Please read the following case study;

Creative accounting is referredto  as income smoothing, earnings management, earnings smoothing, financial engineerin,g and cosmetic accounting. The preferred term in the USA, and consequently in most of the literature on the subject is ‘earnings management, but in Europe, the preferred term is ‘creative accounting’.

Marchant and Rockness (1994, 79) defined creative accounting as “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”. Many research studies examine a particular aspect or technique of creative accounting, and all tend to conclude that creative accounting using that technology does exist.

However, the ethical issues of earnings management are controversial. Few practitioners and accounting scholars stated acts of earning management are ethically justifiable depending particularly on management’s intention either to be truthful or to mislead readers of the statements. The following case study disclosed how public organizations (Cat and Paws Protection Society - CPPS) practiced an example of income smoothing.

It was reported the CPPS largely depend on sponsorship and donations. As such, they are very particular to maintain good financial performance. If the organization makes a loss, doubts about its management and viability may make contributors wary of committing further funds. But a big surplus is equally risky, because it shows that the management has not used all the resources available to it. Contributors may decide that some of their money is no longer needed and may channel their funds elsewhere. The CPPS financed its operation from the following sources of income:

1. Cat and paws show conducted twice a year
2. Sponsorship and donation from individuals and corporates
3. Government funding

Like many other non-profit organizations, the CPPS’ expenses are largely fixed every year. The expenses incurred for the cat and paws shows i.e., venue, honorarium to volunteers, advertising cost, and prizes are all set in advance. The main uncertainties about the success of the show's concern on sales of tickets and entrance fees paid by the cat and paws’ exhibitors.

The financial years start halfway through the first show. By that time, the result for the first half of the financial year is nearly unalterable, and that for the second half depends largely on the attractiveness of the next show to participants and sponsorship. For this reason, the CPPS has little opportunity to manage earnings, either by making discretionary accruals or by structuring real transactions in the short term. However, in the medium term, an unexpected cash surplus in one year particularly from a successful show can be used up by providing extra services in later years, thus incurring an offsetting deficit.

Normally non-profit organizations are expected to amass a large surplus, except to be used in future operations. By smoothing out reported short-term surpluses and deficits, management may show that it has credible ways of using its resources in full, to break even over the medium term. Moreover, allowing a large surplus to be reported without smoothing may put the organization’s future revenue at risk.

Required

a) Referring to the above statement, briefly explain three possibilities of creative accounting area that motivates CPPS to practice creative accounting.

b)Were the earnings management techniques used by the CPPS ethical? Explain your answer.

c) What factors would you consider when determining whether such a decision was ethical?