Creative Accounting: A Review of the Literature

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Creative Accounting: A Review of the Literature

Critical Business Enquiry Project

Supervisor: Mike Davies






Table of Contents




Incentives for the usage of Creative Accounting


Income Smoothing


Agency Theory


Evaluation of the incentives for Creative Accounting


Creative Accounting and Ethics


Controlling Creative Accounting through Corporate Governance


Evaluation of Ethics in Creative Accounting and Control


Creative Accounting and the Law




Implications of Research and Future Recommendations






This paper provides a review of literature on the subject of creative accounting. The intention behind this is to discuss, analyse and evaluate the extent to which this process of accounting is both ethical as well as legal due to its controversial nature. This will then identify areas in which further research is required and, in turn where improvements can be made within the industry.

Accounting gives businesses the opportunity to convey and report their financial records to current and potential investors in order for the proverbial picture to be painted as to whether the firm is performing well or not (Jones, 2011). This allows managers to follow specific, yet flexible guidelines for them to report finances, however this flexibility often leads to a so-called bend in the rules which can, in turn lead to creative accounting (Desti, 2014). This creative accounting can, quite seriously, turn into hugely public scandals for example Enron in 2001 where the company went bankrupt and the CEOs were imprisoned.

The prominence of creative accounting, often referred to as earnings management in the United States, came public due to Griffiths’ (1986) book stating that ‘everyone is fiddling with their profits’ yet it is ‘totally legitimate’. Since then debate has carried on, quite vigorously trying to work out what creative accounting really is. There is a huge discussion and debate on many aspects of creative accounting, yet there is not one single definition that can necessarily be unanimously agreed upon. Amat et al (1998) stated that creative accounting was accountants using their knowledge of accounting rules to manipulate figures reported within a business’ accounts. Shah (1998) goes further stating that it utilises the exploitation of gaps in accounting standards to skew and bias financial performance. This is whilst in the USA creative accounting includes the likes of fraud (Jones, 2011), determining the fact that there is controversy over morality but also the legal nature of this method of book-keeping.



This paper will use studies which have used both quantitative and qualitative data in order to analyse their findings through the usage of empirical and theoretical studies. This will aid this paper to identify whether or not there is an ethical and legal line when it comes to creative accounting, and consequently where this line is.

Incentives for the usage of Creative Accounting

In order to look at both the moral and legal perspectives of creative accounting, it is important to discuss and understand what motivates particular firms to undertake such a controversial form of book-keeping (Shah, 1998). Shah further discusses the inclusion of a number of factors which incentivise managers which are claimed to be both financially and operationally rewarding for the firm in particular. In some senses, Jones (2011) agrees with this, however, he includes a discussion looking at personal incentives involving increased salaries and job security as well as including firm influences for example market expectations which includes forms of smoothing within accounts (Payne & Robb, 2000). Smith (1988), however, agreed more with Shah as opposed to Jones, stating that firms, in this case a governmental department, tend to use creative accounting due to them believing they are bettering the accounts to the firm’s benefit, their incentive being to reduce expenditure.

This section will identify two main incentives, one personal, the other being market based in order for a firm to alter their perceived accounts used by managers. The first of these being income smoothing looking at companies needing to level out their fluctuations, primarily in their income between periods, the other being agency theory discussing possible conflicts of interests between directors and those they employ to manage the firm.

Income Smoothing

In a variety of studies, there has been an identification of two main approaches to income smoothing. Albrecht and Richardson (1990) first discussed these methods of being natural smoothing with the other being known as intentional (also referred to as artificial) smoothing. Fudenberg and Tirole (1995) further discuss this, stating that natural smoothing cannot be identified under creative accounting due to the fact that no manipulation has occurred and therefore this is unintentional. The opposite end of the spectrum however, is the artificial



Income smoothing occurs when management staff believe that an investor is more likely to pay more money into a firm whose income stream is said to be ‘smoother’ (Trueman & Titman, 1988; Ronen & Sadan, 1981). There is a greater vulnerability for companies who release their share price which shows them to be ‘erratic’, this can cause, in very rare instances, a hostile takeover (Jones, 2011). This tends to mean that the probability of financial shocks will be

significantly reduced before they even have the chance to occur (Trivedi, 2013). Moreover, it can include there being a delay in the reporting of costs and therefore performance, this can be seen by firms as having a ‘reserve’ (Hutchinson & Leung, 2007). This has occurred many times, mainly by high performing firms and those in the private sector (Arnedo et al, 2007). This is due to the fact that they work in the attempt of evading wage increase demands through the reporting of high profits for the period, thus utilising a so-called income decreasing approach.

