How directors should respond to creative accounting
By GERARD TAN
The Business Times, 7 April 2023
Under pressure in a dynamic environment, management may, however, seek to portray a different financial image of the company beyond what strict accounting rules might allow.
The more egregious cases result in corporate failures (think Enron and WorldCom), where “true and fair” audited financial statements subsequently turned out to be less than true and fair. Closer to home, the well-publicised cases of Informatics and Noble show that things can go wrong, intentionally or mistakenly, when complex accounting standards are misapplied or misinterpreted.
Stretching “true and fair”
Creative accounting is not necessarily outright fictitious accounting, where transactions are made up and falsified in the books.
It usually arises when the management convinces the audit committee (AC) and the board to accept aggressive accounting policies based on misinterpreting or exploiting ambiguities in the financial reporting standards.
The opportunities for creative accounting are as many as the rules that exist. Some of the common tricks to inflate profit are:
- Recognising revenue in advance. The standards require that revenues be recognised on the income statement when they are earned and realised. Companies have been taken to court for recognising revenue upon the sale rather than the fulfilment of the goods or services.
- Lowering depreciation. Companies reduce depreciation charges (and hence increase income) by using periods for the life of assets that are beyond their useful lives.
- Delaying expenses. The company inflates current period earnings by deferring the recording of current period expenses to future periods.
- Ignoring asset impairment. The company does not recognise the impairment of assets which may have gone obsolete or contracts which have gone bad, thus inflating profit.
- Manipulating inventory value. The value of goods not sold can understate or overstate the cost of goods sold, with a consequential impact on income.
While the income statement is often a focus and more readily understandable, misstatements of the balance sheet could more significantly impact the company.
A common area of concern is contingent liabilities such as lawsuits, penalties and claims (including pension obligations) that are not recognised or fully estimated in the balance sheet, even though they may appear in a note to the financial statements.
The classification of debt can also affect how investors perceive the company’s financial position. The Hyflux case illustrates the complexity of accounting standards in this regard. While still an active case before the authorities, the company maintained that it had complied with Singapore Financial Reporting Standard (International) 1-32, which allows certain forms of perpetual securities to be classified as equity and not a liability. If it were legitimately treated as equity, the interest on perpetual securities would be reflected as a charge to equity, and not in the income statement.
On the other hand, if perpetual securities are recognised as a liability and its interest charged in the income statement, this would naturally reflect a much higher leverage and change the complexion of the health of a company’s financial position, sometimes drastically.
The audit committee
In most corporate governance regimes, much of the responsibility has been put on the AC to avoid creative accounting and ensure sound financial statements.
The Singapore Code of Corporate Governance 2018 sets out the AC’s role, composition and duties in this respect. It requires that the AC comprises at least three non-executive directors, with the majority, including the AC chair, being independent. The AC chair and at least one other member should have “recent and relevant accounting or related financial management expertise or experience.”
The external auditor reports to the AC. The listing rules require that the AC recommends the financial statements to the board and concurs with the board’s comment on the adequacy and effectiveness of internal controls and risk management.
The board’s responsibility
While much responsibility and authority are given to the AC for the financial statements, it does not stop there. Section 201 of the Companies Act holds all directors responsible for ensuring that the financial statements comply with the Accounting Standards and provide a true and fair view of the financial position and performance of the company.
In the 2011 Centro case in Australia, its directors, including non-executive directors, were convicted of failing to exercise care and diligence in the audited financial statements. The directors had failed to notice that more than US$2 billion (S$2.5 billion at the time) of current liabilities were wrongly classified as non-current.
All eight directors charged argued that they relied upon their external auditor. However, the judge found they breached the law by not checking the figures. He said, “All that was required of the directors … was the financial literacy to understand basic financial conventions and proper diligence in the reading of financial statements.”
Directors who do not have accounting or finance-related backgrounds would do well to be trained to understand at least how to read and analyse financial statements. But above all, the abuse of creative accounting methods can be eliminated by improving ethical norms. The board and AC need to lead the way on this.
The writer is a member of the Boardroom Matters committee of the Singapore Institute of Directors.