ODUNLADE, Olapade Gbenga B.Sc., M.Sc., ACA, Department of Accountancy, Faculty of Business Administration, University of Nigeria, Nsukka, Enugu State, Nigeria.
ABSTRACT
This study is an empirical investigation on the opinions of senior audit staff of audit firms on the impact of creative accounting practices on audit failure. To achieve the objective of this study research questions were raised, hypotheses formulated, and a review of related literature was made. The population of this study is the senior audit staff of audit firms in Nigeria. Purposive sampling technique was adopted for this study. The sample used consisted of the 20 senior audit managers, with more than 10 years experience, drawn from the “big four” audit firms in Nigeria. The survey method of research design was adopted and the primary data were employed. The major instrument used for generating the primary data was the questionnaire, which was designed in five-response option of Likert-scale and administered on the senior audit managers chosen for this study. The data generated for this study were analyzed through mean scores while the stated hypotheses were statistically tested using simple linear regression. Our findings revealed that, creative accounting practices have positive impact on audit failure and by implication adversely affect corporate performance. Therefore we recommended among others that auditors should tailor their substantive testing procedures to aid their ability to detect creative accounting techniques. This will prevent audit and corporate failure.
- Introduction
In order to rely on the financial statements prepared by the management, owners of business entities engage external auditors to examine the underlying books and records and thereafter express an independent opinion whether the financial statements represent the true and fair view of the financial position and the affairs of the business entities. However, concerns are often expressed by regulators and other observers as to whether auditors are sufficiently independent and competent, particularly in the aftermath of corporate failures or material changes to previously approved audited accounts [1]. The restatement of the Enron accounts and the collapse of Andersen following the obstruction of justice finding against the firm [2] show the devastating effect of loss of confidence in the integrity of an audit firm.
Failure by auditors to identify and report on misleading financial information undermines the economic value of audit, which is damaging to all firms in the long run. Concerns have also been expressed about aggressive earnings management practices [3]. These practices are referred to as creative accounting practices. Creative accounting is the transformation of financial accounting figures from what they actually are to what preparers desire by taking advantage of the existing rules and/or ignoring some or all of them [4]. Such transformation of figures as pointed out by Naser, questions the integrity of financial statements produced by management.
The credibility and value of the information reported by companies is frequently questioned due to the possibility of having been manipulated through the use of creative accounting techniques. 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. Pressures of litigation derive from the potential losses once audit fails, and requirements from client’s company may make auditors conceal truth to financial statement users. Audit quality is inverse of audit failure, the higher the failure rate, the lower the audit quality [5]. Outright audit failures are difficult to determine with certainty but can be obtained from some sources such as auditor litigation and business failures, investigations by Securities and Exchange Commission (SEC), and earnings restatements [6]. It is upon this background that this study seeks to provide an empirical investigation on the opinion of the senior audit staff of the “big four” audit firms on the impact of creative accounting practices on the audit of the financial statements in Nigeria.
This paper is structured into the following sections: introduction, conceptual framework/literature review, methodology, results/analysis, conclusion and recommendation.
- Statement of the Problem
Failure by auditors to identify and report on misleading financial information undermines the economic value of audit. Accountants and auditors are now more than ever, facing lawsuits brought against them for not detecting material misstatements in the financial statements in the course of an audit. Most of the available studies, such as [7, 8-9], focused on how auditors failed to prevent audit failure and the consequent effect on the capital market, corporate failure and investments. There are limited evidences on how financial statements which have been manipulated could impact the audit exercise and how creative accounting practices could result in audit failure. Moreover, the studies are of foreign origin and their findings may not be suitable for Nigeria considering environmental differences. Similar studies in Nigeria [10-11], focused on audit failure in the ailing bank and highlighted what the auditors did wrong. 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
- Research Objectives
The main objective of this study is to provide an empirical investigation on the opinion of the senior audit staff of the “big four” audit firms on the impact of creative accounting practices on the audit of the financial statements in Nigeria. Specifically, the study aimed at achieving the following:
- To determine the impact of creative accounting practices on audit failure.
- To examine the impact of creative accounting practices on corporate failure.
- Research Questions
The following questions were raised for this study:
- What is the impact of creative accounting practices on audit failure?