There have been a number of studies discussing the arguments for bigger firms implementing smoothing techniques towards their income (Sharp, 2005). The main arguments originate from the fact that these firms, and therefore their finances, have a higher likelihood of having their accounts being made public and consequently higher regulation will be put in place (Moses, 1987). Due to the high level of regulation, there is the possibility of these regulators making the assumption that due to their fluctuations in income being so ‘smooth’, this is the result of a holding in their industry that is monopolistic (Moses, 1987). To further this argument, these higher performing firms, due to their ‘monopolistic practice’, will have better opportunity or access to instruments which encourage or aid this income smoothing (Sharp, 2005) for example intangible assets like improved research and development.

Agency Theory

The term agency theory essentially refers to the principles (directors) and agents, which is often management, within a business (Eisenhardt, 1989). Within the terms of creative accounting, agency theory denotes a conflict of interest between external members of the business, often directors but can be any form of stakeholder and the management staff often causing a separation of ownership from the shareholders (Nini, 2012). For the majority of the stakeholders involved, the reason for holding an interest in the firm is to see the company flourish and consequently maximise return (Arnold and Lange, 2004). Despite this, there is a conflict of interest due to what Jones (2011) identifies as personal incentives. These personal incentives can include increase in salary as well as the likes of bonus related pay and job security. It is unclear,

however, what has driven these managers to need such personal incentives, could it be greed or perhaps even having personal difficulties with their own finances (Jones, 2011).



often hold shares within the company because it may be smaller or because it is a family firm (Schulze et al, 2001). This will, in turn, mean that this is a less relevant theory as to why firms will manipulate their accounts. Despite this, it does not entirely prevent this from occurring. The main reason for private firm’s managers not wanting to incentivise themselves personally is because it reflect better for them personally to have their forecasts etc. being met. This therefore means that due to fewer private companies using it, overall it is less useful than other incentives for firms for example income smoothing, which can therefore throw into question how many firms utilise this and consequently how effective this is (Greenwood, 2003).

Evaluation of the incentives for Creative Accounting

This section has identified, of sorts, two opposite sides, i.e. techniques for the implementation of creative accounting within business. It may be difficult to compare and contrast these due to them being such alternative methods. In saying this, there is a much higher amount of studies based on the subject of income smoothing dating back to over 40 years or so with the likes of Copeland (1968) as well as Ball and Watts (1972). With these, it gives a clear basis on what income smoothing and its acceptance in the early stages of discovery. However, as the years have gone on and more research has been made, even in the very recent years i.e. as close as Bouvatier et al (2014), acceptance has lowered dramatically. Despite this, businesses still utilise this technique for others to perceive their income to be sound.

In regards to this, however, studies often bias their results (Sharp, 2005), this can be done through research only focussing on one instrument used or only identifying effects of their income of one solemn period, which has ignored the resulting period and that effect this has on the income. Therefore, how valid these results come much into question as well as their


Agency theory, on the other hand is much more recent, and often isn’t in business terms due to the fact that it can be in reference to any form of agent or agency (Eisenhardt, 1989). This originated within the early 1970’s (Ross, 1973), however advanced research was not conducted until the late 1980’s with the likes of Eisenhardt (1988). As stated in the section above, however, much of agency theory seems to be relatively pervasive due to the lack of evidence of occurrence within private firms (Schulze et al, 2003), whilst there is still evidence of this occurring within much larger corporations (Jones, 2011). Despite this, there have been a sufficiently higher amount of studies based on the personal incentives applied to creative accounting as opposed to that of agency theory (Mulford & Cominsky, 2011). Due to this, there have been some studies (Jones, 2011) who have made loose links between these incentives and agency theory in order to create a theory for it and then apply this to the explanations they have learned for this



