When Accounting Gets It Wrong
The accounting industry in North America is valued at $150B. An industry devoted to the development, standard setting, regulation and compliance of the accounting practice has continuously grown and matured since currency was invented. Accounting is defined by Investopedia as ‘the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities‘.
Finance is the backbone of organizational stability. There many different partners related to finance that a company needs to have full trust in, working together. Banks, tax specialists, accountants, investors, management all work together to ensure the company can have stability and grow. But for this to happen, they should try to speak the same language. If Financial Statements are a tool in decision-making, accounting is the language.
And therein is the primary purpose of accounting: to give all financial stakeholders a tool and framework to reduce information asymmetry and get everyone on the same page of the financial health of the organization, whether good or bad. But what happens when the accounting goes wrong? What happens when it hurts financial stakeholders rather than supports their decision making.
It is not hard to remember the sins of Arthur Andersen and their role in the fall of Enron. The many accounting frauds they committed served to make the company’s profitability and shareholder wealth seem greater than they actually were. The fall of Enron served as a jumping off point to re-write the rules of accounting, creating more and more complex standards. This in turn created greater margins for interpretation. Most companies are not as complex as Enron though. Most companies are just simple businesses with simple business models, trying to compete, evolve grow and create value for their customers. That does not mean accounting can’t hurt their shareholders just as badly though.
Navigating the rulebook
One example is a privately held asset management company that entered into a Purchase and Sale Agreement with a customer. The company agreed to originate new assets for its customer and manage those assets. The agreement was structured so that in addition to the originating fee, the company would receive in any residual profits from the portfolio, net of credit losses.
Even though the Purchase and Sale Agreement made it perfectly clear that the customer (and not the company) owned and controlled all the assets, the company’s audit firm believed that IFRS dictated that these assets should be reflected on the company’s balance sheet. The rationale was that because the company shared in the portfolio’s residual profits, the full risks and rewards were not yet transferred over to the actual purchaser, regardless of the fact that the agreement clearly stated the customer had purchased and owned these assets and retained all rights and controls.
The result was a Balance Sheet grossed up for assets which the company did not control and debt which they had incurred. And the end product for the company was a set of IFRS compliant Financial Statements which failed in their basic goal of offering clarity and serving the end stakeholders and audience. This confusing reflection of the company’s financial health had made it more difficult to obtain re-financing, generate investor interest, provided a false sense of scale and size to ownership, and put pressure on management credibility, as it was required to produce a second set of statements for any interested parties.
A Cautionary Tale
Accounting can sometimes be viewed as an afterthought of business and dealmaking. Yet a simple thing like the wording of an agreement, can have ripple effects on the financial management of the company. Accounting serves as a tool, a common language to make sure everyone is speaking the same language. Whether a different accounting firm would have interpreted the IFRS rules differently, is up for debate but ultimately, what are the lessons from this cautionary tale?
- Find finance partnerships and relationships (banks, auditors, accountants) that really align with your company’s goals and priorities
- Having trusted members who are consistently involved in the business may offer greater insights on which potential partners really ‘get it’
- While it is fine for simple and smaller organizations starting up, if the finance SMEs are viewed strictly as a cost control or reporting function, the ability to offer value will be limited to a historical and internal perspective
- Companies should from time to time consider, what is it that they are looking to achieve from their finance partnerships, both internal or external
Whether the mistake was not choosing financial partners who truly ‘got it’, or not involving them as trusted partners in the agreement structuring process, the first question that should have been asked was:
If Financial Statements and the accounting it follows, fails to make sense to anybody other than the audit firm that signed off on them, what is the point? Accountants need to remember that the goal is to offer more clarity and help support decision making, not impede it.