Where accounting gets creative

I sometimes wonder whether anyone ever reads IAS 1, Presentation of financial statements, and in particular paragraph 15. This states that ‘statements shall present fairly the financial position, financial performance and cashflows of an entity’. The standard then adds that ‘the application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation’, which is verging on humorous for anyone who has tried to decipher an IAS 7 cashflow statement.

I fundamentally disagree with the IAS 1 contention that compliance equals fairness. As I discussed in my article on spurious accuracy, many numbers in the primary statements are estimates, which immediately creates scope for judgment and in some cases manipulation. My all-time favourite quote from an annual report was from a company engaged in complex multi-year contracts. The notes explained that valuing such contracts was based on detailed calculations but with ‘significant manual intervention’.

The conceptual framework goes further and adds that statements ‘must also faithfully represent the substance of the phenomena that [they] purport to represent’. In the UK, the law goes further still and adds an overriding requirement that statements should give a true and fair view. This concept is often referred to as the ‘true and fair override’, and the principle is that auditors should not sign off on accounts that may comply with the letter of the standards but are misleading.

Creative accounting

You may now be wondering why I am bothering to write about such basic issues. It’s because the raison d’être of creative accounting is to present a view that is not fair, does not faithfully represent the substance of economic reality and is almost certainly untruthful in a legal sense.

Every example I have ever seen of creative accounting fails the true and fair test. When the real story emerges, usually after management change, my first thought is ‘How did they get this past the auditor?’ The answer here usually involves an aggressive and bullying CEO with somnolent non-executive directors.

My second thought is ‘Was this a technical breach of IFRS, or just an overly flattering interpretation?’ This question is always harder to answer, as accounting standards will never be watertight. There will, and should, always be room for interpretation. Very few post-meltdown investigations reach a solid conclusion that a standard was breached, especially if fraud was involved.

My third thought goes back to IAS 1. The standard states explicitly that additional disclosure should be provided when necessary to ensure that the statements give a fair view. In every case I have seen, additional disclosure about what was really going on would have resulted in an investor backlash and probably executive defenestration.

Weapons in the armoury

Auditors then have two powerful weapons at their disposal when faced with creative accounting. I am assuming here that most creative accounting will be known to the auditor except in cases of outright fraud. The first weapon is to insist on additional disclosure to ensure a fair view. The second, particularly in the UK, is to say that the statements do not give a true and fair view. Neither weapon requires the auditor to demonstrate that a technical breach has occurred, just to exercise a bit of common sense.

My final question is why neither weapon ever gets used. To my knowledge, the true and fair override has never been tested in court and is a bit of a nuclear option. So why do auditors almost never insist on additional disclosure as required by IAS 1? I suspect the answer is cultural: it’s just not the done thing. Maybe ever-increasing penalties will force a rethink.