1.

1 Background

Internal and external users have opportunity to find out and understanding about the
financial condition and operating performance from a company’s financial statements
(henceforth, FS). Agency relationship arises when one or more principal (owner) engage
another person as their agent (or steward) to perform on their behalf. Agency theory
explained that the principal-agent relationship between the shareholders (as owners) and
managers (as agent) in the corporate-sector in which assumes that the ordering party and
the agent “tend to maximize the benefits for themselves.” As result of asymmetries and
self-interest, principals lack of reason to trust their agents and will seek to resolve these
concerns by putting in place mechanisms to align the interest of agents. Due to these
conflicting‟ interests”, managers usually have the incentive and ability to maximize their
own objective at the expense of shareholders. The accuracy and reliability of them are very
crucial for all the stakeholders of a corporation in order to make appropriate decisions.

Recently, the unpleasant event attached with frequent scandals especially in the global
corporate sector have raised questions about the effectiveness of transparency and
disclosures practices. Due to widespread and frequent abuse of Creative Accounting
(henceforth, CA) practices stemmed from the collapse of many large high-profits
companies such as Enron and WorldCom, across the world, have left a dirty smear on the
effectiveness of the Corporate Governance (henceforth, CG) system. For instance, 40US
companies went public in 2014 that reported losses under traditional accounting rules, but
claimed profits under their own tailored creative accounting. The bigger they are, the more
likely they are to use CA (Browne, 2015). Thus, the fact that managers want to show good
report to attract more investors. Due to this reason, CA techniques frequently used by
managers of a company to affects the investors’ ability “to properly assess the ‘true’ value
of the company
Subject of Creative Accounting is normally portrayed maligned and negative act. As soon
The image that transpires in one’s mind about “Creative Accounting” is that of
manipulation, dishonesty and deception. According to agency theory ‘the firm is a legal
fiction which serves as a focus for a complex process in which the conflicting objectives
of individuals are brought into equilibrium within a framework of contractual relations.’
Within the agency framework, it is both logical and inescapable that management behavior
will be self-serving. Agency can, therefore, provide a solid framework for the
understanding of creative accounting behavior. However, it may provide an incomplete
theoretical basis for explaining or predicting management behavior; the ethical dimension
of human behavior may provide an important element missing from legalistic and
adversarial agency relationships.
1.2 Definitions of Creative Accounting:

CA refers to the accounting practice that may (or may not) follow the accounting principles
or standards, but deviate from what these principles or standards intend to achieve, in order
to show a desired image of the company to the stakeholders. Alternatively, CA is the
transformation of financial accounting figures from “what they actually are to what the
preparer of financial reports desires by taking advantage of the existing rules and/or
ignoring some or all of them” (Bhasin, 2013). Thus, CA uses the various loopholes in
accounting principles or standards to show the desired results to the stakeholders.

Creative accounting means different things to different people. According to Amat, Blake
and Dowds (1999), four authors in the U.K explored creative accounting from a different
perspective (Including business journalist, accountant, an investment analysis and an
academic view). Definitions of creative accounting vary, and include the following:

‘Is the deliberate dampening of fluctuations about some level of earnings considered to be
normal for the firm’ (Barnea et al., 1976)

‘Is any action on the part of management which affects reported income and which
provides no true economic advantage to the organization and may in fact, in the long - term,
be detrimental’. (Merchant and Rockness, 1994)

‘Involves the repetitive selection of accounting measurement or reporting rules in a

particular pattern, the effect of which is to report a stream of income with a smaller
variation from trend than would otherwise have appeared’. (Copeland, 1968)

(Schipper, 1989) observes that ‘creative accounting’ can be equated with ‘disclosure
management’, ‘in the sense of a purposeful intervention in the financial reporting process.’
What are the Techniques of Creative Accounting?

Recognizing Premature or Fictitious Revenue: The CA practices often begin with

revenue recognition, because of its direct impact on earnings. “Premature” revenue
recognition is recognition of revenue for a legitimate sale in a period prior to that called for
by generally accepted accounting principles (GAAP). On the contrary, “fictitious” revenue
recognition is the recording of revenue for a non-existent sale.

“Big Bath” Accounting: In this technique, instead of showing losses for a couple of
years, a big loss is shown for a single year by charging all expenses in that year. This may
be done if there are apparent reasons for poor profitability in that year and the management
feels that by lumping all expenses in one bad year, they can start showing better profits in
following years.

