In Chapter 3, we do not meet Amanda, although it can be assumed that her business is progressing. This chapter looks at published accounts and the standards that impact such accounts. The message that comes across is that despite more and more regulation and the desire to ensure all companies follow the same standards, the production of a set of accounts requires those responsible to make a series of judgements, where no two people are likely to come to exactly the same conclusion.
The topics covered are the following:
The problems often start with unrealistic expectations. The ‘market’ seems to believe that companies should endlessly grow in terms of sales and profitabil- ity, although it does not show the same level of concern about cash generation.
Reality, usually, is often different; companies operate in cycles where their for- tunes tend to go up and down. Directors know that an announcement reporting a declining growth percentage or a statement suggesting that ‘profits will not meet market expectations’ could result in their company’s share price being savaged. So, the pressure to perform starts at the top.
This pressure percolates down the organisation, so that managers can be sub- jected to the carrot and stick routine. High remuneration is linked with a high standard of performance where mistakes are not allowed. So if things go wrong, managers are tempted to bend the rules; the more punitive an organisation is, greater is the likelihood that some will crack. Sometimes the pressure is self-induced but the point is that it is usually pressure that causes managers to stray from the straight and narrow. Sometimes, though, it may be simply the case that a particular manager wants to impress the senior management and will go to any lengths to achieve this. It is impossible, in the final analysis, to know for certain what motivates employees to bend the rules, but when they do, it can be disastrous for shareholders.
Most organisations produce monthly management accounts, so non-performing managers can be found out well before financial accounts have to be published;
so an under-pressure manager might be tempted to add in (say) two days’
sales from the following month to the current month. The plea to the branch accountant might be the promise that things will be put right at the end of the following month. But two days becomes four days and so on. Of course, the opposite might happen. If monthly sales are ahead of plan, then the manager might hold sales back, in case things go wrong sometime in future. Of course, such indiscretions could be relatively minor and not necessarily significant. In other cases, they could be more serious.
On 26 February 2007, McAlpine (Alfred) plc announced that they had uncov- ered a serious accounting problem. The company said that in the previous week they had discovered a systematic misrepresentation of production vol- umes and sales over a number of years, by a number of senior managers at their Slate subsidiary.
actions had led to suspensions pending further investigation. The company added that independent accountants would be brought in to conduct a detailed forensic analysis that would likely take 4–6 weeks.
The effect of the above announcement was that the company’s share price fell 22% from 613.5 pence to 476.5 pence. The key question is whether or not this disaster could have been predicted from the accounts. The answer is, of course, nothing could be predicted with certainty, but when such events happen the accounts usually throw up the same clue, which is that ‘cash inflow/(outflow) from operations’ is lower than ‘operating profit’, when it should be the other way around (see Chapter 2).
The last published accounts of McAlpine (Alfred) plc stated:
6 months to 6 months to 12 months to 30 June 2006 30 June 2005 31 December 2005
£’m £’m £’m
Profit before interest 17.4 17.3 41.9
and tax
Cash inflow/(outflow) (10.9) 7.6 27.9
from operations
However, as stated in Chapter 2, accounting inaccuracies are usually the result of flawed judgements, rather than fraudulent activity. Either way, it will be the duty of directors of the company to ensure that their accounting records meet the required standards, which means that they give a true and fair view of the start of affairs of their company. Their financial statements must comply with the appropriate Companies Acts, European legislation of stock exchange rules.
In preparing such financial statements, the directors are required to:
• select suitable accounting policies and apply them consistently;
• makejudgements and estimatesthat arereasonable and prudent;
• state whether applicable accounting standards have been followed, sub- ject to any material departures disclosed and explained in the financial statements;
• prepare the financial statements on the going concern basis unless it is inappropriate to presume that the company will continue in business.
The directors also have a general responsibility for taking such steps that are reasonablyopen to them to safeguard the assets of the company and to prevent and detect fraud and other irregularities.
At the end of the financial year, the directors will have gathered in all the information available to them, including details of minor indiscretions if there are any and if they have come to light, and will then be faced with a series of judgements, including:
• the carrying value of intangible assets;
• stock;
• debtors;
• contingent liabilities.
The carrying value of intangible assets. When a company buys another for a price greater than the tangible assets acquired, this gives rise to ‘goodwill’. This is shown as an asset in the Balance Sheet, but its inclusion in the Balance Sheet is dependent upon the goodwill having a genuine value. This means that the ‘goodwill’ must generate future income streams, otherwise it will have to be impaired, meaning that it will have to be partially or wholly written off, as the case may be. As we cannot predict the future accurately, we are relying on judgements made by the directors. To argue with directors’ judge- ment, the auditor would have to be able to prove that the directors were being unreasonable or imprudent.
Stock. At each year end, an ‘age’ analysis of stock will reveal slow moving stock, or stock that is out of specification, even in a small way. Will this stock be sold in the following year? Who knows? A cautious director might want to write off the bulk of this stock, while another, taking a more imprudent approach, might take the view that somehow the company will find a buyer for it. What actually happens will likely be different from either view.
Debtors. At the year end, an established customer owes a large amount and is 60 days overdue. The concern is that this customer has a good record of paying on time. The optimistic view would be that as the customer has always paid in the past, he will do so in future, while the pessimist will believe that there has to be something wrong. Who is correct? The directors cannot tell for certain,
and out of specification, has damaged many batches of his production. Your legal team, having seen only your evidence, believes that you have a 60%
chance of winning, but advises you to write off the debt and offer an equal amount in compensation. They advise you that in their view there is a 90%
probability that the debtor would accept this compromise, but the 10% down- side risk is that he will use your offer to demonstrate your guilt. Beyond that, they cannot advise you and have told you that the recommendation they have made does create a risk profile, for which they cannot be responsible. It is your decision. So what do you do and how much do you reserve in the accounts?
Again it is a matter of judgement.
The judgements detailed above were simply required to meet the ‘prudence concept’ that neither profits nor assets should be overstated and liabilities should be not be understated. However, under IFRS as all costs and assets must be stated at ‘fair value’, the directors are required to make even more judgements.