How to Take the Creative Out of Accounting

You don’t have to search hard to find examples of creative accounting. Forget Donald Trump—go straight to pop culture. The television series The Mandalorian features the amphibious-humanoid Mythrol, Karga’s assistant, who is on the run after engaging in some questionable bookkeeping. 

In real life, overly creative accountants need not go on the lam. In fact, some accountants say there’s nothing to be ashamed of. That’s because aggressive accounting exists in a fuzzy zone. It may push mighty hard against the limits of the law but it doesn’t actually break through.

“Accounting rules have a lot of grey areas,” says Pamela Murphy (retired), E. Marie Shantz Fellow of Accounting at Smith School of Business. “You have to come up with estimates of bad debts or warranties or even the value of your assets. There can be a number of assumptions that cause you to be more aggressive and make things look a little better than they are, but they’re not necessarily illegal.” 

Murphy is a certified public accountant and prolific scholar who has studied the entire fraud continuum. In her latest published study, conducted with Khim Kelly (University of Central Florida), she examined the role that company culture plays—in particular norms around ethics—to check against aggressive accounting. She found that ethical norms are essential but insufficient to really change the behaviour of individual corporate accountants.

In this conversation with Smith Business Insight, Murphy explains what she learned.

If aggressive accounting is legal, why should we care if accountants get a bit creative? 

I think it’s important to study that grey area. I and others have found that if someone is going to commit fraud, particularly fraudulent financial reporting, it often starts with these smaller acts, like using estimates to your best advantage. When that no longer works, it can move into fraud. 

Regulators are concerned about aggressive accounting because they know it can lead to worse things. I’m on the Auditing and Assurance Standards Board, and we’re concerned about auditors allowing aggressive accounting because it’s a red flag for potentially more worrisome behaviour. 

Your latest study suggests that company culture has a role to play in reducing the incidence of aggressive accounting, but that it’s not the whole story. 

It’s definitely two related factors that can affect these aggressive accounting decisions. One factor is the ethical norms in the organization because these norms impact what we do in different ways. The best way to explain ethical norms is when you see others making decisions that seem to be the right thing to do, as opposed to decisions that are best for themselves or for the company. 

The second factor is that these ethical norms have to be activated while the accountant is in the process of having to decide whether or not to take an aggressive approach to an accounting question. It could be a subordinate or a peer saying, we should do this. It could even be a poster that communicates the ethical norms, though the power of the poster will diminish over time. It’s anything that makes the accountant think about those ethical norms at the moment when a decision has to be made.

The biggest takeaway is you can’t just rely on having positive ethical norms in your organization. First and foremost, it’s not always clear to a management team exactly how ethical the norms are in their organization. Leaders often think their organization operates in an ethical manner, but it’s not always the case. But even so, you have to go a step further. And at the point of decision-making is when those norms need to be salient to the decision maker.

Would the opposite be true? Can a super-aggressive approach to accounting be encouraged by corporate ethical norms and a timely trigger?

We didn’t look at the flip side. But an interesting insight from our study is that none of the study participants, who were all accountants, made really aggressive decisions, which is a good thing.

This is just an anecdote, but when I teach auditing and accounting, the accounting students tend to have more of a conservative mindset and are more risk averse. They’re more likely to say, I don’t know if that’s a good idea. But many of the finance students in the same accounting class view it as their job to use the rules to their or their company’s best interests.  Some would say that’s an ethical decision. Others would say ethics has nothing to do with it.

What’s your advice to firms that want to discourage an aggressive accounting approach? 

We’re often motivated to act a certain way. In our study, we intentionally motivated [the accountant-subjects] to want to be aggressive by offering them a bonus. And that reflects real life in so many companies. So if management truly wants to make the right decisions, as opposed to these grey-area decisions that might favour the company, they can find ways to talk about how to approach these decisions and build in prompts at the right time when these decisions are typically made.

I honestly don’t know how many companies would do the kinds of things that we’re talking about or even want to. They will all say they want to, but I’m a bit skeptical.

Companies may enjoy existing in that grey area. A recent study suggested that over the long term aggressive accounting actually benefits investors and the CEO. 

It's possible. Some firms also use these grey areas to smooth earnings over time because investors don’t like big shocks. But aggressive accounting falls apart when things start to go badly for the company. When you do that, you’re basically paying today with some of tomorrow’s revenues. And if your business starts to flip, you’re in trouble. Right now, unfortunately, we’re entering a time where there’s trouble for a lot of companies. 

This ties in with some of my other research in which we’ve interviewed people who either committed financial statement fraud or, more interestingly, were pressured to commit financial statement fraud but resisted. And it is at that point where they say, We’ve taken estimates a little further than we should but now we need to do more. It’s not enough for us to keep up. We’re borrowing more and more from tomorrow to show today. They were under so much pressure and bullied, and it can be an awful situation.