International Financial Accounting

1.0 Introduction

According to agency theory, the ownership and management of a company are separated, in order to satisfy principals, agents may use some techniques to polish financial statements, creative accounting appears. Creative Accounting is the use and abuse of accounting techniques to window dress company’s financial statements or financial performance, breach the basic principles in the International Accounting Standards which emphasize fairness, objective and free from bias.

This paper will show following parts sequently: the first part is motivations and specific methods of creative accounting. The second part illustrate literature review of creative accounting, and the last part is about critical evaluation of creative accounting in a more comprehensive way.

2.0 Reasons of creative accounting

2.1Personal incentives

Healy (1985) examines managers’ earnings motives to manipulate income measurement. Company insiders especially management join in creative accounting in order to pursue individual interests, such as increased salaries, bonus-related pay, shares and share options, job security and personal satisfaction. Moreover, if directors join in 'insider dealing', they can delay releasing information to the market using creative accounting.(Anonymous, 1997)

2.2Market expectations

Hepworth (1953) identified several motivations including convincing outside investors and inside workers by presenting smoothing earnings and polishing something related to ups and downs in anticipated income. Public listed companies expect to attract more investors and collect more funds, the attraction will be reflected by some financial ratios, such as dividend payout ratio, EPS, ROCE and so on. (Van Caneghem, 2002)

2.3Special circumstances

There are some special circumstances to motive companies to make creative accounting. There are some typical situations, such as management gearing ratio and liquidity, significant events like merges or acquisitions, decreasing transparency or adding odd items. Fox (1997) points out how accounting policies in some companies are designed in accordance with accounting criteria so that they can match reported earnings to future profit.

2.4Cover-up Fraud

When fraud and error appear, a company may have to apply creative accounting to cover and disguise the behavior, for example, misappropriation of assets will make the asset on the financial statement contradicts with actual assets, creative accounting will modify some accounts to keep balance.

3.0Methods of Creative Accounting

The specific methods of creative accounting change over time in respond to International Accounting Standard. There are three typical techniques of creative accounting, including regulatory flexibility, off-balance sheet financing and the use of exceptional items. (Cosmin, 2010)