Corporate failures

The 1985 Pan-Electric crisis

The 1985 collapse of Pan-Electric was as sudden as it was catastrophic. Financing its operations with a series of forward contracts (will
be explained later) that brought it into heavy debt (S$450M debt vs market cap of S$230M) which it had trouble refinancing during the
1985 economic recession in Singapore, its financial insolvency were exposed by underwriters during a proposed rights issue. The rights
issue was cancelled, Pan-El trading was suspended, a rescue package planned and aborted, all stock trading on the SGX was suspended;
this chronological series of events happened within the space of half a month from mid- to end-November 1985, at the end of which PanEl went into receivership and was ultimately wound up in 1986.
The company collapsed in 1985 due to unsettled forward contracts, forcing the stock exchanges of both Singapore and Malaysia to shut
down for three days. At its demise, the company had a total debt of S$480 million, and all its shares held by 5,500 shareholders were
found to be worthless overnight. As of 2000, it remains the largest corporate collapse in Singapore's history, and the only instance where
the Stock Exchange of Singapore (SES) had to close. The Malaysian Kuala Lumpur Stock Exchange was also forced to close for three
days as a result.
In the aftermath of the collapse, key people in the company such as Peter Tham, Tan Kok Liang, and Tan Koon Swan were prosecuted
and given varying jail sentences. The collapse of the company shook public confidence in the SES, causing prices of stocks to plunge.
New securities laws were introduced in March 1986 to ensure that stockbroking firms can protect themselves against credit risks."
Causes and Effect of Corporate Failure
Corporate failure could be caused by number of factors, such as;
1) Managerial inefficiency and ineffectiveness
2) Socio-cultural factors.
3) Economic instability.
4) Public policy.
3.1 Managerial inefficiency and ineffectiveness:
This constitutes the most pronounced source of corporate failure.
The first is lack of a well-articulated corporate strategic plan. The
derivatives of this could consist of over expansion, ineffective
sales force, high production cost, inappropriate costing strategies,
low productivity, poor financial management strategy, poor risk
assessment strategy
3.2 Over expansion:
A company that undertakes over expansion is likely to immobilize
short-term funds thereby creating an avenue for corporate failure.
Corporate expansion should therefore be made to follow strictly
corporate strategic plan (Mbat, 2001).
3.3 Ineffective sales force:
The end result of production is to sell the product. If the sales force
is not properly trained and developed, the company may find it
difficult to sell its product especially if the product is sold in a
highly differentiated competitive market. This situation will create
cash flow problem and by implication, solvency problem (Gilman,
2001).
3.4 High production costs:
This is a situation where the production cost of a firm makes its
product not to compete favourably with other differentiated
products in the market. This could be due to over employment of
human and material resources or technical inefficiency in the
production process (Bowen, Morara and Mureithi, 2009).

3.5 Poor financial management:

A firm whose financial manager is unable to take effective
financial management decisions is bound to experience acute
liquidity problem. Such decisions include investment, financing
and dividend policy decisions.
3.6 Risk assessment strategy:
The risk associated with an investment decision should be properly
evaluated. The reason is that investments in assets constitute the
most important source of corporate earnings. Thus, if risk
assessment is not properly done, corporate income would be
impaired (Mbat, 2001).
3.7 Inappropriate commercial policy:
Policies affecting sales especially credit sales should be carefully
evaluated since such could lead to debt build up and by implication
liquidity crises (Alo, 2003).
3.8 Absence of manpower training and development policy:
A firm that does not have manpower training and development
policy cannot make use of well trained and specialized staff that
can help in the achievement of corporate objectives. An evaluation
of strategic business units will show average poor performance of
staff which occupies critical positions in the organization (Bedelan,
1987).
Above factors constitute management inefficiency and
ineffectiveness. They are very important for observation as an
organization moves along the line of achieving its objectives and
goals.

Other factors which can cause corporate failure are:

3.9 Capital inadequacy:
A firm that is undercapitalized is bound to fail sooner or later. The
reason is that the firm will not have enough capital to buy the
relevant fixed assets, invest in enough income generating assets or
enough working capital. Very often than not, such firms experience
underutilization of capacity. This still is an aspect of management
ineffectiveness. example, if the capital structure is highly geared
instead of being lowly geared it may create income sharing
problems (Caballero and Krishnamurthy, 1999).
3.10 Socio cultural factors:
A firm that produces products which are not absorbed by the
immediate environment will have tough times selling its products.

