In any organization, accounting forms part of the main function. There is no standard way for firms to prepare their books of accounts: each firm has its own conceptual framework that is made under the guidelines of the International Accounting Standards (IAS), International Financial Reporting Standards (IFRS) and other relevant accounting standards. The techniques that a firm employs to prepare its accounts are contingent upon the firms industry, environment and many other factors.
This flexibility leaves a lot of room for manipulation of a company’s account to show a fairer financial position and financial performance. Such misrepresentation influences the decision of investors, creditors, shareholders and other stakeholders of the firm. Creative accounting is the subjective use of accounting standards and guidelines in order to show a healthier financial position than is actually the case. The firm can do this without flaunting any rules and regulations (Mulford, 2002).
Why Creative Accounting, In Most Cases, Is Not Apparent Until After the Company Begins To Have Trouble
Specialization of Functions
The responsibility to prepare books of accounts of a company solely lies with the accounting function of the firm. In a contemporary company structure, the company is divided into specialized functional departments such that each department has its own staff that is under a departmental manager. The accountants in the firm will consequently fall under the accounting department. This grouping therefore does not provide any interdepartmental checks and balances since it is easy to achieve internal collaboration.
In addition, staff from the other departments may not be knowledgeable enough to detect creative accounting, what the accounting department presents is final and cannot be challenged. It is also easy to achieve internal collaboration to mislead auditors and investigators in order cover up any form of misrepresentation. Despite the fact that the auditors of HIH by passed the CEO and consulted members of the audit committee, chances are that the committee members and the CEO could be reading from the same script.
Numerous Accounting standards Guidelines and Policies
Apart from internationally recognized accounting standards, there are also national regulatory bodies that govern the accounting profession. The existences of many standards and guidelines enables accountants to choose the ones that best suit them and avoid those that will portray negatively on their financial statement. The accounting framework is subjectively tuned to work in the companies favor. Creative accounting can therefore be carried out without flaunting any laws.
This makes it hard for stakeholders and auditors alike to detect any mischief until trouble starts brewing for the company. In the case of HIH they used one off-item and inflated the goodwill of FAI, the subsidiary being acquired, without raising any eyebrows in 1998. This was discovered in 2002 when the finance director was summoned and he conceded of the act. (Shiliu, 2002)
Nature of the Audit Profession
The main responsibility of auditors is to give an opinion over the truth and fair view of a company’s financial statements. They also have a duty to advice the company and make recommendations where they deem necessary on a company’s accounting and other systems. Since creative accounting is done using recognized accounting procedures, it is hard for auditors to detect creative accounting.
Even if they do, auditing standards concerning creative accounting are shallow. Auditors are left with no option but to approve the accounts and make recommendations that may be followed or not. Auditors therefore lack teeth when it comes to creative accounting matters, accounts are therefore approved only to be questioned later when there is trouble. Just like in the case of HIH, the accounts were ratified and recommendations made but the firm ignored these recommendations.
Accounting is a highly technical profession that requires many years of learning and experience for full grasp. It is therefore easy for accountants to mislead other stakeholders through creative accounting since they do not have the knowledge to discern accounts that give a true view from those that have been creatively manipulated. Auditors can also be easily misled into approving the financial statements. The truth only comes out when something goes wrong and an in depth investigation is carried out.
Does Unexpected Corporate Failure Suggest Limitations In The Roles Of Auditors And Regulators?
The case of HIH clearly demonstrated that an auditor’s approval does not mean that the accounts represent a true and fair view of the company’s finances. HIH failed because the auditor failed to authoritatively point out creative accounting and impose guidelines for change in accounting practice. There are limitations in the roles of auditors that make them incapable of dealing with creative accounting effectively enough to avert a company’s failure in the future.
The standard accounting period is one year. Auditors audit a company’s account after the preparation of the financial statement. Most audit work is done within a certain period, which is shorter than the accounting period. The auditor therefore lacks sufficient time to equip himself with background, historical and industrial information of the firm in order to discern between creative accounting and correct procedure in the accounting process.
Auditors are guided by International Audit standards, which do not give them teeth to deal with creative accounting in a way that can avert future failures. Auditors are limited to making recommendations that may be overlooked just like in the case of HIH. The management of the company can easily compromise the independence of auditors. Despite the existence of the audit committee, which is there to ensure the independence of the auditors is not compromised; managers can still influence an auditor’s decision. Just like in the case of HIH Company’s CEO, the management may dent the auditors name or even advocate for their removal as the company auditors. Fear of losing out on business due to being too strict may compromise the auditor’s impartiality.
Due to limitations of cost and time, audits are normally carried out on a test basis. Only a sample of the company’s accounts and procedures are audited. Since most audits are not comprehensive, existence of sampling errors, limit an auditor in his quest to establish the truth and Fairview of the financial statements.
Accounting estimates are part of the recognized accounting standards. Estimates are subjectively made by the company accounts. It is difficult for an auditor to state the accuracy of some estimates. These estimates can be easily manipulated to show a fairer state of the company’s financial position (Mulford, 2002).
To What Extent Can Normative Accounting Theories Offer Solutions To The Problems Of Creative Accounting?
Using HIH as a case study, we can deduce the problems of creative accounting and the conditions in which creative accounting thrives in.
Problems of Creative Accounting
What makes creative account hard to identify and counter is that it can be done without flaunting any regulations. Just like in the case of HIH, auditors can ratify creatively prepared accounts, which may have harmful effects to the company in the future.
As has already been discussed and can be seen in the case of HIH, creative accounts are noticed later on when the company is facing the problems. In most instances, this is a case of too little too late as the damage has devastating effects on the company’s finances and image.
Creative accounting influences the decision making of shareholders, investors and lenders who based on the misleading financial statements end up making the wrong decision and suffering losses.
HIH insurance company collapse was mainly because of creative accounting, which reduced the losses of the company in order to portray a healthier financial position. In the short term, creative accounting may be good for the firm but long-term effects are normally catastrophic. (Shiliu, 2002)
Normative Theory Solutions
Normative accounting theory recognizes that every firm has unique accounting needs. It uses different approaches to come up with accounting methods that will best suit a firm. Normative accounting is not based on observation of what other firms in the industry are doing hence can be utilized to deal with the problems of creative accounting.
Using normative accounting, a firm can construct an objective accounting framework. This framework if strictly adhered to, limits chances of using only favorable methods in the accounting process. Since Normative accounting theory recognizes industrial peculiarities, the auditor will be in a position to judge whether the procedures are appropriate or not. The auditor will focus on the industry hence can easily establish whether the firm is deviating from company norms.
Normative accounting identifies the best accounting procedures through thorough research and not merely observations. The company, therefore, cannot inflate estimates to reduce losses since the standard way of computing estimates shall already be identified. Normative accounting theory clearly sets apart good accounting methods for the firm and those that are not suitable to the firm. A deviation from the identified ways should be treated as an attempt at creative accounting.
Mulford, E. C. (2002) Financial Numbers Game : Detecting Creative Accounting Practice. New York: Library Of Congress Cataloguing In Duplication Data.
Shiliu, H. (2002) Financial Shenanigans. New York: Macgraw-Hill Trade.