Why does accounting fairness remain more of a legal rather than an accounting construct?

As news about accounting scandals continue to hit the financial press with unnerving regularity, fears are also mounting that the current crisis is likely to lead to the widespread unravelling of ‘cooked’ financial statements in the next several months as unscrupulous companies find it difficult to sustain ‘evergreening’. See here and here for a couple of high profile corporate accounting and audit failures reported widely over the last month. The magnitude of gaps uncovered in these financial statements leave no doubt about their materiality, raising several questions about the fairness of internal accounting controls and the external audit process. All this has renewed my long-standing interest in a question raised by some towering accounting intellectuals of a bygone era. 

Accounting legends of an earlier time (for e.g. Leonard Spacek in the case of the American accounting profession during the mid to late twentieth century – also an outspoken critic, prolific writer and former managing partner with the now defunct Arthur Andersen) identified a particularly interesting phenomenon – why is it that the subject of accounting fairness is one on which there is an overwhelmingly disproportionate focus by the judiciary, as opposed to the accounting profession? I mean, the idea of fairness in accounting is obvious and explicit – it is central to auditors’ reports and management representations in most jurisdictions. Take the concept of ‘True and Fair View’ (TFV) as a fit case. Auditors express separate opinions on the truthfulness and fairness of financial statements through an independent auditors’ report. The requirement to comply with and report on TFV is understood (somewhat tautologically) in terms of compliance with appropriate accounting standards and selection and application of consistent accounting policies. There is also an understanding of accounting expertise ‘standing back’ to ensure that ‘the accounts overall do give a true and fair view’ (says the FRC in the UK, for example). Further, such expectations on truth and fairness are also baked into accounting standards – take for example International Accounting Standard IAS-1 on Presentation of Financial Statements, which states that an entity achieves a fair presentation by compliance with applicable IFRSs.

Quite apart from these technical expectations within accounting as to what truth and fairness mean, the courts have approached the topic somewhat differently. To be sure, there is no consensus within the judiciary. Courts in the UK for example have largely interpreted TFV on the basis of prevailing GAAP and accounting conventions, but when necessary have also relied upon the wider principles of ‘economic and legal substance’. Courts in the US on the other hand have been more open to invoking legal reasoning and interpreting fairness more broadly, with attention revolving on the resolution of conflicting interests – a form of legal philosophical approach, if you will. In other words, Courts have in general been more open to relying upon the social significance of accounting in mediating the interests of various financial statement user groups and determining whether financial statements meet legally interpreted norms of truthfulness and fairness.

All this raises an interesting observation. It appears that the tendency within the accounting profession to equate the idea of fairness with GAAP compliance runs the risk of reducing it to a mere technical construct. One could argue that this is necessary to keep the concept grounded, widely understood and implementable. After all GAAP (whether IFRS or US GAAP) is an outcome of reasonably transparent and widely participative due processes. And yet for all its worth, if one were to go by the rising and frequent episodes of accounting/audit failure in recent decades, this understanding of fairness and truth arguably doesn’t seem to have served the profession or public interest well. 

An alternative could be to draw from outside the accounting profession, including for e.g. law, and acknowledge that such concepts as truthfulness and fairness have an essentially legal/philosophical existence. If judicial interpretation is the final arbiter on the fitness of financial statements and financial reporting, and conflict resolution among multiple interests is at the core, then perhaps the accounting profession in general and standard setting in particular, may be better served by breaking out of narrow interpretations of what and who financial statements are for, and therefore, what truth and fairness in financial reporting actually implies. Such an outcome is likely to be fairer to society and could favourably shape training, education and behaviour of the next generation of accountants. That would however require borrowing ideas and approaches  to reasoning, from outside accounting. That would, in itself require a philosophical change and perhaps, an ideological one.