- What is the impact of creative accounting practices on corporate failure?
- Research Questions
The following hypotheses were formulated for the study:
- Creative accounting practices do not have positive and significant impact on audit failure.
- Creative accounting practices do not have positive and significant impact on corporate failure.
- Conceptual Framework and Literature Review
Failure by auditors to detect a material error or misstatement in accounting information can arise from three main causes, two of which may be attributed to audit failure [12]. First, auditors may either fail to detect a material error or misstatement, or, having detected an error, fail to recognise it, because they have carried out a substandard audit, i.e. the auditors are incompetent. Second, auditors may identify a material error or misstatement and fail to report it or fail to persuade the directors to put it right, i.e. the auditors lack independence. Third, directors may deliberately deceive auditors. In cases of deliberate deception, auditors may not be held responsible for failure to detect problems such as creative accounting practices.
In Nigeria, 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) [13]. 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 practices [8, 14].
In Nigeria, [15] sought to find out whether financial accounting information users including the auditors are aware of creative accounting in the private sector of the economy. They carried out their study in Lagos, through field work questionnaire administered on practicing accountants from randomly selected audit firms. They found out that creative accounting has definitely affected information users.
The preparation and disclosure of true and fair financial information is core of corporate governance, because it enables stakeholders to exercise their rights so as to protect their interests [16]. However, users of financial statements may be misled when creative accounting practices are explored by management and this could constitute threats to corporate investment and growth.
Current accounting practices allow a degree of choice of policies and professional judgment in determining the methods of measurement, criteria for recognition, and even the definition of the accounting entity. The exercise of this choice can involve a deliberate non-disclosure of information and manipulation of accounting figures, thereby making the business appear to be more profitable (or less profitable for tax purposes) and financially stronger than it is supposed to be [15].
Flexibility in the choice of accounting policy
In line with the globalization of the worldwide economy and international capital markets, there is an increasingly strong need from the participants of capital markets and users of accounting information for financial information that exhibits a greater level of quality, transparency and comparability [17].
Accounting Standards used for the preparation of the financial statements are now tailored towards convergence with International Financial Reporting Standards (IFRS) issued by the International Accounting Standard Board (IASB). Most companies now make reference to the equivalent IFRS and adopt the principles and treatments similar to their international counterpart. IFRS specified accounting treatments for important accounting issues such as business combinations and consolidated financial statements, providing comprehensive and more authoritative provisions and guidelines [17].
The IFRS provides the implicit framework used in accounting. As guideline to the accounting practitioners, they define the accepted accounting practices at a particular time, concerning the accounting techniques and financial statements preparations [18].The concepts of fairness, justice, equity and truth are the basic core elements for the ethical validity of financial statements. There are three concepts needed for supporting accounting theory in order to ensure justice and equitable treatment of all interested parties; fairness, unbiased and impartial presentation and true and accurate financial statements without misrepresentation.
However, the flexibility in accounting regulation permits discretion in choosing the accounting policy to follow. This flexibility may result in a completely doctored financial statements presented for audit. Audit failure occurs when there is a serious distortion of the financial statements that is not reflected in the audit report, and the auditor has made a serious error in the conduct of the audit [8].For instance, the International Accounting Standards allow management to choose between valuation of the non-current assets at depreciated historical value or at revaluated value. The management may decide the change of the policies, for creative accounting purpose, and these changes may be difficult to be identified a few years later. Such flexibility also permits management to use their discretionary position in order to obtain the financial position and stability.
Effects of creative accounting practices
Audit firms get engagements from companies to carry out audit work and issue audit report. During the course of audit work, auditors may be encountered with audit risk when collecting audit evidence. As already reviewed, audit risk involves non-controllable risk and controllable risk, among which quality control risk is more important to auditors. It is always determined by auditor’s proficiency and competency. The first approach is based on the number of working hours of auditors and the second approach is on the auditee company’s value [19]. Since the number of working hours of auditors are difficult to be quantified, most audit firms adopt the second approach. But this approach gets lots of critics from practitioners, who believe that business complexity and risks should be considered when deciding audit fees.
