Abstract
Creative accounting can be summed up into one
word: manipulation. It is the manipulation of financial statements in order to
portray a given image about a company which is often not a reflection of the
financial position of the company. This paper examines the practice of creative
accounting in Hong Kong and China and compares it to the practice of the same
in the USA and the UK. The paper evaluates the possible implications of
creative accounting and goes on to relate the prevalence of the practices to
the severity of the financial crises experienced during the global economic
meltdown of the late 2000s. In so doing, the paper seeks to establish whether
there are significant differences in the motives for engaging in creative
accounting and whether or not there are peculiar motives distinguishable by
country or cultural contexts. To this end, the paper establishes that the underlying
motive for creative accounting is the propagation of private interests and this
applies across the board in most countries. However, a few peculiarities may
exist and have been elaborated upon in the paper. Ethics and culture are viewed
as inseparable on many fronts. The ethical considerations of
creative accounting therefore warrant the consideration of the cultural
contexts within which businesses operate. Of relevance are the two dominant
philosophies in the regions under consideration namely: Confucianism prevalent
in China/Hong Kong; and the free market mechanical behaviour prevalent in the
West. With a clear emphasis of morality and ethics as its central components,
Confucianism provides little motivation for self-oriented accounts manipulations.
This paper also explores the developments in the harmonisation of Chinese
accounting standards with the international accounting standards. The merits
and demerits of such harmonisation are also discussed in detail. These discussions essentially cover
comprehensively the objectives of this study.
1.1
Background
Accounting reports are a primary source of information for outsiders who
have reason to monitor the financial performance of companies. Thus, corporate
lenders may rely on statutory accounts and other published or unpublished
financial statements for information to monitor lending. However, many
corporations tend to present attractive and creative statements in order to
attract investors believing the corporations’ profits are higher. One such
example is that of Pfizer. Pfizer encouraged over 3,000 sales representatives
to misrepresent the appropriate uses of Bextra beyond FDA approved areas of
treatment (BBC 2009). Upon discovery of the illegal marketing, Pfizer was
charged with fraudulent marketing and received a record-breaking $2.3 billion
fine (Hensley 2009; AP 2009). A whistleblower in the Pfizer case indicated that
"In the Army I was expected to protect people at all costs. At Pfizer I
was expected to increase profits at all costs, even when sales meant
endangering lives. I couldn't do that” (Blaine 2009). The whistleblower lost
his job and dedicated six years of his life to fighting Pfizer. He attributed
the integrity required to take on Pfizer to his training: “I'm a graduate of
West Point and I think that that grounding in ethics and morality in school
really made the decision quite easy”).
A case resulting in the sentencing of an accounting manager involved
with the multi-billion dollar WorldCom accounting fraud provides insight into
the pressure supervisors can place on subordinates to manipulate accounting
information. ''I felt like if I didn't make the entries, I wouldn't be working
there” (AP, 2005). She was the primary breadwinner for the family as well as
the provider of health insurance (Pulliam 2003) and did not wish to terminate
her employment. Frustrated with the supervisory pressure, she went so far as to
take “her concerns to Scott D. Sullivan, WorldCom's finance chief at the time .
. . who assured her and lulled her into believing that all was well” (AP 2005).
This scenario suggests that the account managers may be pressurised into creating
false reports about the earnings of their corporations.
Studies have demonstrated that senior level accountants negotiate audit
findings with auditors (Hatfield et al. 2008; Sanchez et al. 2007), opening
(but not investigating) the possibility that reported accounting information in
audit work-papers may be manipulated to support negotiations. Managerial accounting
studies focused on budgets have demonstrated that subordinates tend to reach
agreement with supervisors when they know they will have to work together in
the future (Fisher et al. 2000). Studies have shown that managerial accountants
create budgetary slack as a defence
mechanism (Fisher et al. 2002; Fisher et al. 2000; Davis et al. 2006). Overall,
these studies provide some evidence that there are consequences that may arise from interactions between accountants and their clients or
employers.
Earnings management has been described as being on a continuum from real
earnings management (which may involve, for example, timing a transaction so it
falls within a certain period) to fraudulent earnings management (Public
Oversight Board 2000). That accountants manage earnings to meet expectations
has been established by archival, experimental, and survey studies (Prawitt et
al. 2009; Nelson et al. 2002; Hunton et al. 2006; Healy and Wahlen 1999). There
is also archival (Xu et al. 2007) and field-based (Graham et al. 2006, 2005)
evidence that financial executives are willing to sacrifice real economic value
for short-term accounting earnings through the means of legitimate, albeit
counterproductive business decisions. Archival evidence indicates public companies
use the latitude allowed within GAAP to manage the disclosure of information to
their advantage (Botosan and Stanford 2005). Field-based research has also
indicated that financial accountants harbour intentions to fraudulently report
earnings (Gillett and Uddin 2005).
In the last
few years, many developments have taken place within the business environment;
a lot of complicated trading practices and financial dealings have emerged and
new accounting standards have been issued to report on these dealings. This has
increased the alternatives a company can use to achieve its goals, and hide its
real operation results and its real financial position, and show it in a false way
through manipulating the financial statements. This is called creative accounting and may cause difficulty for the national economy (Ahmed, 2008).
The
external auditor needs to know all the different creative accounting practices,
so it will be easy for him to discover these practices and conduct his qualified and efficient audit, and express right
opinion about how true the financial statements he has audited. In this way the expectation gap is minimized, and increases users trust in
the financial statements and the audit services, especially after the collapse
of many big international corporations which resulted in a decline in trust in external auditing. Further, year-end financial
audit work by external auditors appears to play a role in moderating earnings
management by minimizing managers’ opportunities to manage earnings in the
fourth quarter (Brown and Pinello, 2007). Also, the well qualified internal
auditors might play an incremental role in that they can be seen as an
additional third party that monitors management’s actions on a year-round basis
(Prawitt, et al., 2009).
1.2 Draw back
Creative
accounting goals is usually used to achieve management targets through the
manipulation of accounts that enable them project a status that is different
from the true and fair view of their financial status (Prawitt, et al., 2009). Indeed
there are a lot of creative accounting practices whether on or off balance
sheet; there are a lot of accounting problems related with these practices
which force the external auditor to study them in order to discover it and to
express their opinion about the audited financial statements. Analytical
procedures offer warning signs which are risk indicators for creative
accounting practices which allow the external auditor to concentrate his time
and his effort on the areas that have unexpected differentials and substantial
changes (Clarkson et al. 2009; Hatfield et al. 2008). They can therefore identify the areas which cause failure which need
more concentration and care, and
can extend the range of testing
of details of transactions and balances. The operational cash flow allows the
external auditor to detect creative accounting practices done by management in
order to increase the net income of the company; but these activities do not
generate any operational cash flow, so if the adjusted operational cash flow to
income ratio and the excess cash margin are both stable through different
periods; this would indicate that there are no creative accounting practices.
However if they are unstable this would indicate that management is involved creative accounting practices.
A number of
research studies show that in the case of violation of debt covenants companies
do face increased costs imposed by lenders, for example, increased negotiation
costs, financing costs and, on occasions, restructuring costs (Smith, 1993).
This research suggests that there are systematic patterns in lenders' reactions
to covenant breaches and in the impact of costs on borrowers. For example, Chen
and Wei (1993) conclude that lenders are less likely to grant waivers to firms
that have high probabilities of bankruptcy and high debt/equity ratios. Beneish
and Press (1993) examined renegotiated debt contracts and found them to include
new restrictions which increased monitoring of the borrowers' business. Most of
these new covenants were investing and/or financing-oriented rather than
accounting-based. Thus, when firms violate debt covenants, they may pay for it
not only through increased interest costs, but also through increased
monitoring by lenders.
1.3 Research questions
1.
What are the main drivers of creative accounting?
2.
What are the main parameters to creative accounting in
terms of professional standards, and the law?
3.
Has creative accounting been used in the context of
South East Asia generally, and Hong Kong and China in particular?
4.
Are there cultural differences regarding creative
accounting?
1.4 Aims and objectives
The aim of
this dissertation is to examine and investigate creative accounting and its
role in recent banking industry crises and failures. The particular focus of
this study will be on the banks of Hong Kong in order to analyze the accounting
behaviour of these banks before, during and after the credit crunch. For this
purpose, the specific objectives of this study will be:
1.
To
investigate the accounting behaviour
of Hong Kong banks when manipulating
financial statements
2.
To
examine the relationship between creative accounting and the financial crisis as it is affected banks
This study will be composed of seven chapters. The
first chapter has provided the introduction to this dissertation. In the second
chapter, accounting standards differences will be discussed in the context of
the UK, USA, Hong Kong and China. The third chapters will analysis different
creative accounting case studies in each country. The fourth chapter provides
discussion of the impact of how the credit crunch in each country. The fifth
chapter discusses professional accounting behaviour in different cultural
contests. The sixth chapter discusses harmonisation of accounting practices in Hong Kong with the international
accounting standards. The seventh chapter concludes.
