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Globally, regulators, accounting standard setters, preparers and users have settled for principle-based accounting standards because it provides the flexibility that is needed to apply the accounting principles and methods appropriately in various industry settings and business models. Consequently, they allow discretion to preparers to apply the accounting principles stipulated in accounting standards. For example, in deferring revenue recognition in a multi-element sales contract (e.g. loyalty programmes being offered by airlines and family stores), a company uses the discretion to decide what percent of the sale value should be deferred and for how many years. Similarly, a software company may decide at which stage the technical feasibility of a software development project is established, which determines how much of the total project cost can be capitalised.
Discretion is essential but might be misused by managers.
They might use the discretion for their private benefits based on the private information available with them and formulate the accounting policy based on their reporting incentives ignoring the interest of shareholders and creditors. For example, a company may pursue conservatism aggressively to avoid the glare of the regulators, politicians and social activists, in the period of growth.
Some companies hide superlative performance for income smoothing and to protect itself from complacency among employees. Some may argue that it is not a sin to take a conservative approach. In fact, German GAAP, before the adoption of IFRS, allowed companies to create secret reserve as sustainability and growth of companies and creditors’ interest were in focus. Companies follow diagonally opposite strategy during bad times. They adopt aggressive accounting because that suits their reporting strategy. From shareholders’ perspective any type of earnings management is bad because it hides economic reality from users. Excessive discretion provides scope for earnings management.
As we are moving from transaction-based accounting to event-based accounting (e.g. accounting for asset impairment and use of fair value in measuring assets and liabilities), use of judgement in accounting measurement is increasing.
Management develops a perspective on the economic impact of events on the assets and liabilities of the company and based on that perception estimates the amount at which those items are carried in the balance sheet. Increase in the subjectivity in accounting measurement increases the scope for earnings management. Moreover that increases the noise in financial information, which in turn, enhances the contracting inefficiency.
Accounting information is used extensively in contracting arrangements such as contracts with lenders and contract with CEOs. Therefore, perspectives of contracting parties cannot be ignored in evaluating the accounting quality. Too much focus on shareholders’ information needs might undermine this aspect of financial reporting. We can neither avoid discretion in accounting rules nor use of judgement in estimating the value of assets and liabilities. The challenge is to decide the level of discretion and subjectivity that benefits the users of financial statements. Excessive discretion and subjectivity in accounting measurement harm investors and other users, rather than benefitting them.
It appears that in their zeal to bridge the gap between accounting income and economic income, accounting standard setters (e.g. IASB) are making the accounting rules more complex and difficult to implement and bringing in high level of discretion and subjectivity in accounting measurement. A relevant question is whether there is any need to bridge this gap. Analysts can estimate the economic income starting from accounting income reported in financial statements provided they could see through the accounting policy. Perhaps, the focus should be more on transparency and full disclosure. Significant changes in accounting rules in a fast pace confuse investors and enhance contracting inefficiency. Contracting parties should understand and agree to the rules of the game at the inception of the contract. If, that does not happen and the rules of the game continuously change, all the contracting parties face problems. For example, benchmark for various financial ratios in a debt covenant are based on the current accounting rules. Any significant change in accounting rules pose challenges before all the parties involved in managing contractual terms and conditions.
I am not suggesting that the accounting reform or major revisions in accounting standards are not required. They are required because business models change, new types of transaction emerge, which cannot be handled adequately by existing accounting rules, and estimation models stabilise. What I am suggesting is that the pace of change should be managed well and accounting rules should be changed only after completion of the full due diligence process. We need to appreciate that cultural and regulatory mechanisms are primarily local even after globalisation of product and capital markets.