In the next six weeks, most listed companies and banks will have released their financial statements to the public. This is to comply with the regulator's requirement for the publication of the reports within three months of the end of the financial reporting period.
Ideally, board members and more so executives would have full confidence in the financial statements, because they are closely involved in their preparation. Through the auditing process, the auditors would give their opinion on whether the results give a true and fair view of the financial affairs of the company. The public would then rely on the representation of executives, board members and the auditors to make investment decisions.
That is the ideal world. The reality is different. One, preparation of financial reports necessarily depends on the estimates and judgment calls that can be widely off the mark, even when made in good faith. Two, the statements are not always the best or sole reflection of the financial and economic prospects of a company. No one, for example, would have thought M-Pesa would grow to what it is today. Finally, managers routinely face strong incentives – and tremendous pressure – to deliberately inject errors into financial statements.
Admittedly, financial reporting standards and regulations have tried to bring the reality closer to the ideal, with some success. The increase in reporting standards and regulations, however, comes with its own pitfalls in complexity and the number of pages of financial statements. The possibility of diminishing marginal returns of standards and regulations is a reality and the public is no better for it.
In fact, as the standards and regulations increase in number, length and complexity, they provide yet another loophole to game the system. The public does not have the time and the expertise to go through pages and pages of financial statements. The result is that the longer the statements, the higher the likelihood the public will miss something important.
Perhaps more destructive is that manipulating the operating decisions that generate the numbers rather than the numbers themselves is becoming more common. For instance, if results are off-target, companies may have strong incentives to postpone recognising expenses, or to recognise unearned income. Several areas are accounting minefields such as provision for nonperforming loans, unrealised losses and, or, gains on financial instruments, related party transactions, slow moving inventory, valuation of properties – the list goes on. For example, there is unlikely to be consensus, even among auditors, on how to estimate the value of deposits held at the distressed Chase and Imperial banks.
These are opportunities to make good faith errors or deliberately tilt the decisions in order to meet financial targets. Gaming the operating decisions rather than the numbers remains an accounting minefield and harder for auditors and regulators to detect, let alone the public.