The Fairy Tale of 'True and Fair View' and a Modest Proposal for Real 'Core Principles'

I had a pleasant back and forth correspondence with one my readers a few weeks ago. Carlomagno, as he called himself (I don't know his true identity), is a proponent of IFRS; and like me, he is of the opinion that IFRS overlaid with the distinctive system of corporate governance in the U.S. could be disastrous.

Carlo and I also agree that the generalizations of 'rules-based' US GAAP and 'principles-based' IFRS aren't as clear-cut as they are often made out to be by proponents of IFRS. Carlo wrote, "I think David Tweedie goes around the lecture circuit saying that the only truly principles-based accounting standard would consist of one sentence: 'The accounts shall present a true and fair view of the company's financial situation.'" Searching the internet, I found this Tweedie quotation in a KPMG publication, which is reasonably close to Carlo's assertion: "We should start off [a financial reporting standard] with the core principle, which is really the 'true and fair' core of the standard."

Ironically, any discussion of the 'true and fair' principle does not exist in IFRS, save for one boiler plate reference in Paragraph 46 of the IASB's conceptual framework. The purpose of this post is to expose the idea of true and fair in accounting as little more than faith-based accounting, and most certainly not the appropriate starting point for any process of developing high-quality accounting standards.

'True and Fair' as Fairy Tale

One of my hobbies is collecting plain English words and phrases that accounting policy makers have cunningly exploited to dress up an accounting procedure that is anything but what is implied by the straightforward term associated with it. Examples I have discussed previously include foreign currency 'translation' in accordance with FAS 52 or IAS 21, which would be more accurately characterized as 'random number generation'; 'goodwill' would be more accurate as 'the lump left over.' 'True and fair view,' commonly found in auditor reports outside of the U.S., is in a category all by itself: ineffable as either every-day English, or term of art.

At least, and however unsatisfying it may be, U.S. auditing standards provide us with a technical definition for the meaning of 'present fairly in accordance with U.S. GAAP.' Ask 100 accountants who prepare financial statements purporting to be a true and fair view of financial condition and results of operations and they will give you one hundred different explanations as to its meaning. Ask the two Big Four audit firms who confidently stated that Société Générale's financial statements were true and fair and you'll get version number 101.

As far as I can tell, the concept of 'true and fair view' was first introduced into British law by the 1947 Companies Act. It was later adopted by the European Union in 1978 in its Fourth Directive as the ultimate criterion for financial reporting. To be as generous as I can be, the term appears to express an overriding concern for substance over form in the application of professional judgment; financial statements are valued not so much for their compliance with particular rules as their ability to create an overall picture of a company's financial affairs. (Note: you can read a somewhat more expansive discussion in International Financial Reporting Standards: A Contextual Emphasis, a textbook that I co-authored with Mark Haskins and Ken Ferris in 1996 on pp. 71-73, 416.  That is, if you can still find a copy.)

The elusiveness of a meaning for 'true and fair' in an accounting context stems from a lack of meaning for that quintessentially British phrase in a capital markets context. Financial reporting is about producing information: is it possible that truth telling could not result in fair reporting? Answer: no way. Therefore, 'and fair' adds nothing whatsoever.  That leaves us with 'true'; everyone learns in Accounting 101 that accrual accounting and 'truth' don't mix anyway.

The point is that cunning Tweedie, like Soc Gen and its auditors, can construe 'true and fair' to mean anything, at any time to suit their own agenda.  Just like the emperor in the cautionary fairy tale, IFRS wears no clothes; his royal highness and subjects are deceived by the Tweedie tailor (pun intended) to disbelieve their eyes, and to behave as if IFRS is adorned with some noble British bromide.

A Modest Statement of Core Principles for the IASB or FASB

Though David Tweedie's abuse of 'true and fair' has been the direct object of this particular rant, I am generally weary of the pap that standard setters have offered up as core principles, principles-based standards, or what have you. Today's hodgepodge of rules has little or nothing to do with substantive core principles. They can only be seen as the product of the incentives of those who wrote them, or paid for them to be written: accounting board members seeking compensation, security and status; company men seeking influence over reported earnings; and auditors seeking what company men are seeking—without being exposed to malpractice litigation. Notice, too, that investors' incentives are generally absent. That's because, for whatever reason, they haven't been able to muster the dough to buy enough seats at the table.

