EFFECTS OF CREATIVE ACCOUNTING PRACTICES ON AUDIT RISK AND AUDIT FAILURE IN NIGERIA

ABSTRACT

This study sought to examine the effect of creative accounting practices on the audit of financial statements. The conflict of interests within corporate firms has been largely linked with creative accounting  behavior.  Management  may  engage  in  fraudulent  financial  reporting  to  boost earnings and to present sound and stable financial performance. The independent opinion of the external  auditors  thus  provides  a  reasonable  assurance  to  the  owners  that  the  financial statements are free from material misstatements. In spite of this, financial reporting scandals and  large case frauds have been  reported in  big  business Corporations around  the globe. External auditors have either failed to detect creative accounting techniques used or colluded with management to manipulate the financial statements. Book entries such as provisions and reserves were the common techniques used by the affected Corporations. Therefore, this study aimed at ascertaining the impact of creative accounting practice on audit failure; impact of creative accounting on audit risk; impact of provision for depreciation and deferred tax on firms’ performance. Using the responses from a sample of senior audit managers of the big four audit firms in Nigeria, the Pearson’s Chi Square method of data analysis was used to determine whether there is a significant association between creative accounting practice and audit risk and whether there is a significant association between creative accounting practice and audit failure. Also, ex-post factor design was used to extract a time series data for 10- year period from the   Nigerian Stock Exchange Fact Book to compute two (2) sets of ratios; Returns on equity and Long term debt to equity ratios. The provision for depreciation and deferred tax were reclassified while computing the ratios. The results were estimated using the Wicoxon Signed- Ranks methods of data analysis. The study found that creative accounting practice has a positive and significant effect on audit failure (X2C = 24.861> X2t  = 9.49; P < 0.05). Creative accounting practice has a positive and significant impact on audit risk (X2C = 14.139 > X2t = 9.49; P < 0.05). Provision for depreciation has a positive and significant impact on corporate performance (ZC   = 8.730 > Zt    = 1.96; P < 0.05) and   provision for deferred tax   has a positive and significant impact on corporate performance (ZC  = 8.224 > Zt   = 1.96; P < 0.05). These imply that creative accounting affect the audit of financial statements. The study therefore recommends that detection of creative accounting techniques should be given more attention by external auditors. Appropriate sufficient audit evidence should support audit opinion. Flexibility permissible by accounting standards should be minimized and those charged with governance should improve their oversight and monitoring roles.

CHAPTER ONE

INTRODUCTION

1.1      Background to the Study

According to Sanusi and Izedonmi (2014), the real causes of creative accounting lie in the conflicts of interest among different interest groups. Managing shareholders’ interest is to pay less tax and dividends. Investor-shareholders are interested to get more dividends and capital gains. Country’s tax authorities would like to collect more and more taxes. Employees are interested to get better salary and higher profit share. But creative accounting puts one group or two  to  advantageous position at  the expense  of others.  Amat,  et  al (2003)  therefore concluded that within the agency framework, it is both logical and inescapable that management behavior will be self-serving. Agency Theory can, therefore, be said to provide a solid framework for the understanding of creative accounting behavior.

Creative Accounting has been defined as the transformation of financial accounting figures from what they actually are to what the management desires by taking advantage of the existing accounting rules and standards or ignoring some or all of them (Naser, 1993). Other notable words used to describe creative accounting include manipulative accounting, fraudulent accounting, income smoothing, earnings management, earnings smoothing, financial engineering, window dressing and cosmetic accounting.

In separate studies, Mulford and Comiskey (2002) and Van der Poll, (2004) discover that management may use book entries as strategic tools to manipulate the financial statements and this, in the long run, may mislead the firm’s stakeholders. When premature or fictitious revenue is recognized, a book entry is used because no real transaction exists. Aggressive capitalization and extended amortization policies as well as the revaluation of assets and liabilities, are brought about by book entries. In like manner, when items in the income statement as well as the cash flow statement are reclassified, book entries are also used. According to Mathew and Perere (1996) creative accounting increases the risk faced by auditors in the course of an audit. Naser and Pendlebury (1992) questioned senior corporate auditors about their experience of creative accounting. They were able to conclude that a significant proportion of all categories of companies employ creative accounting techniques to some extent. External auditors have either failed to detect creative accounting techniques or colluded with management to manipulate the financial statements.

