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

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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”.

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