It will force the firm to look for distant markets which will lead to
higher marketing costs and inability to sell its products
(Hopenhayn, 1992).
3.11 Income instability:
Environmental economic instability can lead to corporate failure.
The reason being that any downturn in the economy can create
some form of financial distress due to a firms inabilityto sell its
products.
3.12 Public policy:
Public policy is a very important external source of corporate
failure. When government policy is against the interest of a firm
within the short-term period, the firm could go bankrupt. For
example, if government places a ban on importation of a firms
input, production will be impossible when the existing stock inputs
are exhausted

The possible effects of corporate failure include:

1) Increase in the level of unemployment.
2) Decreasing standard of living.
3) Underutilization of resources.
4) Increase in crime level.
5) Instability of the banking system due to inability to pay back
borrowed funds.

6) Instability of the financial markets where short to medium and

long-term funds were sourced and corporate failure makes it
impossible to meet such obligations

Examples:

Asset Loan Group

ABC Learning Centres

Date: September 2008

Sector: Financial services, property
Lesson: Another company that seemed to believe the good times
would last forever. When the credit crisis hit, this small
Queensland financier-turned-property-developer began frantically
trying to sell assets to repay debt. But as the property market went
into freefall, getting a sale across the line took too long, and Asset
Loan Group went under. As administrator John Greig said, timing
was the companys biggest problem in the end.

Date: November 2008

Sector: Childcare
Lesson: ABC Learning founder Eddy Groves had a pretty good
little business going in Australia profitable, fast growing and
underpinned by government childcare subsidies. But his forays
into the US and British markets distracted Groves from the day-today running of the Australian business, and without his scrutiny the
low-margin operations started losing money. Eddys ambition of
creating a global childcare giant was his undoing had he stayed
focused, ABCs fate could have been very different.

Australian Discount Retail (Crazy Clarks, Go-Lo, Sams

Warehouse)

Date: November 2008

Sector: Financial services
Lesson: Like fellow fallen finance groups such as MFS, Allcos
problem was simple too much debt. Add this to a business model
that was insanely complex and you have a recipe for disaster.

Date: January 2009

Sector: Retail
Lesson: The collapse of Australian Discount Retails three cheapand-cheerful chains was a shock discount stores generally do
well in a recession. But the companys private equity owners had
loaded the company with $201 million of debt, giving ADR little
room to move when retail spending slowed. As always, debt kills.

Apollo Life Sciences

Bill Express

Date: October 2008

Sector: Biotechnology
Lesson: You have to feel sorry for companies in the biotechnology
sector. It takes years of research, product development and trials
for these companies to turn a profit, which means they must
continuously raise cash to stay alive. The funding freeze has hit the
sector particularly hard no-one wants to be involved in
companies with long-term risks. As always, cash is king.

Date: July 2008

Sector: Financial services
Lesson: The collapse of electronics payment provider Bill
Express hit the companys customers mainly newsagents and
small telecommunications providers very hard. In hindsight, the
companys financials were clearly a mess despite reporting a
profit in every year it was listed (since 2004) the company
managed to rack up debts of $180 million by the time it collapsed.

Allco Finance Group

Beechwood
Date: May 2008
Sector: Construction
Lesson: The collapse of New South Waless largest homebuilder
sent shockwaves through the property sector. The company was
squeezed from three angles; demand dried up as the economy
tanked, the cost of contractors and tradesman continued to escalate,
and the credit markets froze. But Beechwood and the other
collapsed home builders were guilty of undercutting each other and
destroying margins in the process.
CFK Childcare
Date: November 2008
Sector: Childcare
Lesson: The collapse of ABC Learning sealed CFKs fate its
attempts to sell its assets became impossible when ABC went
under. The lesson from the childcare sector collapses is that
apparently cottage industries such as childcare (which had, until 10
years ago, been largely dominated by community groups and
single operators) are not always as easy to corporatise as it may
appear.
Commander Communications
Date: August 2008
Sector: Telecommunications
Lesson: Technology experts say Commander
Communications treated its customers poorly, overcharging them
for relatively old technology solutions. That was OK when the
company had a strong position in the SME market, but as
competition increased, customers turned away and revenue fell.
Destra
Date: November 2008
Sector: Digital media
Lesson: Digital media company Destra was always difficult to
describe, mainly because it had so many different elements, from
digital music businesses through to publishing through to
marketing. The speed at which these diverse businesses were
cobbled together proved to be the companys undoing Destra
bought separate companies in the three years before its collapse,
with most of the acquisitions funded by debt. In the end it was a
case of too much, too fast.
EBS International
Date: July 2008
Sector: Online retail
Lesson: EBS International was better known as EBusiness
Supplies and became one of the biggest traders on eBay until its
collapse last year. The companys grow-at-all-costs mentality
seemed to have been its undoing it kept selling more and more
goods even as its problems with suppliers and delivery mounted,

