Every company in the country is fiddling its profits. Every set of accounts is based on books which have been gently cooked or completely roasted.
That was the assertion made in the original version of Creative Accounting when it was first published in 1986. Much may have changed in the intervening years but the basic premise still holds true. While many of the more flagrant abuses of the flexible accounting regime with which this country was once blessed have been outlawed those who are charged with the responsibility of preparing a set of accounts still have an extensive range of techniques available to them which can be used to massage the figures which are presented to the watching world.
This is not a criticism of the Accounting Standards Board which was set up in 1990 to bring some order to the chaos which then passed for a regulatory framework. Indeed under Sir David Tweedie's leadership the ASB has made tremendous progress in restoring the credibility and integrity of accounting standards.
Rather, it reflects the imprecise nature of a financial reporting process requiring every company to present accounts each year which reflect a true and fair view of how the business has fared. This never was and never can be an exact science. Instead it is a subtle combination of objective fact and subjective assumption. Except in the simplest cash-based businesses it is impossible, even with the best will in the world, to produce accounts which are anything other than an approximation which have their basis in the transactions and events of the year under review.
How close that approximation is to the original starting-point will depend on a number of factors. Creative accounting represents the means by which that deviation will be achieved.
The big problem facing investors is that there is nothing illegal in companies using to their best advantage accounting rules which are drafted to allow accounts preparers a high degree of flexibility. That flexibility is given not because of any laxity on the part of the standard setters but simply to give the regulatory framework a fighting chance of having a degree of relevance for those who must be guided by it.
The biggest difficulty is that companies are required to report annually. As a period of accountability there is a lot to be said for the twelve-month cycle. Unfortunately it has no relevance at all to the natural business cycle of any company you care to mention. A baked-bean manufacturer would have a cycle which was measured in weeks. A construction company would, however, have a cycle measured in years. Yet both are obliged to report their results on an annual basis and to report them using the same accounting standards.
It is this mismatch between the reporting and business cycles together with the need for a common set of standards to apply to all industries which provides the need and the justification for flexibility. It is flexibility which feeds creative accounting. And it is creative accounting which in the wrong hands can undermine the credibility of a set of accounts.
In this accounting chain the logical conclusion to be drawn is that the greater the degree of flexibility in accounting standards the higher the risk that the quality of reported figures will be distorted. This was indeed the case in the mid to late eighties where a combination of a weak accounting standards setting regime and an orgy of self-indulgent corporate activity conspired to erode significantly the integrity of financial reporting. It was against this backdrop that Sir Ron Dearing's committee was established by the accountancy profession to make recommendations on the standard setting process. His
conclusions, presented in September 1988, were to provide the basis for the creation of the new regime of which the Accounting Standards Board represents the cornerstone.
The timing of his report was helpful for the cause of reform, coming as it did towards the end of the eighties take-over boom and just before the onset of recession. It was in the field of acquisition and merger accounting that some of the most outrageous abuses had been developed. Encouraged perhaps by weak and feeble standard setting a variety of techniques was developed which allowed some acquisitive companies to paint a more positive picture of their position than reality could ever justify.
There were enough warnings about the dangers of an overenthusiastic use of creative accounting. Indeed every contested take-over seemed to involve at some point a vitriolic attack on the quality of the opposition's accounting policies. Unfortunately no one was prepared to pay too much attention and it was only when some of the acquisition-driven conglomerates began to unravel in the face of a less benevolent trading climate that concern began to mount. A series of high profile corporate collapses provided the most compelling argument for reform of the standard setting process. Accounting policies which were accepted without question while share prices were on the way up were discredited as companies came tumbling down.
That reform was spearheaded by the ASB which assumed responsibility for standard setting in its own right in August 1990. There was much to differentiate it from the old Accounting Standards Committee which it replaced and therefore every reason to hope that it would have a greater degree of success in constructing a framework which was more in keeping with the demands of the nineties.
Perhaps most importantly the ASB is independent. Its predecessor had merely been acting on behalf of the Consultative Committee of Accountancy Bodies, the umbrella organization for the profession. The whole process was cumbersome and lacked any real degree of authority and self-confidence» The ASC had no full-time chairman and lacked the focus which was desperately needed. It relied extensively on the goodwill and support of practitioners who were becoming increasingly frustrated by the steadily eroding reputation of the ASC.