Audit risk is fundamental to the audit process because auditors cannot and do not attempt to check all transactions. Large companies usually have vast number of transactions in a statement of comprehensive income and a statement of financial position. It would be impossible to check all of these transactions, and no one would be prepared to pay for the auditors to do so, hence the importance of the risk‑based approaches toward auditing.
Traditionally, auditors have used a risk-based approach in order to minimise the chance of giving an inappropriate audit opinion, and audits conducted in accordance with ISAs must follow the risk based approach, which should also help to ensure that audit work is carried out efficiently, using the most effective tests based on the audit risk assessment. Despite the use of the risk based auditing approach, cases of audit failures have been reported in different climes. The reported cases of Enron, Tyco, and Global Crossing, and even Vivendi in the United States, as well as the 54 banks that collapsed in Nigeria between 1994 and 2005, come in here as clear examples [13]. Their auditors have consistently asserted that the financial statements of these firms gave a true and fair view but upon investigation, these firms have consistently manipulated their accounts.
Audit failure does not occur if the auditor has followed Generally Accepted Auditing Standards or the provisions of ISAs, regardless of the fairness and accuracy of the financial statements. However, a properly done audit does not guarantee that serious distortions of the financial statements have not occurred. However, a properly done audit does make serious distortions unlikely. Thus, audit failure cannot occur unless there is serious auditor error or misjudgment [20].
In today’s multifaceted and multidisciplinary economic environment, management of organization places more and more emphasis on increasing results with fewer resources through evaluation of the economy, efficiency, and effectiveness of the organization’s operations [21]. While the audit provides an after-the-fact opinion that financial statements present a fair view of company affairs, no guarantee is made to conclude that company operations are conducted in the most economical, efficient, and effective manner.
Due to a number of external and internal factors, more and more listed companies resort to falsification and fabrication on their financial statements for various purposes, for instance, to be competitive, maintaining market position or merely surviving. Normally, accounting fraud arises when entities begin to suffer loss but have to maintain their market position in stock market, thus fraudulent accounting techniques are employed by company management to achieve organizational or individual goals.
The recent corporate financial scandals like Enron, WorldCom and Chinese Guangxia in the early part of this decade shocked financial markets and presented a lot of problems existing in the capital market, such as auditor independence, corporate governance, and legislation and so on. A corporate financial scandal always arises with an aggregation of a number of factors which provide a breeding ground for fraud. For example, the loopholes in auditing controls and corporate governance can to some extent encourage companies to perpetrate fraud [5].
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External auditors in this context are obligated to collect audit evidence and take audit trial to give an opinion that the financial statements of auditee company has a true and fair view. But auditors may fail to detect fraud and material misstatements from the financial statements, especially when the company internal control is weak and company intentionally make frauds. However, that may not be the excuse for high audit risk and hence audit failure.
Although the inherent risk is high due to business complexity and internal control is weak, auditors should detect the apparent problems within financial statements if regular procedures are followed. However, the auditors are negligent on audit work and losing auditor independence, thus leading to audit failure. In Nigeria, an example of this is the alleged Afribank’s financial misstatements, an accusation levelled by its former managing director that the Board of Directors colluded with its external auditors to cook the books [22].
In USA, leading public accounting firms who act as external auditors for different failed corporation such as Arthur Andersen, Deloitte and Touche, Ernst and Young, KPMG, Pricewaterhousecoopers admitted to or have been charged with negligence by their failure to identify and prevent fraud, insider abuses and falsification of financial reports by their clients.
According to [20] auditor may unknowingly fail to appropriate his or her opinion on financial statements that are materiality misstated. This results in audit failure which means that certified public accountant (CPA) provides error audit opinion for unfaithful financial statements because he or she doesn’t conform to audit standards. To them, the main difference of audit failure and audit risk is that CPA whether or not conforms to audit standard. This differs from the views [23] who opined that audit failure occurs when there is a serious distortion of the financial statements that is not reflected in the audit report, and the auditor has made a serious error in the conduct of the audit.
Audit failures make the accounting and auditing profession to be confronted with a crisis of confidence and credibility. Criticism of the profession is widespread due to investment loss when a corporate failure occurs. Audit failures will endanger the existence of the profession and its development in the long run [21].