Using Cookie Jar Reserves: Over-provisioning for accrued expenses when revenues are
high helps to bring down profits to a level that is safe to maintain in the future. Similarly,
failure to provide all the accrued expenses can help show larger profits during tougher
times when such is the need of the hour. This technique includes making unrealistic
assumptions to estimate liabilities for such items as sales returns, loan losses or warranty
costs, so that they stash accruals in cookie jars during the good times and reach into them
when needed in the bad times.

Aggressive Capitalization and Extended Amortization Policies: One alternative way

for companies to reduce expenses is “aggressively capitalizing expenditures that should
have been expensed.” Although determination of the portion of an expenditure to capitalize
is straightforward in many cases, items as direct-response advertising and software
development costs require judgment in determining whether capitalization is appropriate
or not. To lengthen amortization periods for costs that have been capitalized previously is
also used to reduce expenses and boost earnings.
 Manipulating Inventory: Firms can engage into inventory manipulation by either
manipulating the quantity of the inventory or by valuing it.” In years when profits need to
be increased the quantity can be manipulated by doing a particularly rigorous stock-take.
Provisions for absolute and slow-moving inventory and changing the actual method of
inventory valuation are the practices of manipulating inventory values (Jones, 2011).

Abuse of Materiality Concept: It includes misusing the concept of materiality by

intentionally recording errors within a defined percentage ceiling. Firms indulging in this
practice try to find an excuse for it by arguing that the effect on the net income is too small
to matter. A change in an immaterial item can help the firm billions of dollars. For example,
some companies do not recognize n expenditure under say $5000 as an asset, even if its
benefits is likely to be spread over several years. Varying this limit to say $2,000 can easily
increase profits while hiking up this limit may lead to lower profits.

Revenue Recognition

Firms virtually have a free hand in timing the booking of their revenues at any stage starting
from the moment sales contracts are signed till the promised product or service has been
fully delivered to and accepted by the clients. For this we can refer to a classic example of
Microsoft which was heavily fined by US SEC for its manipulative revenue recognition
policy. Microsoft recognized only a small percentage (20-30%) as revenue at the time of
the sale and remaining amount was kept as provision for future after sales services. Why
Microsoft adopted that strategy. The answer is to (1) hide substantial profits, (2) signaling
effects, (3) avoiding complacency and last but not the least (4) to report smoothed earnings
to its shareholders & stakeholders

Problems with Cash-flow Reporting: Another way for companies to communicate a

higher earning power is “reporting higher and more sustainable cash flow.” A company’s
apparent earning power will be greater with the potential recurring quality of operating
cash flow. Therefore, a firm can classify an operating expenditure as an investing or
financing item, or investing or financing inflow might be classified as an operating item.
Even if these steps will not alter the total change in cash, they will increase the cash flow
from operations.

Creative Accounting Practices Scenario in the Malaysia Companies

Transmile Group Bhd

In financial years 2004, 2005 and 2006, Transmile Group Berhad was suspected to have
overstated its revenue of RM522 million in total. Transmile’s property, plant and
equipment account of RM341 million appear to have been fabricated as the amount was
little supported by evidence and documents (Abdullah Zaimee, 2007). In another occasion,
Lim Guan Eng in his press release mentioned that “accounting scandals in Transmile group
where revenue and profits are falsified through creative accounting indicates 3 structural
failures in regulatory oversight and full disclosure of our capital markets, unreliability of
financial statements and poor corporate governance in Malaysia” In May 2007, the new
Board appointed a forensic auditor to conduct a special audit of the company’s account and
its subsidiaries. The auditor found that the revenue was overstated by a total of RM622
million for three consecutive financial years from 2004 to 2006 (Fong, 2007b; Zaimee,
2007). In addition to that, another cash outflow of RM341 million was “purported property
plant and equipment” because there was discovered to be little supporting documentation
for that transaction (Zaimee, 2007). Furthermore, the company was said to have made
payments totalling RM189 million without supporting payment vouchers (Zaimee, 2007).
The special audit into its subsidiary accounts found items on related-party sales
transactions in which the subsidiary owed to the business more than RM103 million.

