Creative Accounting

Difficult problems are sometimes solved when viewed from a different perspective. Whether an examination of the current state of financial reporting in the UK should begin from a point nearly 2000 years ago is open to debate but the Parable of the Dishonest Steward seems a useful place to start. It may not be the earliest known reference to the existence of financial reporting but I can think of few better descriptions of its purpose. Fearing that his property had been squandered, the rich man wanted information about his financial affairs. He therefore asked for a suitable account to be drawn up.

In November 1987, the Consultative Committee of Accountancy Bodies (CCAB) appointed a committee to review and make recommendations on the process of setting accounting standards in the UK and Ireland. Chaired by Sir Ronald Dearing, it presented its report in September 1988. The Committee’s recommendations have led to radical changes in the financial reporting environment. They represent an attempt to improve the quality of financial reporting by increasing the level of regulation. The chairman of the Financial Reporting Council (FRC) was able to describe the process rather more elegantly in the FRC’s Second Annual Review, dated November 1992:

The effective working of the financial aspects of a market economy rests on the validity of the underlying premises of integrity in the conduct of business and reliability in the provision of information. Even though in the great majority of cases that presumption is wholly justified, there needs to be strong institutional underpinning.

That institutional framework had been shown to be inadequate. The last two to three years have accordingly seen a series of measures by the financial and business community to strengthen it.¹

The measures originate to a very significant extent from the recommendations contained in the Dearing Report. They are worth examining in detail because they reveal a great deal about the perceived effectiveness of regulation in securing an improvement in financial reporting practices.

On 16 May 1991, an article in the Financial Times by David Waller observed that:

Ever since Coopers & Lybrand attacked BTR’s profit record during the middle of the conglomerate’s battle for Pilkington in January 1987, it has been customary for those engaged in takeover battles to attack each other’s accounting. Given the subjectivity inherent in all accounting, and the ease with which ingenious finance directors and merchant bankers can manipulate the numbers to demonstrate the irrefutable logic of whatever case they are trying to prove, this is not surprising.²

The implication that accounting could be used as a tool to achieve certain objectives of the preparer is significant. The article also reveals the perceived need to expose deception, lest shareholders be misled into making economic decisions they might later regret. The proposition that accounting could be ‘creative’ in its ability to portray a picture vastly different to the underlying reality, formed the subject of Terry Smith’s book Accounting for Growth. Its introduction explained that:

The title Accounting for Growth was a deliberate pun. We felt that much of the apparent growth in profits which had occurred in the 1980s was the result of accounting sleight of hand rather than genuine economic growth, and we set out to expose the main techniques involved, and to give live examples of companies using those techniques.³

Smith accordingly set out to prevent his readers from losing money by showing them ‘where to find the information and how to perform the calculations needed to spot creative accounting techniques.’ ⁴ That accounting could be used as a tool to distort the user’s view of the underlying reality is a concept far removed from the purpose of financial reporting as previously defined.

According to the Accounting Standards Board (ASB), the objective of financial statements is to provide financial information about three aspects of the reporting entity. The second of these is information about its financial performance. ² To most users, this means a statement showing whether it has made a profit or a loss. Their understanding of the profit concept is probably similar to the Concise Oxford Dictionary’s definition of the term:

profit n. 1. advantage, benefit, (have studied it to my profit; no profit in such pursuits). 2. pecuniary gain, excess of returns over outlay, (sold at a ~, for more than one paid to get it);

The purpose of this chapter is to examine whether the existing accounting rules provide useful information about the financial performance of the reporting entity. At first glance, the Companies Act 1985 appears to be supportive of the user’s desire to find out whether the reporting entity has made a profit or a loss. It requires companies to draw up a profit and loss account using one of four prescribed formats. Format 1, the most commonly used format, specifies that the profit and loss account should consist of the following items (unless special circumstances require them to be adapted): ³

The Chairman’s Statement in the 1990 Annual Report of Cadbury Schweppes Public Limited Company contained the following paragraph:

Following implementation of our 1990 funding strategy, the Balance Sheet shows strength, with net borrowings at £364 million, down £60 million from [the] 1989 year end, interest cover at 5.8 times and gearing at 49.7%.