Moreover, audit failure results in stock crisis and diminished public trust on stock market and those small and medium investors who rely on audited financial statements suffer great losses and have no compensation. The effects of audit failures are numerous. [5], found that the long time effect of creative accounting practices is the distrust of the investors and other stakeholders of the firm in the audit conducted by the external auditors owing to the collapse of companies that take advantage of creative accounting practices.
- Methodology
The survey method of research design was adopted in this study. The population of the study is the senior managers of the “big four” audit firms in Nigeria. Purposive sampling technique was adopted for this study and the sampled members consisted of twenty (20) senior managers; each from KPMG, PWC, Akintola William Delloite and Ernst and Young.
The main instrument used for the collection of data in this study was the questionnaire, which was designed in five response options of likert-scale (i.e. strongly agree, agree, disagree, strongly disagree and neutral). The questionnaire was administered on the selected senior audit managers who have more than 10 years audit experience. A total number of 20 questions were contained in the questionnaire.
The data generated for this study were analyzed using mean scores. The stated hypotheses were statistically tested using simple linear regression.
- Results and Analysis
In the section we present the result of hypotheses testing and data analysis.
Test of Hypotheses
- Creative accounting practices do not have positive and significant impact on audit failure.
| Descriptive Statistics | |||
| Mean | Std. Deviation | N | |
| Audit Failure | 1.6500 | 1.03866 | 60 |
| creative accounting | 2.4000 | 1.36791 | 60 |
| Correlations | |||
| Audit Failure | creative accounting | ||
| Pearson Correlation | Audit Failure | 1.000 | .864 |
| creative accounting | .864 | 1.000 | |
| Sig. (1-tailed) | Audit Failure | . | .000 |
| creative accounting | .000 | . | |
| N | Audit Failure | 60 | 60 |
| creative accounting | 60 | 60 | |
| Model Summaryb | |||||
| Model | R | R Square | Adjusted R Square | Std. Error of the Estimate | Durbin-Watson |
| 1 | .864a | .746 | .742 | .52801 | .354 |
| a. Predictors: (Constant), creative accounting | |||||
| b. Dependent Variable: Audit Failure | |||||
| ANOVAb | ||||||
| Model | Sum of Squares | df | Mean Square | F | Sig. | |
| 1 | Regression | 47.480 | 1 | 47.480 | 170.301 | .000a |
| Residual | 16.170 | 58 | .279 | |||
| Total | 63.650 | 59 | ||||
| a. Predictors: (Constant), creative accounting | ||||||
| b. Dependent Variable: Audit Failure | ||||||
| Coefficientsa | ||||||
| Model | Unstandardized Coefficients | Standardized Coefficients | t | Sig. | ||
| B | Std. Error | Beta | ||||
| 1 | (Constant) | .076 | .139 | .549 | .585 | |
| creative accounting | .656 | .050 | .864 | 13.050 | .000 | |
| a. Dependent Variable: Audit Failure | ||||||
R = 0.864
R2 = 0. 746
F = 170.301
T = .549
DW = 0. 354
Interpretation:
The regression sum of squares (47.480) is greater than the residual sum of squares (16.170), which indicates that more of the variation in the dependent variable is explained by the model. The significance value of the F statistics (0.000) is less than 0.05, which means that the variation explained by the model is not due to chance.
R, the correlation coefficient which has a value of 0.864, indicates that there is positive relationship between creative accounting and audit failure. R square, the coefficient of determination, shows that 74.6% of the variation in audit failure is explained by the model.
With the linear regression model, the error of estimate is low, with a value of about .52801. The Durbin Watson statistics of 0.354, which is not more than 2, indicates there is no autocorrelation.
Decision: The creative accounting coefficient of 0.864 indicates a positive relationship between creative accounting and audit failure though not statistically significant (with t = 0.549). Therefore, the null hypothesis is rejected and the alternative hypothesis accepted. This implies that creative accounting practices have positive impact on audit failure.