Creative Accounting and Ethics

One issue to discuss is, despite the huge amount of firms implementing such techniques as income smoothing and agency theory as mentioned above, whether successfully or not, how ethical is creative accounting? If so many firms use it then surely everyone is fine with other companies and corporations to use such a contentious method of book-keeping? Regardless of the fact that creative accounting has been around for such a long time now, there continues to be a debate on whether or not the utilisation of techniques to so-called falsify company accounts is moral. But, in reality, how far can these corporations go before ‘fiddling’ with their accounts becomes wrong and immoral? This theme will discuss the morality of creative accounting as well as the need, or perhaps the failure of corporate governance in order to control and constrain the idea of such a controversial subject.

There is no doubt about it, creative accounting is an incredibly controversial subject, with a variety of academics and companies alike, claiming that it is something completely unthinkable, whereas Amat (1999) explains that there are authors that believe that it is legitimate. Griffiths (1986) agrees with the latter stating that every firm in the country ‘fiddles’ with their books, no matter how much, and therefore this must mean that because ‘everyone’ does it then this must be fine. Despite saying that it is a legitimate process, he further goes on to discuss how it is a huge ‘con-trick’ and surely this must cause it to be unethical (Amat, 1999; Griffiths, 1986). Jameson (1988) helps to add to this by claiming that it is an opportunity for deceit and misrepresentation, which can ultimately, question the legality of creative accounting never mind the morality. To add to this, Naser (1993) states that this includes taking advantage of rules or even ignoring some or all of them. These ‘rules’ are set out by the International Accounting Standards (IAS) as ‘generally accepted accounting principles’ (GAAP) (Stice & Stice, 2006, p. 13) If some abide by these rules and some don’t, unlike what Griffiths (1986) says, then this will be unfair to those who do, potentially meaning that the profits of those who have bent said principles to be higher than those who have not.



In order to gauge whether or not something can be deemed ethical, the prima facie case may be used to check consistency in behaviour across all standards of accounting and finance as well as other walks of life (Cowton, 1999). This prevents the likes of hypocrisy, for example would the head of the Financial Accounting Standards Board (FASB) in the USA have held shares in Enron, who used an aggressive form of creative accounting in 2001 and proceeded to go into bankruptcy, causing a huge scandal at the time. Crisp & Cowton (1994) claim that this can be done through what they call accounting with a clear mind, identifying the need for integrity.

The original prima facie has set out eight main obligations (Ross, 1987), of which a number of these can be applied to creative accounting. This includes fidelity which identifies keeping to contracts and refraining in deception (Dancy, 1991). This to start with, looking at what authors have written discussing creative accounting shows, ideally Jameson (1988) that deceit is one of the main factors within creative accounting, as it can hide numbers as well as moving profits from one period to the next, which will deceive both auditors as well as directors aiming to gain maximum profits. The duty of fidelity within the ethical prima facie framework overrides all other duties bar the duty or guideline of non-injury which includes the duty to prevent injury to others (Thiroux, 2001). This ‘injury’ can be either physical and/or psychological, therefore, there is no clear indication as to whether having a financial ‘injury’ would constitute being

psychological or not. This is something that may need to be clarified, and therefore, this for the time being, is not possible to identify as a duty in which creative accounting and the firms that use it can say to have broken.



Controlling Creative Accounting through Corporate Governance

Corporate governance could be implemented to aid the prevention of fraudulent behaviour within a company (Jones, 2011), ideally, this means that the likelihood of creative accounting can be reduced this way through the application of internal controls. These controls include the likes of an effective control environment as well as risk assessment and the monitoring of activities (Solomon, 2007). If these controls lack strength or efficacy, the higher there is a likelihood or risk of an accounting scandal related to earnings management (Brennan & McGrath, 2007; Bell & Carcello, 2000). More often than not, the scandals studied in these papers also identified the lack of separation or division of responsibility of duties, therefore contributing to the failure of internal controls (Jones, 2011).

