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Home > Accountancy Best Practice > Creative Accounting: Auditors’ Roles in the Detection of Financial Fraud

Accountancy Best Practice

Creative Accounting: Auditors’ Roles in the Detection of Financial Fraud

by Zuraidah Mohd-Sanusi and Yusarina Mat-Isa

This Chapter Covers

  • An introduction to creative accounting concepts and methods.

  • Areas of possible manipulation of company accounts.

  • The use of a checklist to help in the detection of creative accounting practices and accounting fraud.

  • Case studies of two companies in Malaysia that have used creative accounting practices.

  • What is expected of auditors in detecting creative accounting practices.

Introduction: Understanding the Concepts of Creative Accounting

“Creative accounting practices” is a term used to describe any means that may be employed to manipulate financial data, and it includes the aggressive choice and application of accounting principles as well as fraudulent reporting (Mulford and Comiskey, 2002). These practices may fall within or beyond the boundaries of Generally Accepted Accounting Principles (GAAP). Creative accounting practices cover a wide range of areas, especially premature recognition of and over- or underestimation of revenue, aggressive capitalization and extended amortization policies, misreporting of assets and liabilities, and getting creative with the income statement and cash flow reporting. If an organization wishes to practice creative accounting, there is plenty of scope for the manipulation of accounting information. Such manipulation may well leave external or other interested parties confused as to what is real or unreal, or true or false, in a published set of financial statements.

Accounting techniques are normally chosen to produce more meaningful financial numbers, and any changes in these techniques will usually be clearly indicated in the notes to the accounts. In contrast, creative accounting is more often applied as way of hiding a particularly bad performance. The management may opt for accounting techniques that will give the impression of an exceptionally good year, or one that presages a sound financial performance in the future. Reported results may be smoothed out to give an impression of stability or sustained improvement, or to boost assets to avoid takeover (Mulford and Comiskey, 2002). Another benefit that management may derive from this practice is to influence the confidence of shareholders by being able to report stable earnings or positive changes in anticipated income.

It is difficult to draw a line in regard to creative accounting practices because of the complexity of business transactions, which may make it difficult to detect misstatements or omissions. GAAP offers various accounting methods for companies to choose from, and which method a company adopts will depend on the nature of its business. The availability of these different methods provides options for companies to choose the one that best projects their financial performance. Although GAAP requires consistency in the adoption of an accounting method, some companies may exploit the opportunity to use more than one over the years. Even with the restrictions imposed by rules, regulations, and standards, there are many ways in which accounting methods can be manipulated that give scope for a wide range of creative accounting practices. For example, the ambiguity that arises in the area of provision expenses and valuation of assets could lead to the adoption of methods that favor the company but not the stakeholders. The loopholes in certain accounting areas, or unclear definitions in financial reporting standards, may also provide opportunities for the financial players to manipulate the numbers—sometimes very aggressively.

In many instances creative accounting practices are associated with fraud. There is a high possibility that misstatements are the result of the managers misrepresenting the company’s true financial condition. A misstatement may be attributed to changes in the regulatory requirements or accounting rules, or it may be part of a management strategy on earnings (Coffee, 2004). Management has a strong incentive to manage earnings in order to maximize its own compensation, particularly when compensation is based on measures of earnings (Kothari, Leone, and Wasley, 2005). Maximizing compensation is not the only incentive for managers to engage in creative accounting practices, as shown in Figure 1.

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) recognized that frauds went to the very top of many organizations in which a significant portion of the company was owned by founders and board members. COSO’s 1999 study “Fraudulent Financial Reporting: 1987-1997” has found that in 72% of cases the CEOs appeared to be associated with the financial manipulation. It showed that managers had incentives to manipulate earnings around the specific, predictable events of the periodic earnings reporting as they expected the returns to be rewarding.

“In many instances, creative accounting practices are associated with fraud. There is a high possibility that misstatements are the result of the managers misrepresenting the company’s true financial condition.”

Whether creative accounting practices result in fraudulent financial reporting depends on the intentions of the managers. Fraud and error, although both show up as misstatements, differ in substance depending on whether intention is present or not. Fraud occurs when a misstatement is made with knowledge of its falsity and there is an intention to deceive, whereas error is not deliberate and there is no intention to deceive other parties. Although not all creative accounting practices amount to fraud, it is sometimes hard to distinguish between fraud and creative window-dressing in financial statements.

The International Standard on Auditing 200 (ISA 200) requires that an audit be designed to provide reasonable assurance that both errors and frauds in the financial statements are detected, and the audit must be planned and performed with an attitude of professional scepticism and due professional care. Hence, auditors need to be vigilant for the indicators of creative accounting practices. They are required to detect the “red flags” of creative accounting practices that may signal fraudulent financial reporting. These flags may not necessarily indicate fraud, but auditors need to be on the alert for them. A failure to conduct an audit with proper care may expose the auditor to potential legal liabilities.

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Further reading

Books:

  • Albrecht, W. Steve, Conan C. Albrecht, Chad O. Albrecht, and Mark Zimbelman. Fraud Examination. 3rd ed. Mason, OH: South-Western Cengage Learning, 2009.
  • Coffee, John C., Jr. Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms. Oxford: Oxford University Press, 2006.
  • Mulford, Charles W., and Eugene E. Comiskey. The Financial Numbers Game: Detecting Creative Accounting Practices. Hoboken: NJ: Wiley, 2002.

Articles:

  • Amat, Oriol, Jordi Perramon, and Catherine Gowthorpe. “Manipulation of earnings reports in Spain: Some evidence.” Journal of Applied Accounting Research 8:3 (2007): 93–115. Online at: dx.doi.org/10.1108/96754260880001055
  • Beatty, Anne, and Joseph Weber. “The effects of debt contracting on voluntary accounting method changes.” Accounting Review 78:1 (January 2003): 119–142. Online at: dx.doi.org/10.2308/accr.2003.78.1.119
  • Cerullo, Michel J., and M Virginia Cerullo. “Using neural network software as a forensic accounting tool.” Information Systems Control Journal 2 (2006). Online at: tinyurl.com/8xkvufc
  • Healy, Paul. M., and James. M. Wahlen. “A review of earnings management literature and its implications for standard setting.” Accounting Horizons 13:4 (December 1999): 365–383. Online at: dx.doi.org/10.2308/acch.1999.13.4.365
  • Kothari, S. P., Andrew J. Leone, and Charles. E. Wasley. “Performance matched discretionary accrual measures.” Journal of Accounting and Economics 39:1 (February 2005): 163–197. Online at: dx.doi.org/10.1016/j.jacceco.2004.11.002

Reports:

  • Beasley, Mark S., Joseph V. Carcello, Dana R. Hermanson, and Terry L. Neal. “Fraudulent financial reporting: 1987–1997: An analysis of US public companies.” Committee of Sponsoring Organizations of the Treadway Commission (COSO), 1999. Online at: tinyurl.com/7l4ogtf
  • International Federation of Accountants (IFAC). “International Standard on Auditing 200 (ISA 200): Overall objectives of the independent auditor and the conduct of an audit in accordance with international standards on auditing.” IFAC. Online at: tinyurl.com/6pz48a9

Websites:

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