Measuring not massaging

Nobody but the naive ever believed accountancy was an exact science.

Filing annual accounts has always involved making judgements, and there are plenty of areas for legitimate disagreements. But what has shocked even battle-hardened audit staff is the extent to which aggressive earnings management had grown in the gung-ho climate of the late 1990s.

A survey* carried out in the US a couple of months ago by two academics uncovered 2,630 attempts at earnings management by corporations. The academics arrived at their figure by confidentially questioning 253 audit partners from a Big Four firm about pre-audit release decisions that lead to managed earnings.

The auditors allowed 56% of the attempts because they felt the company had demonstrated GAAP compliance (21%), or because they couldn’t find evidence to refute the company’s position (17%) or because of other reasons (18%), usually to do with materiality. One of the most common abuses was building “cookie-jar” reserves, often by taking higher than reasonable charges on acquisitions that could be released in future years.

No comparable research seems to have been carried out in the UK. But if it were, most financial reporting specialists suggest aggressive earnings management incidents would be fewer, though by no means negligible.

There are certainly strong pressures to manage earnings. Steve Brice, national technical manager at Mazars Neville Russell, has studied aggressive earnings management. He says: “The pressures on those responsible for preparing the accounts to show the ‘right’ results have certainly been growing in recent years.” Those pressures include bonus or share options which are triggered by results, the need to meet legal and regulatory thresholds such as bank covenants, the desire to reduce tax liabilities by understating profits and, for listed companies, the need to meet market expectations to keep the share price buoyant. And they are only likely to become more significant should economic conditions decline further.

When the Auditing Practices Board issued a consultation paper last year, it pointed out that “aggressive earnings management results in stakeholders and the capital markets generally being misled to some extent about an entity’s performance and profitability. At the extreme, aggressive earnings management can involve acts that may constitute a criminal offence”.

Jon Grant, the APB’s technical director, says that the consensus of the consultation was that “it was an important topic and action was needed”.

But he points out that cracking down on aggressive earnings management isn’t just a task for auditors. “There is a broader need to strengthen the environment surrounding financial reporting and that involves accounting standards, corporate governance issues and the integrity of management,” he says.

Merrill Lynch analysts Fiona Ellard and Simon Hazlitt believe the economic downturn of the past few months has brought more earnings management problems to the surface. “Such practices tend to be exposed when recession arrives because falling rates of final demand reduce the opportunity to roll over recognition policies,” they say in a recent investment commentary. “In simple parlance, the bath starts to empty faster than it fills up.”

Yet, for all its faults, it is easy to see how aggressive earnings management has developed, driven by the expectations of hype-fuelled markets. A financial reporting partner at one of the Big Four, who understandably wants to keep his head below the parapet, believes the pressure to improve earnings at the end of each reporting period is at the root of the problem. He says: “The reason the problem isn’t as bad in the UK is that our companies don’t have the same quarterly pressure to perform as US companies. The pressure from Wall Street to drive better quarter-on-quarter earnings is absolutely ferocious.”

The Big Four partner is concerned about talk of adopting quarterly reporting as a European Union standard. “I’m far from convinced that would be a positive move,” he says. “When you get an FD off the record, they usually admit short-termism is a major problem.”

What many financial reporting specialists agree has probably saved the UK from the worst US excesses is the UK’s principle-based approach to GAAP, a fine legacy of David Tweedie’s reign at the Accounting Standards Board. It’s much harder to wriggle around a broad principle than a prescriptive rule.

A good example of the sort of principle it is difficult to get around is FRS18 (accounting policies), published in December 2000. This states that companies must choose the most appropriate accounting policies – not the ones they like best. It also makes it difficult to practice “smoothing”: it cautions against using “prudence” as an excuse to build up “hidden reserves”. Furthermore, it warns about any policy of understating assets and gains, or overstating liabilities and losses – “that would mean that the financial statements are not neutral and are therefore not reliable”.

The regulatory authorities have been willing to nip unsavoury practices in the bud. For example, during the height of the dotcom boom, the Financial Reporting Council’s Urgent Issues Task Force whizzed out two abstracts on website development costs and barter transactions. The abstracts are credited by auditors with preventing arrangements, such as artificial revenue swaps, appearing in the accounts of hard-pressed dotcom companies eager to prove they actually had revenues.

Even so, not all is quite as rosy as it seems in the UK’s accounting standards garden. One serious omission is a proper standard for revenue recognition policies. The use and, more often, abuse of revenue recognition has proved to be one of the most egregious features of aggressive earnings management.

Last year, the Accounting Standards Board published a discussion paper on revenue recognition. ASB chairman Mary Keegan said the ASB wanted to stimulate debate about “the underlying principles, rather than have standard-setters and regulators confront issues on a case-by-case basis”. But nothing will happen fast. This is because, from 2005, all EU-listed companies will switch to international financial reporting standards, and any standard on revenue recognition will only emerge as the product of cooperation between the ASB and the International Accounting Standards Board.

However, the discussion paper suggests a key principle is that revenue arises only when a benefit is transferred to a customer under a contract – what it calls an “exchange transaction”. The paper deals with issues such as recognising revenue on incomplete contracts and where there is an ability for customers to return goods during a warranty period. Both of these have caused problems in recent high-profile cases. But the fact the paper ran to 154 pages suggests it will not be easy to develop a simple revenue recognition standard.

As authorities on both sides of the Atlantic crack down on aggressive earnings management, another issue they will have to tackle is materiality.

A UK accounting standards insider admits: “There is a suspicion that the concept of materiality is used as an excuse by companies for bad accounting.

You can find 50 immaterial items but when you add them, they are material in the aggregate.” But he adds: “We haven’t seen any evidence of materiality giving rise to problems in the UK.”

The general edginess among FDs and auditors is likely to make companies want to appear whiter than white. Meanwhile, the accounting standards insider says there is evidence regulators are rushing to make changes, although so far they are being reasonably sensible. “But,” he adds, “there is a risk ill-thought-out rules get put into place which prove damaging.”

* How are earnings managed? Evidence from auditors by Mark Nelson and John Elliott of Cornell’s Johnson Graduate School of Management and Robin Tarpley of George Washington University.