Creative Accounting: Nature, Incidence and Ethical Issues

Introduction

According to agency theory ‘the firm is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals… are brought into equilibrium within a framework of contractual relations.’ (Jensen and Meckling, 1976). Within the agency framework, it is both logical and inescapable that management behaviour will be self-serving. Agency can, therefore, provide a solid framework for the understanding of creative accounting behaviour. However, it may provide an incomplete theoretical basis for explaining or predicting management behaviour; the ethical dimension of human behaviour may provide an important element missing from legalistic and adversarial agency relationships (Horrigan, 1987).

The informational perspective (Schipper, 1989) is a key element underpinning the study of the creative accounting phenomenon. A conflict is created by the information asymmetry that exists in complex corporate structures between a privileged management and a more remote body of stakeholders. Managers may choose to exploit their privileged position for private gain, by managing financial reporting disclosures in their own favour. The informational perspective assumes that accounting disclosures have an information content that possesses value to stakeholders in providing useful signals.

It may be difficult or impossible for individual stakeholders to discern the fact and the effect of accounting manipulation, because of an insufficient personal skill set, indifference or an unwillingness to engage in detailed analysis (the mechanistic or naïve investor hypothesis, discussed by Breton and Taffler, 1995). From a market efficiency perspective such failures in understanding may not matter. Breton and Taffler point out in the conclusion to their study establishing that analysts’ perception of creative accounting devices is somewhat deficient, only a small number of effective accounting experts may be required ‘for the market as a whole appropriately to process window dressed numbers’. On the other hand, Healy and Wahlen (1999) cite studies that find that creative accounting prior to equity issues does affect share prices, suggesting that investors do not necessarily see through creative accounting.

This paper is positioned within an informational perspective, tempered by the naïve investor hypothesis; it is based upon the propositions, firstly, that financial reporting does possess valuable information content, and secondly that distortions in it may not be readily discernible by all stakeholders or that their effects may not be truly appreciated.

There is a substantial literature on creative accounting, much of it originating in, and concerned with, the United States. However, the US literature offers valuable insights into creative accounting in any country with a reasonably highly developed capital market (a recent comprehensive review of the US literature is provided by Healy and Wahlen, 1999). Also, beyond the US, there has been a growth in the volume of literature discussing creative accounting issues.

The paper is structured as follows. First, we provide some definitions of creative accounting. Second, we analyse different motivations for its use and several creative accounting techniques. We continue by reporting various empirical studies that have sought to identify its existence, nature and incidence. The paper continues with a review of some ethical issues concerning creative accounting and concludes by suggesting possible solutions for this problem.

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