use methods of creative accounting in order to maximize the value of the stocks.

- The approach of the users of financial information. Nowadays, financial statements can be a tool used for promoting and sustaining the image of a company regarding the competition as well as investors and analysts. That is why managers often use creative accounting;

- The pressure of the stockholders to obtain large dividends. Managers can be compelled to use creative techniques so as to maximize the profit which will yield large dividends.

- Maintaining a constant result. Companies rated on the stock market prefer publishing constant results or those who show a slight but riskless increase instead of revealing situations which record a significant fluctuation of the result;

- Fiscal rules. When managers want a certain taxable profit they can use several methods to manipulate the numbers in accounting.

Other factors that support the use of creative accounting:

- The diversity of economic activity. Because of the various economic activities a certain freedom is necessary in order to present a favorable image of a company. This situation favors the existence of many accounting options therefore allowing companies to ''alter'' results;

- The insufficient number or lack of accounting norms. Due to the ongoing economic development the rules of accounting do not cover all the possible scenarios that a company can face which is why there is a need for using professional reasoning in finding solutions.

- The ambiguity of accounting norms. Accounting norms as well as the estimations and forecasts implied are submissive to interpretation which favors creativity when approaching different issues.

The classifications of creative accounting methods

The managers of a company can use the following methods of creative accounting:

- The freedom of choice allowed by the multiple accounting options can influence the financial position and performance of the company as well as economi c indicators namely solvency and debt ratio;

- The estimations and forecasts used to determine the monetary value linked to the measurement basis selected for assets, debts, earnings, losses and the equit y evolution can create the opportunity for manipulating values according to the desired scenario;

- Using artificial transactions creates the possibility to manipulate the sums from the balance sheet or to influence the result;

- Choosing the moment to make certain transactions so that it creates a certain image of the company's financial position and performance.

The effects of using creative accounting methods

Most commonly used to support the management's interests, creative accounting can have several effects:

- Increasing or reducing expenses. The accounting rules leave a certain degree of leeway in quantifying expenses. For instance, for certain assets it is indicated only the maximum number of years in which it should be depreciated. The period of depreciation influences the value of the result. Similarly, we can analyze the provisions and the possibility to activate certain expenses;

- Increasing or reducing incomes. There are cases when the process of quantifying the expenses can be quickened or slowed down by applying the precautionar y principle or the principle of connecting expenses to revenues;

- Increasing and reducing assets. Due to the fact that there is some flexibility regarding the calculus of depreciations and provisions there is a possibility for increasing or decreasing the net value of assets. Also, the stocks can be evaluated through other methods therefore their value can be different, affecting the profit and loss account. These changes affect the size of current and non-current assets and well as the indicators connected to them;

- Increasing and reducing owners' equities. Changes in income and expenses influence the result and also the reserves. In consequences, the owners' equities and all the indicators linked to them are modified;

- Increasing and reducing debts. In some countries the accounting norms allow the regularization of some debts such as those connected to retirement in a certain amount of time. So, an entity interested in increasing the results will proceed to allocating the debt on the maximum allowed period of time;

- Reclassifying assets or debts. Doubts may exist regarding the classification of an element in a category. For example, the case of titles which have to be included in either current or non-current assets according to the intention of the entity;

- Manipulating the information in the appendix. There are parts in the appendix which may include more or less information. The lack of relevant information ma y affect the decision of the external users.

Creative accounting techniques

As mentioned above, creative accounting uses as its main practices the choice between different methods of accounting and artificial transactions or administrative decisions.

- Practices may include:

- Practices that have an impact on the profit and loss account;

- Practices that have an impact on the presentation of the balance sheet;

- Practices that have an impact on the quantification of the result.

Identifying creative accounting techniques

Taking into account the meaning and effects of using creative accounting techniques, we may state that it is difficult to identify and correct the financial statements in which they have been used in order to take relevant decisions.

There are creative accounting practices which can be detected in the annual accounts of the company. As such it would be useful to analyze the accounting policies present in the appendix.

In order to identify modifications a comparison of the policies used b y the entity in the previous years is required as well as those applied by its competitors. Also, the audit report must be revised if the auditor expresses a change in opinion. This situation may arise when certain changes have been made in the accounting policies or when are elements not included in the financial statements.

Another technique which can be used is the analysis of extraordinary results and those and that of the results of previous years, because these may try to hide a fluctuation of the profit. The analysis of days outstanding for receivables, stocks and suppliers is also recommend for detecting such manipulation.

There are cases in which accounts are altered through third party entities with which fictitious transactions are made at prices different for the market. Therefore, it is essential to evaluate third party operations. There are other account manipulations which cannot be detected by analyzing annual financial statements. In these cases, the accounting registers must be revised. This t ype of control is done by the auditors.

