Ensuring that financial statements give a faithful account of the economic performance and well-being of a firm lies at the foundation of corporate financial reporting. Indeed, the nineteenth century British law which first allowed companies to be incorporated through registration rather than through royal charters or acts of parliament—the Joint Stock Companies Registration and Regulation Act of 1844—also required these companies to prepare a ‘full and fair’ balance sheet. Another founding legislation, the UK Companies Act of 1900, required auditors to report whether the balance sheet exhibits a ‘true and correct’ view of the state of the company’s affairs. Today’s regulatory practices continue to aim at the same goal of ensuring transparency and unbiasedness in accounting.
However, regulators face a dilemma. Ensuring faithfulness requires the framing of rules and guidelines for accounting. Yet, a rule which is too strict may fail to capture the essence of an economic situation when applied in settings not foreseen by the framers of the rule. Moreover, as business becomes more complex, unscrupulous entities can actually exploit such narrow rules to fulfil the letter of the law while defying its spirit.
An early statement of this dilemma can be found in the Institute of Chartered Accountants of England and Wales’ demand for an amendment in the “true and correct” requirement of the Act of 1900. They said, “The word ‘correct’ has always been too strong because it implies that there is one view which is ‘correct’ as against all others which are incorrect. In published accounts there is no standard of absolute truth and the Institute’s suggested amendment would recognise that the presentation of figures can only be that which a fair view is, in the personal view of the auditor,” (The Accountant, 1 July 1944, p. 2). Following this, the term ‘true and fair view’ was introduced in British legislation through the Companies Act, 1948.
The Indian Companies Act too imposes a general requirement that financial statements give a true and fair view of the state of affairs of the company and its performance. Schedule III of the Act provides the format for the presentation of balance sheet and stipulates principles for the preparation of balance sheet and profit and loss account. But adherence to the disclosure requirements is subservient to the overriding requirement of “true and fair”, and departures from schedule III are allowed if that is necessary in order to give a true and fair view.
True and fair view expresses a broad philosophy which cannot be restricted by a specific legal definition. Rather, the need is to understand the spirit underlying the concept. The general understanding is that “true and fair” implies that financial statements should not only be made out correctly, but they should convey an overall fair view and should not give any misleading impression. There should be transparency in reporting the financial position and working results.
But in practice, accountants take a narrow view of the concept of true and fair. According to them, financial statements give a ‘true and fair’ view if, they are free from any material error or bias, and that they are prepared and presented in accordance with legal requirements and by applying the accounting principles and methods stipulated in various accounting standards. Auditors do not take into account whether any disclosure beyond the minimum required by law and accounting standards is required for financial statements to give a true and fair view and whether voluntary disclosures are adequate. Moreover, accountants and auditors are reluctant to deviate from the principles and methods set out in accounting standards even if there are strong indications that application of accounting principles other than those stipulated in accounting standards will improve the presentation of financial statements.
The Companies Act too requires that every profit and loss account and balance sheet shall comply with the accounting standards and any deviation from the accounting standards should be disclosed along with the reasons for deviation. It does not make it clear, as in the case of Schedule III, that true and fair overrides the requirements of accounting standards. Courts usually take the view that financial statements drawn up in accordance with legal requirements and generally accepted accounting principles (GAAP) present the true and fair view. Thus, for the legal systems accountants and auditors, true and fair view has become subservient to accounting standards.
In 1988, a strong dissent was made against this by Sir David Tweedie, the past Chairman of the International Accounting Standards Board (IASB), when he was the Chairman of the Accounting Standard Board (ASB) of UK. He stated, “In its progressive form it (true and fair view) can be used to replace antiquated laws and indeed outdated accounting standards prior to their revision.” Regulators might not agree with this progressive interpretation. Allowing companies to apply the true and fair view concept without any bound, such as the one being imposed by accounting standards, provides huge opportunities for creative accounting. Therefore, it is unlikely that the true and fair view will override accounting standards.
This leads to a more fundamental question. What should be the bounds or limits that should be imposed by accounting standards? At one extreme, we may live with only the conceptual framework which sets out the fundamental accounting principles relevant and appropriate in the present-day context and replaces the bunch of accounting conventions. At the other extreme, regulators may issue rules-based accounting standards. In between the two extremes lies principles-based accounting standards. The moot question is how much flexibility should be provided to accountants and auditors in deciding the accounting policy. Too much flexibility is as bad as too little flexibility. In this, principles-based accounting standards strike the right balance.
There is a need to change the perception that a standard that permits fewer allowable alternative accounting methods is superior to one that permits more alternatives. If we accept the paradigm that accountants and auditors should be provided adequate flexibility to formulate accounting policy, taking into consideration specificity of transactions and the nature of industry, an accounting standard that permits adequate number of alternatives should be considered superior to the one that provides no alternative. Ideally, an accounting standard should clearly articulate the objectives of the standard and stipulate accounting principles without detailing the rules. Examples may be given to explain the principles. This will provide enough flexibility to accountants and auditors to apply the concept of true and fair view and formulate appropriate accounting policy based on stipulated accounting principles. Accounting bodies should refrain from issuing large number of interpretations and opinions. For example, the Institute of Chartered Accountants of India (ICAI) should stop providing expert opinion on accounting for transactions specific to a particular company. Although much lower in hierarchy than accounting standards and other technical pronouncements, they become a part of the rule book and a reference point for accountants and auditors and reduce the desired flexibility in formulating company-specific accounting policy.
The proposed approach will reduce the work of standard setters and they will find it difficult to justify their present organisational structure. But that should not be a consideration in reforming the format of accounting standards.