Anthony Hilton: Accountancy standards need a closer look

But, even after 40 years and what amounts to a global effort, we are still not there. Only yesterday, Hans Hoogervorst, chairman of the International Accounting Standards Board, pointed out in a speech which should be read by every shareholder and finance director that companies on both sides of the Atlantic were using misleading information to inflate their profits in ever-growing numbers.

The scale of the problem shocks even through his accountancy-laden jargon. “More than 88% of the S&P 500 currently disclose non-GAAP metrics in their earnings releases,” Hoogervorst said — GAAP being the US accounting guidelines. “Of these releases, 82% show increased net income and are clearly designed to present results in a more favourable light.”

In this world, PR trumps accounting and creativity beats reality every time. Executives remove the nasty bits and class costs that in fact occur in some form every year as exceptional. They make like-for-like comparisons that are not like last year at all. They take credit for profits that have not been and may never be earned. They pay people in shares rather than cash but don’t deduct the cost of those shares. They describe the result as “core earnings”. They could equally be described as “fictional figures” — albeit the latter term inspires less confidence.

They do this crucially because most management remuneration packages — and the chief executive’s public reputation — are based on these massaged figures, not the real numbers. Hence the excess. According to one research study, these core earnings are typically 30% higher on average than what the standard-setters believe is the real thing. Adjustments on this scale allow the executives to smooth out earnings and, shorn of real-world shocks and fluctuations, deliver the smooth progression of profits that creates the impression of a team in control — even when it is not.

Thus we live in a surreal world in which remuneration committees promise bonuses to management in return for hitting a certain level of earnings — but then leave it to management to decide how these earnings are calculated.

Every so often, shareholders wake up to what is happening.

Hoogervorst cites a recent case in which they actually revolted because even they twigged that the result bore too little relation to reality. The adjustments turned what had been a £6 billion loss under IFRS accounting standards into a near-£6 billion profit — a turnaround of £12 billion. What really got to them, however, was that the company was paying the chief executive a multi-million-pound bonus linked to this performance.

For the record, Hoogervorst declined to name the company — but it sounds remarkably like BP.

Stopping this getting totally out of hand is a job for regulators but standard-setters could help by reducing the amount flexibility that boards and executives clearly find impossible to resist. They could, for example, develop a more rigorous definition of what constitutes profit, something less open to adjustment. They could usefully create a template for what is allowable within earnings before interest and tax (ebit), which is another measure beloved of executives and which invariably flatters to deceive.

There could be closer definitions of the other items of income and expense that may or may not be brought into the mix. And boards should be encouraged to collude with shareholders rather than managements in deciding how the information should be presented. They should be less easily seduced by the sugar-coated metrics and remember that the whole system depends on the information being reliable so that investors and analysts can make a reasonable stab at predicting how the business is likely to perform in the future.

Hoogervorst believes the standard-setters should take on this challenge but he has no illusions that it will be easy. The future is unpredictable and full of surprises and uncertainties that will inevitably cause fluctuations which managements may find embarrassing, particularly if they have devoted much of their earlier time to trumpeting profit forecasts and inflating growth expectations.

Reality matters and it is hard to disagree with Hoogervorst’s conclusion that “the number that counts most is the unadjusted bottom line” and that this number should be as inclusive as possible and show everything, warts and all.

But, even after 40 years, it is probably right to expect them not to get there any time soon.