further compounding its problems and eventually leading to its

demise.
Elderslie Finance
Date: July 2008
Sector: Financial services
Lesson: Former Liberal leader John Hewson resigned as chairman
of Elderslie just weeks before the company was placed in
receivership. The companys problem was simple it ran out of
cash as investment markets tumbled and fee revenue shrunk.
Another example of a business model built for good times but
unable to weather the downturn.
Environinvest
Date: September 2008
Sector: Agribusiness
Lesson: Environinvest, which was founded by former Victorian
state government minister Roger Prescott, was an unlisted public
company that operated agricultural investment schemes, including
tree plantations and cattle projects. While the companys debt and
poor cashflow forced it into administration, there were clear issues
with management in correspondence with the company, auditor
David Nairn of HLB Mann Judd noted ambiguous transactions
with little documentation and questioned the timeliness of
financial reporting.
EzyDVD
Date: December 2009
Sector: Retail
Lesson: EzyDVD is one of those rare birds a collapsed company
that actually found a new buyer, the Franchise Entertainment
Group. Poor management seems to be the big problem here. The
company reportedly lost $3 million in its last few years of
operation and founder Jim Zavos went through two CEOs in quick
succession in 2008. Now that the companys unprofitable stores,
warehouse and headquarters have been shut, the new owner should
be able to turn the business around.
Freightlink
Date: November 2008
Sector: Infrastructure
Lesson: The collapse of Freightlink, owners of the Adelaide-toDarwin railway, surprised no-one in the transport and logistics
sector. The sheer cost of building the line meant the company had
to take on huge borrowings, but revenue never lived up to the
companys over-inflated expectations. Freightlink was doomed to
fail.

GMC
Date: December 2008
Sector: Manufacturing
Lesson: The collapse of power tool maker Global Machinery
Company was a shock, but the reason was clear Bunnings. When
the hardware giant took GMCs products of its shelves in early
2008, GMCs sales plummeted and its debt load became difficult
to manage. The lesson? If you cant get on the shelves of the
dominant retailer in your sector, you are in trouble.
Herringbone
Date: December 2008
Sector: Retail
Lesson: Luxury shirt brand Herringbone revelled in its image as
outfitter to the financial services whiz kids of Martin Place and
Collins Street. But as the financial crisis swept through the office
towers of Australia, Herringbones sales fell by 23% in two
months. Luxury goods always struggle in a recession, but
Herringbones position was made all the more precarious by its
debt levels.

Kleins
Sector: Retail
Date: June 2008
Lesson: As well as the usual problems of mismanagement and too
much debt, low-cost jewellery retailer Kleins was guilty of one of
retails biggest sins failing to keep up with its consumers. The
arrival of costume jewellery chain Diva should have forced Kleins
to freshen its product range and chase a younger consumer, but the
company simply didnt move quickly enough. Sales dried up, stock
built up, and eventually the doors closed.
Lift Capital
Date: May 2008
Sector: Financial services
Lesson: It was no coincidence that stockbroker and margin lender
Lift Capital collapsed shortly after Opes Prime. While the
company was tottering because of market conditions, the ripple
effects from Opes caused a run by clients, almost immediately
condemning the company to administration. The lesson is clear
when one of your competitors goes down, be prepared to feel
referred pain.
MFS (aka Octaviar)
Date: September 2008
Sector: Financial services, property, tourism
Lesson: It took MFS the best part of year to die, but the companys
fate was sealed in a few short weeks at the start of 2008 when a
billion dollar pile of debt crushed the company as the credit crisis
struck. Debt is bad enough, but when your entire business model is
built around the idea of borrowing money to buy over-priced

assets, you will almost always hit trouble when the business cycle
turns.
Midas
Date: January 2009
Sector: Automotive retail
Lesson: Midas was put in administration early this year by its highprofiled shareholders, including former Coles boss John Fletcher,
although the administrator is hopeful of finding a buyer. Midass
ill-fated move into LPG conversions (which were suddenly less
attractive because of falling petrol prices) didnt help its cause, but
its incredibly acrimonious relationships with franchisees was also a
constant distraction for management.
Opes Prime
Date: April 2008
Sector: Financial services
Lesson: In hindsight, the collapse of margin lender Opes
Prime was the moment the global financial crisis hit Australian
investors. While the Opes mess will probably take years to sort
out, at the heart of its problems was poor management. When a key
clients debts exploded, the company appears to have been
unwilling or unable to act. But in the end, this brought the entire
company and about 1400 clients down too.
Raptis Group
Date: February 2009
Sector: Property
Lesson: Jim Raptis was all but wiped in the property crash of the
late 1980s and early 1990s, but the spectacular boom in Gold Coast
property during the last decade allowed him to rebuild. Now, its
all gone again. Not surprisingly, the problem was the same
Raptis Group was so heavily geared that when the apartment
sales dried up, the company was simply unable to pay its financiers
and subcontractors.