There is nothing remarkable about this statement. An equivalent is to be found in the annual report of virtually every UK company. Its significance derives from the importance it attaches to the balance sheet as an indicator of financial strength. As noted in Chapter 3, existing and potential investors are likely to take a keen interest in the financial position of the reporting entity. The extract suggests that preparers of financial statements are well aware of the user’s desire for this information. Its tone is reassuring — a strategy is in place to manage the company’s finances in a prudent manner and the balance sheet provides evidence of its successful implementation. The purpose of this chapter is to examine whether the balance sheet is capable of providing valuable information about the reporting entity’s financial position.

In September 1990, Carr, Kitcat & Aitken published an investment analyst’s report on Polly Peck International PLC. The company’s shares were then trading at approximately 260p each. Impressed by the strength of trading in Polly Peck’s food and electronics divisions, the Carr, Kitcat & Aitken analyst predicted a substantial improvement in pre-tax profit in 1990 and 1991. He recommended that Polly Peck’s shares be bought at their current price of 260p.

The ASB’s statement of the objective of financial statements requires them ‘to provide information about the financial position, performance and financial adaptability’¹ of the reporting entity. To use more common terminology, financial statements have to include a balance sheet, a profit and loss account, a statement of total recognised gains and losses and a statement of cash flows, in addition to various note disclosures.

Chapter 7 outlined the advantage of having a backdrop against which to assess the accounting allocation process which creates the profit and loss account and the balance sheet. The disadvantages of relying on these two statements as the primary sources of financial information about the reporting entity have been stressed throughout this book. The purpose of this chapter is to examine whether closer analysis of the funds statement might have assisted users of the last financial statements produced by Polly Peck International PLC. It also questions whether the traditional ratio based approach to financial analysis is capable of dealing with the uncertainties, estimates and predictions which underlie the preparation of the profit and loss account and the balance sheet.

The FRC’s 1991 review of the State of Financial Reporting contained the following comment by the chairman of the ASB:

The collapse of Polly Peck International has highlighted the treatment of certain foreign currency losses relating to investments and trading overseas, and posed the question whether SSAP 20 Foreign currency translation fails to specify with sufficient precision the nature of adjustments that should be made to the profit and loss account to take account of the loss in value of overseas assets that is caused by currency depreciation in a highly inflationary environment. Unless the results of foreign subsidiaries from such an environment are adjusted for inflation before their accounts are translated into sterling, there is a risk that the group’s reported profit for the year may be inflated at the expense of currency translation losses which are deducted from reserves rather than shown in the profit and loss account.²

The extract provides a clue as to one of the consequences of the Polly Peck International disaster. The apparent failure of accounting standards to provide users with a reliable indicator of financial performance was clearly of concern to the body responsible for issuing them. On 29 October 1992, the ASB issued FRS 3 Reporting Financial Performance. As discussed in Chapter 4, greater prominence is now required to be given to gains and losses previously excluded from the profit and loss account. ‘Accordingly, the FRS requires, as a primary statement, a statement of total recognised gains and losses to show the extent to which shareholders’ funds have increased or decreased from all the various gains and losses recognised in the period.’³

In April 1992, the ASB published a discussion paper which contained guidelines for the inclusion in company annual reports of an Operating and Financial Review (OFR). Although the document was issued by the body responsible for setting accounting standards in the UK, the OFR would not have the status of an accounting standard. The reason for this was explained in paragraph 3 of the discussion paper:

The ASB believes that the desired standard of contents and drafting of such OFRs can only be achieved by general consensus rather than by regulation, but that the climate is now such that a consensus could be achieved by the issue of guidelines that are backed by influential bodies. The Financial Reporting Council (FRC) also took the view that a statement of best practice was the only feasible route.²

The approach outlined above contrasts with that adopted in North America. The Securities and Exchange Commission in the USA and the Ontario Securities Commission in Canada require a Management Discussion and Analysis report to be filed for all listed companies in their jurisdictions. The UK proposal does ‘not provide any formal method of enforcing the preparation of OFRs of the desired quality.’³ It hopes that ‘the existence of the ASB Statement would establish a benchmark for disclosure which investors, analysts and financial journalists would treat as a reference point in their evaluation of the standards of reporting by large companies.’⁴