Accounting is not the black and white concept which many believe it to be, leading to many borderline areas where those in charge of the Company must use their experience and knowledge of accounting standards to decide on the best treatment.
A Company will be bound by their local reporting requirements. In some instances the company will have a choice between which guidelines to use, for example Companies in the UK can usually adopt UK Generally Accepted Accounting Practices (UK GAAP) or the International Financial Reporting Standards (IFRS). The financial statements will include an accounting policy which clarifies which framework has been adopted.
All of the major accounting frameworks include an element of estimation required by management. Consider the depreciation policy of a vehicle; it is not possible for management to accurately anticipate the point in time where the residual value becomes £nil. This is where a considered estimation is required. For an everyday vehicle a residual life of anywhere between 3 and 5 years would most likely be accepted as reasonable by the external accountant or auditor. Although this is a simple example and other points of reference would be used, such as looking at historical profits or losses on asset disposals, it is clear that estimations can directly affect the figures within the financial reporting carried out by the Company.
Accounting in the UK also relies on key principles which underpin the accounting framework. One of these principles is that of matching. The matching concept states that if income is recognised then the corresponding costs should also be booked.
The application of this principle has been topical recently due to the news of a potential overstatement within Tesco’s interim reporting. It is understood that the supermarket has overstated profit within its six monthly report by £250m leading to a revision in its full year profit target from £1.1bn to £850m.
The cause of this overstatement is reported to be accelerated income recognition coupled with the delayed accrual of associated costs. In Tesco’s defence the misstatement is speculated to have occurred on commercial income which is notoriously a grey area for accounting. This stream of income is derived from manufacturers as an incentive to sell their products, the most common example would be promotions such as ‘Buy One Get One Free’, although it could extend to merely placing products in prime locations within stores.
Tesco’s listed status will automatically raise questions amongst the general public over whether this misstatement was an honest mistake, an aggressive interpretation of acceptable accounting, or a deliberate attempt to portray a better picture to the market. The water is further muddied by the fact that the finance director, Laurie McIlwee, was not replaced after resigning in April 2014. The gap in the internal control environment caused by the lack of a key individual could have fuelled the competitive culture of a company where constant growth is expected.
The pressure on listed entities to consistently provide the markets with positive and timely data gives rise to the ideal environment for accounting misstatements. This is illustrated by the troubles faced by a top 20 firm of accountants, Tenon, who were listed on London’s Alternative Investment Market.
Tenon embarked on an aggressive acquisition policy as a strategy for quick growth. However they were forced to restate their 2010/11 accounts after uncovering inconsistencies in the application of accounting policies in their published financial statements, meaning that pre-tax profit was £12.1m lower than originally reported. Tenon were subsequently forced to cut their workforce after posting a loss of £70m in the first six months of the next financial year, due in part to goodwill amortisation charges of £60m.
There are ways which the management of companies can minimise the likelihood of accounting blunders. Effective corporate governance at board level can instil an inquisitive culture from the top down. If conducted in the correct manner, internal and external auditors can also give assurance over the accounting and control system through their independent professional scepticism.
In some cases intentional behaviour from rogue stakeholders can override areas of the internal control system.
For proactive companies, a forensic accountant can be used to perform an independent review of the system to suggest potential areas of weakness. Where management have suspicion that a dishonest act has already occurred, a forensic accountant can retrospectively analyse agreed areas to quantify the size of any misstatement. If required the forensic accountant can then perform the role of an expert witness to communicate the evidence gained together with an opinion, to the Court.