Enron and similar high-profile cases of accounting fraud have again brought the conflict between the economic substance and the legal form in the accounting of transactions into sharp focus. Within the theoretical framework of the accounting standards there appears to be a greater global thrust towards reporting the economic substance. This has been very much the UK and European approach in contrast with the USA which in the past has been formula or rules driven.
"Despite this move the accounting profession in the practical application thereof in many instances continues to focus on the legal form of a transaction as opposed to the inevitable financial consequences of the transaction - as driven by the legal form", says Ian Matthews, executive director of equity and debt specialists Bravura.
"This results in a set of accounts that are less than useful to investors in being fully informed of a company`s true economic circumstances." In fact, Matthews says, the plethora of new accounting standards and revisions of existing standards is exacerbating this tendency. For example one of the most complex accounting standards (AC133) was issued in April 2001, reissued after a substantial revision in September 2002 and was open for further comment and revision by October 2002, that is. two months later.
"Accounts are useful to the extent that they disclose the economic substance of the transactions the reporting entity has entered into." In contrast to the Americans, the South African accounting profession, like its British and European accounting counterparts, has adopted an approach that is more oriented towards substance. "This is clearly the way to go," Matthews says. "Obviously the legal form is important; but this needs to be balanced with a strong intention to accurately reveal the underlying economic realities inherent in the reporting entity as well."
Another issue facing the accounting profession is a new level of skepticism among investors about the accuracy of financial reporting. "There is a sense that accounting standards are malleable and that, at times, accounts are drawn up in the best interests of management, not investors." Matthews believes that investors` lack of faith in accounts is a contributing factor to the substantial loss in market value over the last few years. "Investors have no real faith in the accounts that have been produced for their benefit, and thus lack confidence in the true value of a business.
A positive development in accounting is a move towards a marked-to-market format whereby the changing values of the financial assets and liabilities of an organisation are reflected as opposed to the historical cost as per AC 133. "This is certainly a much more informative way of reporting," Matthews says. Investors need to understand, however, that a marked-to-market approach will produce financial results that are more variable from year to year. But, Matthews concludes, this approach definitely provides a better understanding of the risks associated with a particular investment and can also simplify interpretation for investors, who are generally not well informed about how accounts are structured.
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