Please read the following case study; Creative accounting is referred as income smoothing, earnings management, earnings
Posted: Sun Jul 03, 2022 1:13 pm
Please read the following casestudy;
Creativeaccounting is referred as income smoothing, earnings management,earnings smoothing, financial engineering and cosmetic accounting.The preferred term in the USA, and consequently in most of theliterature on the subject is ‘earnings management’, but in Europethe preferred term is ‘creative accounting’.
Marchant andRockness (1994, 79) defined creative accounting as “any action onthe part of management which affects reported income and whichprovides no true economic advantage to the organization and may infact, in the long-term, be detrimental”. Many research studiesexamine a particular aspect or technique of creative accounting,and all tend to conclude that creative accounting using thattechnique does exist.
However, theethical issues of earnings management are controversial. Fewpractitioners and accounting scholars stated acts of earningmanagement are ethically justifiable depends particularly onmanagement’s intention either to be truthful or to mislead readersof the statements. The following case study disclosed on how publicorganization (Cat and Paws Protection Society - CPPS) practiced anexample of income smoothing.
It was reportedthe CPPS largely depend on sponsorship and donations. As such, theyare very particular to maintain good financial performance. If theorganization makes a loss, doubts about its management andviability may make contributors wary of committing further funds.But a big surplus is equally risky, because it shows that themanagement has not used all the resources available to it.Contributors may decide that some of their money is no longerneeded and may channel their funds elsewhere. The CPPS financedtheir operation from the following sources of income:
Like many othernon-profit organizations, the CPPS’ expenses are largely fixedevery year. The expenses incurred for the cat and paws shows i.e.,venue, honorarium to volunteers, advertising cost and prizes areall set in advance. The main uncertainties about the success of theshows concern on sales of ticket and entrance fees paid by the catand paws’ exhibitors.
The financialyears starts half-way through the first show. By the time, theresult for the first half of the financial year is nearlyunalterable and that for the second half depend largely on theattractiveness of the next show to participants and sponsorship.For this reason, the CPPS has little opportunity to manageearnings, either by making discretionary accruals or by structuringreal transactions in the short term. However, in the medium term,an unexpected cash surplus in one year particular from successfulshow, can be used up by providing extra services in later years,thus incurring an offsetting deficit.
Normallynon-profit organizations are expected to amass large surplus,except to be used in future operation. By smoothing out reportedshort term surpluses and deficits, management may show that it hascredible ways of using its resources in full, to break even overthe medium term. Moreover, allowing a large surplus to be reportedwithout smoothing may put the organization’s future revenue atrisk.
Required
a) Referring to the above statement, briefly explain threepossibility of creative accounting area that motivates CPPS topractice creative accounting.
(15 markah /marks)
b)Were the earnings management techniques used by the CPPSethical? Explain your answer.
(5 markah /marks)
c) What factors would you consider when determining whethersuch a decision was ethical?
(5 markah /marks)
[Jumlah / Total: 25 markah/ marks]
Creativeaccounting is referred as income smoothing, earnings management,earnings smoothing, financial engineering and cosmetic accounting.The preferred term in the USA, and consequently in most of theliterature on the subject is ‘earnings management’, but in Europethe preferred term is ‘creative accounting’.
Marchant andRockness (1994, 79) defined creative accounting as “any action onthe part of management which affects reported income and whichprovides no true economic advantage to the organization and may infact, in the long-term, be detrimental”. Many research studiesexamine a particular aspect or technique of creative accounting,and all tend to conclude that creative accounting using thattechnique does exist.
However, theethical issues of earnings management are controversial. Fewpractitioners and accounting scholars stated acts of earningmanagement are ethically justifiable depends particularly onmanagement’s intention either to be truthful or to mislead readersof the statements. The following case study disclosed on how publicorganization (Cat and Paws Protection Society - CPPS) practiced anexample of income smoothing.
It was reportedthe CPPS largely depend on sponsorship and donations. As such, theyare very particular to maintain good financial performance. If theorganization makes a loss, doubts about its management andviability may make contributors wary of committing further funds.But a big surplus is equally risky, because it shows that themanagement has not used all the resources available to it.Contributors may decide that some of their money is no longerneeded and may channel their funds elsewhere. The CPPS financedtheir operation from the following sources of income:
Like many othernon-profit organizations, the CPPS’ expenses are largely fixedevery year. The expenses incurred for the cat and paws shows i.e.,venue, honorarium to volunteers, advertising cost and prizes areall set in advance. The main uncertainties about the success of theshows concern on sales of ticket and entrance fees paid by the catand paws’ exhibitors.
The financialyears starts half-way through the first show. By the time, theresult for the first half of the financial year is nearlyunalterable and that for the second half depend largely on theattractiveness of the next show to participants and sponsorship.For this reason, the CPPS has little opportunity to manageearnings, either by making discretionary accruals or by structuringreal transactions in the short term. However, in the medium term,an unexpected cash surplus in one year particular from successfulshow, can be used up by providing extra services in later years,thus incurring an offsetting deficit.
Normallynon-profit organizations are expected to amass large surplus,except to be used in future operation. By smoothing out reportedshort term surpluses and deficits, management may show that it hascredible ways of using its resources in full, to break even overthe medium term. Moreover, allowing a large surplus to be reportedwithout smoothing may put the organization’s future revenue atrisk.
Required
a) Referring to the above statement, briefly explain threepossibility of creative accounting area that motivates CPPS topractice creative accounting.
(15 markah /marks)
b)Were the earnings management techniques used by the CPPSethical? Explain your answer.
(5 markah /marks)
c) What factors would you consider when determining whethersuch a decision was ethical?
(5 markah /marks)
[Jumlah / Total: 25 markah/ marks]