Scepticism on ethics all-pervasive
ACCOUNTANCY
| They express concerns that current principles and methods provide a significant scope for earnings management and that the managements of companies definitely bend the rules to boost reported earnings. I see a kind of scepticism about the ethical standards of companies. |
| The scepticism is not baseless. A case in point is the restatement of profit by Dell Inc. In August this year, Dell Inc reported that it would restate more than four years of financial results ending a year-long probe. The probe found some teams changed accruals and reserves, estimates of expenses or losses that have occurred and haven't yet been paid, to meet quarterly goals. Some officials didn't report complete information and purposefully gave incorrect or incomplete data to auditors. |
| Accrual accounting is the most acceptable account system and is used universally. |
| Under accrual accounting income and expenses are recognised without waiting for realisation or payment of cash. Similarly accrual accounting involves allocation (for example, depreciation on fixed assets) and deferment (for example, deferment of revenue when collectibility is uncertain or the earning process is not complete). Thus, estimation is at the centre of the accrual accounting. In many situations, management is required to form an opinion about a situation and based on that opinion it estimates assets, liabilities, income and expenses. Opinion should be supported by evidence and the auditor should be satisfied that the estimation is fair. |
| In some situations even the auditor has to depend on the information provided by the management. Accounting for fixed assets is an example. For subsequent expenditure on existing item of property plant and equipment (PPE) should be added to the carrying amount only if, the expenditure increases the service potential of the asset beyond originally estimated service potential. |
| The original estimate of service potential should be made at the time of acquisition. For example, assume that a company, engaged in a tourism business, had purchased a used car and at the time of purchase, it estimated that Rs 200,000 would be incurred to get the car ready for intended use. However, while the car was in the workshop, the engineer found an accidental damage, which had been camouflaged, and hence could not be detected. The actual expenditure incurred is Rs 700,000. According to the accounting rule, the company should add only Rs 200,000 to the acquisition cost and recognise Rs 500,000 as an expense for the period, because the additional expense does not increase the service potential beyond the originally estimated service potential. In this situation, the question of ethics is important. None other than the management would ever know whether the accidental damage was detected at the time of purchase. If the company does not disclose that it could not detect the damage at the time of purchase ,none (including auditors and audit committee), would ever know the fact. |
| This example is a simple example, but similar situations regularly arise in actual business operations. I know a case, where a manager of a foreign branch capitalised a costly seat cover of a car only to avoid the need for seeking the approval of headquarter. According to the rule of concerned company, if the capital expenditure/ revenue expenditure exceeds a predetermined amount, the branch manager need to seek approval of the headquarters; the limit for capital expenditure is higher as compared to the amount set for the revenue expenditure. This also brings ethical questions, may not be at the corporation's level but at the individual level of managers. |
| Another example is accounting for provision and contingent liabilities. There is a thin difference between provisions and contingent liabilities. For example, a company may file a frivolous appeal against a demand from the revenue department in order to avoid recognition of a provision for the claim in the balance sheet. The company will present the liability as a contingent liability by way of disclosure in the foot note. The accounting rule stipulates that a provision should be recognised at the best estimate of the management. Therefore, if the management estimates that the appeal will be dismissed it should provide for the liability. The management should form an opinion based on the legal interpretation and precedence and then to estimate the liability. Usually a company takes a legal opinion to support its best estimate. However, it is generally believed, though it might not be true, that a company can always find a lawyer who will give an opinion to support the opinion of the management. The practice of under-statement of provision for such liabilities is so prevalent that the Narayana Murthy Committee in its reports on corporate governance recommended that contingent liabilities should be disclosed in plain English and in detail. But that is not practical, because explanation to each contingent liability requires significant space. |
| The disclosure of information on estimation of liabilities for employee benefits (e.g. liability for pension) before the revision of the Accounting Standard 15 was inadequate. It is believed that the companies could obtain an estimate of pension liability from an actuary of its choice. This again raises a question of ethics. It is understood that the actuarial profession has disciplined its members. But the situation might continue because the demographic information and information regarding salaries etc provided by the company to the actuary should reflect the best estimate of the management. An unscrupulous management may understate the liability unless the audit committee and the auditor are alert. |
| In fact almost all the new Accounting Standards (e.g. accounting for impairment) provide significant potential for earnings management. We should not expect that the management of companies will suddenly improve the ethical standards. When I talked to managers of different companies, I often get the feel that they believe that earnings management to smoothen earnings is legitimate. They believe that and therefore, earnings management is sometimes required to protect the interest of shareholders. They find the accounting rules too harsh. However, it is well established that accounting policy and its implementation should not aim at smoothing earnings. The temptation to manage earnings, particularly at the time of poor performance is natural. |
| Managers generally want to keep bad news under the carpet with the expectation that things will definitely improve in future. Therefore, we have to rely much on the audit committee of the Board and auditors. The Board of directors has the primary responsibility to set high ethical standard for and appropriate culture in the company. The Board should always question unethical practices and should not approve decisions, which may be construed as unethical, irrespective of whether or not the management has ulterior motive. In most occasions, compliance report on ethical standard is considered to be a mere formality and the Board does not pay due attention to the same. As regards the formulation of accounting policy and implementation, the audit committee should be very attentive and should exercise its authority without leaving the same to the CEOs and CFOs. |