Accounting standards need cleaning up

In the world of economics, accounting standards are not the subjects most likely to thrill the mind. They are the financial equivalent of North Korea; everyone’s happiest ignoring them, until they declare they’ve got a nuclear bomb. Some things, as tempting as they are to ignore, must be confronted. The recent disaster at Tesco, who overstated profits by £250 million in their latest earnings report, is just one in a long series of fundamentally destabilising errors and obfuscations that together have continually undermined the smooth operation of the free market.

On Monday, shares in Tesco plummeted 11 per cent after it announced what could charitably be called “creative accounting practices” in its August earnings report. The firm stated that the error was caused by a premature recognition of rebates from producers and a delayed cost structure. This comes during a torrid year for Tesco, as it has had to slash its half-year dividend by 75 per cent after a long series of profit warnings.

Masking poor profitability is a practice as old as the corporate earnings report itself. In 2011, HP took an $8.8 billion dollar write-down on its purchase of Autonomy, a software firm, due to gross misrepresentation of current revenues by the latter. More recently, hit firm Alibaba discovered accounting irregularities after its purchase of ChinaVision Media for $804 million. These three scandals are some of the biggest examples of misreporting, and are emblematic of a severe problem. Lying firms hamper the ability of the market to create value from deals, investments, and entrepreneurship. This prevents the broad growth that creates jobs, fosters innovation, and provides income for both shareholders and governments. In undermining the stability of the market, these practices have knock on effects for consumers, who are forced to bear the brunt of the costs of reduced market competitiveness: higher prices and fewer job opportunities. Look in any economics textbook and you’ll see how important the principle of equal information is; without it, the market cannot function efficiently.

There are some proposals to clean up accounting standards. As we have seen in the examples above, it is revenue reporting that generally draws the biggest scrutiny. This is usually couched in terms of recognition – when should revenues be put on the books? Revenue recognition is complex, as subscriptions, promised income, future rebates and more muddy the picture of when income is received. These issues are problematic by themselves but, if there were universal consensus on how to recognise revenues, most would evaporate as investors and managers would be working from the same framework. At the moment, there is no global standard. The USA uses a system called GAAP that, while clearly delineated, is enormously costly to implement. Europe and much of the world uses a principle-based system called IFRS, which, while less costly to implement, is broader in its guidance. A new system devised jointly by the GAAP and IFRS governors to simplify the global accounting system has been slow to get off the ground.

A balance between a clear, solid system and small implementation costs is a difficult one to strike. Costs that are too large eliminate the efficiency that is gained through transparency; too little transparency makes the costs irrelevant. After the scandal at Tesco, it is clear that the system needs to be more rigorous, to prevent abuse. This needs to come from corporate governance and investors rather than regulators; only once the market is satisfied that due diligence is achieved can confidence in market information, and all the subsequent benefits from this, return.

 

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