Neither could the ASC respond quickly to the issues of the day. At one point a new standard was published even though a loophole to render it worse than useless had already been devised. It was considered in those days that any standard, no matter how defective, was better than no standards at all.
Under the new regime that has changed. The ASB does not operate in isolation and is supported by a number of other bodies. It is overseen by the Financial Reporting Council which provides a broadly based umbrella committed to the promotion of good financial reporting.
More important, however, are two other bodies which have given the new regime a tum of pace and the teeth which had not previously existed. The pace is provided by the Urgent Issues Task Force which was set up by the ASB in 1991 to give it the ability to respond much more swiftly to emerging questions which demand quick action.
The pace of development of new accounting techniques quickened considerably during the eighties to an extent where they quite easily outstripped the cumbersome standard setting process. They were not just outwitting new standards; they were touching the parts which had not yet been considered let alone actually reached. That was not a reflection of the cunning creative accountant poring carefully over the small print of standards and devising ingenious ways to bend the rales. Many of the techniques were developed to reflect rapidly changing business and financing practices.
A slow, inefficient and uncertain regime was easily overwhelmed. However, the problem of dealing with refinements to and new interpretations of the rules and regulations did not disappear with the arrival of the ASB. If the flow of contentious questions slackened it was a function of economic slowdown rather than a sudden upsurge in accounting correctness. The
UITF was established specifically to bring clarity by offering authoritative rulings on the practices in question. This mechanism has allowed the ASB to clamp down on specific abuses without having to go through the process of redrafting a standard entirely.
If the UITF gave the new watchdog more spritely legs then its teeth were provided by the Financial Reporting Review Panel. This was set up to deal with any departures from the reporting obligations of the Companies Act. More importantly it has the power to force a company to redraft its financial statements if these are deemed not to show the requisite true and fair view. This represents teeth that are sharp. It is not so much the cost of redrafting accounts which represents the penalty but rather the public humiliation.
An independent and more professionally based ASB with the ability to respond to emerging issues and supported by not just the enforcement power of the FRRP but also legislation which was amended in 1989 to require companies for the first time to state whether their accounts had been prepared in accordance with the applicable accounting standards represents an altogether more effective regime than the one it replaced.
Yet despite these improvements creative accounting still flourishes. As we will find in later chapters many of the most basic areas of the profit and loss account and balance sheet can still be manipulated. The ASB has had its greatest success in outlawing the most flagrant abuses but without changing the entire basis of accounts preparation it will struggle, on its own, to erase creative accounting entirely.
The biggest problem it faces is the unwitting conspiracy between the City and industry which ensures that the black and white which so many appear to demand will be condemned always to a murky grey. While much is made of the tension between companies and their investors there is a remarkable overlap in their interests. Both would like to see a steady increase in a business's earnings growth profile. In reality it is rarely achievable. However, that does nothing to diminish the zealous pursuit of this elusive Holy Grail. It is when there is a demand to use accounting to shift the reported figures ever so slightly away from reality that the potential for problems begins. It is easy to see where that demand comes from. If investors were asked to choose between a company which over a five-year period showed pretax profits of £1 million, £2 million, £3 million, £6 million and £8 million and one which showed a profit of £1 million, a loss of £2 million, a profit of £4 million, a profit of £9 million and a profit of £8 million they would always choose the former. Shareholders much prefer a company showing steady growth. Yet over the period the actual net pre-tax profits of both companies is exactly the same at £20 million. The first company has merely used creative accounting to iron out the natural fluctuations of the business cycle.
There is nothing fundamentally wrong with that, many would argue. Indeed it is hard to find a reason why shareholders should be subjected to violent fluctuations when the underlying trend line is upwards. The question which arises, however, is where do you draw the line? That is a matter for debate. Where there is debate there is uncertainty. Where there is uncertainty a judgement needs to be made. When judgements need to be made the creative accountant is operating in the most fertile ground available.
There is nothing wrong with smoothing out confusing distortions. But it is a thin line between that and using creative accounting to introduce distorting confusion into the financial statements. The problem both for companies and investors is that the flexibility which is so essential to make sense of a company's trading performance can quite easily make the reported numbers a nonsense. When creative accounting is used to try to reverse the business trend rather than give it more clarity then there is real danger for all involved in the process. Creative accounting can do many things but it cannot save a company which is in difficulties because of fundamental trading problems.
