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A note on the use of creative accounting
British Accounting Review (1992) 24, 111-118
A N O T E O N THE USE OF CREATIVE ACCOUNTING KAMAL NASER
Cardiff Business School, University of Wales College of Cardiff MAURICE PENDLEBURY
Cardiff Business School, University of Wales College of Carcliff Although much has been written about creative accounting and about the various schemes of window dressing and off-balance sheet financmg, very little is known about how widely such schemes are used by companies. This note reports the results of a survey of senior auditors concerning their expemence of creative accounting. The auditors were asked to indicate how frequendy they had encountered schemes of creative accounting and their responses are analysed by type of company, industrial classification and type of scheme. The perceptions of auditors concerning: the motives companies might have for using creative accounting; the consequences of the continued use of creative accounting; and the steps that need to be taken to eliminate the use of creative accounting are also analysed.
Although creative accounting probably dates back almost as far as accounting itself, the relatively high level o f interest now shown in it has much more recent origins. Discussions and analyses of creative accounting are now appearing in the literature (see, for example, Grifl~ths 1987, Morris 1988 and Jameson 1988). A feature o f the discussion to date is that there is relatively little empirical evidence concerning the use of creative accounting in practice. This note reports the results o f an attempt to obtain empirical evidence which might help to address the following issues: whether the use o f creative accounting is related to the type of company or its industrial classification; the reasons behind the use o f creative accounting; the perceived legitimacy of the use o f creative accounting; the perceived consequences o f the continued use of creative accounting; and measures to be taken to minimise its use. Because creative accounting is a topic o f much concern it would probably have been largely unproductive to attempt to collect data by asking companies about their own creative accounting practices. However, it was Address correspondenceto: Professor M. W. Pendlebury, Cardiff BusinessSchool, Colum Drive, Umverslty of Wales College of Cardiff, Cardiff CF1 3EU, UK. 0890-8389/92/020111+08 $03.00/0
© 1992 AcademicPress Limited
112
K. NASER a n d
M. PENDLEBURY
felt that external auditors ought to represent an alternative source o f reliable information about the use o f creative accounting, providing that client confidentiality could be preserved. A postal questionnaire, which guaranteed the anonymity o f both the respondents and their clients, was therefore used to obtain information from auditors about the various types of creative accounting they had encountered. 1 In 1988, five o f the then top eight firms o f accountants and one firm outside the top eight agreed to take part. Five copies o f the questionnaire were sent to the technical partners o f each o f these firms for distribution among their senior audit colleagues/partners. Out of the 30 questionnaires issued in this way, 20 were returned completed. In addition, the local branches o f four o f the major accounting firms were sent copies o f the questionnaire, two o f which were returned completed. The total number o f usable responses that are included in the analysis that follows is therefore 22. In an attempt to provide some information on whether the type o f company (e.g. quoted, unquoted, etc.), or the industrial classification o f the company had any impact on the use o f creative accounting, the respondents were asked to classify the examples o f creative accounting that they had detected. The results are reported in Table 1. This reveals, for example, that of the 15 (out of 22) respondents that had had experience o f auditing quoted companies, 1 (7%) had never encountered any example o f creative accounting, 11 (73%) had found between 1 and 5 examples and 3 (20%) had come across more than 5 examples. The lack of precision in the frequencies makes it difficult to be conclusive but the information that perhaps can be gleaned from Table 1 is that private companies provided the most frequently encountered examples o f creative accounting. What is more interesting, however, is the extent to which creative accounting was encountered, with a significant proportion of all categories of companies appearing to make some use o f it. Similarly, for industrial classification, the results illustrate that creative accounting is likely to be used by companies operating in any industry and there is perhaps an indication that banks and financial institutions are the most frequent users. Table 2 reports the extent to which respondents agreed or disagreed with four possible reasons for the use o f creative accounting. From this it can be seen that the respondents considered that meeting limits on borrowing levels and gearing ratios was the reason they were most in agreement with, with over 90% agreeing or strongly agreeing. The 'desire to control dividends' and 'the pressure from big institutional investors' resulted in the least amount o f agreement. However, these reasons did attract a large proportion o f 'no view' responses, and unfortunately this leaves the picture far from clear. Nevertheless, the suggestion by Griffiths
