The ethics of creative accounting techniques

Introduction

While accounting aims to provide an accurate representation of a company's financial

position, there are frequently incentives for companies to paint a more positive picture

through creative accounting techniques. This assignment will examine some common

creative accounting practices and discuss the ethical issues they raise.

Creative accounting defined:

Before exploring specific techniques, it's important to define what is meant by "creative

accounting". In essence, creative accounting refers to the intentional manipulation of

financial reports and accounts to either mislead stakeholders about the underlying economic

reality of the company, or to influence perceptions in a way that may not strictly follow

accounting standards and guidelines. The goal is usually to make the company appear more

profitable or financially sound than the economic facts alone would suggest.

Common creative accounting techniques:

Some common creative accounting techniques that businesses may employ include:

- Accelerating revenue recognition: Recognising sales revenues earlier than strictly warranted

by accounting principles. For example, by counting expected future sales orders as current

revenues. This artificially inflates current revenues.

- Delaying expense recognition: Delaying the recognition of expenses, such as maintenance

costs, to future accounting periods. This makes current profits appear higher than they truly

are.

- Changing depreciation methods: Changing the depreciation method used for long-term

assets to faster methods that deduct more depreciation expenses earlier. This improves

current period earnings at the expense of future periods.

- Aggressive reserves management: Overly generous releases of reserves in good times that

were created in bad times to even out reported earnings across periods.

- Special one-time charges: Taking opportunistic large one-time charges against earnings to

hide underlying problems.

- Financial engineering: Complex transactions are structured solely to achieve a desired

accounting treatment or reports, rather than for real business purposes. For example, “park

and loan” arrangements where companies undertake transactions merely to temporarily move

bad debts or losses off their balance sheet.

- Creative pension accounting: Making aggressive assumptions to understate pension

liabilities or overstate pension assets.

- “Big bath” restructuring charges: Taking an oversized one-time restructuring charge to

mask continuing problems or hide losses in other units.

These are some of the main areas where companies may employ judgment, estimates or

structural complexity to massage the numbers. The intent is to make performance appear

better to shareholders, analysts or other external audiences. However, such practices deviate

from the principle of providing a true and fair view of financial results.

Ethical issues with creative accounting:

While creative accounting may provide short term benefits like inflated share prices, there are

several ethical issues such practices raise:

1. Misleading stakeholders: The primary ethical concern is that creative accounting misleads

investors, analysts, creditors and other stakeholders about the actual financial and operating

performance of the company. It paints a picture of financial results that does not faithfully

represent economic reality. This undermines the reliability and decision usefulness of

financial reports.

2. Eroding investor trust: Repeated cases of aggressive or fraudulent creative accounting have

seriously eroded investor trust in financial reports over time. A lack of trust in reported

numbers makes it difficult for capital markets to efficiently allocate capital to companies. It

increases uncertainty and the cost of capital.

3. Distortion of business decisions: If reported numbers are artificially inflated, it may cause

distortions in real business decisions. For example, unjustified investments may get funding

or underperforming managers and projects receive incentives based on misleading numbers.

This wastes capital and resources.

4. Unfair impact on employee compensation: Bonuses or other pay incentives for managers

often depend on reported earnings targets being met. Creative accounting that massages the

numbers to hit targets results in unwarranted pay to executives while the true performance

may be lower.

5. Disadvantaging prudent businesses: Companies that responsibly report true performance

are placed at a disadvantage relative to those engaging in aggressive accounting practices.

This weakens the overall integrity of financial reporting practices over the long run.

6. Violation of accounting standards: In many cases, creative accounting required bending or

violating existing accounting standards and guidelines. While standards permit judgement in

some areas, overly aggressive practices cross acceptable boundaries. This seriously

compromises the credibility of reported accounts.

7. Fraud risk: The line between aggressive and fraudulent accounting is often blurry.

Practices initially started to simply manage impressions may graduate into intentional

misrepresentation or willful non-disclosure of information. This significantly increases legal

and reputational risks for companies. Various accounting scandals over the years started with

questionable judgments and gradually crossed over into fraud.

8. Short term thinking: The focus of creative accounting is usually on massaging numbers for

the current reporting period to meet analyst targets or hit incentive thresholds. However, this

emphasis on short term optics often comes at the expense of long term financial and

operating resilience. Problems are papered over rather than addressed, resulting in a false

sense of security that stores up troubles for the future.

9. Unethical corporate culture: Widespread use of creative accounting within a company

signals, promotes and necessitates a culture where unethical practices are tolerated to meet

numerical goals. This eats away at the overall integrity and ethical standards within the

organisation and encourages a narrow “ends justify the means” approach.