Megan Media Bhd

Megan Media Bhd was established in 1994 and listed in August 2000 under the second
board. Megan Media Bhd after moved to the main board of the exchange in year 2002. A
year after the Transmile case was made public, the cooking-the-books activity of the
company shocked the local securities market. The signal of accounting irregularities
become public knowledge in April 2007, when two of its subsidiaries made a default
payment to all of their maturing trade facilities obtained from the local bank amounting to
RM893.97 million (the principal amount). As a result of that, the company proposed a debt
restructuring plan to regularize its financial position. As such, the bankers requested the
company to appoint a forensic auditor to conduct the investigation into the company’s
books and its subsidiaries (Oh, 2010). The initial findings found irregularities in a
subsidiary’s account regarding fictitious trade debtors and creditors amounting to RM456
million. Furthermore, the auditor found that the subsidiary had financed the payment of
fictitious trading creditors through borrowing and recycling the cash through other business
entities, and the evidence shows payments being made to non-existent creditors using the
bank trade facilities (Fong, 2007a; Oh, 2010). For Megan Media the governance failure
began when it two subsidiaries namely Memory Tech and MJC Pte Ltd. defaulted on a
RM47 million payment to bondholders. This failure drove to reporting failure whereby a
preliminary report found that “substantial irregularities” and financial position of the
company’s financial position had been misstated and RM211 million deposits for 13
production lines was fictitious. Consequently it resulted to the receivables amounting
RM334.3 million. On top of that the payments made to creditors were actually made to
other parties in a move to channel cash out of Memory Tech.

 RM1.03 billion reported in its consolidated accounts for the year ending 30 April 2006

 RM 230 million in its consolidated quarterly report for the financial period ending 31
July 2006

 RM238 million in its consolidated quarterly report for the financial period ending 31
October 2006

 RM306 million in its consolidated quarterly report for the financial period ending 31
January 2007

Based on the above figures, a large amount of its past revenue had been falsified, so it
failed to submit its regularization plan to the Stock Exchange. For the financial year ending
in 2007, the company had incurred a net loss of RM1.27 billion and a negative cash flow
of RM897 million.

1 Malaysia Development Berhad

The 1 Malaysia Development Berhad Scandal is an ongoing political scandal occurring in

Malaysia. There was talk that 1MDB sell or liquidate certain assets, but the extent of
damage caused by the transaction will only be known after the audit report on the company,
in late June.

 In 2014, the company took a RM2 billion loan from Powertek Investment Holdings
Sdn Bhd to finance a RM6.17 billion bridging loan taken in 2012, but missed the 31
December 2014 deadline for settlement and received an extension of up to 30 January
2015.

 There are also claims that 1MDB overpaid top businessman, Ananda Krishnan with
an RM8.5 billion on the acquisition of his power assets in 2012. Latest news report
that Krishna will loan the company RM2 billion to help settle a debt obligation to
Malayan Banking Bhd and RHB Bank Bhd due soon.

 Controversies also highlighted the over-priced cash purchase of Tanjung and Genting
Sanyen independent power producers (IPP).

 Another issue was 1MDB’s action to build two power plants in Malaysia, which were
not even required yet to meet energy demands.

 Also, the whereabouts of the investment yields from Cayman Islands in 2012
amounting to RM1.63 billion (from an investment of RM6.25 billion) has been
questioned as this amount could have used to clear off a portion of the debts.
 In 2015, Malaysia's Prime Minister Najib Tun Razak was accused of channelling over
RM 2.67 billion (nearly USD 700 million) from 1MDB, a government-run strategic
development company, to his personal bank accounts.

 According to its publicly filed accounts, 1MDB has nearly RM 42 billion (USD 11.73
billion) in debt. Some of this debt resulted from a $3 billion state-guaranteed 2013 bond
issue led by Goldman Sachs, who is believed to have made as much as $300 million in
fees from that deal alone, although it disputes this figure Conference of Rulers in
Malaysia has called for the investigations by the government to be completed as soon
as possible, saying that the issue is causing a crisis of confidence in Malaysia.
Conclusion

Creative accounting is not a fraud but it takes the benefits of loopholes in the accounting
standards and regulations. It cannot be said fraud because it works within the framework
of law. It takes advantage of multiple options available in accounting standard to show the
transactions like different methods of depreciation method and estimating useful life of the
assets, different options available in revenue recognition as well as loss recognition,
different methods are available in valuing stock inventory whether use lifo or fifo method
for valuation of inventory. Managers use that method which increases their benefits in that
year and shows higher profit.