1.6 Literature review
The existence of creative accounting practices is commonly reported in
both the United Kingdom (Griffiths, 1996) and the United States (Sherman and
Young, 2001). Accounting manipulation may be achieved through changes in
accounting policy or the manipulation of accruals. Accounting policy concerns
matters such as the choice of stock valuation method (for example, FIFO versus
LIFO) or depreciation policy (for example, straight line versus reducing
balance). Although considerable research has been undertaken in search of
evidence of manipulation of accounting policy, strong and consistent evidence
of such policy manipulation has not been discovered. One explanation of this
may be that debt contracting incentives are not in practice strong enough to
induce managers to change accounting practices to avoid disclosing potential
covenant breaches. It may be that changes in accounting policy are just too
difficult or expensive in contracting terms to undertake for managers of
indebted companies, even those in financial distress. The arguments for this
view are compelling: accounting regulations require accounting policy changes
to be disclosed in notes to the accounts (for example, under SSAP2 in the
United Kingdom) and, if they result in material effects, regulations require
prior period adjustments to be made to reserves. This suggests little benefit to managers from
accounting policy changes per se, indeed such changes which are
advertised in financial statements may create their own contracting costs if
counter-parties are alerted to accounting problems or dysfunctional management
behaviour. These arguments suggest that accounting policy changes may not be
very likely to occur, particularly in companies already under close scrutiny
because of financial problems. In addition, there is ample evidence that
accounting method choice in a firm can also be determined by other factors such
as the firm's financing policy, historical or industry trends and even
influential individuals. Such factors may dominate the influence of debt
contracting costs. If this is so, it is perhaps to be expected that empirical research
will have only a patchy record in identifying evidence of management
manipulation of accounting policy per se.
This may lead us to conclude that lenders can take comfort that their
loan monitoring may not be confused by dubious accounting. However, this would
be a premature conclusion. Even if accounting policy is not a likely focus of
manipulation, lenders remain in danger since other means are available for
accounting manipulation. Managers may instead try to manipulate accruals or
change accounting estimates because these are easier to achieve and easier to
disguise, and if detected, easier to explain away as caused by factors other
than manipulation. In short, accruals changes or changes in accounting
estimates may involve smaller contracting costs than changes in accounting
policy and, when set against the likely costs of technical default, they may
represent a more efficient solution to the problem of how to circumvent
lenders' monitoring processes.
Examples of accruals changes which might be manipulated are the timing
or pattern of sales recognition (i.e. recognising sales earlier in order
to increase turnover in an accounting period and, other things being equal,
profit), the adjustment of estimates of bad debts (for example, taking a more
optimistic view of debtors' payments patterns and so maintaining the values of
current assets and profits), optimistically adjusting estimates of stock
obsolescence (with equivalent effects to the previous example of debtors), or
changing the estimated lives of fixed assets (for example, taking a more
optimistic view of asset life and thus reducing the annual depreciation charge
to the benefit of annual profit and the carrying value of the fixed asset). All
these examples would increase profits and asset values (and equivalent ones
might reduce liabilities). Paradoxically, changes to accruals and estimates in
relation to items such as sales, debtors or fixed assets would be
characteristic of companies in financial trouble, but the changes which would
be most likely to occur if driven by economic factors would tend to be in the
opposite direction to the examples given (i.e. sales declining, bad
debts increasing, stock obsolescence increasing and asset lives falling). Thus,
if accruals and estimates are changed for manipulative reasons rather
than as a reflection of economic reality, there is increased difficulty and
danger for creditors attempting to monitor such companies through their
financial statements.
Evidence from audit research suggests that auditors tend to observe
frequent judgment errors amongst accruals items on the part of company
managers, suggesting that if manipulation was discovered it could be passed off
as error by management and excused as such by auditors. For the reasons just
discussed, analysis of accruals manipulation has become a popular alternative
to studies of accounting policy change, particularly in relation to financially
distressed companies.
Some interesting studies of potential accruals manipulation have been
undertaken by researchers which the researcher will briefly describe below. The
first study is that of DeFond and Jiambalvo (1994) who examined a sample of 94
U.S. firms which had reported covenant violations in their annual reports. They
tested for an association between abnormal accruals and covenant violation.
Actual accruals were compared with predicted normal accruals in both the year
of reported covenant violation and the year preceding it using both time-series
and cross-sectional approaches. The authors found mixed results as Table 1
shows.
Table 1: Summary of findings of DeFond and Jiambalvo on
accruals manipulation
Time-series study
|
Cross-sectional study
|
|
In year preceding covenant breach
|
Evidence of accruals manipulation to increase accounting profit
|
Evidence of accruals manipulation to increase accounting profit
|
In year of covenant breach
|
Evidence not consistent with accruals changes to increase accounting
profit
|
Evidence not consistent with accruals changes to increase accounting
profit
|
Abnormal accruals in the year before violation were found to be
statistically significantly positive for violating firms under both the
time-series and cross-sectional approaches, indicating evidence of
manipulation. However, the evidence for the year of violation was not
supportive of managers manipulating accruals to increase profit to disguise
covenant breaches. Indeed, evidence was present of an opposite tendency: that
is, to change accruals so as to reduce accounting profit. Such
paradoxical behaviour may be explained however. DeFond and Jiambalvo argued in
particular that two factors might work against managers manipulating accruals
in the expected (positive) direction once a covenant violation had occurred:
closer attention from the firm's auditors and management changes. Such
influences may work as follows. Financial distress may lead to closer attention
from auditors which may discourage managers from attempting manipulation or,
more directly, auditors may insist on more conservative accounting. These
tendencies may be strengthened if new auditors have been brought in because of
financial problems in the audited firms, but in any event, auditor's concerns
over audit liability risk may motivate them to audit a financially troubled
(and indebted) company more closely. An extreme case of close auditor
monitoring is where going concern qualifications have been made and 26 per cent
of DeFond and Jiambalvo's sample of troubled companies were in that position.
The second complicating factor in financially distressed companies is
management change. Management change may arise during financial distress as
owners and other stakeholders attempt to exercise closer control. New managers
can be expected to behave differently from their predecessors in several ways.
One important difference will be an increased likelihood to take painful
decisions which include radical changes in the staff composition and the manner
in which accounting and accountability is handled. DeFond and Jiambalvo's
sample of troubled companies contained 29 per cent of companies which had
experienced recent changes in senior management. DeFond and Jiambalvo attempted
to correct for the potential influence of these factors by excluding from their
sample those firms which had experienced going concern qualifications or
management changes. When the remaining covenant violating firms were studied
the behaviour of abnormal accruals changed to the expected direction (i.e.
profit-increasing). This helps shed light on our third research question in
suggesting that the behaviour of auditors and the phenomenon of management
changes influence the likelihood of accounting manipulation in troubled
companies.
Similar research has been undertaken by DeAngelo, DeAngelo and Skinner
(1994). They analysed accounting behaviour in 76 companies listed on the New
York Stock Exchange which had experienced financial distress. Financial
distress was manifest through persistent losses and dividend reductions but not
necessarily covenant breaches. They examined a much longer period than DeFond
and Jiambalvo, covering the 10 years before the first occurrence of financial
problems and three years after. They found only limited evidence of accruals
changes which could be associated with covenant breaches and, moreover,
observed a tendency for accruals changes to be in the wrong direction (i.e.
profit-decreasing) in the three years prior to the onset of financial problems
for all the companies which they studied. When DeAngelo et al. analysed
individual accounting changes by their sample companies they concluded that
they were dominated by economic decisions (for example, fixed asset
write-downs, increased bad debt provisions or inventory reduction). The
apparently greater influence of economic factors rather than covenant breach
costs on accounting changes was explained by DeAngelo et al. as arising
from a number of factors.
DeAngelo et al. also identified other contractual circumstances
which might bear on managers' decisions to make accounting changes to reduce
profit (or asset values) rather than increase them. Amongst these were
relations with shareholders (with managers using profit reductions to excuse
dividend cuts necessary to conserve cash flow),
negotiations with trades unions (with profit reductions being used to persuade
unions to make concessions to management), and government or regulator lobbying
(to achieve subsidies or other assistance). These findings and explanations
suggest that contracting costs may be powerful factors in influencing
accounting method choices but that debt contracting costs are only one element
in this and the broader contractual circumstances of a company must be taken
into consideration by lenders in their monitoring of loans.
The researcher reviewed the literature to identify whether financially
distressed U.K. companies manipulate their accruals to disguise covenant
breaches (Aljifri, 2000). The first step was to identify a sample of companies
that had breached their debt covenants or were suspected of doing so. To do
this the researcher used a “key words” search of Financial Times
articles on CD-ROM covering the years 1991-95. Key words such as “covenant”,
“negotiation”, “covenant breach”, and “losses” were used together with other
possibilities. This procedure identified 77 companies as having been mentioned
in the Financial Times as having had problems in relation to their debt
covenants. Direct study of the accounts of the 77 showed that 43 companies
reported that they had experienced debt covenant default. For the remaining 34
companies there was no definitive statement of covenant default but they may be
considered to have been in danger of breaching their debt covenants. The
researcher attempted to increase the sample size by utilising proxies for
covenant default. Accordingly, gearing levels and other proxies were calculated
for the companies known to have breached debt covenants and the financial
database Datastream was searched for companies exhibiting similar
characteristics. The above selection procedures resulted in a total potential
sample of 121 companies (43 reporting covenant violations in their accounts, 34
being reported in the Financial Times as having such problems, and 44
identified from Datastream as having similar financial characteristics
to the 43). The potential sample of 121 was checked for data availability for
the period 1987-97 in Datastream (available for 83 companies). Financial
statement data were available on the database One Source UK Large Companies
for a further five companies. Non-availability of sufficient data reduced the
potential sample by 22 companies to 99 companies. The 99 financially troubled
companies were matched with a control sample. Control companies were matched to
sample companies on industry and size and were selected to have debt but to
exhibit low gearing and not to be in financial difficulties.
