Consistency means that companies can change their accounting policies whenever they like

11.67 Consistency

Accounting policies provide a framework within which assets, liabilities, income and expenditure are recognised, measured and presented in financial statements, and they help to improve the comparability of financial information. Both company law and FRS 18 require accounting policies to be applied consistently within an accounting period and from one financial year to the next. However, situations will inevitably arise from time to time which make it necessary for an entity to change one or more of its accounting policies. For instance, a new accounting standard may have been introduced which requires a different accounting treatment to the one previously adopted, or the nature or scale of activities may have changed so that an existing accounting policy is no longer acceptable. FRS 18 requires accounting policies to be regularly reviewed, and sets out specific accounting and disclosure requirements that apply whenever an accounting policy is changed.

10.58 Consistency

Accounting policies provide a framework within which assets, liabilities, income and expenditure are recognised, measured and presented in financial statements, and they help to improve the comparability of financial information. Both company law and FRS 18 require accounting policies to be applied consistently within an accounting period and from one financial year to the next. However, situations will inevitably arise from time to time which make it necessary for an entity to change one or more of its accounting policies. For instance, a new accounting standard may have been introduced which requires a different accounting treatment to the one previously adopted, or the nature or scale of activities may have changed so that an existing accounting policy is no longer acceptable. FRS 18 requires accounting policies to be regularly reviewed, and sets out specific accounting and disclosure requirements that apply whenever an accounting policy is changed.

Creative Accounting

“Creative accounting” is any method of accounting that overstates revenues or understates expenses. Creative accounting is a sure sign that something is amiss. Lenders view it as a smokescreen to hide real operating results in order to prolong the company’s credit standing and to confound investors. It has been a longstanding tradition for borrowers on an economic downspin to pass off inflated financial results, in an attempt to fool lenders into thinking performance was better than it actually was. For example, companies might choose to inflate income, produce fictitious revenues, overstate assets, capitalize expenditures, misappropriate assets, book premature revenues, understate expenses and liabilities, or navigate around accounting rulings governing revenue recognition. Creative accounting shenanigans are a violation of fundamental accounting principles.

Same accounting policies as annual

The same accounting policies should be adopted in the interim report as are applied in the annual statements, except for accounting policy changes made after the date of the most recent annual financial statements that will be reflected in the next set of annual statements.

The guiding principle for recognition and measurement is that an enterprise should use the same recognition and measurement principles in its interim statements as it does in its annual financial statements, e.g. a cost would not be classified as an asset in the interim report if it would not be classified as such in the annual report.

11.1 Introduction

The current earnings management literature has examined earnings management from either a transaction-specific or a firm-specific point of view. In their review of earnings management literature, Healy and Wahlen (1999) mention that firms manage their earnings when they raise capital or when they need to meet analyst expectations or performance targets related to executive compensation schemes. However, these studies disregard the fact that market conditions, like economic growth and industry valuation, are not constant over time. Focusing on the latter, we hypothesize that industry valuation will influence managers’ decisions to engage in earnings management. This can provide an explanation as to why earnings management occurs more frequently in some periods than in others.

Jensen (2005) argues that overvalued firms have incentives to sustain their overvaluation. Kothari et al. (2006) empirically test Jensen’s argument and find that overvalued firms’ discretionary accruals are much higher than those of firms with lower valuations. However, we differ from Kothari et al. (2006) in arguing that the level of industry valuation can influence the earnings management decisions of all firms in that industry, not only overvalued ones. This is because industry valuation level can change the benefits and costs of managing earnings for all firms in that industry.

We employ a large sample of US firms taken from Compustat. The sample period covers 20 years, from 1985 to 2005. We test our hypothesis by examining the association between industry valuation and the aggregate current discretionary accruals in the industry. Following the behavioral finance literature (Baker et al., 2007), we use market-to-book ratio to proxy for the valuation level.

First, we find that after including the usual explanatory factors for earnings management, such as leverage, size, and performance, our measure for industry aggregate earnings management of each quarter remains significantly positively associated with the lagged industry market-to-book ratio. This result holds for both current and total discretionary accruals. In economic terms, this implies that one standard deviation increase in the industry valuation is associated with a significant increase of 2.4 cents in an average firm’s quarterly earnings per share due to earnings management. Second, to exclude alternative explanations, we run several robust analyses and continue to find a significant, positive association between aggregate current discretionary accruals and the industry market-to-book ratio.

This chapter is organized as follows. Section 11.2 discusses related literature and develops our hypotheses. Section 11.3 describes our data and variables. Section 11.4 presents our results.

Definitions

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Accounting policies. The specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting its financial statements.