Porter et al. (2003) define audit risk as the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit failure is said to have occurred when there is a serious distortion of the financial statements which is not reflected in the audit report, and the auditor has made a serious error in the conduct of the audit  (Arens, et  al 2002).   Thus, a properly done audit  does not  guarantee that  serious distortions have not occurred though it makes such distortions unlikely. Thus, audit failure cannot occur unless there is serious auditors’ error or misjudgment (Tackett et al., 2004). Several research studies have examined the issue of motivations for creative accounting behaviour. According to Balaciu and Cosmina (2008), the managers are interested in paying less tax and dividends, the shareholders in receiving higher dividends, the employees in obtaining better salary and higher profit share, while the government wants higher taxes and so  on.  These  conflicting  interests  are  often  argued  to  be  the  motivations  for  creative accounting practices. Amat, et al (2003) also note that creative accounting may help maintain or boost the share price both by reducing the apparent levels of borrowing, so making the company appear subject to less risk, and by creating the appearance of a good profit trend. Informational perspective is another key element  underpinning the study of the creative accounting phenomenon. A conflict  is said to be created by the information asymmetry (privilege  to  certain  information)  that  exists  in  complex  corporate  structures  between  a privileged management and a more remote body of stakeholders (Okoye and Alao, 2008). The  informational  perspective  assumes  that  accounting  disclosures  have  an  information content that possesses value to stakeholders in providing useful signals. The information perspective provides explanation for management’s goal of impression management. According to Clatworthy and Jones (2011), in corporate reporting, impression management consists of controlling and manipulating the impression conveyed to users of accounting information financial reporting communication involves a number of corporate disclosures, both mandatory and voluntary. Managers that engage in self-serving disclosure practices may do  so  at  several  levels  of  firm  communication  through  creative  accounting  or  earnings management as a result of privy information at their disposal.

There are both positive and negative perspectives of creative accounting practice. Both the management and the owners of the firm may benefit  from creative accounting practice. According to Mathew and Perere (1996), “while creative, in connection with accounting, is often thought of as a dirty word with negative connotations, from a creativity point of view, it may have positive effects if it enhances the development of accounting practice”. Lei (2009), however, observed that when creative accounting techniques are used by a company, audit risk increases and may consequently result in investment loss if such company fails.

1.2      Statement of the Problem

External auditors are statutorily expected to conduct audit exercises on organizations and give an independent opinion on their financial statements. Such opinion gives the users of the financial statements some level of confidence that the accounts give a true and fair view of the financial position of the firm. In spite of such opinion, corporate failures have been witnessed and material misstatements have been discovered after audit. According to Iwu- Egwuonwu  (2011),  the  defunct  Lever  Brothers  Nigeria  Plc  and  Cadbury  Nigeria  Plc overstated their earnings, through the cooking of accounts, and were appropriately sanctioned by the Securities and Exchange Commission (SEC).  Cadbury and Lever Brothers’ auditors had consistently asserted that the financial statements of these firms gave a true and fair view but investigations revealed that these firms had consistently manipulated their accounts. In the United States, failure of corporations such as Enron Corp., WorldCom Inc., and Waste Management Inc. was also traced to the practice of Creative Accounting through the use of book entries which often go unnoticed by the auditors during their audit (Largay, 2002, Sundi et al 2006, Mulford and Comiskey, 2002 and Van der Poll, 2004).

According to Mathew and Perere (1996), Accountants and auditors are now more than ever, facing lawsuits brought against them for not detecting creative accounting practices in the course of an audit thereby issuing an inappropriate audit opinion in their reports. Thus, it would  appear  that  a  properly  executed  audit  exercise  does  not  guarantee  that  serious distortions of the financial statement, often described as creative accounting practices, have not occurred. What, then, is creative accounting? What impact do creative accounting techniques have on financial statements and in relation to audit, what effect do they have on the audit of financial statements? These questions beg for answers.

Several authors have tried to investigate the concept of creative accounting and the various techniques used by management to manipulate financial statements. However, the impact of creative accounting practices on the audit of financial statements and the consequent effect on audit  failure  has  not  been  given  much  attention.  This  study  aimed  at  filling  this  gap. Additional  empirical  evidence  on  the  use  of  creative  accounting  techniques  by  firms’ management and their effect on the audit of financial statements will enhance the quality of literature in this field of study.

1.3        Objectives of the Study

The aim of this study is to find out the impact of creative accounting practice on the audit of financial statements. The specific objectives of this study are to:

1.   determine the impact of creative accounting practice on audit risk.

2.   ascertain the impact of creative accounting practice on audit failure.

3.   determine the impact of provision for depreciation on corporate performance.

4.   ascertain the impact of provision for deferred taxation on corporate performance.

1.4        Research Questions

For the study, the following questions derived from the statement of problem and objectives of the study are posed:

i.    What is the impact of creative accounting practice on audit risk?

ii.  What is the impact of creative accounting practice on audit failure?

iii. To what extent does provision for depreciation impact on corporate performance?

iv.  To what extent does provision for deferred tax impact on corporate performance?