The time-series analysis of financially troubled companies generally
showed positive abnormal accruals in the years prior to violation (or its
equivalent) and the second year after violation. Positive abnormal accruals
indicate that managers may be adjusting accruals to increase reported profits.
These findings of positive discretionary accruals are consistent with
expectations and the discussion above. Our findings for the year of violation
(or its equivalent) and for the first year thereafter showed negative abnormal
accruals. Negative abnormal accruals indicate that managers may be adjusting
accruals to reduce reported profits. As with the U.S. findings discussed above,
this may seem inconsistent with expectations based on the discussion of the
costs and incentives facing the managers of financially troubled companies.
However, as it has been noted for the U.S. findings, if financial distress is
associated with changes in management or the identity or behaviour of auditors,
this observation may have a logical explanation. For example, the findings of
negative (profit-reducing) abnormal accruals may be consistent with a “big bath”
effect associated with new managers which may have a (negative) impact for more
than one accounting period. To test whether this was indeed the case the
companies which had management or auditor changes were excluded from the sample
and the behaviour of accruals in the year of violation (or equivalent) and the
first year after was examined again. With those companies excluded abnormal
accruals were, as expected, positive.
In the cross-sectional analysis the researcher compared the financially
troubled companies with a sample of companies (the control sample) that were
not in financial difficulties. This comparison was in the year of violation (or
equivalent) and the year immediately after. As noted above, the control sample
companies were chosen so that they were comparable to the troubled companies by
industry and size. Comparing the abnormal accruals of the two samples revealed
that the financially troubled companies were more likely to adopt
profit-increasing accruals than the non-troubled companies in both years that
we studied. This adds further support to the case that managers in financially
troubled companies may tend to manipulate accounting information.
1.64 Evidence from Asia
The 1997-98
financial crisis hard hit the East Asia economy and widespread banking and
corporate failures were evident. The fiscal costs in the affected countries
were enormous and estimated at nearly 20-30% of gross domestic product (ADB,
1999). In Indonesia, Korea and Thailand, three hardest hit countries, the
non-performing loans at the peak of the crisis were estimated at around 70%,
35% and 33% of the total bank loans respectively (Caprio and Klingebiel, 2003).
Although the primary causes of this financial turmoil have still been hotly
debated, the banking system failure is usually considered a primary cause of
the crisis. The relationship-based economic cultures in the financial sectors,
which had been credited with fuelling the miraculous growth of East Asia, were
exposed by the crisis as inefficient and corrupt (Krugman, 1998 and Rajan and
Zingales, 1998). The strong linkages between government, banks and corporate
sectors led to implicit guarantees against corporate and bank failure in the
pre-crisis era (Krugman, 1998). On the whole, the fragilities of the banking sector made the Asian countries vulnerable to
the economic shock (Krugman 1998, Corsetti, Pesenti and Roubini, 1998, ADB,
1999 and Mitton, 2002).
Realizing
that the banking system is critical for sustainable economic growth (King and
Levine, 1993, Wurgler, 2000 and Summers, 2000), and that bank financing is
still the major source of corporate financing, the crisis countries, including
Indonesia, Korea, Malaysia and Thailand, urgently restructured their distressed
banking sectors. Even countries that seem to have escaped from the maelstrom of
crisis, say Hong Kong, Singapore and the Philippines, sensed a degree of
vulnerability, and launched their banking reform programmes to better withstand future crisis (ADB, 1999). To
tackle the structural weaknesses of the banking sectors, the Asian governments
launched comprehensive reform to transform the banking sectors from crony - or
relationship-based to be more arms-length based in the aftermath of the crisis.
The banking reform measures include the opening of domestic banking markets to
foreign investors, the enhancement of prudential regulation and supervision,
and the introduction of codes of governance to the banking organisations and so on. As stated in Rajan and Zingales
(1998, p. 16), "the Asian crisis may be the most opportune moment for
these (Asian) economies to effect the transition between systems".
Ball et al.
(2003) argue that the incentives of managers and auditors who prepare the
financial statements have an impact on the quality of accounting information.
They test a sample of four East Asian countries: Hong Kong, Malaysia,
Singapore, and Thailand. When characterising
these countries based on accounting standards alone, they predict that
financial statements will exhibit high “transparency”, while when characterising them based on prepare incentives, they predict low
“transparency”. The empirical results support the low transparency hypothesis.
The analysis implies that classifying countries in terms of accounting
standards, or standard-setting institutions, is incomplete and may be
misleading without adequate consideration of incentives.
Chapter Two: Professional
accounting standards in Hong Kong/China
This chapter explains the applicable accounting
standards in China and Hong Kong and makes a comparison with the accounting standards in the USA and the UK. The presumed similarity between the standards in the
UK and the USA, and those in
Hong Kong and China forms the basis for the batching up of the four accounting
standards into two distinct bands. The accounting practices in China and Hong
Kong were harmonised in 2010 making the accounting systems in the two areas
similar with differences only in wording that may not amount to a difference in
the accounting structures (Lehman, Lee and Xu, 2011). The two accounting
systems are therefore treated as one when it comes to making comparison between
their standards and those in the UK/USA. Hereafter, the UK and USA have been
variously described as ‘the West’.
Since the admission of China into the WTO in 2001,
there has been a concerted effort towards realigning the accounting practices
in China with the international accounting standards that have made accounting
somewhat similar across international borders (Ding, Hong, JeanJean and
Stolowy, 2007). This move was taken in an effort to ensure that the accounting
standards were in conformity
with the international standards in order to enable them to attract international investors. The changes were also
expected to help in the realignment of their business practices in line with
international practices, a move which would be expected to not only appeal to
investors, but also boost the image of Chinese companies in the global markets
and therefore encourage the demand for their products (Ding, Hong, JeanJean and
Stolowy, 2007). According to the proponents of this move, China would reap
significant benefits as a result. However, there persist fundamental
differences in the accounting systems that range from the approach to
accounting, the perceptions towards it, and the expectations on its role as
defined by the professional accounting standards and other legislations.
One of the main similarities between accounting
standards is the requirement that the accounts of companies reflect a true and
fair view of their financial status. A subtle difference however exists in the
sense that while the laws in the UK and the USA makes explicit provisions for
the understanding of the term ‘true and fair value’, the Chinese standards
leave the meaning to interpretation (Deloitte, 2011). This has led to some
sense of unease in relation to the same where international investors fear that
the lack of clear provision leaves the Hong Kong accounting systems largely
prone to ‘legally accepted’ manipulations (Hung, 2001). Another difference lies
in the treatment of assets where the Chinese systems require that purchases are
recorded at net purchase cost (meaning that the element of any impairment is
valued and deducted from the purchase cost) with a strict prohibition of
arbitrary revaluations (Ding, Hong, JeanJean and Stolowy, 2007). The Western
models on the other hand provide guidelines on the mode of revaluation
acceptable. The treatment of land use rights also differ slightly. In Hong
Kong, these rights are classified as intangible assets while in the West, they
are classified as operating leases (Ding, Hong, JeanJean and Stolowy, 2007).
Moreover, the requirement for true and fair value for land rights recognisable
as investment property whereas the in the West the revaluations are allowed in
cognisance of true and fair view (Deloitte, 2006). The Chinese on the other
hand put emphasis on the cost model. Similarly, the biological assets are
valued predominantly using the cost model except where there can be found
evidence of a reliable fair value according to the strict provisions of their
regulations (Ding, Hong, JeanJean and Stolowy, 2007). The West on the other
hand recognises fair value. Biological assets mainly comprise plants and
animals. As would be expected, farms are considered as businesses where the
biological assets are the main source of income. Once the plants or animals
have either been harvested or slaughtered, they turn from being biological
assets to being agricultural produce.
Another persistent difference is the fact that the
Hong Kong systems only recognise the equity method of accounting while the West
recognises both the equity method and proportionate consolidation (Deloitte,
2006). The equity method is hailed as simple and straight forward hence less
prone to manipulation by the creative accountant’s pen. On the other hand, the
provision for proportionate consolidation leaves a number of grey areas which
could easily be used to manipulate financial statements hence making the
practice of creative accounting more rampant in the West than it is in China
and Hong Kong (KPMG, 2011). The prohibition of all impairment losses in Hong
Kong also differs from the practice in the West where prohibitions are only on
the impairment of goodwill. Moreover, borrowing costs that meet capitalisation
criteria under the Chinese systems are required to be capitalised. This differs
from the West where companies are allowed to treat all their borrowing costs as
expenses (Deloitte, 2011). There are also differences that arise in the
treatment of state funding. In Hong Kong, state controlled entities do not get
the treatment normally accorded to organisations that are related while in the
West, no exceptions are made for state controlled entities (Deloitte,
2006).
When it comes to the attitude informing the accounting
practice, the systems in the West are tuned towards serving the interest of
stakeholders which include investors, suppliers, creditors, employees, and
interest groups among others (Bushman and Piottroski, 2006). The focus of the
Chinese systems is however to serve the interest of the government which they
creatively interpret as the interest of the larger public in the country
(Bushman and Piottroski, 2006). This is especially so with the financial
services sector where the largest banks are still state-owned and continue to
have the highest proportion of the market share. As Bushman and Piottroski
(2006) observe, this factor informs the little emphasis on true and fair value
in the Chinese system where the accounts are deemed to be reliable upon the
attainment of the threshold deemed to be adequate to the government through the
designated regulatory bodies.
