Whenever in the classroom I discuss contemporary principles and
methods for the preparation and presentation of financial
statements, with executive and students, I always see discomfort
gripping the participants.
They express concerns that current principles and methods provide a
significant scope for earnings management and that the managements
of companies definitely bend the rules to boost reported earnings. I
see a kind of scepticism about the ethical standards of companies.
The scepticism is not baseless. A case in point is the restatement
of profit by Dell Inc. In August this year, Dell Inc reported that
it would restate more than four years of financial results ending a
year-long probe. The probe found some teams changed accruals and
reserves, estimates of expenses or losses that have occurred and
haven't yet been paid, to meet quarterly goals. Some officials
didn't report complete information and purposefully gave incorrect
or incomplete data to auditors.
Accrual accounting is the most acceptable account system and is used
universally.
Under accrual accounting income and expenses are recognised without
waiting for realisation or payment of cash. Similarly accrual
accounting involves allocation (for example, depreciation on fixed
assets) and deferment (for example, deferment of revenue when
collectibility is uncertain or the earning process is not complete).
Thus, estimation is at the centre of the accrual accounting. In many
situations, management is required to form an opinion about a
situation and based on that opinion it estimates assets,
liabilities, income and expenses. Opinion should be supported by
evidence and the auditor should be satisfied that the estimation is
fair.
In some situations even the auditor has to depend on the information
provided by the management. Accounting for fixed assets is an
example. For subsequent expenditure on existing item of property
plant and equipment (PPE) should be added to the carrying amount
only if, the expenditure increases the service potential of the
asset beyond originally estimated service potential.
The original estimate of service potential should be made at the
time of acquisition. For example, assume that a company, engaged in
a tourism business, had purchased a used car and at the time of
purchase, it estimated that Rs 200,000 would be incurred to get the
car ready for intended use. However, while the car was in the
workshop, the engineer found an accidental damage, which had been
camouflaged, and hence could not be detected. The actual expenditure
incurred is Rs 700,000. According to the accounting rule, the
company should add only Rs 200,000 to the acquisition cost and
recognise Rs 500,000 as an expense for the period, because the
additional expense does not increase the service potential beyond
the originally estimated service potential. In this situation, the
question of ethics is important. None other than the management
would ever know whether the accidental damage was detected at the
time of purchase. If the company does not disclose that it could not
detect the damage at the time of purchase ,none (including auditors
and audit committee), would ever know the fact.
This example is a simple example, but similar situations regularly
arise in actual business operations. I know a case, where a manager
of a foreign branch capitalised a costly seat cover of a car only to
avoid the need for seeking the approval of headquarter. According to
the rule of concerned company, if the capital expenditure/ revenue
expenditure exceeds a predetermined amount, the branch manager need
to seek approval of the headquarters; the limit for capital
expenditure is higher as compared to the amount set for the revenue
expenditure. This also brings ethical questions, may not be at the
corporation' s level but at the individual level of managers.
Another example is accounting for provision and contingent
liabilities. There is a thin difference between provisions and
contingent liabilities. For example, a company may file a frivolous
appeal against a demand from the revenue department in order to
avoid recognition of a provision for the claim in the balance sheet.
The company will present the liability as a contingent liability by
way of disclosure in the foot note. The accounting rule stipulates
that a provision should be recognised at the best estimate of the
management. Therefore, if the management estimates that the appeal
will be dismissed it should provide for the liability. The
management should form an opinion based on the legal interpretation
and precedence and then to estimate the liability. Usually a company
takes a legal opinion to support its best estimate. However, it is
generally believed, though it might not be true, that a company can
always find a lawyer who will give an opinion to support the opinion
of the management. The practice of under-statement of provision for
such liabilities is so prevalent that the Narayana Murthy Committee
in its reports on corporate governance recommended that contingent
liabilities should be disclosed in plain English and in detail. But
that is not practical, because explanation to each contingent
liability requires significant space.
The disclosure of information on estimation of liabilities for
employee benefits (e.g. liability for pension) before the revision
of the Accounting Standard 15 was inadequate. It is believed that
the companies could obtain an estimate of pension liability from an
actuary of its choice. This again raises a question of ethics. It is
understood that the actuarial profession has disciplined its
members. But the situation might continue because the demographic
information and information regarding salaries etc provided by the
company to the actuary should reflect the best estimate of the
management. An unscrupulous management may understate the liability
unless the audit committee and the auditor are alert.
In fact almost all the new Accounting Standards (e.g. accounting for
impairment) provide significant potential for earnings management.
We should not expect that the management of companies will suddenly
improve the ethical standards. When I talked to managers of
different companies, I often get the feel that they believe that
earnings management to smoothen earnings is legitimate. They believe
that and therefore, earnings management is sometimes required to
protect the interest of shareholders. They find the accounting rules
too harsh. However, it is well established that accounting policy
and its implementation should not aim at smoothing earnings. The
temptation to manage earnings, particularly at the time of poor
performance is natural.
Managers generally want to keep bad news under the carpet with the
expectation that things will definitely improve in future.
Therefore, we have to rely much on the audit committee of the Board
and auditors. The Board of directors has the primary responsibility
to set high ethical standard for and appropriate culture in the
company. The Board should always question unethical practices and
should not approve decisions, which may be construed as unethical,
irrespective of whether or not the management has ulterior motive.
In most occasions, compliance report on ethical standard is
considered to be a mere formality and the Board does not pay due
attention to the same. As regards the formulation of accounting
policy and implementation, the audit committee should be very
attentive and should exercise its authority without leaving the same
to the CEOs and CFOs.
Asish K Bhattacharyya / New Delhi September
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