But, financial reporting is not rocket science: it shouldn't be too hard to set forth investor-friendly core principles for financial reporting, should it? It also should not be hard to establish a core set of principles that, going forward, may not be violated as changes to accounting standards are made. I am not asking you to assume that my motives are purer than others who have set pen to paper, but I am inviting you to consider whether these principles, below, in contrast to what we now have, are what accounting should be based on in a fully consistent manner:

• The sole purpose of financial reporting standards promulgated by the IASB or FASB is to provide timely and relevant information to investors, period.
• Investors should be provided with information relevant to assessing the amount of wealth available to the reporting entity, claims on wealth, and how wealth has changed over time.
  • The balance sheet is the principle financial statement for reporting wealth (assets) and claims on wealth.
  • The claims on wealth are distinguished by non-owner claims (liabilities) and owner claims (owners' equity).
  • The income statement reports changes in assets and liabilities for a given period resulting from transactions between the reporting entity and non-owners (or owners in a non-owner capacity). Such changes should clearly delineate the effects of operating and financing activities.
• Wealth is the command over goods and services.
• Providing information about wealth is costly. Financial reporting standards must weigh the aggregate costs an entity will incur in producing information against the benefits of being provided with information. This weighing of costs and benefits, has, among other things, the following implications:
  • Not all assets and liabilities of the reporting entity may be recognized on the balance sheet.
  • The most accurate approach to measurement of some recognized assets and liabilities may not be economically justifiable. Therefore, financial reporting standards may require or permit alternative measures that are less accurate, without sacrificing the objective of wealth measurement.
• The needs of regulators, managers, or auditors are not directly germane to establishing financial reporting standards, except to the extent that their past and future actions cause the costs of producing information for investors to change.

The More Things Change…

Because 'true and fair' means bupkis, it could mean anything, and David Tweedie could say that what I have set forth is, more or less, what he meant by 'true and fair' all along.

Whatever… I prefer to refer to my enunciation of core financial reporting principles as 'efficient,' if you know what I mean.

Comments

[Tweedification]

The point about principle based standards is that you can't arb them by being clever. Can you really argue that the QSPE, concept, for instance, has resulted in more successful financial reporting than the IAS's `risk and reward' principles? Yes, `true and fair' is woolly. It needs to be to account for the diversity of evolving company practice. But it is at least an aspiration, while a static set of rules cry out `why not find a way of arbitraging me?' I've seen far too many accounting driven transactions think that _any_ set of rules can provide good financial reporting. Principle-based reporting at least puts the burden back on the auditor to affirm that the financials really are true and fair.

[Carlomagno]

Tom,

Thanks for my 15 minutes in the limelight. ;-)

"he is of the opinion that IFRS overlaid with the distinctive system of corporate governance in the U.S. could be disastrous."

I don't think I used the word "disastrous", I said that implementation of IFRS in the US faces formidable challenges. To some extent, this is true of any jurisdiction that moves towards IFRS. The EU also faced significant challenges when it switched to IFRS in 2005. On the whole, the transition went surprisingly well though. With adequate planning & preparation, the US should also be able to introduce IFRS without disrupting its capital market. Assuming the target date for US adoption mentioned on the lecture circuit (2013), the timing is admittedly tight but not undoable.

My point about the challenge of introducing IFRS in the US not so much that it would lead to lots of creative accounting or downright accounting fraud - US GAAP is quite adequate for that - but that lots of people would feel the need to "fill the gap" that IFRS's more principles-based approach would leave compared to current US GAAP.

I mean, are the SEC & others going to stop issuing all manner of interpretations? I doubt it; that would be "unamerican". If I'm right, the risk is that adoption of IFRS in the US will subvert the principles-based approach from the inside.

[Darla,]

Mirror Mirror on the wall which is the fairest of them all IFRS or US GAAP? Don't youknow that fairness (beauty) is in the eyes of the preparer.

I write a blog on IFRS implementation in Canada but I follow US developments very closely.

It is going to be a very interesting next few years. Or perhaps I should just get a life.

Glad to fing your blog a will follow you.

[Euro]

I am European. I worked both in Europe and in the US - I am now retired. I have professionally experienced both environments. My feeling is that US GAAP is out of control. Rules failed with Enron, Worldcom and now again with the subprime crises. Also Cox admitted that SIC 12 (2 pages) performed better than FIN 46R (200 pages... maybe more...). There is no question that the principles-approach is superior to the rules-approach. Unfortunately Americans do not want to admit that and they keep hurting themselves. As usual, with Americans is always a question of pride and a bit (... I want to be generous) of arrogance. Everybody that has experienced rules and principles know that rules can be overriden, but with principles this is almost impossible. The principle-approach is not perfect, but finance is a humnan science and therefore it cannot be perfect by defition. The entire non-US world looks at US GAAP and knows exactly what it does not want. IFRS is about what is right and common sense. Judgement is norrowed down dramatically when people applying IFRS really know IFRS. All this noise around judgement and loose principles is totally unjustified.