Storm Financial
Date: January 2009
Sector: Financial services
Lesson: The collapse of financial planning group Storm Financial
has been covered in depth, but the key problem was the companys
inability to build a business that could last through a business
cycle. The companys model and its advice to clients was based
around the bull market, and when financial markets crashed Storm
was unable to cut its cost quicker than its revenue was falling. A
business must be strong enough to make it through good times and
bad.
Strathfield

Date: January 2009

Sector: Retail
Lesson: The management of mobile phone and car audio retailer
Strathfield has been a problem for the last few years, with
directors, executives and shareholders coming and going at an
alarming rate. The revolving management door has not helped the
companys profitability and a disastrous Christmas trading proved
to be the final straw. As any good manager knows, stability is
crucial to business success.
CBD Energy
Date: December 2014

An administrators report seen indicates inadequate cash flow was

the major reason for the collapse.
Administrators comments also pointed to issues of the ongoing
trading losses of a number of subsidiaries, high overhead cost base
that was not adjusted down as revenues declined, alleged
misappropriation of funds by the former executive director, poor
management structure and a lack of corporate governance
principals.
CBD Energys related companies, KI Solar, CBD Solar Labs and
Westinghouse Solar are also in administration.
The company, which was established in 1989, had previously
expanded from its Sydney base to open offices in London and New
York.

Big Shift in Accounting Rules Nears

U.S. execs welcome the clarity of the SEC's new timetable for switching from GAAP to international standards. But adopting new ways won't
be easy or inexpensive
Searching for what he called a "lingua franca" of financial statements, Securities & Exchange Commission Chairman Christopher Cox
announced on Aug. 27 a road map by which U.S. companies may report their numbers using international accounting rules beginning in 2009.
The convergence of the U.S. rules, known by the acronym GAAP, for "Generally Accepted Accounting Principles," and international ones has
been inching along for more than a decade. But the specific timetable laid out by the SEC's new proposal, which will be open for comment
until a final vote in 60 days, gives the process added certainty.
That came as a relief to many companies and audit firms that are looking for a clear direction. "What I've heard consistently from my clients
is, 'We just need to know,'" says Todd Markus, vice-president for accounting, finance, and enterprise governance at the New York financial
consulting firm Accretive Solutions.
Under the SEC's proposal, the very largest U.S. companies, approximately 110 in all, could be eligible to file their 2009 statements using the
international standard. Smaller companies could phase in after that. The SEC would keep track of the experience of those early adopters as
well as continue to study the companies in Europe and elsewhere that already use the global rules. By 2011 the commission would make a
final determination as to whether all companies would have to switch. All U.S. companies could be using the standard in 2014.
FASB Seeks Harmony
The Financial Accounting Standards Board (FASB), which writes GAAP, has already been trying to harmonize its major rules with the global
standards. But there are still many areas where there is no common ground, says Danita Ostling, a partner at accounting giant Ernst & Young.
And that's what the SEC's move would fix. "There remain a number of differences in the details, and the devil is in the details," says Ostling.
"Having two different standard-setting bodies working over time isn't a sustainable model."
Clearly for investors, having all companies report on the same basis is a good thing. Years ago most countries had their own reporting systems.
Their dramatic differences were made clear in the early 1990s when Daimler-Benz (DAI) adopted GAAP, famously erasing all the
domestically reported profits of the automaker, leaving it with a loss.
Much has changed since then. As Cox noted, more than 100 countries, including all of Europe, use the common international standard. In all,
companies based in those countries represent 35% of global market capitalization, compared with 28% for the U.S. market.
Consumer Advocates Miffed
Not everyone is happy with the proposal. Barbara Roper, director of investor protection for the Consumer Federation of America, argues that
the move may not result in uniform reporting at all. In a statement issued after the SEC meeting, Roper argued that the SEC's move "promises
a long detour through accounting chaos on its way to eventual uniformity." The international standard's lack of clarity and uniform
application, she said, particularly in the areas of revenue recognition, business combinations, and accounting for illiquid investments, could
well mean "that promised uniformity may be more mirage than reality."
For major U.S. companies with global operations, the benefits of switching are obvious. They already keep multiple sets of books and will be
able to simplify without having to learn a whole new standard.
Domestically focused companies will incur big costs in adopting new rules, with uncertain benefits. However, E&Y's Ostling argues that even
U.S.-centric corporations will benefit from bigger companies going before them and working out the kinks. Markus notes that many
companies, whatever their marketplace, chafe under the highly detailed U.S. rules and would prefer the opportunity to move toward the
"principles-based" style the international accounting standard embraces. U.S. GAAP rules historically have been much more specific, with
bright lines drawn on matters such as the reporting of income from stakes in other businesses.
GAAP Seen as Inflexible