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(1987, p. 2) that creative accounting occurs as a response to pressure from big institutional investors does not appear to have been strongly supported on this occasion. There are differences in opinions surrounding the legitimacy or otherwise of the use of creative accounting. Table 3 shows that 45.5% of the respondents agreed or strongly agreed that creative accounting is a legitimate business tool. If the respondents accept that the purpose of creative accounting is to mislead, then it is difficult to explain these results. Although, as revealed in Table 3, 54-5% of the respondents agreed or strongly agreed that the use o f creative accounting is a serious problem, as many as 95.5% agreed or strongly agreed that it is a problem that can never be completely solved. Also reported in Table 3 are responses to questions concerning the perceived consequences flowing from the continued use of creative accounting. O f the respondents, 59% agreed or strongly agreed that the continued use o f creative accounting would put the usefulness of the statutory accounts, for decision-making purposes, in jeopardy. Table 3 also shows that 72.7% of the respondents agreed or strongly agreed that the continued use of creative accounting represents a serious threat to the integrity of financial reporting. Table 4 reports the response to a question that asked what should be done to eliminate the use of creative accounting. The solution that attracted the most agreement was that there should be more standards aimed at specific problem cases. None o f the respondents registered disagreement with this solution. The solution that attracted the lowest level o f agreement was that there should be more detailed accounting legislation, with only 54.5% o f the respondents agreeing. What is interesting about Table 4 is that the respondents show support for all o f the solutions identified in the question. This suggests that auditors feel that rather than treating substance over form and detailed prescription as mutually exclusive approaches to the problem, they should be accepted as being just two examples drawn from a range of possible solutions, all of which have a part to play in combating creative accounting. SUMMARY AND CONCLUSIONS The results o f this note indicate that external auditors feel that attempts by companies to comply with hmits on borrowing requirements and gearing ratios are important in explaining the use o f creative accounting. It was also clear that although the majority view was that creative accounting is n o t a legitimate business tool, a surprisingly large minority held the contrary view. The consequences of the continued use of creative accounting, according to the respondents, are that it will lead to a reluc-
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tance to use statutory accounts for making decisions, and it will put at risk the integrity o f financial reporting and yet there was almost total agreement that there was unlikely to be a solution to the problem. A partial remedy might be to place a greater responsibility on external auditors to draw attention to creative accounting and to state that accounts containing such devices do not give a true and fair view. The questionnaire responses indicated that external auditors did detect a widespread use o f creative accounting. The crucial question that then needed asking is 'what did they do about it?' Did they ask the companies involved to give explanations and assurances that it would not happen again?; did they qualify the accounts?; did they turn a blind eye? Unfortunately such a question was ruled out for inclusion in the questionnaire because it was felt that it wouldjeopardise the response rate. However, the question does need answering.
NOTE The normal hnutauons of quesuonna~re-based research, such as non-response b~as, possible amb,gmties in the questions, lack of control over completion, accuracy of the responses, etc., must be acknowledged. We are, however, encouraged by a response rate of 67%, parucularly given the usual reluctance of external auditors to take part in this kind of research for reasons of confidentmhty. However, th~s need for confidenuality also led to a further hmltation because the only way of ensuring complete anonyrmty was to leave the &stribuuon of the questionnaire to the technical partners of the firms Although th~s resulted in a loss of control over the sample frame, it seemed hkely that any alternauve approach would have led to a very limited response. We also attempted to faohtate the completion of the quesuonnalre and thereby boost the response rate by asking respondents to give approximate frequencies (1 e. 1-3 umes, more than 3 umes, etc.), rather than precise frequenoes. Finally we must acknowledge that the sample s~zeis too small to generate statlsucs from which inferences could be made about the atutudes of the underlying population of auditors. This could only be done by undertakmg a much larger survey. Although we accept that our results are impressionistic we do feel that they do offer some interesting pointers about the reactions of auditors to creative accounting.
REFERENCES
Griffiths, I. (1987). Creative Accounting, London: Unwln Paperback. Jameson, M. (1988) A Pract,cal Gutde to Creative Accounting, London: Kogan Page Morns, M. (1988). Creative Accounting: Cause for Concern or Constructwe Communicatwn?, Juhan Hodge Accounting Lecture, The University of Wales, Aberystwyth, November. Dates. Received 14 February 1991, final version received 10 Aprd 1992.
