After Enron there was Sarbanes-Oxley, then the 2008 credit crunch followed by the Dodd-Frank Act in the US. But despite regulatory attempts to flush out misleading corporate accounting practices, as well as progress made on US Generally Accepted Accounting Practices (GAAP) and International Financial Reporting Standards (IFRS), an article in the Harvard Business Review (HBR) argues that financial reporting is still an imperfect and inaccurate measure of a company's financial value and health.

No such thing as standard

One of the problems, according to the HBR article, is that “managers and executives routinely encounter strong incentives to deliberately inject error into financial statements”.

Although progress has been made in making corporate accounting more transparent, standardised and valid, “understanding the true value of a firm and comparing company accounts across countries continue to be major challenges”

One problem noted in the article is that the 'universal' accounting standards are far from standardised, with significant differences between US GAAP and Europe's IFRS, as well as different levels of competence and implementation of standards in individual countries.

The problems with revenue recognition

The article also touches on the problems of revenue recognition, which particularly affects companies selling bundled products, such as huge software implementations that include future updates, service and maintenance over a number of years, all under one contract. Under current rules, the company can only report the revenue when the contract ends and all services and products have been completed.

From next year, both IFRS and GAAP will allow companies to recognise revenue in the year it is earned by using estimates of future costs and revenues. However, this then leads to another problem, which is that managers will have to estimate the revenue earned, opening the door for inaccurate estimates and human error. HBR states: “investors will need to examine closely the assumptions and methods used to estimate costs and report revenues.”

The article goes on to discuss alternative measures of earnings, some of which, although idiosyncratic, can provide a more realistic representation of a company's financial situation than either IFRS or GAAP. Fair value accounting, too, brings a subjective element into financial statements, which investors have to interpret as best they can – not an easy task when annual reports usually run to hundreds of pages.

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CTMfile take: The HBR article really highlights the difficulties and pitfalls of achieving clear, transparent and harmonised financial reporting standards. It chimes with a recent statement issued by the Corporate Reporting Dialogue (CRD), which calls for greater clarity in corporate reporting.