In China, independent audits have traditionally not
been greatly emphasised. The bulk of the audits are arbitrary and geared
towards checking the level of compliance with the tax regulations (Deloitte,
2006). On the other hand, the accounting reports in the West are geared towards
the general public and are mainly expected to reflect the true and fair value
of the organisations even to the stakeholders that understand little or nothing
about financial terms (Deloitte, 2006). This is why independent auditing is
compulsory and auditors are expected to act with absolute independence in order
to give the financial statements the credibility needed. As opposed to the
government which has adequate instruments to ensure that no misleading
information is projected by the companies, the investors and the general public
may at times prove gullible hence giving accountants the opportunity to engage
in unethical creative accounting practices. In addition, the Chinese government
is the holder of the tax-payers resources and can easily back the position
portrayed by the state-corporations’ financial statements (Bushman and
Piottroski, 2006). This is as opposed to the companies in the West which in many occasions have been unable to cover up their
accounts manipulation practices.
Despite the core differences, the move towards compliance
with the international accounting standards (which are mainly a reflection of
the standards in the UK and the USA) has seen a dramatic movement towards
making the systems similar (Lehman, Lee and Xu, 2011). This has especially been
due to the need to attract international investors and to have Chinese
companies allowed to operate in international markets and trade their
securities in international stock markets (Lehman, Lee and Xu, 2011). These
areas of similarity include the description of financial statements and their
components; the basic recognition of the double entry systems in accounting;
the treatment of currency and differences in currency rates; as well as the
need to ensure that the financial statements largely reflect the financial
status of the organisations among others (Deloitte, 2011).
Chapter Three: Creative Accounting in Hong Kong,
China, USA and the UK
Creative accounting has been blamed for many of the
accounting scandals that happen in economies around the world. It involves the
practice of accounting where the letter of the regulations are followed without
due regard for the spirit of the same (Forbes, 2011). All countries in the
world have faced the adverse effects of this practice and this chapter explains
its uses (through the use of case studies) in four of these countries, namely:
Hong Kong and China; USA and the UK. The motivation for engaging in such
practices has also been expounded on with similarities and differences in the
causes of some of the accounting failures in the named countries duly
explained.
Creative accounting refers to a level of manipulation
of financial statements with an aim to create perceptions about the welfare of
the companies that may not entirely be true. This practice often falls within
the letter of the regulations even though it defies the spirit of the same. For
instance, where a law allows for recognition of revenues and expenses at
different points, an accountant intending to portray an organisation as more
profitable than it actually is may opt to delay the recognition of expenses and
recognise the revenues more promptly in order to achieve their aim (Moldovan,
Achim and Bota-Avram, 2010). Such a manipulation may be done with the hope that
the business may perform well in the future hence making it possible to cover
up the ‘creativity’ (Moldovan, Achim and Bota-Avram, 2010). Creative accounting
has in most cases been blamed for some of the accounting scandals that have hit
companies around the world and its practice is increasingly being frowned upon
in recent times. Perceptions on creative accounting start from the predominant
views about the same. For instance, the US’s view of creative accounting
includes fraud while that of the UK excludes fraud in its assessment of the
practice (Yeoh, 2007). Similar differences exist in the world with countries
like China only criminalising only those elements viewed as contrary to the
interests of the state. The Chinese approach is informed by its strong hold of
the economy especially in the financial services sector where creative
accounting may be practiced by the corporations as part of a larger scheme to
portray desired image of the whole economy (Yeoh, 2007). Motives viewed to be
contrary to the will of the state such as tax evasion are on the contrary
treated as criminal offences and the offenders subjected to harsh state
sanctions (Yeoh, 2007).
In the USA, several scandals have been discovered that
could be easily attributed to the practice of creative accounting. In 2002,
Adelphia Communications was caught up in a litigation in which it was accused
of exaggerating their profits after the founding members of the corporation
injected some money in an off – the – balance
sheet loan (Patsuris, 2011). Such off the balance sheet funding is
considered a manipulation due to the fact that the resultant financial position
of the organisation is usually presumed to be solely as a result of activities
and transactions reported in the company’s financial statements (Johns, 2010).
To cover up the scandal, Adelphia Communications inflated their capital
expenses and made efforts to hide the debts (Patsuris, 2011). In response to
this, the regulatory agencies stepped in and charged the parties involved with
fraud. The second example also in 2002 involved AOL Time Warner. While AOL was
in the process of negotiating the purchase of Time Warner, they sought to
project themselves as a stable company with a somewhat constant growth rate as
far as revenues were concerned (Holt and Eccles, 2002). To do this, they
inflated their sales through the booking barter deals. They also recognised advertisements they had sold on behalf of other parties as their own
hence boosting their sales volumes; and went on to seal ‘round trip’ deals with
suppliers and advertisers in order to realise this goal (Holt and Eccles,
2002). The use of creative accounting to portray a company in better a standing
than it actually has is considered fraudulent in the United States and formed
the basis for the prosecution of this company (Holt and Eccles, 2002). Other
corporate scandals with elements of creative accounting involve Peregrine
Systems and Halliburton which occurred in February 2002 and May 2002
respectively. In the case of Peregrine systems, the company was accused of having recognised revenues from third
party resellers hence overstating its revenues by over $ 100 million (Patsuris,
2011). Halliburton also committed a similar manipulation during the same period
when they chose to record revenues of about $ 100 million before the customers
had actually agreed to pay for them hence overstating their revenues and
portraying themselves as more profitable than they actually were (Patsuris,
2011). In March 2002, a similar case was noted in WorldCom where the company
sought to increase its cash flow by mischievously booking a $ 3.8 billion
capital expense as operating expenses (Collegiate Case Study, 2011). These
three cases are illustrative of the belief that investors and other stakeholders
are largely moved by the good performance of the organisations. Whenever a
company is known to perform well, stakeholders tend to be more cooperative with
them hence providing the motivation to ‘create’ accounts (Holt and Eccles,
2002). The most famous case against creative accounting may have been triggered
by the experiences and practices of Enron between 1993 and 2001 where the
company is known to have failed its creative accounting principles (Collegiate
Case Study, 2011). The accountants at Enron are known to have manipulated their
accounts to understate their tax obligations; hide their losses in their on and
off-balance sheet subsidiaries; inflate their stock prices; to inflate incomes
and profits; and to allow for the channelling of funds to themselves and to their friends (Collegiate Case Study,
2011). As can be seen from the cases, the practices were in most cases directed
at portraying misleading interpretations of profitability for purpose of
inspiring stakeholders’ confidence or to enable a higher bargaining power in
acquisition deals. The ulterior motives that accompany the practice of creative
accounting make the practice largely unethical and are the reason behind its
treatment as fraud in the USA (Jones, 2010).
The UK has also not been spared from the negative
effects of creative accounting. Some of the corporate failures that have
affected UK companies in the past have been closely linked to creative
accounting (Patsuris, 2011). Most of the companies that faced failure in the
recent past took advantage of the fact that the UK legislations do not
explicitly regard creative accounting as fraud unlike their US counterparts
(Shover and Hochsteller, 2006). Some of the adverse effects of creative
accounting have been observed in Poly Peck International Plc, Tesco Plc, and
Rentokil Initial Plc. The application of creative accounting in relation to
Poly Peck International Plc (PPI) related to their use of off the balance sheet
financials through which they established off the balance sheet subsidiaries
which were set up in the Cayman Islands
(Yeoh, 2007). These subsidiaries enabled PPI to access funds with more ease
which propelled their accelerated acquisitions. This subsidiary allowed the
company to hide its debts and therefore portray its financial position as
better than it actually was. For instance, after the administrators were
appointed for the corporation, they discovered that whereas the company had
reported a net assets record of £ 933 million, the actual position was that
there was a deficit of £ 551 million owed to creditors meaning that the company
had been in bad standing long before it was discovered and that the off-the
balance sheet subsidiary was used to cover up the situation through the use of
creative accounting (Yeoh, 2007). The practice of recognising assets and income
from subsidiaries without the ability to acquire such funds is regarded by
scholars as unethical and forms the basis for the condemnation of the practice
(Yeoh, 2007). The use of off the balance sheet subsidiary by Tesco can be
quoted as a successful use of creative accounting where the subsidiary enabled
the company to remain liquid and helped it to stabilise its operations and to
grow into one of the largest retailers in the UK (Yeoh, 2007).
The recent corporate scandals in relation to
accounting malpractices and ‘legally allowed’ creative accounting in Hong Kong
and China are credited for some of the corporate failures in the country. One
such corporate is Hong Kong’s Satyam Computer Services whose accounting practices
were characterised by fraud and manipulation with the total figure of
manipulation amounting to RMB 3.53 billion (Chen, Hu and Xiao, 2010). The
company was accused of engaging in shady deals and exaggeration of financials
as well as the delayed recognition of debts in order to make them appear more
profitable (Chen, Hu and Xiao, 2010). A wave of accounting manipulations among
corporate organisations in China has been on the rise and has been behind the
wavering confidence that investors have in their securities (Opdyke, 2011).