A N O T E O N THE USE OF CREATIVE ACCOUNTING KAMAL NASER
Cardiff Business School, University of Wales College of Cardiff MAURICE PENDLEBURY
Cardiff Business School, University of Wales College of Carcliff Although much has been written about creative accounting and about the various schemes of window dressing and off-balance sheet financmg, very little is known about how widely such schemes are used by companies. This note reports the results of a survey of senior auditors concerning their expemence of creative accounting. The auditors were asked to indicate how frequendy they had encountered schemes of creative accounting and their responses are analysed by type of company, industrial classification and type of scheme. The perceptions of auditors concerning: the motives companies might have for using creative accounting; the consequences of the continued use of creative accounting; and the steps that need to be taken to eliminate the use of creative accounting are also analysed.
Although creative accounting probably dates back almost as far as accounting itself, the relatively high level o f interest now shown in it has much more recent origins. Discussions and analyses of creative accounting are now appearing in the literature (see, for example, Grifl~ths 1987, Morris 1988 and Jameson 1988). A feature o f the discussion to date is that there is relatively little empirical evidence concerning the use of creative accounting in practice. This note reports the results o f an attempt to obtain empirical evidence which might help to address the following issues: whether the use o f creative accounting is related to the type of company or its industrial classification; the reasons behind the use o f creative accounting; the perceived legitimacy of the use o f creative accounting; the perceived consequences o f the continued use of creative accounting; and measures to be taken to minimise its use. Because creative accounting is a topic o f much concern it would probably have been largely unproductive to attempt to collect data by asking companies about their own creative accounting practices. However, it was Address correspondenceto: Professor M. W. Pendlebury, Cardiff BusinessSchool, Colum Drive, Umverslty of Wales College of Cardiff, Cardiff CF1 3EU, UK. 0890-8389/92/020111+08 $03.00/0
© 1992 AcademicPress Limited
112
K. NASER a n d
M. PENDLEBURY
felt that external auditors ought to represent an alternative source o f reliable information about the use o f creative accounting, providing that client confidentiality could be preserved. A postal questionnaire, which guaranteed the anonymity o f both the respondents and their clients, was therefore used to obtain information from auditors about the various types of creative accounting they had encountered. 1 In 1988, five o f the then top eight firms o f accountants and one firm outside the top eight agreed to take part. Five copies o f the questionnaire were sent to the technical partners o f each o f these firms for distribution among their senior audit colleagues/partners. Out of the 30 questionnaires issued in this way, 20 were returned completed. In addition, the local branches o f four o f the major accounting firms were sent copies o f the questionnaire, two o f which were returned completed. The total number o f usable responses that are included in the analysis that follows is therefore 22. In an attempt to provide some information on whether the type o f company (e.g. quoted, unquoted, etc.), or the industrial classification o f the company had any impact on the use o f creative accounting, the respondents were asked to classify the examples o f creative accounting that they had detected. The results are reported in Table 1. This reveals, for example, that of the 15 (out of 22) respondents that had had experience o f auditing quoted companies, 1 (7%) had never encountered any example o f creative accounting, 11 (73%) had found between 1 and 5 examples and 3 (20%) had come across more than 5 examples. The lack of precision in the frequencies makes it difficult to be conclusive but the information that perhaps can be gleaned from Table 1 is that private companies provided the most frequently encountered examples o f creative accounting. What is more interesting, however, is the extent to which creative accounting was encountered, with a significant proportion of all categories of companies appearing to make some use o f it. Similarly, for industrial classification, the results illustrate that creative accounting is likely to be used by companies operating in any industry and there is perhaps an indication that banks and financial institutions are the most frequent users. Table 2 reports the extent to which respondents agreed or disagreed with four possible reasons for the use o f creative accounting. From this it can be seen that the respondents considered that meeting limits on borrowing levels and gearing ratios was the reason they were most in agreement with, with over 90% agreeing or strongly agreeing. The 'desire to control dividends' and 'the pressure from big institutional investors' resulted in the least amount o f agreement. However, these reasons did attract a large proportion o f 'no view' responses, and unfortunately this leaves the picture far from clear. Nevertheless, the suggestion by Griffiths
113