10. Negative societal impact: On an aggregate level, widespread questionable accounting

practices erode the usefulness, reliability and credibility of reported financial information for

society. This decreases transparency and accountability of corporations. It also undermines

the legitimacy and integrity of capital markets and trust in business institutions more broadly

over the long run. Society relies on credible financial reporting for efficient allocation of

capital, policymaking and due oversight of corporate behaviour.

Need for balanced approach:

While the ethical issues with creative accounting are clear, it's also true that some judgement

and flexibility is inevitable and necessary in financial reporting, especially on issues where

accounting standards are still evolving or where precise measurement is challenging.

Furthermore, not all practices labeled as creative accounting result in intention

misrepresentation - the motives and materiality of impact must also be considered.

Therefore, a balanced, principle-based approach is preferable to an outright ban on the use of

estimates or flexibility in select areas. The focus should be on ensuring any judgements

made:

1) Are disclosed and their impact/rationale understood

2) Remain within reasonable boundaries

3) Do not obscure the underlying economic reality

4) Are not used repeatedly or over extended periods solely to manipulate reported numbers

rather than reflect business performance

5) Do not violate the overarching principles of true, fair and faithfully represented reporting.

Regulatory approach

Given the ethical dilemmas and issues of trust posed by aggressive creative accounting,

regulatory and standard setting bodies have tried to curb the more egregious practices through

new guidelines, prohibitions and penalties over time:

- Tighter revenue recognition standards: To restrict unwarranted acceleration, many

accounting bodies have strengthened the criteria required to recognise sales revenues.

Judgement is limited and upfront revenues prohibited on expected future earnings.

- Improved reserves transparency: Statement of cash flows and additional reserve balance

disclosures have been mandated to improve visibility of aggressive reserves management.

- Restrictions on one-time charges: Large unusual items must be clearly disclosed and

described so they cannot be used to arbitrarily bolster or depress earnings.

- Stiffer pension assumptions: More conservative criteria have been imposed on discount

rates and other assumptions used to value pension obligations to limit understatement.

- Fraud provisions: Various laws like the Sarbanes Oxley Act in the US introduced new

criminal penalties and whistleblower incentives to deter intentional misleading reporting.

- Auditor responsibilities: Auditing standards have been fortified to place greater onus on

auditors to confirm reasonableness of estimates used and robustly challenge aggressive

practices. Non-audit services restrictions prevent conflicts.

- Independent investigations: Exchanges and regulators now have greater powers to

independently investigate questionable reporting practices beyond reliance on audit sign-off

alone.

- Top management accountability: CEO/CFO certifications now require top executives to

personally attest to the accuracy of reported numbers and disclose known issues rather than

turning a blind eye.

While enforcement continues improving, room still exists in many jurisdictions for further

regulatory strengthening, especially with respect to consistency in penalties and preventing

revolving doors between enforcement agencies and former accounting firm executives.

Overall, raising the costs and consequences of being caught engaging in misleading reporting

acts as one deterrent against questionable practices.

Company role in maintaining ethics

Beyond regulatory compliance alone, companies themselves play a central role in setting the

appropriate ethical “tone at the top” through their internal control environment and corporate

governance practices:

- Written ethical policies: Clear policies and zero tolerance should exist for efforts to

intentionally mislead through accounting, backed up by whistleblower protection.

- Oversight priorities: Boards and audit committees should focus more on integrity of

numbers and less on superficial metrics alone when overseeing management.

- Culture of transparency: An open, learning culture that encourages identification and

correction of unintentional errors without fear of punishment helps maintain integrity.

- Performance metrics: Incentive structures should reward long term value creation, operating

improvements and stakeholder trust more than short term income management.

- Internal controls: Strong financial controls and segregation of duties prevent opportunities

for manipulation. Subcertifications curb unwarranted judgement in select areas.

- Critical self evaluation: Regular bottom up risk assessments identify areas prone to bias to

strengthen disclosures and oversight protocols.

- Tone from top: Executives must lead ethically through personal action and intolerance for

breaches, rather than simplistic pronouncements. Hypocrisy erodes credibility.

- Investor engagement: Maintaining constructive two way dialogue helps address information

needs and earn back trust where damage has occurred from prior incidents.

- Whistleblower protection: An open door policy and protection for raising

accounting/control concerns helps curb problematic behaviors that often thrive due to silence.

Conclusion:

In summary, while some judgement and flexibilities will always exist in financial reporting,

aggressive creative accounting that obscures true performance crosses important ethical

boundaries. It undermines integrity, erodes trust, distorts decision making and places honest

reporters at a disadvantage. Both strengthened regulatory deterrence and proactive ethical

leadership within companies are required to reverse such troubling trends and help restore

credibility in financial reporting over the long run. Oversight should focus on ensuring

latitude given does not diminish transparency or mislead, so that numbers remain a useful

yardstick of measuring bona fide business success and prudently allocating capital in the

interest of all stakeholders.