Another Hong Kong based company to be involved in accounting manipulation is
Longtop Financial Technologies. The accounting practices in the company were
characterised by underrating the expenses while exaggerating the revenues in
order to portray the company in good standing (Duh, Xiao and Chow, 2009). This
was also accompanied with numerous off – the – balance sheet transactions which
added weight to the manipulation prompting the resignation of their independent
auditor (Duh, Xiao and Chow, 2009). The coming into light of the manipulations
prompted investors to avoid their securities leading to a serious plummeting of
the same.
As
can be seen from the case studies, various motives exist for the engagement in
creative accounting with most of the motives being similar in Hong Kong and in
the United States and the United Kingdom. However, there seems to be an extra
motivation for participation in the same in the China and Hong Kong (Duh, Xiao
and Chow, 2009). This may be due to the fact that the implementation of
policies in accounting in the two regions is mainly hinged on ensuring tax
compliance rather than ensuring that the financials present a picture of ‘true
and fair value’ (Stolowy and Breton, 2004).
The accounting standards in China have recently been upgraded to
international standards but the regulatory agencies appear to lag behind in
ensuring compliance. This is evident from the comments of international
accounting bodies operating in China who decry the fact that regulators seem
stuck to the idea of auditing for the sole purpose of ensuring tax compliance
as opposed to ensuring a larger reflection of true and fair value (Ding, Hope,
Jeanjean, and Stolowy, 2007). Moreover, one of the main motivators for creative
accounting is the reduced risk of being apprehended. The Chinese market is
vibrant and still on a constant growth path with companies recording favourable
projections for future performance (Chow, Duh and Xiao, 2007). Such an outlook
makes accountants more comfortable with accounting manipulation which they
undertake in the confidence that the organisations are bound to perform well in
the future and allow them to cover up the manipulations.
As can be observed from the cases quoted in this
chapter, creative accounting is done to suit various prevailing desires of the
executives. The use of off the balance sheet loans allows an organisation
struggling with crippling debt the opportunity to boost its liquidity and
profitability (Agarwal, 2008). With such an improved image, it comes easier for
such an organisation to recover through the sale of its enhanced stocks; and
other avenues whose availability may have been limited by their dwindling image
(Agarwal, 2008). The same motive informs the use of off the balance-sheet
subsidiaries as was the case with Poly Peck International (PPI) and Tesco in
the United Kingdom. Most executives aim to project their companies as more
profitable although there may still exist motivations to the contrary. For
instance, where executives are offered the option of acquiring the securities
of their companies, they may want to cast the organisation as less profitable
in order to bring down the prices of the shares (Shover and Hochsteller, 2006).
This would enable them to buy into the company at lower prices before the stock
values return to their normal price range.
Perhaps a more common source of motivation is the need
to reap personal benefits as contained in the employment contracts of most
senior executives. Where remuneration is tied to the profitability, executives
may want to exaggerate profitability in order to assure their performance
bonuses (Shover and Hochsteller, 2006). As has been seen in the cases above,
manipulation to affect profitability can be done through the delay in recognition
of expenses, prompt recognition of revenues (especially where such recognition
is done before the customers make the final decision to purchase), recognition
of revenues not accruing to the organisation such as revenues belonging to
resellers, recognition of barter deals as revenue, and deal swapping among
others (Jones, 2010). Creativity can also be done to offer a company the
bargaining power when negotiating a deal or an acquisition. This is observed in
the case of AOL Time Warner where AOL engaged in manipulation to show that it
was on a constant growth pattern.
From the examples above, it can be deduced that motivation for creative accounting cut
across the board with very little distinction between motivations in specific countries. This underscores the need to take a
common approach towards the eradication of the practice on an international
scale and has provided the basis for the adoption of International Accounting
Standards in China and Hong Kong.
Chapter Four: The credit crunch and its degree of
severity in selected countries
The severity of the global financial crisis in any
particular country may be associated with the applicable accounting standards
and existing regulations. This chapter compares the experiences of the UK/USA
to those of Hong Kong/China with an aim to establish to what extent creative
accounting practices, accounting standards and prevailing regulatory provisions
influenced the severity of the credit crunch. The chapter also gives a brief overview
of the global financial crisis giving details regarding its genesis,
development and end. This chapter aims to demonstrate the fact that accounting
standards and regulations are crucial instruments for assuring stable and
sustainable economies.
The credit crunch is also known as the global
financial crisis or the subprime mortgage crisis and has its origin in the USA.
The genesis of the crisis was in the real estate sector where the growing
bubble in the housing sector collapsed triggering an economic crisis that later
spread to the rest of the world thus the term global financial crisis (Yao and
Chen, 2009). Several factors may be blamed for the occurrence of the crisis.
The crisis started in 2007 in the USA even though the global dimension of it
was realised in 2008 (Yao and Chen, 2009). The effects of this crisis were
severe and widespread and were characterised by sharp declines in demand for
products due to a decline in the disposable incomes of consumers; investor
apathy which resulted in lack of investment and a severe slowdown in the
activities of the various securities markets; massive failure of business
enterprises; and massive layoff of workers among other effects (Merrouche and
Nier, 2010). Countries in the West namely the USA and the UK bore the greatest
brunt of the crisis with many countries in Asia such as China only bearing a
pale comparison of the Western experiences (Merrouche and Nier, 2010). These
differences have a lot to do with the accounting practices and the regulatory
frameworks as well as the structure of the markets in the two distinct regional
setups.
The occurrence of the global financial crisis can
mainly be attributed to the practice of creative accounting backed by lack of
sufficient regulation in the USA and the UK (Francis, 2010). To start with, the
USA and the rest of the Western world had been embarking on a series of
systematic deregulation of their markets where business enterprises were
operating under less supervision as time went by (Merrouche and Nier, 2010).
The state-controlled regulation was steadily being replaced by industry
standards which were mainly arrived at through negotiation and therefore
largely a reflection of the private interests of the entrepreneurs (Pritchard,
2011). When this practice became rampant in the financial sectors, it
encouraged banks to engage in practices that were unsound such as excessive
subprime lending and predatory lending (Pritchard, 2011). The conditions for
acquisition of funds were also dramatically lessened due to the availability of
disposable funds after the reduction of the Federal Reserve rates to a dismal
1% (Merrouche and Nier, 2010). This led to excess liquidity in the market which
in turn led to the rise of prices in the real estate market hence fanning the housing bubble. When the housing
bubble eventually collapsed as a result of unsustainable high prices, massive
defaults rocked the financial sector industry leading to the infamous global
financial crisis (Merrouche and Nier, 2010). As can be seen from the
illustration above, the housing bubble in the USA and the UK were fuelled by
the practices of a largely unregulated financial services sector where
increased liquidity contributed to the rapid price rises in real estate
(Aikins, 2009). The Chinese experience was somewhat different with the
activities of the leading banks largely regulated by the state and liquidity
mainly kept in check. Even though there were general price rise in the real estate prior to the financial crisis, the
prices had not reached the unsustainable levels observed in the United States
(Overholt, 2010). Moreover, the Chinese traditional culture that had been
emphasising less the importance of having wealth saw a large proportion of the population largely uninterested in
acquiring houses as opposed to the West where most individuals dreamed of at
least owning more than one house (Overholt, 2010). The Chinese monetary policy
may also have been responsible for the disparity to a limited extent. Fuelled
by cheap Chinese exports, China’s foreign reserves were on a dramatic rise and
China chose to offload such amounts by buying bonds from countries such as the
USA instead of offloading the excess liquidity within its economy (Overholt,
2010). This created excess liquidity in the USA while China retained manageable
levels within its economy.
The most distinct elements of creative accounting in
the UK involved the securitisation of accounts receivables and the manipulation
of accounts that amounted to fraudulent underwriting or property insurance
(Francis, 2010). Fraudulent underwriting in most cases included the
exploitation of the provisions for revaluation of property to reflect the
values of the properties at amounts other than the true value depending on the
financing needs of the loan applicants (Francis, 2010). This certainly led to
poor pricing of the risks which left the financial sector vulnerable in light
of the fact that over 60% of the insurance underwritings just before the crisis
were actually noted to be fraudulent (Merrouche and Nier, 2010). The assets
that were securitised included: loans, auto loans, mortgages, and credit cards
among others. This practice entailed the packaging of the loans offered to
customers into a form that would enable the banks to sell the stocks for them
to investors. The securitisation certainly led to a realisation of the
receivables much earlier than recognised in the books hence creating a false
impression on the status of the organisation (Moldovan, Achim and Bota-Avram,
2010). Securitisation in China was however quite limited due to the fact that
the state owned corporations who are the leaders in the industry had no
motivation to engage in such a practice. Securitisation is mainly done to boost
the liquidity of the corporations and the state-owned corporations would only
need to request for more funds from the government in order to obtain more
funds (Overholt, 2010). The small banks on the other hand feared engaging in
the practice as they would be vulnerable to sanctions without the benefit of
protection from the larger banks. The emergence of the shadow banking
sub-industry in the USA and
the UK also contributed significantly to the crisis. The shadow banking
sub-industry included players such as investment banks, insurers, money market
funds providers and the providers of hedge funds (Overholt, 2010). The existing
regulatory frameworks catered for the main banking sector while effectively
leaving the shadow banking sector completely unmonitored (Norris, 2011). This
certainly rendered their irregularities unnoticeable hence further weakening
the banking sector. Various loopholes also existed in the accounting standards
that allowed banks to manipulate their financials to present information that
did not necessarily reflect a fair view of their financial health. Some of the
most common practices included the exaggeration of profits, deal swapping, and
securitisation of the assets (Francis, 2010). The financial sector was as a
result appearing stronger than it actually was hence reducing any need to
implement reforms in the sector before hand. This rendered the sector unable to
pull the USA and the UK out of the recession forcing them to rely on the heavy
stimulus package funds which proved inadequate as the activities exposed in the
sector had already damaged the credibility of the financial services sector
(Francis, 2010).