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(1987, p. 2) that creative accounting occurs as a response to pressure from big institutional investors does not appear to have been strongly supported on this occasion. There are differences in opinions surrounding the legitimacy or otherwise of the use of creative accounting. Table 3 shows that 45.5% of the respondents agreed or strongly agreed that creative accounting is a legitimate business tool. If the respondents accept that the purpose of creative accounting is to mislead, then it is difficult to explain these results. Although, as revealed in Table 3, 54-5% of the respondents agreed or strongly agreed that the use o f creative accounting is a serious problem, as many as 95.5% agreed or strongly agreed that it is a problem that can never be completely solved. Also reported in Table 3 are responses to questions concerning the perceived consequences flowing from the continued use of creative accounting. O f the respondents, 59% agreed or strongly agreed that the continued use o f creative accounting would put the usefulness of the statutory accounts, for decision-making purposes, in jeopardy. Table 3 also shows that 72.7% of the respondents agreed or strongly agreed that the continued use of creative accounting represents a serious threat to the integrity of financial reporting. Table 4 reports the response to a question that asked what should be done to eliminate the use of creative accounting. The solution that attracted the most agreement was that there should be more standards aimed at specific problem cases. None o f the respondents registered disagreement with this solution. The solution that attracted the lowest level o f agreement was that there should be more detailed accounting legislation, with only 54.5% o f the respondents agreeing. What is interesting about Table 4 is that the respondents show support for all o f the solutions identified in the question. This suggests that auditors feel that rather than treating substance over form and detailed prescription as mutually exclusive approaches to the problem, they should be accepted as being just two examples drawn from a range of possible solutions, all of which have a part to play in combating creative accounting. SUMMARY AND CONCLUSIONS The results o f this note indicate that external auditors feel that attempts by companies to comply with hmits on borrowing requirements and gearing ratios are important in explaining the use o f creative accounting. It was also clear that although the majority view was that creative accounting is n o t a legitimate business tool, a surprisingly large minority held the contrary view. The consequences of the continued use of creative accounting, according to the respondents, are that it will lead to a reluc-
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tance to use statutory accounts for making decisions, and it will put at risk the integrity o f financial reporting and yet there was almost total agreement that there was unlikely to be a solution to the problem. A partial remedy might be to place a greater responsibility on external auditors to draw attention to creative accounting and to state that accounts containing such devices do not give a true and fair view. The questionnaire responses indicated that external auditors did detect a widespread use o f creative accounting. The crucial question that then needed asking is 'what did they do about it?' Did they ask the companies involved to give explanations and assurances that it would not happen again?; did they qualify the accounts?; did they turn a blind eye? Unfortunately such a question was ruled out for inclusion in the questionnaire because it was felt that it wouldjeopardise the response rate. However, the question does need answering.
NOTE The normal hnutauons of quesuonna~re-based research, such as non-response b~as, possible amb,gmties in the questions, lack of control over completion, accuracy of the responses, etc., must be acknowledged. We are, however, encouraged by a response rate of 67%, parucularly given the usual reluctance of external auditors to take part in this kind of research for reasons of confidentmhty. However, th~s need for confidenuality also led to a further hmltation because the only way of ensuring complete anonyrmty was to leave the &stribuuon of the questionnaire to the technical partners of the firms Although th~s resulted in a loss of control over the sample frame, it seemed hkely that any alternauve approach would have led to a very limited response. We also attempted to faohtate the completion of the quesuonnalre and thereby boost the response rate by asking respondents to give approximate frequencies (1 e. 1-3 umes, more than 3 umes, etc.), rather than precise frequenoes. Finally we must acknowledge that the sample s~zeis too small to generate statlsucs from which inferences could be made about the atutudes of the underlying population of auditors. This could only be done by undertakmg a much larger survey. Although we accept that our results are impressionistic we do feel that they do offer some interesting pointers about the reactions of auditors to creative accounting.
REFERENCES
Griffiths, I. (1987). Creative Accounting, London: Unwln Paperback. Jameson, M. (1988) A Pract,cal Gutde to Creative Accounting, London: Kogan Page Morns, M. (1988). Creative Accounting: Cause for Concern or Constructwe Communicatwn?, Juhan Hodge Accounting Lecture, The University of Wales, Aberystwyth, November. Dates. Received 14 February 1991, final version received 10 Aprd 1992.