The lack of division of responsibility identifies the requirement that the chief executive of a company and the chairman should be two separate persons (Cadbury, 2002). This allows two people having authority over decisions within the boardroom, without this, the one person could be said to have ‘absolute power’ (Solomon, 2007) which is what happened within the ‘Polly Peck’ scandal in the 1980’s, allowing the CEO and chairman at the time to steal millions of pounds from the company (Jones, 2011). This is supported by the research from Persons (2005) and Farber (2005) who identified those firms who practiced behaviour related to creative accounting also did not divide their responsibilities accordingly. Due to the fact that these two studies, both of which researched a huge number of firms, including those who do use creative accounting and those who do not, support each other’s findings, increasing the reliability for the need for this to be implemented.

Due to the relatively recent requirement for a corporate governance reform, one outcome was an audit committee (La Porta, 2000). This is essentially a supervisory board for the auditors,



Evaluation of Ethics in Creative Accounting and Control

This section has shown that there is still a debate on the morality of creative accounting, discussing both sides of the coin. With the aid of the extensive work conducted mainly through Amat (1999); Amat et al (1998), a conclusion could be made that ideally, creative accounting is not an ethical accounting practice. Despite this, there have been enough calls made by a number of authors stating that because ‘everyone does it’ it is a legitimate method of bookkeeping, mainly argued by the likes of Griffiths (1986). This, however is a call that was made 30 years ago, therefore this can’t be a viable, ethical practice, not after such massive and public scandals by the likes of Enron in 2001 and Tyco in 2002. It would be interesting to discuss the educated views of these authors in the world of today.

Corporate governance in order to prevent ethical questions being raised seems to be a viable answer to right so-called wrongs (Jones, 2011). This can be through the likes of internal controls as well as division of responsibility, to avoid potential scandal (Bell & Carcello, 2000). Brennan & McGrath (2007) support this to state that control in this environment is essential. Methods of control are becoming simpler, yet they are becoming more apparent, for example the likes of audit committees (Xie et al, 2003). However, with the likes of these controls, questions can be raised about flexibility, accounting will be highly rigid and therefore harder to get around but at the same time harder for firms to estimate, one could make the argument that it may cause a struggle for firms to flourish. Yet in the interests of firms not going bust and, on occasion, the public’s money it would be best for controls to be in place.

Creative Accounting and the Law

In terms of creative accounting, despite the law tending to be black and white, this is a confusing topic to discuss, primarily due to the fact that there are differing views in differing countries, logically in the area where the majority of scandals happen, it is illegal, yet in countries for example the United Kingdom it is legal (Jones, 2011). The former can be seen with the

imprisonment of the likes of Jeff Skilling the CEO of Enron as well as Bernie Madoff. Because of some of these Scandals, law-makers in the United States implemented the Sarbanes-Oxley Act (Kim, 2003) in order to clamp down on the malpractice performed by many firms worldwide. Even though that this act has been implemented within the United States, this has a far-reaching jurisdiction, meaning that many companies in the UK may well become susceptible to this law (Romano, 2004). To further this, much of this act is in compliance with much corporate



In the United Kingdom, creative accounting is seen to be a legal entity, due to the exclusion of fraud as well as it being seen as it works within the regulatory system and thus only firms use this for the flexibility to serve interests of themselves (Jones, 2011). The fact is that, within the United States, this is different, Mulford & Comiskey (2002) explain that this is because the definition of creative accounting is much wider than that of within the UK (Jones, 2011). The definition involved for creative accounting made by Mulford & Comiskey (2002) involves that of fraudulent financial reporting. This paper explains that fraudulent financial behaviour being “International misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users, that are determined to be fraudulent by an

administrative, civil or criminal proceeding” (Mulford & Comiskey, 2002, p. 3). This, in turn, identifies what has much been discussed within the ethics section of this paper, potentially calling that anything which has been deemed unethical should be illegal. But in this sense, how can everything that everyone believes is wrong necessarily be illegal within a court of law? However, there are previous studies that do, in senses, agree with this definition which includes that of Beasley et al (1999) which can support this statement.