As opposed to their Western counterparts who had been
on an overdrive to deregulate their markets, especially the financial services
industry, the Chinese remained essentially well regulated. Having emerged from strict application of
communist practices, the Chinese government was gradually privatising and
giving up control to private investors. The financial services sector was
however viewed as too strategic to let go of as it was key to ensuring that the
economy continued to run as desired (Overholt, 2010). This was also in
recognition of the fact that the Chinese judge their government based on the
economic performance (Overholt, 2010). Even though China had embraced open
market policies, it applied such policies to most sectors of the economy while
holding on to some of the sectors they considered as strategic to their
interests (Lo, 2011). One such sector is the financial services sector. In
China (and Hong Kong), the largest banks which control over 75% market share
are either fully or partially state-owned (Lo, 2011). The prevailing practices
in such institutions were therefore presumed to be for ‘public good’ giving the
executives in such institutions less incentives to engage in account
manipulation or creative accounting (Morrison, 2009). The proportion of
privately owned providers of financial services whose practices may have been
motivated by private interest was therefore so small that their engagement in
creative accounting would not be sufficient to adversely affect the
economy. The nature of creative
accounting in application in China and Hong Kong was significantly different
from that in the USA and UK in the sense that, whereas the financial services
sector of the Western countries is almost fully owned by private interests, in
China it is almost fully
owned by the state (Morrison, 2009). This fundamental difference in the market
structures informs the attitude towards creative accounting and its effects on
the economy. For instance, the state owned banks in China obtain their funding
from the government who is their main creditor (Overholt, 2010). These loans
are in turn loaned to the public and private enterprises as demand arise. Where
market upheavals inhibit the public’s ability to repay their debts and the
rates of default become more than the banks can bear, the state finds political
motivation to write off the debts allowing the banks to do the same (Overholt,
2010). The banks therefore remain largely liquid irrespective of the
circumstances and creative accounting is used to make such amounts to disappear
from the banks’ financials. In many cases, the state may also opt to do an off
the balance sheet grant which is then used to offset to outstanding loans and
to keep the banks liquid without the ‘unnecessary’ burden of accounting for the
funds (Moldovan, Achim and Bota-Avram, 2010). This ‘healthy’ interaction
between the financial sector and the government helps inspire confidence in the
sector and keeps the economy relatively stable. The privately owned banks in
the West on the other hand cannot enjoy such privileges in that defaults reduce
the disposable funds available to the banks and where such defaults are
overwhelming, the markets have to contend with low liquidity and recession sets in
(Overholt, 2010). These differences therefore give strength to the assertion
that the advancing of private interest is the main motivation for engaging in
creative accounting. Where little or no incentive is found, the executives
prefer to follow the letter and spirit of the accounting standards.
The differences in accounting standards between the
Chinese/Hong Kong and the USA/UK may have also played a significant role in
‘checking’ the levels of accounting manipulations practiced. While the Chinese
accounting systems mainly place emphasis
on the cost model of evaluation which is largely straight forward and less
prone to manipulation, the UK and the USA allow for the use of revaluations
which are prone to manipulation by the creative accountant. In addition,
differences in approach when it comes to equity system as opposed to
proportionate consolidation whose provisions allow for manipulation depending
on the aims of the accountant.
The financial crisis in the USA which eventually
affected international markets drew
the attention of regulators to the fact that regulation should be effective
both domestically and internationally. This realisation has led to the widespread
calls for countries to align their accounting practices along the International
Accounting Standards and to take a common approach towards the eradication of
the adverse effects of accounting manipulation (Norris, 2011). Towards this
end, Hong Kong has already embraced the mainland Chinese accounting standards
which are largely compliant with the IFRS (Lehman, Lee and Xu, 2011). However,
there persist calls for the Chinese to exercise more effective supervision of
the accounting practices of the organisations operating under their
jurisdiction (Lehman, Lee and Xu, 2011). Even though the scandals have not
reached levels where it would be seen as threatening the financial stability of
the whole economy, accounting scandals among the companies in Hong Kong and
China have been rampant and in need of prompt control before such concerns are
translated into a collapse of confidence
among investors.
As can be seen from the provisions of this chapter,
creative accounting indeed played a role in the genesis of the global financial crisis and played a role in determining
the severity of the same. The market of the USA and the UK faced a more severe form of the crisis than in China or Hong
Kong whose financial services industry were still tightly under the control of
the state.
Chapter
five: cultural differences between Hong Kong and Western countries and their
influence on accounting practices
5.1
Chapter introduction
The practice and attitude to the practice of accounting and other business is a function of the cultural setting within which
organisations operate. There exist fundamental differences in the cultural
beliefs between Hong Kong/ China and USA/ UK. This chapter explores these
differences with a special emphasis on the philosophies of Confucianism as opposed
to those of free market mechanical behaviour. The practice of creative
accounting allows the accountants to make decisions on whether or not what they
do may be considered as morally sound or not. This makes cultural contexts (on
which business ethics rely) to be critical to the accounting practices.
5.2
Cultural foundations in
Hong Kong compared to those of the
UK/USA
China has established itself as the epitome of the
Asian thought as opposed to the Western thought and its philosophies have
mainly been informed by Confucianism which emphasises the centrality of the
moral code in any human society (Buckley, Walthall and Palais, 2006).
The philosophy of Confucianism is closely associated
with one of the most famous Chinese philosophers named Kong Qiu popularly
referred to as Master Kong (Theobald, 2010). The teachings of this philosopher became so popular that they were elevated
to the level of being the state doctrine during the Former Han Period which
lasted between 206BC to 8AD (Theobald, 2010). This fundamental elevation
resulted in a firm belief in the philosophies, a belief that still largely
defines the essentials of the Chinese culture to date. The philosophy has
remained dominant in the Chinese culture despite the pressure from the Western
culture whose influence in China has been on the rise in the face of increased
globalisation. The adoption of both socialist and Confucian philosophies
weakened it significantly. However, the general movement towards the
abandonment of the socialist tendencies led to a renewed prominence of
Confucianism as the unifying factor of the Chinese (Gier, 2001).
The famous saying that largely summarised the essence
of the whole philosophy is that a small man with virtue is better than a noble
with no virtue (Gier, 2001). Confucianism emphasised the doing of good deeds
that were essentially good for the general public. For instance, one of the
acclaimed members of the Chinese royal family, the Duke of Zhou, was branded as
the first Confucian due to his benevolence. He is known to have possessed
righteous virtue and bore great loyalty to his brother and even went on to
govern on behalf of his nephew where he used his time at the helm of power to
stabilise the kingdom for his nephew as well as bringing various advantages to
the wider population through the establishment of a reign of peace (Theobald,
2010). Such is the virtue that earned him the favourite accolades by the
Confucians.
The Confucius philosophy envisages a righteous
government whose sole purpose is to benefit the public (Clarke, 1997). This
philosophy envisions leaders as the models for righteousness whose example must
be followed by the rest of the population. When it comes to taxes and other
revenues collected by the government, Confucians take the view that these
collections were only to serve the purposes of enriching the public and not to
exploit them (Theobald, 2010). The ministers of government were similarly seen
as servants whose main goal was to work together with the rulers to ensure that
their people were happy. Where the rulers failed to live up to the expectations
of the people as far as selflessness was concerned, the people and the
ministers bore the duty to criticise them with an aim to making them change for
the better (Nitsch and Diebel, 2011). The development of this philosophy was
against a background of incompetence, greed, usurpation, war, negligence, and
disloyalty in government ranks. The philosophy therefore comprised of an
idealised past based on the ancient belief on how rulers conducted affairs: a
practice believed to be a sharp contrast of what was happening at the time
(Nitsch and Diebel, 2011).
The philosophy recognises the unique contribution of
every member of society where a clear hierarchy is drawn and all members of are society called upon to behave in accordance with
their designated positions (Theobald, 2010). Duties were to be executed
accordingly although the underlying principle would have to be kind
heartedness; the basic principle for Confucians. This principle emphasises that
individuals must at all times be responsible for others and must act with
utmost sincerity in all situations. A good person would be selfless and would
help hose who need it long before any requests were made to them (Gier, 2001).
This principle applied to both the leaders and the people. The rulers would be
taught about virtue intensively by experts from birth. At the family situation,
the father would assume the ruler’s position and lead their families with
utmost benevolence and sincerity making the whole society a happy society
(Gier, 2001). The service to others was therefore supreme to any other forms of
service. This explains why Confucianism does not recognise the existence of a Supreme Being or in the least sense the importance of
rendering any kind of service to them.