Some companies complain those inflexible boundaries force them into accounting that often doesn't make economic sense. In the worst case,
they can lead to embarrassing restatements. Such restatements soared in the years after the Sarbanes-Oxley accounting reform legislation was
signed into law in July 2002 and only fell for the first time in 2007, according to a study by Compliance Week.
But for some industries, particularly financial firms, translating reports into the new financial language may not be so easy. Some experts
worry that could leave room for shenanigans. Financial firms will be highly affected by the international standards for fair-value disclosure,
for instance, which govern how they document hedges and encompass other compliance requirements. A 2008 survey by the American
Institute of Certified Public Accountants found that most members believe it will take three to five years to prepare for the move.
Washington has been generally supportive of the idea. Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson
have both come out for merging the standards. But not everyone is enthused. Senator Jack Reed, the Rhode Island Democrat who chairs the
securities and investments subcommittee of the Senate Banking Committee, has criticized U.S. regulators for not being tough enough. He has
opposed adoption of international standards on the grounds that regulation will become even more lax.
Controversy About Financing
Another topic of controversy has been the method by which the International Accounting Standards Board (IASB) is financed. Presumably,
U.S. officials and investors would like to see it entirely funded, as FASB is now, by a standard levy on public companies. The IASB now has
some mandated funding from companies using the international standards, but much of its budget still comes from voluntary donations from a
small number of large U.S. companies and the big audit firms. Critics say that can give companies and auditors too much influence at the
expense of investors.
All of the big accounting firms quickly came out in favor of the SEC's road map. But some experts wonder whether auditors will be able to so
quickly abandon their old ways in favor of a new path. "U.S. auditors have grown up knowing, loving U.S. GAAP," says Markus. "Can they
wipe all that clean? That's going to be a struggle for everyone."

Principles Based vs. Rules Based

One of the major differences lies in the conceptual approach: U.S. GAAP is rule-based, whereas IFRS is principle-based.
The inherent characteristic of a principles-based framework is the potential of different interpretations for similar transactions. This situation
implies second-guessing and creates uncertainty and requires extensive disclosures in the financial statements.
In a principle-based accounting system, the areas of interpretation or discussion can be clarified by the standards-setting board, and provide
fewer exceptions than a rules-based system. However, IFRS include positions and guidance that can easily be considered as sets of rules

instead of sets of principles. At the time of the IFRS adoption, this led English observers to comment that international standards were really
rule-based compared to U.K. GAAP that were much more principle-based.
The difference between these two approaches is on the methodology to assess an accounting treatment. Under U.S. GAAP, the research is
more focused on the literature whereas under IFRS, the review of the facts pattern is more thorough.
However, the professional judgment is not a new concept in the U.S. environment. The SEC is addressing this topic in order to find the right
balance between the educated professional judgment, that is acceptable, and the guessed professional judgment.
Differences Between IFRS and U.S. GAAP
While this is not a comprehensive list of differences that exist, these examples provide a flavor of impacts on the financial statements and
therefore on the conduct of businesses.

Consolidation IFRS favors a control model whereas U.S. GAAP prefers a risks-and-rewards model. Some entities consolidated in
accordance with FIN 46(R) may have to be shown separately under IFRS.

Statement of Income Under IFRS, extraordinary items are not segregated in the income statement, while, under US GAAP, they
are shown below the net income.

Inventory Under IFRS, LIFO (a historical method of recording the value of inventory, a firm records the last units purchased as
the first units sold) cannot be used while under U.S. GAAP, companies have the choice between LIFO and FIFO (is a common method for
recording the value of inventory).

Earning-per-Share Under IFRS, the earning-per-share calculation does not average the individual interim period calculations,
whereas under U.S. GAAP the computation averages the individual interim period incremental shares.

Development costs These costs can be capitalized under IFRS if certain criteria are met, while it is considered as expenses
under U.S. GAAP.
How to Anticipate the Transition?
Companies have a tendency to focus their attention on the accounting and financial statements impacts of the transition to IFRS. However, this
process has had a much broader impact than expected.
As a first step, the transition phase has to be segregated from the going-forward application of IFRS. A reconciliation approach (i.e.
identification of differences and work only on those) may be effective for the transition (less time, less cost), but going forward, this approach
may create a lot of unexpected difficulties, since the tools will not be in place.
Some of the questions to consider before the start of the project are:
What will be the consequences on your company or organization?
The Finance department will obviously have to update its processes, as will Operations, which will face potential impact on how contracts are
written or how the information is gathered and maintained; and Human Resources, which will have to review the compensation packages,
especially when linked to business performances.
What will be the impact on management reporting and IT?
The transition to IFRS will imply a change in management reporting and, in some cases, in the format of data required. For example, systems
will have to be upgraded in order to gather information on liquidity risks in accordance with IFRS 7 Financial Instruments Disclosures.
Likewise for R&D costs, your company will have to define procedures to enable the gathering and review of costs related to development that
may be capitalized.

When will changes have to be looked at?

Long-term transactions should be looked at with the IFRS lenses. If a company intends to enter into a joint-venture agreement, it should
review the potential IFRS accounting in order to avoid unexpected results at the time of the transition.