Change in accounting estimate. An adjustment to the carrying amount of an asset/liability or the amount of the periodic consumption of an asset that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. They are not errors caused by new information or developments.

Prior period errors. Omissions or misstatements for one or more prior periods due to a failure to use or a misuse of reliable information that:

was available when financial statements for those periods were authorised and

could have reasonably be obtained and taken into account while preparing and presenting those financial statements.

Includes mathematical mistakes, mistakes in applying policies, oversights and fraud.

12.9 Definition of Going Concern

FRS 18 Accounting Policies describes the going concern basis as the hypothesis that the entity is to continue in operational existence for the foreseeable future and notes that this basis will usually provide the most relevant information to users of the accounts. The standard therefore requires directors to assess, when preparing accounts, whether there are any significant doubts about the entity's ability to continue as a going concern. In making this assessment, the directors must take into account all available information about the foreseeable future. The guidance in the standard emphasises that the degree of consideration needed in order to make this assessment will vary depending on the circumstances of the entity. If there is a history of profitable operations with ready access to financial resources when required, and this situation is expected to continue, the consideration of going concern may be less detailed than when there are concerns over issues such as expected profitability, the ability to meet debt repayment schedules and the availability of alternative sources of finance.

A similar definition of going concern is given in the IASB's Framework for the Preparation and Presentation of Financial Statements and IAS 1 Presentation of Financial Statements requires management to make an assessment of the entity's ability to continue as a going concern and to take account of all available information about the future. The standard also includes similar guidance on the degree of consideration required and the fact that this depends on the circumstances of each case.

6.87 Definition of Going Concern

FRS 18 Accounting Policies describes the going concern basis as the hypothesis that the entity is to continue in operational existence for the foreseeable future and notes that this basis will usually provide the most relevant information to users of the accounts (for information on obtaining copies see the Accounting Standards Board website at www.frc.org.uk/asb). The standard therefore requires directors to assess, when preparing accounts, whether there are any significant doubts about the entity’s ability to continue as a going concern and requires the financial statements to be prepared on a going concern basis unless:

the entity is being liquidated or has ceased trading;

the directors intend to liquidate the entity or to cease trading or

the directors have no realistic alternative but to liquidate the entity or to cease trading.

In these circumstances, the entity should prepare its financial statements on a different basis. The JWG guidance (see 6.86 above) emphasises that it will not usually be appropriate to adopt the going concern basis for the accounts if there is any intention or need to enter into a scheme of arrangement with the company’s creditors, make an application for an administration order or put the company into administrative receivership or liquidation. However, the restructuring of a business, even on a major scale, is a relatively common practice these days and will not usually result in the going concern basis being an inappropriate basis for the preparation of the accounts.

Similarly, where IAS accounts are prepared, para 23 of the International Accounting Standards Board’s (IASB’s) Framework for the Preparation and Presentation of Financial Statements states that:

financial statements will normally be prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future;

if there is an intention or need to liquidate or curtail materially the scale of the entity’s operations, the financial statements may need to be prepared on a different basis – if so, the basis used must be disclosed.

IAS 1 Presentation of Financial Statements requires financial statements to be prepared on a going concern basis unless management either intends to liquidate the entity, or to cease trading, or has no realistic alternative but to do so. IAS 1 also requires management to make an assessment of the entity’s ability to continue as a going concern and to take account of all available information about the future, and includes similar guidance to FRS 18 on the degree of consideration required and the fact that this depends on the circumstances of each case.

Hedges that do not qualify for hedge accounting

If a hedge does not qualify for hedge accounting as it fails to meet the criteria, gains and losses arising from changes in the fair value of a hedged item that is measured at fair value after initial recognition are recognised in one of two ways (see Gains and losses section). Fair value adjustments of a hedging instrument that is a derivative would be recognised in profit or loss.

A good example of a detailed accounting policy for derivatives and hedging with a tabular back up note on derivative activity is provided by CRH Plc:

CRH Plc Year Ended 31 December 2005

Hedging

23. Derivative Financial Instruments

Derivative financial instruments recognised as assets and liabilities in the Group Balance Sheet are analysed as follows:

Segment accounting policies

Segment information should be prepared in conformity with the accounting policies adopted for preparing and presenting the financial statements of the consolidated group.

IAS 14 does not prevent the disclosure of additional segment information prepared on a basis other than the accounting policies adopted for consolidated statements provided that (a) the information is reported internally to the board for making decisions on allocating resources and (b) the basis of measurement is clearly described.

Assets that are jointly used by two or more segments should be allocated only if their related revenues and expenses are also allocated to those segments. For example, an asset is included in segment assets only if the related depreciation or amortisation is deducted in measuring segment result.