As can be seen, Confucianism emphasised the practice
of moral codes and the value of the person was to be derived from their
application of the moral code. Every member of the society owes a duty of care
to the others. This situation can be applied to the practice of business. In a
situation where there is information asymmetry, it is reasonably easy for the
business executives and accountants to paint an image about the company that is
not entirely true (Shover and Hochsteller, 2006). This is due to the fact that
different stakeholders to any business tend to have conflicting interest and it
is therefore easy for the accountants to manipulate the information such that
the interests of one or two groups are served at the detriment of the other
stakeholders. For instance, the need to portray higher levels of profitability
than there actually is may be profitable to employees who may get pay
increments and bonuses while being detrimental to the investors where
investment decisions are made without accurate calculation of the risks
involved (Stolowy and Breton, 2004). This is an unethical application of
accounting. The emphasis on the duty to be responsible for others as stipulated
by the Confucians may be the only appropriate solution to curb this vice. This
is due to the fact that motives may be difficult to determine where the
evidence is not obvious or where the levels of manipulation are arguably
limited but never the less; misleading (Fiester, 2011). Some of the motives for
engaging in creative accounting go directly against the beliefs held by
Confucians. For instance, whereas Confucians encourage selflessness and actions
characterised by sincerity and responsibility for others, manipulations to
mislead stakeholders for the company’s or personal benefit denotes selfishness
and a lack of concern for others (Theobald, 2010). This fundamental belief is
believed to be the reason why the practice of creative accounting in China may
have yielded less disastrous results than experienced in the USA and the UK.
Even though the firm belief in Confucianism in China is not as strong as it has
been traditionally, it remains the fundamental belief system and therefore more
influential than any other. The interaction between the Chinese and the
international markets have somewhat transformed the bare minority of them into
self seeking individuals modeled alongside the Western capitalist philosophies
(Lo, 2011). The Confucian philosophy also informed some fundamental government
practices where the state would take reasonable measures to ensure that the
corporations do not override the public good while conducting their business.
The deregulation of market operations was therefore very slow with the
government maintaining control over some of the crucial elements of production
such as the availability of finances in the market (Lo, 2011). The government
was therefore able to coordinate its activities with the aim ‘to serve
responsibly’ by controlling the level of liquidity in the market hence keeping
price changes within manageable levels. This perhaps explains why the financial
crisis only affected China and Hong Kong marginally, when compared to the adverse effects of the crisis in
the UK and the USA.
The free market as envisioned by the Western states
envisions an environment where businesses conduct their affairs with no or
minimal government regulation (Ayal and Karras, 1998). Ideal free markets are
virtually non existent in today’s world. However, this term is used where the
government participation is restricted to taxation and/ or the enforcement of
contracts and ownership of property. As opposed to Confucianism where
selflessness is acclaimed, the free market approach advocates the pursuit of
personal goals provided that such pursuit does not significantly inhibit the
rights of others to do the same (Ayal and Karras, 1998). This results in a
capitalist economy where individuals take all necessary measures to enrich
themselves through the exploitation of the forces of demand and supply and strategic
positioning in such markets. The steady movement towards the deregulation of
the financial services sector in the USA and the UK since the 1980s shows the commitment by the two countries in
promoting the free market ideals as much as possible (Aikins, 2009). The
proponents of the move argue that deregulation encourages innovation in the
industry hence leading to economic development.
One of the main prerequisites for the good performance
of the free market is the availability of information which is free and
accessible to all those who need it within a reasonable time (Feinman, 2007).
However, this feature becomes difficult to find in the so called free markets
due to the concept of information asymmetry. Information asymmetry refers to
the situation where the information at the disposal of one party is often
unknown to other parties at a particular time (Fiester, 2011). For instance, it
is only the business executives that can have information about the true
functioning of the business in terms of its financial status. Other
stakeholders only get to obtain such information from company publications and
annual statements long after the executives were aware of it (Fiester, 2011).
This asymmetry gives such executives the opportunity to shape stakeholders’
opinions in the manner they deem fit.
Creative accounting is essentially an ethics issue and
this forms the basis for the consideration of business ethics in relation to
the free market system (Stolowy and Bane, 2004). Under this system, the pursuit
of self gain is acclaimed and the practice of ethics is done in accordance with
the laws or in pursuit of personal interests. The free market philosophy does
not emphasise any cultural values above the established business practices in
law (Feinman, 2007). Ethical practices are therefore broadly interpreted as
those that do not result in criminal offences
of those that would not normally lead to the filing of civil cases. Business
ethics under this model is also seen as an avenue to maximise profits for the
individual (Feinman, 2007). The underlying basis for this assertion is found in
the fact that consumers view businesses that are deemed to be more ethical more
favourably hence more business volumes are available to such entrepreneurs. The
problem with this approach to business is that ethics cannot be fully regulated
by law or for profitability reasons. The laws tend to provide a myriad of
loopholes that can be exploited by the creative accountant to portray an image
that is not true and fair (Jones, 2010). In most cases, only the accountants
know when they are being ethical or not. This explains why the practice is
significantly higher in the West than in Hong Kong/ China where cultural
beliefs help keep the practice in check. The influence of cultural beliefs on
the practice of accounting and the consequent occurrence of financial crisis is
therefore well established.
Chapter
six: Harmonisation of accounting practices in Hong Kong with the international
accounting standards
6.1
Chapter introduction
There have been decisive steps taken towards the
harmonisation of accounting
standards in China/ Hong Kong with international
accounting standards. Several steps have already been taken to ensure
compliance and this chapter outlines such measures. The chapter also outlines
the merits and demerits of such moves given that the current accounting
practices in China/ Hong Kong may be viewed as the tool that enabled them to
avoid the adverse effects of the global financial crisis.
6.2
Harmonisation of accounting standards
Harmonisation
of accounting standards is said to be central to the process of rapid
globalisation and China has been keen to position itself as a key player in
global business (Zhenfen and Yi, 2010). In terms of harmonisation of accounting
standards, it has been done at three levels. To begin with, the international
accounting standards themselves are a harmonised version of the accounting
models in a number of countries which include the United States, Continental
Europe, United Kingdom, and Latin America (Weber, 2011). By June 2011, the
International Accounting Standards had been adopted across 106 countries and up
to 31 standards issued (Yu and Qu, 2011). Having started in 1973, the
harmonisation process only seemed to factor in the accounting practices in
other regions except China and Asia (Yu and Qu, 2011). This may to a
significant extent explain why the members of the population and especially the
local government agencies tend to treat the standards as alien and hurtful to
the pride of the Chinese. However, in the minds of policy makers in the
country, the move is worth the risks associated with it. For instance, the
attraction of investors into the country enables development of its economy at a higher rate hence creating
employment and encouraging further innovations useful to compete in the
international market (Wang, 2005). Under normal circumstances, investors attach
a significant premium to the interest
required from undertaking investments in a country whose accounts are not easily
understandable. This pushes up the cost of obtaining capital making it
difficult for the companies in such countries to obtain the capital needed for
expansion and growth. This assertion is based on the assumption that investors
are generally rational and will always avoid highly risky ventures or attach an extremely high premium on the perceived
high risks (Deloitte, 2002). Harmonisation solves this problem by ensuring that
financial statements are well understood across the board thereby giving investors the confidence needed to inject their money into any
given venture.
Harmonisation also targets areas such as the
standardisation of the operations of financial markets and accountability
within government (Deloitte, 2002). The push for harmonisation of accounting
standards is believed to have the process of globalisation as its launching
pad. With increased globalisation and frequency of movement of capital and
products across international borders, countries find it necessary to ensure
that they can clearly understand the accounting mechanisms used by their
neighbours (Ong, 2005). This is due to the fact that such accounting practices
have a bearing on the prices of the products- a key component of the elements
of global competition. The push to harmonise the accounting systems in Hong
Kong and China is therefore two-way: by the Hong Kong and Chinese officials in
order to be the destination of choice among foreign investors; and by the
international communities who find it necessary to monitor the accounting
systems to ensure that the low prices which characterise Chinese products and
which contribute the most to their popularity are arrived at fairly with no
unethical practices in them (Ong, 2005). The regimes in China and Hong Kong
have acknowledged that harmonisation of accounting practices is necessary due
to the fact that they would need to inspire international confidence before
they can exploit the benefits of globalisation. For instance, China which has
in the recent past been characterised by rapid growth in liquidity needed to
offload some of this liquidity into the international market in order to avoid
inflating local prices beyond acceptable levels (Qu and Gao, 2006).
Harmonisation must be distinguished from
standardisation. Harmonisation reduces the number of alternatives available to
the accountants in the course of doing their work (Yu and Qu, 2011). It however
maintains a high level of flexibility in the practice of accounting among the
different systems (Yu and Qu, 2011). This is as opposed to standardisation
which simply calls for the elimination of alternatives to the creation of a uniform accounting standard. Harmonisation is therefore more popular than
standardisation due to the fact that it allows different countries to retain
their identity to a significant extent while also ensuring that the information
produced by their institutions is understandable across the board (Qu and Gao,
2006).
The move to harmonise the Chinese and Hong Kong accounting principles to
those in the West is fundamentally flawed. To begin with, the attitude towards
accounting and the perceptions on the ethics of the practice are informed by
the cultural background of the people, namely; Confucianism (Theobald, 2010).