It was when companies began to creak and crumble that investors really began to sit up and take notice. The sudden
realization that stated earnings were not necessarily a reliable guide to the underlying strength of a business provided the greatest spur for a renewed interest from the investment community in the quality of financial reporting. That interest has certainly helped the ASB's cause. However, it has not always been translated into the kind of positive involvement in the process that some would have liked. Although there has been a concerted attempt by the ASB to get investors more actively involved in the overall process there has been surprisingly little active support. Everybody agrees that they would like to see an improvement in reporting quality but there are fewer who have ideas on how this might be achieved.
It has been said that it is often easier to describe what you don't want than what you do want, and so it is with accounting standards. There was disquiet with the old system but as far as a new regime is concerned investors really want the impossible. What they would like is to have perfect accounting information on which they can base their investment judgements. But as we already know accounting is an imperfect science.
There is a further confusion because of the fixation with the single number approach to assessing corporate performance. There is a peculiar thirst for a single snapshot figure which allows instant assessment of how a company is doing. Traditionally that role has been filled by the earnings per share figure. What Sir David Tweedie at the ASB has been doing is to try to wean people away from one number and persuade them to look at a whole range of indicators.
It is an entirely sensible approach but it does rely upon the users to take much more interest in a set of accounts than they have done traditionally. Part of the problem here is that there is residual disenchantment with financial reporting. The task for the ASB is therefore not just to provide clearer and more decisive rules but also to restore the credibility of accounts in their entirety.
It is all very well obliging companies to improve the level of disclosure in a set of accounts but if no one is ever going to bother to read the document then it is all to no avail. A further question therefore arises of the relevance of accounts themselves to the investment decision process. More City attention still appears to be focused on a company's preliminary announcement of its results. In many cases these are quite detailed documents, but they can never have the scope or authority of the full set of accounts.
Institutional investors and City analysts also have a range of other means at their disposal which they can use to supplement . the raw details of a company's financial performance. Most companies are today much more conscious of the need to have good relationships with the City and are prepared to make themselves available to answer questions about the results and to talk about long-term strategy at private meetings. Some would argue that these are much more valuable as decisionmaking tools than the accounts themselves.
It is not however just the City's lack of detailed interest in the accounting process which provides a stumbling block to a rapid improvement in the quality of financial reporting. Companies themselves are also in danger of inhibiting the rate at which progress can be made.
For while they have been generally quite supportive of the approach which the ASB has taken the fact remains that it has not yet strayed into too many areas of great controversy. The vast majority of companies never bent the rules too far. If you have never benefited from using some of the more outrageous creative accounting techniques you do not miss them when they are gone.
Some companies which relied on sleight of hand have simply gone under. Others have been chastened by their creativity and have been forced to unravel the schemes and policies which once flattered them so generously. Most businesses have found, however, that the recessionary years have forced them to concentrate on some quite basic issues. Few have been in expansionary mode and questions of the longer-term implications of a new reporting regime have tended to be pushed further down the main board agenda.
But with the economic outlook improving and the changes
that the ASB are making nudging closer to more controversial areas there are just the first signs that the corporate sector is beginning to look more closely at those implications. It does not always like what it sees. We are a long way from open revolt but the generally supportive stance of accounts preparers will not always be given in future.
The difficulty for the ASB is that companies believe that they are being subjected to increasing regulation. This can come in any shape or form but it almost inevitably imposes an additional burden. There is a genuinely held fear that they are reaching information overload. There is a danger that the ASB's moves to improve the overall quality will be misinterpreted.
The ASB's reforms also coincide with the introduction of the Cadbury Committee's proposals on corporate governance. The Committee, ironically, had its foundation in the level of dissatisfaction with financial reporting. Its terms of reference demanded that it consider a range of issues in relation to financial reporting and accountability. The first of these was 'The responsibilities of executive and non-executive directors for reviewing and reporting on performance to shareholders and other financially interested parties; and the frequency clarity and form in which information should be provided'.
On the basis of that wording it could be assumed that there would be considerable overlap between the work of the ASB and the work of Cadbury. However, because of the way in which the Cadbury Committee developed its thinking its recommendations became much more concerned with board structure than accounting policies.