- Creative accounting practices do not have positive and significant impact on corporate failure.
| Descriptive Statistics | |||
| Mean | Std. Deviation | N | |
| corporate failure | 2.1833 | 1.32117 | 60 |
| creative accounting | 2.4000 | 1.36791 | 60 |
| Correlations | |||
| corporate failure | creative accounting | ||
| Pearson Correlation | corporate failure | 1.000 | .943 |
| creative accounting | .943 | 1.000 | |
| Sig. (1-tailed) | corporate failure | . | .000 |
| creative accounting | .000 | . | |
| N | corporate failure | 60 | 60 |
| creative accounting | 60 | 60 | |
| Model Summaryb | |||||
| Model | R | R Square | Adjusted R Square | Std. Error of the Estimate | Durbin-Watson |
| 1 | .943a | .890 | .888 | .44165 | .647 |
| a. Predictors: (Constant), creative accounting | |||||
| b. Dependent Variable: corporate failure | |||||
| ANOVAb | ||||||
| Model | Sum of Squares | Df | Mean Square | F | Sig. | |
| 1 | Regression | 91.670 | 1 | 91.670 | 469.961 | .000a |
| Residual | 11.313 | 58 | .195 | |||
| Total | 102.983 | 59 | ||||
| a. Predictors: (Constant), creative accounting | ||||||
| b. Dependent Variable: corporate failure | ||||||
| Coefficientsa | ||||||
| Model | Unstandardized Coefficients | Standardized Coefficients | t | Sig. | ||
| B | Std. Error | Beta | ||||
| 1 | (Constant) | -.004 | .116 | -.031 | .975 | |
| creative accounting | .911 | .042 | .943 | 21.679 | .000 | |
| a. Dependent Variable: corporate failure | ||||||
R = 0.864
R2 = 0. 746
F = 170.301
T = .549
DW = 0. 354
Interpretation:
The regression sum of squares (91.670) is greater than the residual sum of squares (11.313), which indicates that more of the variation in the dependent variable is not explained by the model. The significance value of the F statistics (0.000) is less than 0.05, which means that the variation explained by the model is not due to chance.
R, the correlation coefficient which has a value of 0.943, indicates that there is a positive relationship between creative accounting and corporate failure. R square, the coefficient of determination, shows that 89.0% of the variation in corporate failure is explained by the model.
With the linear regression model, the error of estimate is low, with a value of about .44165. The Durbin Watson statistics of 0.647, which is not more than 2, indicates there is no autocorrelation.
Decision: The creative accounting coefficient of 0.943 indicates a positive relationship between creative accounting and corporate failure though not statistically significant (with t = 0.-031). Therefore, the null hypothesis is rejected and the alternative hypothesis is accepted accordingly. This implies that creative accounting practices have positive impact on corporate failure.
- Conclusion and Recommendations
The results of our analysis revealed that creative accounting practices have significant impact on the level of audit risk in Nigeria and by implication adversely affect the audit opinion on financial statements. Our survey report for this purpose showed that R, the correlation coefficient, has a value of 0.864, indicating a positive relationship between creative accounting practices and audit failure. This finding agrees with [24] who argued that audit failure occurs when there is a serious distortion of the financial statements that is not reflected in the audit report, and the auditor has made a serious error in the conduct of the audit though not based on empirical findings.
Finally, the result of our analysis indicated that creative accounting practices have positive impact on audit corporate failure and by implication on corporate performance. Our analysis for this purpose showed that R, the correlation coefficient, has a value of 0.943 indicating a positive relationship between creative accounting and corporate failure. This finding lends support to [5], who found that the long time effect of creative accounting practices is the distrust of the investors and other stakeholders of failed corporations in the audit conducted by the external auditors owing to the collapse of companies that take advantage of creative accounting practices.
Based on the findings from this study, the following recommendations are made:
- Auditors should carry out extensive analysis to evaluate positive and steady corporate performance in order to determine whether they reflect actual performance.
- Auditors should ensure that sufficient audit evidence is obtained while carrying out the audit of financial statements in order to ensure that appropriate audit opinion is expressed on financial statements of firms with indices of possible corporate failure.
- Auditors should tailor their substantive testing procedures to aid their ability to detect creative accounting techniques. This will prevent audit and corporate failure.
- Accounting Standards setting bodies should minimise the flexibility in accounting regulation which permits discretion in choosing the accounting policies and estimates often used to improve firms’ performance.
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