It can be explained that fraud has different definitions from country to country (Jones, 2011), despite that this clarifies that all over, fraud is defined as breaking the regulatory framework of the industry involved (Shah, 1996). Much of this, however was explained as there being a financial statement fraud, Jones (2011) identifies that this is already a subset of fraud as a generalised term and therefore may not necessarily account for creative accounting. Popescu & Nisulescu (2014) found that fraud and creative accounting are two separate entities with clear differences, despite the fact that both these two aspects are objective and so is the law. This study, however was conducted in Romania, and therefore has worldwide relevance although significance in terms of having a major effect on worldwide proceedings is questionable.




All of the research that has been cited has been conducted through a secondary data basis, i.e. due to the fact that this is a literature review, none of the findings involved are primary. Much of the research takes an objective view (Denzin & Lincoln, 1994) and can therefore often be stated to be free of bias, research being either theoretical or empirical. Both of these aspects of

research, can in turn, use either quantitative or qualitative analysis, or in some instances, both, all of which have their benefits.

Much of this literature looks into a large quantity of the research of Jones (2011) of which is a compilation of a large number of authors (21 in total) using analysis from their own biographies as well as personal experience, the majority of which is contained in quantitative research, and thus is interpreted as such. A lot of this book works in conjunction with Weick’s (1995)

manifesto due to the fact that much of this work is interpretive, without a necessary hypothesis. Furthermore, all of the work in each of the pieces within the book supports each other as well as many of the worldwide scandals included within the writing. Due to large variety of different qualitative methods within the wide number of reports involved in this paper, including the likes of interviews as well as ethnography e.g. Banerjee (2002), there can be an argument for this being a phenomenological process. Despite much of this work being objective, due to the interpretive nature, subjectivity is the basis for phenomenological research (Lester, 1999). However, due to the supporting views and research from many authors within the book, the reliability and much of the validity is high.

Within much of the research and methodology within the section for incentives for creative accounting including income smoothing and agency theory possesses the inclusion of quantitative data. In these terms, a lot of this entails the process of positivism (Bryman & Cramer, 1990). A large volume of this positivist work involves a scientific methodology perspective for example Payne & Robb (2000) as well as Albrecht & Richardson (1990) which can be advantageous due to the scientific nature, often allowing the subject to have an objective view on proceedings. However, there can be seen to be views that are disadvantageous for a positivist approach, especially that of a scientific report due to the sheer size of numbers which can cause confusion to the untrained eye and therefore cause difficulty in interpreting. With some of these studies, for example the likes of Smith (1988) and Albrecht & Richardson (1990) with relevance, this is due to the fact that of the age of these studies, however these have been cited in a number of other studies causing other authors to believe its relevance and therefore reliability should not come into question.



fact that public sector firms are more likely to use the likes of income smoothing yet less likely to involve in agency theory. There could be an argument within this, however, that non-scientific studies could be a product of realist ontology (Martin, 2001). This can be included with the likes of the work conducted by Mulford & Comiskey (2002); Griffiths (1986) as well as the work made by Naser (1993) and Crisp & Cowton (1994). The likes of these have identified, discussed and often theorised different points of view on both ethical and legal standpoints of creative accounting. Much of these are definitions, for example that of Mulford & Comiskey (2002) where definitions have been produced which has been supported and cited by various other works. Despite this, theories do often have to be backed up by scientific data and therefore comes into question whether or not they can be classed as realist ontology.

As already discussed, the phenomenological research process lacks objectivity due to the fact it is down to interpretation and therefore allows for subjective views to be raised. This mainly occurs through the qualitative approach raised within works for example the likes of Shah (1998) and Amat (1999). Much of the work within Amat (1999) looks within the ethical approach of creative accounting, of which is majorly down to interpretation, and therefore the likes of

Griffiths (1986) and Jameson (1988) which discuss alternative ‘views’ with the lack of numerical data, it is hard to judge, effectively who is so-called correct or not. This can therefore, often be deemed to be unreliable as many of these works aren’t necessarily similar to many others within the industry.



Implications of Research and Future Recommendations

In order to identify the implications for the research conducted in this literature review, it is important to look at the specific sectors and departments in which improvements are

significantly required. Therefore, this review is mainly aimed at the likes of government departments, for example law-makers all over the globe, the department of justice’s in nations such as the USA and the UK where a high percentage of creative accounting scandals have arisen. Furthermore, financial boards and frameworks e.g. Generally Accepted Accounting Principles (GAAP) and the International Accounting Standards Board (IASB). Moreover, there can be the belief that every single firm, however difficult to enforce, should take this into account, whether they are practicing creative accounting or not, in order for them to become better informed of the situation.