The predominant philosophy in Hong Kong emphasises the fact that humans earn
greater value to themselves when they prove to be selfless and responsible for
others. This philosophy therefore places the responsibility for sincerity in
the information presented about the companies by the accounting officers. It has been hailed as the most effective tool
for ensuring ethical practices. This is due to the fact that ethical behaviour
is best determined by the individuals who must refrain from utilising the
existence of information asymmetry to mislead the users of the financial
statements (Fiester, 2011). The international practices which are largely
reflective of the Western models on the other hand do not hold a predominant
cultural position and view ethics as an extension to the pursuit of personal
interests. This assertion finds its backing in the fact that consumers
generally tend to be more supportive of organisations whose practices they see
to be ethical (Fiester, 2011). This makes ethical organisations more
sustainable in the long run hence providing the rationale for ethics. However,
being that there is no guiding moral code; ethics is restricted to the body of
laws which are in most cases flexible enough to allow for manipulation of
accounts to suit the interests of a select number of stakeholders.
The disparity in the levels of severity of the global
financial crisis between China and the West is cited as the basis for the
arguments against harmonisation of accounting standards (Zhengfen and Yi,
2010). Critics continue to hold the opinion that the Chinese model should have
been the one to be adopted instead of the international standards due to its
proven level of effectiveness in the last financial crisis. In their view, the imposition of the ‘Western
dominated’ international accounting standards in China was an act of political
chauvinism which sees the Western countries disregard the sound systems found
in the East from time to time (Zhengfen and Yi, 2010). They further observe the
Western countries have been keen to exploit their possession of great amounts of capital and technical knowhow to impose
their practices on the less affluent countries. Proponents of harmonisation on
the other hand hold the view
that even though the financial crisis may have been less severe in China than
in the West, their accounting systems remained fundamentally flawed and were
bound to land the globe into yet another serious if not a worse global
financial crisis, especially in light of the fact that China is growing in
stature as far as the world economy is concerned (Yu and Qu, 2011). In their
opinion, cultural premises are an inadequate guard against unethical business
practices. There is a firm belief that humans tend to be selfish in nature and
when the desire to remain benevolent comes into direct conflict with the need
to protect private interest, the latter would prevail. This would mean that in
the increasingly competitive global environments, the Chinese are bound to
relax on their firm adherence to the principles of Confucianism and embrace the
gains that capitalism offers the individual (Nitsch and Diebel, 2011). The
principle of selflessness is bound to give way to selfish interests with time.
The recent development in the Chinese and Hong Kong markets where there is an
increasing number of millionaires is illustrative of this (Yu and Qu, 2011).
Such millionaires generally drift away from the traditional lifestyle of
modesty and selflessness to lavish lifestyles hence contributing to the rapidly
growing luxury goods market which is currently the second largest in the world
(Yu and Qu, 2011). In the increasingly globalised world, cultures are on a
general movement towards convergence and it will be increasingly difficult for
cultures to exist in isolation from the
trends expected to be in favour of private interest. It therefore would appear
that the merits for harmonisation may outweigh the risks associated with the
same hence forming a strong case for harmonisation.
Chapter
seven: Conclusion.
The practice of creative accounting may be facilitated
by two main factors namely: the existence of information asymmetry and the lack
of financial analysis skills among the users of the financial information.
Information asymmetry refers to the situation where one party is privy to
information that the other parties do not know about. This enables them to
manipulate such knowledge to advance their goals at the expense of the other
stakeholders hence making the practice largely unethical. Creative accounting
in many cases complies with the letter of the law while defying the spirit of
the same. For instance, where the law allows for the use of the cost model and
revaluations in determining the value of assets, the creative accountants may
exploit the provisions of both models to either inflate or deflate the asset
values from one year to another.
This research has established that self interest is
the highest motive for engaging in creative accounting. Creative accountants
may want to portray their businesses as more profitable than they actually are
in order to attract performance based incentives or to attract investors to
their businesses. This is due to the fact that investors are known to prefer
investing in companies that are seen as stable and therefore more likely to
provide the desired returns. The portrayals of good financial standing can be
done through the recognition of revenues before they are realised,
securitisation to boost the cash flow balances, delays in the recognition of
liabilities, understatement of liabilities, overstatement of assets, and
recognition of third party revenues among other measures. This paper
establishes that there are very few distinct country-based motives for engaging
in creative accounting. Most motives appear to be similar across the board.
However, the differences in the prevalence of the practice may be informed by
the nature of regulatory frameworks in the different economies. For instance,
the Western countries which are largely unregulated tend to see more of the
practice than China and Hong Kong which still maintain a strong level of
regulation of companies. With the
largest market share under the control of state-owned corporations, the
government maintains a strong influence over the economy. This is in contrast
to the Western free market ideals which see most people take steps to advance
their own private interests.
The main differences in accounting standards related
to the costing of various items. While the Chinese emphasise the cost model, their Western counterparts allow for models
for revaluation which in turn provide the accountants with the flexibility
needed for creative accounting. The proportionate consolidation accounting
method which characterises accounting for joint ventures is also prone to
manipulation as opposed to China’s equity method which is simple and
straightforward.
The study recognises that the prevalence in creative
accounting in Western countries may have contributed to the severity of the
financial crisis which was more serious than that in China and Hong Kong. While
China’s use of creative accounting was notably well targeted and credited for
China’s remarkable recovery from the crisis, the creative accounting practices
in the West played a contrary role leading to fundamental weakening of the
financial systems, a fact that significantly contributed to the severity of the
global financial crisis in such countries.
Creative accounting is viewed differently in different
countries. In the USA, creative accounting is considered to be fraud while in
the UK the practice is generally acceptable except in situations where such a
practice proves to be largely unreasonable. In China/ Hong Kong, creative
accounting is judged on the basis of its effects on the state with the
practices seen as contrary to the will of the state sanctioned more harshly.
Some of the common creative accounting practices in the UK and the USA have
involved wrongful recognition of third party revenues, irregular use of asset
revaluation and disposals, and the undermining of liabilities through
discounting or total lack of recognition of the same.
Creative accounting may be blamed for the occurrence
of the global financial crisis to a significant extent. The crisis hit
different countries with different levels of severity with the Western
countries facing the harshest part of it. Having been sparked by the housing
bubble in the USA, the crisis went on to paralyse the economies; first in the
USA and then to the UK before advancing to affect the rest of the world. The
move towards the deregulation of the markets is known to be responsible for the
runaways practices that saw the financial systems weakened fundamentally.
Exaggerations and manipulations in the financial services sector went largely unchecked leading to a situation where
risks were wrongly priced hence leading to a weakened financial system. Another
most prevalent creative accounting practice in the West involved the use of
securitisation where banks repackaged accounts receivables into packages that
were then sold to customers. This would serve the purpose of boosting the companies’
cash flows thereby depicting them as more stable than they actually were. This
practice was however not prevalent in China/ Hong Kong due to the fact that the
largest banks which would normally shape activite in the economy were state owned. With the state being their biggest
creditor and investor, they had insufficient motive to engage in the
securitisation. The property bubble in China/ Hong Kong was also within
sustainable levels. This is due to the fact that the state continued to play an
active role in controlling the level of liquidity in the market. Instead of
injecting the excess liquidity into the market, the government opted to offload
such funds in the international bonds market by buying securities from
countries such as the UK and the USA. This step helped ensure stability in
their economies.
Creative accounting is largely an ethics issue and
therefore goes to the heart of the cultural belief systems. This brings the
fundamental differences in the philosophies between the Chinese and the Western
countries where the former belief in the Confucian philosophies with the latter
largely advocating free market behaviour. Confucian philosophy emphasises
the importance of upholding moral standards. People derive their true value
from their adherence to the moral code where they are encouraged to be selfless
and always assume responsibility for others. This outlook places the duty of engaging in ethical behaviour on the
individuals who are expected to use their positions to contribute to the public
good. The practice of creative accounting is therefore frowned upon except in
situations where it serves the purposes of the state which by extension is
described as ‘the public’. This emphasis on Confucian principles influences the
organisations to refrain from ‘creating’ their accounts. The free market
philosophies on the other hand emphasise the importance of less regulation of
business practices in the market. According to the proponents of this
philosophy, free market philosophy encourages innovation. Regulation is seen as counterproductive and should
therefore be restricted only to the protection of private property rights,
enforcement of legal contracts, and taxation. Under this system, the pursuit of
private interests is encouraged hence creating a good platform for creative
accounting as players seek to reap the highest level of benefits attainable.
The influence of globalisation has seen various
attempts made by China to harmonise its accounting systems with the
international systems. This move is hailed as positive when it comes to
attracting investors who tend to have more confidence with evaluating financial
information that they can easily understand. The harmonisation greatly
contributes to the internationalisation of the accounting standards hence
giving China the market positioning required to exploit the benefits of
globalisation. However, there have been various arguments raised against the
adoption of international standards with critics holding the opinion that the
Chinese accounting practices had been proven superior due to China’s rapid
recovery from the financial crisis. In their argument, the adoption of
international standards may potentially erode the cultural values of the
Chinese. Proponents of the process however hold that in the globalised world,
divergent cultures are likely to converge around the pursuit of private
interests and countries must therefore prepare for such a reality through the
adoption of appropriate accounting standards.
Creative accounting has been found to cause more harm
than good and should therefore be regulated against with a pragmatic approach
that aims to eradicate the practice across international borders.
For more theory and case studies on: http://expertresearchers.blogspot.com/
For more theory and case studies on: http://expertresearchers.blogspot.com/
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