The two initiatives are not therefore seen as a response to the same problem; they are viewed as different animals. Cadbury extends regulation rather than supplements the work of the ASB. Against this backdrop it is perhaps not surprising that companies begin to feel under a little bit of pressure.
But there is yet another dynamic at work which colours to a certain extent the attitude of companies to financial reporting. This relates specifically to their communications with the press and the City. Stock Exchange guidelines, designed to clamp down on the leaking of price-sensitive information, have served only to restrict the way in which companies deal with the outside world.
In crude terms, the old system allowed companies to marshal the array of analysts' forecasts of their profits' performance into a tolerable range of acceptability. This was done through an informal system of nods and winks which ensured that those analysts who were out of line with the reality could be guided towards more appropriate territory.
It was a system which worked to everyone's advantage. Whether it was healthy is another matter entirely. However, it meant mat when results were finally announced there were never too many great shocks and surprises. This avoided embarrassment on the part of the forecasters and would also protect a company's share price from the kind of excessive volatility which always follows the unexpected.
Under the Stock Exchange's new guidelines this kind of gentle shepherding has been effectively outlawed. Any price-sensitive information must be put into the public domain on a more formal and even-handed basis. The ability to correct misinformed forecasts is therefore restricted to set-piece events. The potential for surprises is therefore greatly increased.
Many companies have devised different approaches designed to give as much assistance as they can but there is still considerable room for error. If a business finds itself in the unfortunate situation where the market's expectations are much greater than the reality can deliver it has two choices: it can put out what would effectively be deemed to be a profits warning with all the grief that this entails; or it can turn to the finance director and see what dodges and wheezes there are whkh might massage the profits profile towards the City's forecasts.
The corporate sector is faced therefore with a number of pressures which make it more difficult to embrace wholeheartedly the ASB's improved disclosure ethos. There is a
natural resistance to being overburdened by reporting and regulatory requirements. There is a greater awareness of accountability and governance and there is a critical City audience which it has less ability to influence.
There is a final piece to today's creative accounting jigsaw -the auditor. Once the butt of cheap jokes he is now the butt of expensive lawsuits. A by-product of the corporate collapse is the search for the guilty party. Unfortunately in these situations there can be no such thing as joint and several liability. Someone is to blame, therefore someone has to pay. It is all very well to point the finger at the company but the very nature of the corporate collapse means there is no chance of extracting financial retribution. It is therefore the auditor who is shuffled uncomfortably into the firing line.
The reason is understandable. How is it, people ask, that a company which in a set of audited accounts is showing a healthy performance can in a matter of months be bankrupt? It is a good question for which there is no satisfactory answer. As auditors are deemed to have deep pockets and comfortable insurance they are natural targets for aggrieved investors.
The problem here is that no one really understands the auditor's role. It is known as the 'expectation gap' which represents the difference between the outside world's view of what the auditor is supposed to do and what a firm is legally and contractually obliged to undertake. If this gap had a geographical equivalent it would be the Grand Canyon, so great is the divergence.
The auditor may have the law on his side but the profession has discovered that this is not a defence guaranteed to secure sympathy in any great degree. There has been something of an attempt by the auditing profession not just to explain itself more clearly but also to move its work more closely towards what is expected of it. Even so firms still find themselves under considerable pressure. A firm's opinion that a set of accounts shows a true and fair view is still nowhere near as reliable as some users believe. That will always expose an auditor to probing and difficult questions when things go wrong. At the same time a firm which is theoretically acting on behalf of shareholders to whom it reports is actually paid by the company and must deal on a daily basis with its executives.
Few directors are crude enough to suggest that a failure by an auditor to endorse a particular accounting policy will jeopardize their position. However, it is a tough old world and companies are always obliged to keep their costs under review. Who is to tell whether a competitive tender for the audit might not produce great savings?
None of this is helpful for the ASB. If neither preparers nor users have the same degree of commitment to its goals and objectives then the danger of ebbing closer towards compromise is increased significantly. And if auditors themselves are not brimming with self-confidence their chance to act as an effective arbiter of good accounting tastes, particularly in an area which is dominated by opinion rather than fact, is much reduced.
It is against this backdrop that the development of the standards setting process and therefore the motivation for creative accounting must be seen. For while the climate has changed superficially many of the basic design faults are still in place.
As the following chapters will demonstrate there is still tremendous scope for manipulation.