Accounting: Feeling exposed

As the tide of prosperity recedes further out of sight, previously submerged wrecks can no longer remain hidden. One of the most pernicious of those wrecks is creative accounting. It was recently possible, for a moment, to believe the era of creative accounting was over. However, that expectation, or hope, now seems set to be disappointed. With our global economic system, we are now more likely than ever to see cross-border accounting scandals emerging over the next 18 to 24 months. Indeed, a couple have already appeared; the Madoff collapse in the US and the eye-wateringly astonishing tale of Indian outsourcing giant Satyam are bound to be front of a queue of what will surely be a long line of business and investment frauds.

The benign conditions of the last few reporting seasons have altered dramatically now and the prevailing conditions may expose companies that have made accounting errors. These come about in two ways: either the data the company has been working off is erroneous, or accounting standards have been misunderstood and therefore accounting polices have been misapplied. It has long been accepted that the introduction of IFRS presented the perfect excuse for accounting cock-ups to take residence, even allowing for the presence of auditors confirming that all is well. How many mistakes and how serious are complete unknowns.

The second major ingredient that could plunge us into a creative accounting crisis is the desire for management to keep the numbers looking healthy, either because they want to hit targets to trigger bonus payments, or to make the numbers read a certain way. This creative accounting is a two-way street: while some may want the figures to look as good as possible, others may have perfectly valid reasons for deciding they look as terrible as possible. If you are going to make a loss, you may as well make a massive one. But with so much bad news expected in 2009, your biggest-ever corporate loss may well go unnoticed. Nevertheless, the advantage of exaggerating the bad news is that when things get better, it can start to look a lot better.

At the beginning of the year, fund manager Schroders announced it was screening European companies for ‘imprudent’ accounting practices. It claimed that the good times led some companies into aggressive accounting practices which may become apparent and unsustainable in a downturn. This, says Schroders, will lead to accounting revisions and a collapse in confidence in individual companies. The action of Schroders is reminiscent of the dots used to such devastating purpose by Terry Smith in his early 1990s book, Accounting for Growth. For reasons of competitive advantage, Schroders is shy about revealing what it is looking for, but it is looking at big movements in items on the balance sheet, such as other current assets and a lack of correlation over the long-term between net income and cash generated.

The auditing profession, or at least its regulator the Financial Reporting Council, seems to be in agreement with Schroders over the creative accounting risk and determined to learn from the accounting profession’s mistakes in this regard. It sent a warning to auditors to watch for finance directors pushing the boundaries of creative accounting too far. In the US, the Securities and Exchange Commission ­ smarting from the Madoff affair ­ has made crystal clear it is ready to take on anyone it can find who steps out of line.

It still points out the fact that it charged Fannie Mae and Freddie Mac with accounting fraud in 2006 and 2007 respectively and that both paid more than $450m in penalties to settle the charges.

Few will become embroiled in such schemes. For the majority of FDs, the greatest danger lies in the inevitable grey areas. Who could blame FDs for pushing boundaries and for testing if their auditor is up to the job of spotting the odd little stroke pulled? One FD I spoke to recently admitted he would be looking for what he labelled “innovative solutions”. In particular, he will be taking a very careful look at the technical definition of debt. Imaginatively exploring precise definitions of cash, working capital and liquidity is important, not only because of external reporting requirements but in a bid to stay within ratios set out in loan and banking agreements.
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f there is flexibility, then FDs are going to make sure that any slack swings their way. As well as cash and cash equivalents, they know the usual suspects that may be brought into play: revenue recognition, the robustness of debtors, the completeness of liabilities, impairment and derivative accounting. FDs are bound to go right to the edge. The hope has to be that not too many step over it ­ but then, what is there to stop them?

The weakness of the international process at the moment is the lack of an enforcement arm. This magazine has previously called for the international equivalent of the Financial Reporting Review Panel (FRRP). With creative accounting set to undermine global confidence in corporate reporting, such a body now seems more urgent than ever ­ and just as unlikely.