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Alec Jemwa

IN a perfect world, investors, board members, and executives would have full confidence in companies’ financial statements. 

They could rely on the numbers to make intelligent estimates of the magnitude, timing, and uncertainty of future cash flows and to judge whether the resulting estimate of value was fairly represented in the current stock price. And they could make wise decisions about whether to invest in or acquire a company, thus promoting the efficient allocation of capital.

Unfortunately, that is not what happens in the real world, for several reasons. Firstly, corporate financial statements necessarily depend on estimates and judgment calls that can be widely off the mark, even when made in good faith. 

Secondly, standard financial metrics intended to enable comparisons between companies may not be the most accurate way to judge the value of any particular company, especially the case for innovative firms in fast-moving economies, giving rise to unofficial measures that come with their own problems. Finally, managers and executives routinely encounter strong incentives to deliberately inject error into financial statements.

Despite the raft of reforms, corporate accounting remains murky. Companies continue to find ways to game the system, while the emergence of online platforms, which has dramatically changed the competitive environment for all businesses, has cast into stark relief the shortcomings of traditional performance indicators. The Institute Chartered Secretaries and Administrators in Zimbabwe is committed to train professionals who cemented with integrity and ensures good corporate governance in the entities that they are engaged in.

This report looks at the more insidious, and perhaps more destructive practice of manipulating not the numbers in financial reports but the operating decisions that affect those numbers in an effort to achieve short-term results. Finding ways to reduce such behaviour is a challenge for the accounting profession, but one that new analytic techniques can address.

Back in 2002, the world seemed to be on the verge of an accounting revolution. An initiative was under way to create a single set of international accounting standards, with the ultimate aim of uniting the US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) that European countries were in the process of adopting. By 2005, all public companies in the European Union had, in theory, abandoned their local accounting standards in favour of IFRS. Today, at least 110 countries around the world use the system in one form or another.

But in a broad sense, convergence has stalled, and further substantive changes seem unlikely in the near future. To be sure, progress has been made, but understanding the true value of a firm and comparing company accounts across countries continue to be major challenges. 

Revenue recognition is also a tricky piece of the regulatory puzzle. Suppose a business sells a smartphone or an internet service or a $20 million software package to an individual or a company. The contract for that product or service often includes future upgrades whose costs cannot be predicted at the time of the sale. 

Therefore, it is impossible to determine how much profit the sale will generate. Under current GAAP rules, if there is no objective way to measure such costs beforehand, a business is not allowed to record any revenue from that sale until all upgrade requirements have been delivered and their costs are known, which could take a few years.

This regulation has prompted some software companies to write contracts that carve out and separately price upgrades and other hard-to-value services. In doing so, the companies solve an accounting problem, but compromise their ability to adopt a conceivably more attractive bundling strategy. 

The result is a perverse system in which accounting rules influence the way business is done, rather than report on companies’ performance. The shortcomings of revenue-recognition practices have also caused companies to increasingly use unofficial measures to report financial performance, especially for businesses operating in the virtual space.

– Alec Jemwa is the technical manager of The Institute of Chartered Secretaries and Administrators in Zimbabwe (ICSAZ). For your Board induction and training, finance for non-finance people, Corporate governance training contact ICSAZ on 242 700553-5