1.5      Hypotheses of the Study

The hypotheses of this study described in clear terms, what the researcher expected would happen and were subjected to test (collation and analysis of data) which determined their acceptance or rejection. The hypotheses, stated in null form include:

1.   Creative accounting practice does not have positive and significant impact on audit risk.

2.   Creative accounting practice does not have positive and significant impact on audit failure.

3.   Provision for depreciation does not have positive and significant impact on corporate performance.

4.   Provision  for  deferred  taxation does not  have  positive  and  significant  impact  on corporate performance.

1.6      Scope of the Study

Based  on  the  nature  of  this  research,  two  approaches  were  adopted  in  executing  the objectives: survey and content analysis methods. The survey research entailed the administration of questionnaire to a sample of auditors from the “big four” audit firms in Nigeria. This was to identify the perception of the respondents about creative accounting practice and how the practice affects the audit of financial statements. The respondents were limited to the most senior audit staff of the biggest audit firms in Nigeria. The big four audit firms were selected because they very big international firms, largest by fee income and have global affiliations (ICAN, 2006).

The content  analysis of the annual reports  is  limited  to  a sample of the  manufacturing companies listed on the Nigerian Stock Exchange (NSE). The annual reports of the selected companies for a period of 10 years were used for our analysis. The Manufacturing subsector was selected because it is one of the most active on the Nigerian Stock Exchange floor, making it the toast of most investors.

1.7      Significance of the Study

The significance of this research can be viewed from two major standpoints – practical and academic.

a.   Practical Significance: This study will assist in broadening the   knowledge of the following:

    Auditors:  With the increasing litigations against auditors, it has become imperative for auditors to be aware of certain techniques which may be used by unscrupulous management to manipulate their financial statements. This study will bring to the awareness of auditors, certain creative accounting techniques that are used to manipulate the financial statements being audited by them. It will also provide a guide on critical audit areas that required special attention during the audit of the financial statements. Furthermore, the study will help them know whether book entries are used as creative accounting techniques and how such techniques affect audit work.

    Managers: Managers often engage in manipulative accounting unconsciously due to the  flexibility  in  the  choice  of accounting  methods  often  allowed  by  accounting standards. Financial directors had in time past, been penalized for engaging in the manipulative accounting and as a result lost their jobs. This study will guide firms’ management on the need to ensure that accounting standards are adhered to and to ensure that necessary disclosures in respect of the accounting methods used should be contained in the financial statements.

    Other stakeholders: The conflict of interest of the firm’s stakeholders has been a major reason why financial statements are often manipulated. Management, in a bid to meet the conflicting interests of the firm’s stakeholders often present financial statements that portray good performance. This study will assist the various stakeholders to be well guided in using the financial statements to make investment decisions and other vital decisions. Specifically, it will assist current and potential investors to make informed decision about investing in quoted companies.

b.  Academic Significance

In academia, this study will prove to be significant in the following ways:

i.          It  will  contribute  to  the  enrichment  of  literature  on  creative  accounting,  the concept of audit risk and audit failure.

ii.        It  will explain  further  the relationship,  causative and  ordinary,  between audit failure and creative accounting.

iii.       It will suggest ways, based on empirical findings, by which creative accounting practices, through the use of book entries, can be detected to prevent their impact, if any, on audit failure.

iv.        Finally, this study will serve as a reference point for other researchers.

1.8.     Operational Definition of Terms

For this study, the following definitions were relevant:

Accounting Standards are policy documents or rules that guide the preparation and presentation of financial information.

Accrual accounting is described as an accounting process of recognising non cash events and circumstances as they occur.

Auditing Standards are policy documents or rules that guide the conduct of the audit of a set of financial statements.

Auditor Independence means Auditors being independent of their audit clients, their clients’ managements, and any other influences which might impair their objectivity and impartiality.

Big four audit firms refer to the four largest international audit firms in Nigeria, namely, PricewaterhouseCoopers, Ernst  and Young,  Akintola Williams Deloitte and Touche, and KPMG.

Corporate governance has been described as “rigorous supervision of the management of a company by ensuring that business is done competently, with integrity and with due regard for the interests of all stakeholders”.

International Accounting Standards (IAS) is a body of accounting standards issued by the International Accounting Standards Committee (IASC), now known as IASB.

International Accounting Standards Board (IASB) is the international standard- setting body responsible for issuing International Financial Reporting Standards.

International Financial Reporting Standard (IFRS) is a body of accounting and financial reporting  standards  promulgated  by  the  IASB;  it  includes  standards  and  interpretations adopted by the IASB.

International Standards on Auditing (ISAs) are policy documents or rules that guide the conduct of the audit of a set of financial statements.

Nigerian Accounting Standards Board (NASB) is the Nigerian accounting standards- setting body responsible for issuing Statement of Accounting Standards (SAS).

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