Companies can leverage on the convergence process by implementing new pronouncements as soon as possible, especially those that are
aimed to converge with IFRS, such as SFAS 141(R) on business combinations or SFAS 160 on the accounting for non-controlling interest.
PRINCIPLES-BASED STANDARDS
Despite the demand for rules-based standards, the FASB (2002, 2004) and the SEC (2003) reject them and have turned to proponents of
principles-based standards, presumably because in the light of the accounting scandals they consider the costs of rules-based standards to
outweigh their benefits. The SEC Report states
Unfortunately, experience demonstrates that rules-based standards often provide a roadmap to avoidance of the accounting objectives inherent
in the standards. Internal inconsistencies, exceptions and bright-line tests reward those willing to engineer their way around the intent of the
standards. This can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and
events. In a rules-based system, financial reporting may well come to be seen as an act of compliance rather than an act of communication.
Moreover, it can create a cycle of ever-increasing complexity, as financial engineering and implementation guidance vie to keep up with one
another. (SEC, 2003, at note 13)
For these reasons, and based on an example of how corporations (mis)used the bright lines given in APB Opinion No. 16 that specify when a
business combination could be accounted for with the pooling of interests method rather than the purchase method, the Report concludes that
a rules-based system is not desirable.
Other critics of rules-based standards have pointed out that rules can become useless and, worse yet, dysfunctional when the economic
environment changes or as managers create innovative transactions around them (Kershaw, 2005, pp. 596 7). Moreover, such standards need
not reduce earnings management and increase the value relevance of financial reports in so far as the rules increase managers ability to
structure transactions that meet these rules while violating the intent (e.g., Nelson et al., 2002) and real earnings management may
overcompensate for judgmental discretion (see Ewert and Wagenhofer, 2005).
The Report therefore examines what it terms principles-only standards, which it defines as high-level standards with little if any operational
guidance (at note 13). It then dismisses this alternative, since principles-only standards typically require preparers and auditors to exercise
judgment in accounting for transactions and events without providing a sufficient structure to frame that judgment. The result of principlesonly standards can be a significant loss of comparability among reporting entities (at note 14).12 The Report does not further consider
whether or to what extent the financial statements of different entities can be more or less meaningfully compared even when based on
common rules or principles. The Reports page numbers differ depending on the format in which the electronic version is printed. Hence, we
locate quoted material by the nearest footnote.
The SEC Report (2003, at note 15) gives two numbered additional concerns that could be ascribed to principles-only standards: (2) a greater
difficulty in seeking remedies against bad actors either through enforcement or litigation, and (3) a concern by preparers and auditors that
regulatory agencies might not accept good faith judgments. These are not further discussed. However, in a section entitled The Role of
Judgment in Applying Accounting Standards, the Report appears to dismiss (3), as it states: it is simply impossible to fully eliminate
professional judgment in the application of accounting standards (p. 15 at note 21). Nor would we wish to, as we discuss later.
See Dye and Sunder (2001, p. 266) for cogent arguments pointing out the shortcomings of uniformity (the same rule, e.g., expense research
and development, yields different results when one firms activities are successful and anothers efforts are a failure) and the benefits
(reporting choice reveals strategies) from allowing financial statement preparers to choose among alternatives.
Rather, it offers only two related examples to explain its rejection of principles only standards, impairment of long-lived assets and recording
depreciable assets at their historical time of acquisition cost. The Report criticizes the lack of implementation guidance, which leads to a loss
of comparability. However, it does not recognize that, no matter how a long-lived asset is initially recorded, comparability is lost as soon as
the asset is purchased, as its value in use differs among users. Over time, both value in use and value in exchange or replacement value also
change and the alterations will differ among companies; furthermore, the changes often cannot be determined objectively. Consequently,
comparability would only be possible if strict rules for revaluing assets at unambiguously specified values were used. It is not principlesonly that is at fault here, but the inevitable and, indeed, desirable lack of comparability due to different economic environments.
Further, the Report does not recognize that a companys choice of accounting measurement or presentation can convey information that is
valuable to investors about the managers operational and investment approach and decisions.
The Report proposes, rather than principles-only, what it calls objectives oriented standards, which are said to be optimal as between
principles-only and rules-based standards, apparently because they offer a much narrower framework that would limit the scope of
professional judgment but allow more flexibility than rules-based standards. Objectives-oriented standards are similar to what the FASB
(2004) calls principles-based standards. They appear to be those where the accounting reflects the economic substance of the accounting
problem and is consistent with and derived from a coherent conceptual framework, from which there are few exceptions. These standards, the
Report asserts, should:

 Be based on an improved and consistently applied conceptual framework;