This literature has aimed to discuss the extent to which the process of creative accounting was both ethical and legal. An implication of conducting this is mainly the lack of research as well laws surrounding the legality of creative accounting. It therefore allows the firms exercising this to not be punished accordingly for doing something that is clearly unfair to those not exploiting some ‘gaps’ within the regulatory framework. Consequently these frameworks, including the likes of the GAAP and IASB, need some major adjustments in order for there to be little, or even better, no gaps available for exploitation, often causing there to be little flexibility but much more clarity. This can work in conjunction with the suggestion of law makers and politicians potentially lobbying for criminal action for those breaking, or possibly bending, the new

regulatory frameworks once implemented. It is therefore recommended that for future research, academics can look over the effects of this new framework and how it is perceived and exercised by those who have previously used creative accounting. This can also work hand-in-hand with research on corporate governance for example the audit committee and how they overlook the firms now these new rules are in place.

The aspect of ethics has required a much more subjective approach due to the fact that many people, including academics, possess differing views on the subject. This allowed a wide range of work on ethics in accounting as well as the views of the authors of papers on creative

accounting. However, due to the fact that it is so subjective, it’s difficult to work out the extent to which this is an ethical matter or not, however, it seemed that creative accounting fell on the side of immoral, if only slightly due to more academics and papers arguing this way. This could consequently implicate the research due to the fact that validity may come in to question.



Incentives were another aspect discussed, in terms of what motivates firms to take up creative accounting. There was much research that has been conducted over the years, mainly giving quantitative data which allows reproducibility and therefore can be performed time after time. Due to the fact that there were so many varying incentives that could be discussed, it is accounted for that not every single one of these could be debated and therefore there is a

possibility that more appropriate motivations are available, but in order to get a relevant message out it could be said that these are sufficiently fitting for this review. A suggestion that could be made for this aspect is to research further using more qualitative procedures to gain further understanding for the motivations.

In summary, there needs to be much more research done in this sector of the industry. With there being an increase of interest in both the usage as well as the prevention, there needs to be greater understanding as to why it is used and what people within the industry feel about this. To further this argument, there needs to be a discussion on tightening rules and frameworks within the accounting industry with the potential for criminal punishment if these are not adhered to.


Creative accounting can be defined in the terms of accountants using their knowledge of accounting rules to manipulate figures reported within a business’ accounts (Amat et al, 1998) which first came to global acclaim in a Griffiths (1986) book on the subject (Jones, 2011). There are a number of methods in which firms can exploit the flexibility in the regulatory rules outlined by the GAAP as Jones (2011) explains for example the likes of increasing assets as well as decreasing the firm’s expenses. This shows that firms are able to hide and even bias their

finances for them to look stronger financially. This review has discussed the extent of which this procedure can be classed as ethical as well as legal.

Creative accounting has been a much debated issue within the accounting world for decades now. The aspect of ethics has arisen many times with the likes of Griffiths (1986) and Jameson (1988) agreeing upon the legitimacy of the process. This is however can be debatable, much of which through the prima facie ideology (Cowton, 1999; Ross, 1987). Through using this aspect of ethics, it can be discussed to which creative accounting is an immoral form of book-keeping, with the aid of the age of much of the research conducted being around 30 years old. This therefore means that there is a need for future research on the ethics within creative accounting, potentially through interviews with professionals which can, in turn, clarify whether or not this is an appropriate form of accounting.

The legal aspect of creative accounting is much harder to debate due to the little research



of fraud within the United States (Jones, 2011) but is not within the United Kingdom. This is aided through the likes of Mulford & Comiskey (2002) as well as Beasley (1999). This can additionally be shown through the custodial sentences given to many individuals that have performed such scandals which have rocked the world of accounting for example Enron in 2001. Despite this, either further research on this or clearer laws are required in order for understanding to be better on the subject meaning that, many firms may perform creative accounting with a lack of knowledge on the legality of the matter. Despite this, there can be an argument that globally, creative accounting is a legal matter.




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