Creative accounting and the IASB conceptual framework – a futile relationship?

Creative accounting, a term first introduced by Ian Griffiths (1986), is commonly defined in the UK as “a form of accounting which, while complying with all regulations, nevertheless gives a biased impression (generally favourable) of the company’s performance” (CIMA, 2000 cited by Jones, 2011). However, this definition is very narrow in comparison to others such as that by Gowthorpe and Amat (2005), who identified that manipulation occurs at both a macro and micro level.

Macro–manipulation focuses on the political dimension of creative accounting, whereby political pressures, such as lobbying, influence accounting choice. For example, property investment companies lobbied hard against SSAP 12 (now FRS 15), and got their own accounting standard SSAP 19 (now IAS 40). Micro–manipulation, on the other hand, involves creative accounting at an individual entity level, where policies and disclosures are chosen to create a view of reality the company wishes to present e.g. WoldCom (2002) – categorising ordinary expenses as capital expenses and inflating revenues to disguises losses.

The conceptual framework aims to address both levels of manipulation. The framework still allows choice and judgement e.g. choosing depreciation policy, estimating/judging provision and impairment amounts etc., which enables companies to continue to practice creative accounting. For example, the choice of a particular depreciation policy will affect the NBV of a non-current asset, which may therefore overvalue the assets in the statement of financial position, thus affecting the accounting ratios. This type of choice operates at a micro level, however, by limiting the options available e.g. companies can no longer value inventory on a LIFO basis, the framework helps restrict the practice of creative accounting which had previously been practiced on a much larger scale with devastating effects e.g. Enron (2001).

The conceptual framework serves as the definitive reference document for the development of accounting standards, providing guiding principles and fundamental definitions. The provision of these definitions e.g. assets and liabilities, income and expenditure etc., makes it harder to deviate and practice creative accounting. One of the main examples of the defence provided by the framework in this sense is that of the change in definition of operating and finance leases under IAS 17. Historically, creative accounting had involved the manipulation of accounts through leases, as both operating and finance leases were not included in the statement of financial position. Now, finance leases must be presented on the statement of financial position, demonstrating clearly that the framework emphasises economic substance over legal form, recognising economic reality and reducing the scope for manipulation.

One criticism of the framework  is that it recognises that there are various measurement methods, but is indecisive as to how assets and liabilities should be measured: at cost or at a valued amount. This failure at such a basic level results in many standards being on the fence regarding how to measure them. For example IAS 16 Property, Plant and Equipment and IAS 40 Investment Properties both allow the preparers of reports the choice to formulate their own accounting policy on measurement, increasing the opportunity for creative accounting. Therefore, the framework lacks decisiveness, and this weakens its justification as a defence against creative accounting.

Agency theory separates management from ownership, establishing a power gap. Mundel (2016) suggests “occurrence of creative accounting is related to weakness of corporate governance“. The conceptual framework and the standards it produces establish principles for accounting practices, but fail to reach as far as forming a defence against corporate governance that may influence creative accounting. Therefore, the framework alone is not a strong enough defence, hence the development of the UK Corporate Governance Code. Similarly, the conceptual framework also fails to form standards in respect of ethical issues, and this task is left to the IESBA and professional accounting bodies’ individual Code of Ethics.

In conclusion, there are still quite a large number of opportunities for public companies to continue to engage in creative accounting practices, whether this be through macro-manipulative activities, complex taxation networks, or the simple manipulation of individual accounts. It is my opinion that the IASB conceptual framework acts as a fairly strong defence against creative accounting, however it is not the only defence. Despite creative accounting being legal, it is morally reprehensible, and therefore the strongest form of defence against creative accounting is arguably one that is based on principles and morals i.e. the conceptual framework and ethical codes. However, the on-going cases of creative accounting prove as evidence that the framework is not a definitive defence mechanism.

References

Amat, O. & Gowthorpe, C. Creative Accounting: Some Ethical Issues of Macro- and Micro-Manipulation. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.563363

Griffiths, I. (1986). Creative Accounting: How to Make Your Profits What You Want Them to be. Sidgwick & Jackson Ltd.

Jones, M. (2011), Creative Accounting, Fraud and International Accounting Scandals, Chichester, West Sussex, England: John Wiley & Sons.

Mudel, S. (2016) A Study to Show the Relation between Creative Accounting and Corporate Governance. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2710567

Featured image courtesy of http://onlinenumerologist.com/wp-content/uploads/2015/02/shutterstock_87799399.jpg

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