Clearly state the accounting objective of the standard;
Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis [Note 1 of the Report
says: In doing so, however, standard setters must avoid the temptation to provide too much detail (that is, avoid trying to answer virtually
every possible questions within the standard itself) such that the detail obscures or overrides the objective underlying the standard. ];
Minimize exceptions from the standard;
Avoid use of percentage tests that allow financial engineers to achieve technical compliance with the standard while evading the intent of the
standard. (SEC, 2003, p. 5 at note 1)
This is a sensible and desirable list of characteristics and admonitions. Indeed, it is a wish list to which all standard setters would subscribe.
But it begs the question as to how much detail should be included in objectives-oriented standards.
Indeed, the Report gives no indication of how such an objectives-oriented standard should or can be derived. The AAA Financial Accounting
Standards Committee (2003) also uses the term concept-based standards and attaches the following characteristics to them: an emphasis on
the economic substance rather than the form of a transaction, a description of the particular transaction that is the subject of the standard,
disclosure requirements, and some implementation guidance in the form of examples.
The Committee says (p. 76): Concept-based standards have the potential to promote the financial goals of the FASB in ways that rules-based
standards cannot . . . Concept-based standards reflect a more consistent application of the FASBs Conceptual Framework and enhance
individuals understanding of the framework.
We agree with the view that optimal standards are somewhere in the continuum of principles-only and rules-only. In search of a universal,
if not an optimal approach to standards, the FASB has been including more principles in their recent standards and exposure drafts (some
examples are given below), while the IFRS has added significantly more guidance to their principles-based format in their recent standards (as
shown from the increase from year to year in the number of pages of the printed version). In the following, we hypothesize two avenues to
correct flaws in this search for improvement to U.S. standard setting:
(a) recognizing that the format of standards is related to their contents and (b) a true-and-fair override in the standards.
International Financial Reporting Standards
International Financial Reporting Standards (IFRS) are purportedly more principles based than is U.S. GAAP and less permissive with respect
to a true-and-fair override than is U.K. GAAP. This less specified GAAP-dominated approach results in less verbose standards than with
rules-based standards.36 An example is accounting for leases, wherein under both IFRS and U.S. GAAP a distinction is made between finance
(capital) leases (which give rise to an asset and a liability) and an operating lease, which is not included in the balance sheet of the lessee. IAS
17 (22 pages) defines a finance lease (all others are operating leases) as a lease that transfers substantially all the risk of rewards incident to
ownership of an asset (IAS 17, para. 3). A lease is a finance lease when its term is for the major part of an assets economic life or the
present value of the minimum lease payments are substantially all of the fair value of the leased asset. In contrast, FAS 13 (48 pages)
specifies bright-line rules. Under the broader more principles-based IAS, accountants might account for the same leases differently, depending
on how they interpret a major part and substantially all.37 Under the more specific FAS, a manager who wants to have a lease recorded as
operating rather than financing can structure it to violate some prescribed requirement. Thus, both approaches might result in differences or be
abused.
The IASB (and its predecessor, the IASC) has been struggling with the true-andfair override, as it was torn between the U.K. and the U.S.
approaches. Before 1997, it did not allow for a true-and-fair override and the IASB Framework still states: Financial statements are frequently
described as showing a true and fair view of, or as presenting fairly, the financial position, performance and changes in financial position of an
entity. Although this Framework does not deal directly with such concepts, the application of the principal qualitative characteristics and of
appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of,
or as presenting fairly such information. (Framework, para. 46)
A notable exception is FAS 5 on loss contingencies, which is extremely thin relative to IAS 37. Ironically, FAS 5 was once voted as one of the
best U.S. GAAP standards (Reither, 1998). In practice, there seems to be a tendency to appeal to the bright-line guidance in U.S. GAAP in
interpreting IAS 17.
In 1997, a highly restrictive true-and-fair override was introduced by an amendment of IAS 1. Presumably, it was at the behest of the
European Commission (which had an observer seat in the then IASC) to avoid conceptual differences with the accounting directives, which
include a true-and-fair override. In its current version, IAS 1, Presentation of Financial Statements, states: Financial statements shall present
fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the

effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the Framework.
The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair
presentation. (IAS 1 [rev. 2003], para. 13) But it also requires an entity to depart from a standard or interpretation if compliance would be so
misleading that it would conflict with the objective of financial statements set out in the Framework (IAS 1, para. 16). In that case it must
make extensive disclosures in the notes. This is very much in line with the U.K. situation, and with the European accounting directives,38 but
caused controversy as the IASC did not want to include an override initially.
Recognizing that the override may conflict with the regulatory framework in some jurisdictions, in the 2003 revision of IAS 1, the IASB
qualified the overriding principle and restricts it to cases in which the relevant national regulatory framework requires or permits a departure
from a standard. Otherwise the company is required to make extensive disclosures. This appeal to country-specific jurisdiction is
unprecedented in other IFRSs and is in contrast to the IASBs strategy to avoid a country differentiation in its standards.
We are not aware of any studies that provide statistics on the use of the override in IFRSs, but casual observation suggests it is used only
rarely, if ever.40 This is not surprising, as in the past relatively few companies used IASB standards voluntarily and compliance was patchy
and not enforced. In summary, the ability to use the override with IFRS is highly restricted. But the ability to use it where allowed nationally
will allow comparisons to be made and provide some evidence as to the importance of an override for a well-functioning accounting standard
setting system. New demands for the use of an override with IFRSs may be generated as the substantial majority of first-time adopters gain
experience with IFRS. Its introduction into the Fourth Directive reflected again the U.K.s demands. It caused con- troversy in European
countries, and there are countries that still have not incorporated it into national law (which presumably should be in conformity with the
Directive).
However, country-specific IFRS may also result if a country does not adopt full IFRSs but introduces modifications. Research by Company
Reporting found only one example of an IFRS override. The European Aeronautic Defense and Space Company (EADS) in its 2001 and 2002
financial reports did not capitalize development as required by IAS 38, but now follows IAS 38 . Although EADS justified this deviation as
providing a better view of the firm, it did not formally invoke the override (nor did the auditor when it gave an exception to the audit
opinion).and discover problems in conveying the economic substance of the company under in this regime.
CONCLUSIONS AND SUGGESTIONS
The SEC (2003) Report states that the rules-based nature of U.S. GAAP has generated a mass of detailed rules and guidance and bright-line
specifications in the standards encouraging financial engineering to meet the letter but not the intent of GAAP, resulting in less informative or
misleading financial statements. We agree with this analysis and support the move towards principles-based standards suggested by the SEC
and subsequently followed by the FASBs standard setting strategy. Due to the United States status as lead example for international standard
setting, this change in the format of U.S. GAAP has a significant impact also on other countries.
We are concerned, however, that standard setters do not seem to take into sufficient account that the format of standards and their contents are
interdependent. In particular, the more judgment an accounting principle requires, the more difficult is it to cast it into a standard without
plenty of guidance and, perhaps, exceptions. The FASB continues to permit and may well extend the fair measurement
of assets and liabilities even though those valuations are often not based on relevant (applicable) and reliable (objectively determined) market
prices. In our view the FASB will have to promulgate very detailed rules governing the permissible inputs to and applications of pricing
alternatives even when ostensibly using a principles-based regime. Otherwise, on what basis could auditors challenge managers assertions
about appraisals, comparable prices and valuation-model inputs such as expected cash flows, probabilities and relevant discount rates? The
result, we believe, will be a continuation and extension of the present rules-based accounting standards model, with all its attendant faults.
This is an important reason for our preference for the traditional revenue/expense model, which provides more trustworthy and auditable
procedures than the asset/liability approach in combination with fair value measurement.
We also advocate the inclusion of a true-and-fair override into GAAP standards, especially when these are rules-based. The more rules a
standard includes the more conceivable is it that the rules contradict principles (and most likely that lower-level principles contradict higherlevel principles). And thus, the more essential is an override with clear factual disclosure to sustain the main objectives of financial statements.
This necessity is reinforced by noting that in a given regime rules develop over time with often inconsistent conclusions by the same or
different standard setters. U.K. evidence does suggest that an override is not often needed in what is generally regarded as a principles-based
regime. It is impossible to test our hypothesis of the need for such an override in a rules-based system. A true-and-fair override puts the
responsibility for accounting judgments where it ultimately belongswith managements and independent auditors. There is reason, though,
for concern that some auditors would cave in to demands by opportunistic, overoptimistic or dishonest managers. These auditors might claim
that, at the time that they accepted management-demanded exceptions, in their professional judgment those exceptions to GAAP that mislead
investors were justified.
However, managers use of and auditors acceptance of (or, possibly, insistence on) a true-and-fair override would have to be disclosed and
explained, which would allow users of financial statements and regulators to form their own opinion on the validity of the exceptions.
Allowing companies some leeway to choose accounting, as long as the choices are accepted by their independent public accountants and are

clearly disclosed, can offer investors useful insights on the way the managers view their enterprise. Indeed, U.K. experience is contrary to the
assumption that auditors and regulators would give in easily. In contrast, opportunistic behaviour by U.S. corporations that have used strict
adherence to GAAP rules to produce misleading financial reports has been a much worse outcome.
Nevertheless, we recognize that the usefulness of a true-and-fair override relies on effective disciplinary measures against managers and
auditors.41 We would also add transparency to actions taken or not taken by bodies such as the U.S. Public Companies Accounting Oversight
Board (PCAOB) to discipline rogue and incompetent auditors as well as recalcitrant firms. In the end, we agree with the FASBs (2004, p. 6)
view that a move toward more objectives-oriented standards will require shifts in attitude, behavior, and expertise of preparers and auditors.
Unfortunately, FASB has not suggested measures to bring about such a shift.