Proposal to improve the credibility of financial statements

Users expect that an entity's financial statements reveal viable, objective, pertinent information comparable to other local or international companies. But it seems that creative accounting techniques which reduce the reliability of the accounting information are more frequentl y used by the economic entities and are facilitated by current accounting norms. The precautionary principle and that of historic cost together with the lack of information on intangible assets causes the lack of relevant accounting information. Also, the differences between the accounting standards of every country determine the lack of comparison of accounting information at a global level.

Furthermore, the possibilities of using the extraordinary and reported result should be limited. An additional advice would be to include the auditor's opinion in the financial statements when they can be quantified, especially for entities listed on the stock exchange. Moreover, it is necessary that the punishments for using creative accounting by managers be harshened.

Finally, until all these recommendations will be applied it is desired that financial analysts include in their reports information regarding creative accounting practices in order to help investors make the best decisions. For instance, when they use accounting data they should also consider the auditors opinion included in the reports.

Literature review

The most common opinion in the specialized literature addresses the negative aspects of creative accounting, for example it is seen as "representing the practices of accounting informing, often at the edges of the law, practiced by some entities, which, taking advantage of the limits of normalization, seek to beautify the image of the financial state and economic and financial performance''.(B. Colasse, "25 ans de comptabilité générale, une nouvelle naissance d'une vieille discipline", in Paris Dauphine, 1995);

Regarding the positive view of creative accounting we may quote François Pasqualini who sees it as being "a virtue which allows the imagination to keep up with the growth and diversification of financial markets and instruments".

Methodology

The article is trying to increase the government's awareness to identify and analyze the main creative accounting techniques and the way in which they influence the information present in the annual financial statements. This article entails some methods in which they can be detected. Furthermore the role of the financial auditor to reduce the occurrence of creative accounting is stressed.

Conclusions

The insufficient number of accounting norms, their interconnectivity and the ongoing harmonization process which will result in a freedom of decision making process allowed by elaborators of norms are a series of factors that permit the perpetuation of creative accounting.

Creative accounting entails that the company takes advantage of the gaps regarding the norms and their flexibility in order to distort the published information, company management with the possibility to either alter the result or offer a favorable image depending on their interests. Although there is a clear difference between creative accounting and deliberate breaking of the law, bought phenomena appear in times of economic distress and are based on the intent to deceive. Consequently, even if the use of creative accounting is not always illegal it shows that managers which are under financial pressure look for solutions without obeying certain ethical standards. In other words, half-truths and lies may bought be considered susceptible of fraud. Creative accounting practices will not vanish until the causes that created them will be solved. As a result, the norms' elaborators should take into account the circumstances that allow these types of manifestations. Although experience reveals that whenever a new norm is published entities find a way to minimize its impacts.

To sum up, the mission of professional accountants is not a simple one: creativity can only be fought with creativity.

References

References

1. FASB, Statement of Financial Accounting Concepts No. 2: Qualitative Characteristics of Accounting Information, http://www.fasb.org/cs

2. IASB, Framework for the Preparation and Presentation of Financial Statements, par. 24 - 46, http://eifrs.iasb.org/eifrs/bnstandards/ en/framework.pdf

3. OMFP 3.055 din 29/10/2009 for the approval of accounting norms acording to European directives published in the Official Gazette , Part I nr. 766 din 10/11/2009, sect. 2, pct. 23

4. FASB, Conceptual Framework for Financial Reporting, http://www.fasb.org/cs

5. Balaciu, Diana; Vladu, Alina Beatrice, Creative accounting - players and their gains and loses, University of Oradea. The Faculty of Economic Sciences, tom XIX, nr. 2, decembrie 2010,

6. Blake, John; Bond, Robert; Amat, Oriol; Oliveras, Ester, The ethics of creative accounting - some Spanish evidence, în "Business Ethics A European Review", vol. 9, nr. 3/2000,

7. Gowthorpe, Catherine; Amat, Oriol, Creative Accounting: Some Ethical Issues of Macro- and Micro-Manipulation, în "Journal of Business Ethics",vol. 57, nr. 1/2005,

8. Laínez, Jose; Callao, Susana, Contabilidad creativa. Editorial Civitas, Madrid, 1999,

9. Naser, Kamal, Creative financial accounting: its nature and use, Prentice Hall, Hemel Hempstead, 1993,

10. Raffournier, Bernard, Comptabilité créative et normalisation comptable, La Revue du Financier, nr. 139, 2003,

11. Shah, Atul, Exploring the influences and constraints on creative accounting in the United Kingdom, în "EuropeanAccounting Review", vol. 7, nr.1/1998.