Loopholes and Ambiguities in Financial Regulations in the United Kingdom

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Table of Contents

Introduction
Financial Reporting and Regulatory Schemes
Regulation of Accounting Processes in the United Kingdom
Exploitation of Ambiguities in UK’s Financial Standards
Conclusion
References

Introduction

There are multiple accounting concepts underpinning the assumptions made in the preparation of financial reports. Different countries have varying regulations depending on the reality on the ground. The United Kingdom (UK) has one of the most regulated processes as far as accounting is concerned. However, the existence of these controlling frameworks does not eliminate cases of ambiguities. For example, there are various estimations and assumptions made by preparers of financial statements in the UK. Principles informing the preparation of accounting reports are formulated against the background of various rules and regulations. With these varied options at the disposal of the accountants and auditors, instances where companies exploit loopholes in financial regulations are on the rise. The motive of such companies is to take advantage of the undefined areas to serve their own selfish interests. They do this by misrepresenting financial figures.

In this paper, the author analyses the various loopholes existing in the UK financial regulatory frameworks. In addition, the author reviews how companies exploit these ambiguities and the impacts of their actions on the financial market and the economy as a whole.

Financial Reporting and Regulatory Schemes

Scenarios of accounting malpractices persist in many financial institutions. The situation is the same in bureaucratically controlled market environments. Financial analysts are of the opinion that regulatory agencies are the same parties responsible for the creation of loopholes. Accounting regulations are not static. They change with time. As these standards evolve, financial agencies become creative and start exploiting the resulting weaknesses. Milne, Guthrie and Parker (2008) contend that creative accounting is not identified by law as an illegal practice. However, the intention of those participating in these acts is to deviate from the norms. Financial reports arising from creative accounting are misleading to the public and to other consumers. They are only deemed to satisfy the needs of the preparers and the companies.

Regulation of Accounting Processes in the United Kingdom

The UK has some of the highly regulated institutions in the developed world. There are various agencies and legislations put in place to safeguard the interests of the public as far as accounting is concerned. Generally Accepted Accounting Practice (GAAP) is one such institution charged with the responsibility of overseeing the operations of players in the accounting industry (Milne et al. 2008). In addition, GAAP is used as a statutory provision in UK’s tax acts. To enhance the effective reporting of financial figures, the agency has put in place mechanisms referred to as Standard Accounting Practices [SAP] (Kausa, Humphrey, Loft & Woods 2011).

When incidences of fraud are reported, the Accounting Standards Board (ASB) is tasked with the responsibility of looking into the matter. It achieves this by implementing new rules to safeguard the integrity of the accounting process. After new rules are implemented, they are referred to as the Financial Reporting Standards [FRS] (Kausa et al. 2011). Before financial reports are released to the public, they are scrutinised by ASB and FRS. The scrutiny is carried out using Statements of Standard Accounting [SSAP] (Lehman 2010). Experts report that in spite of these regulations, there are different forms of loopholes in the industry. The ASB assumes the responsibility of ensuring that such cases do not occur.

ASB is also involved in the formulation of new financial reporting policies. Members of the public are brought on board before new amendments or regulations are passed into law. However, there are some issues that call for immediate action from the authorities. In such cases, it is not possible to involve the public. The Urgent Issues Task Force (UITF) intervenes when this happens. The committee is made up of influential individuals drawn from the accounting industry. The provisions formulated by this body are then turned into law with immediate effect (Lehman 2010).

The process of reporting financial statements is constantly changing. As a result, players in the accounting industry are faced with the challenge of revising the existing laws on a regular basis. For instance, listed companies in the UK are required to operate under European laws. International Financial Reporting Standards (IFRS) are some of the European legal frameworks that such entities should adhere to. Institutions that are not listed publicly have the option of operating either under IFRS or GAAP regulations. The challenge of revising new laws has resulted in the exploitation of loopholes emanating from these changes (Peecher, Ira & Trotman 2013).

Despite the numerous legislations involved in the accounting process, UK’s financial regulations are still vulnerable to frauds from unscrupulous companies and auditors. Soderstrom and Sun (2007, p. 678) are of the opinion that cases of creative accounting are on the rise. The development poses a threat to the accounting profession in the country. As already indicated, creative accounting is not illegal in nature. However, deviation from the SAPs regulations is considered to be in bad faith. Companies that engage in this act take advantage of the ambiguities existing in financial regulations to improve their image and attract investors. The complex nature of the measures needed to curb unethical accounting practices needs to be addressed by sealing the existing loopholes (Soderstrom & Sun 2007).

Exploitation of Ambiguities in UK’s Financial Standards

Exploiting Cash and Accruals Loopholes

Companies continue to approve financial reports that have been generated through engineered accounting processes. Such statements contain toxic debts that are hidden from the public. Consumers of these financial reports are not aware of the company’s real financial position. It is noted that wishful thinking defines the nature of complex accounting practices in the market. The final statements are characterised by such issues.

Deustsche Bank is one of the leading corporations in the world. It has operations in the UK and in other global markets. The company was recently thrust into the limelight for submitting misleading financial results to the public. For instance, the bank was accused of failing to account for $12 billion in unrealised losses. It did this in 2013 during its financial crisis. Whistleblowers opine that the bank breached the IFRS by failing to treat super-senior securities in the right manner (Peecher et al. 2013).

Accrual accounting is another channel through which creative reporting is achieved. It comes into play when internal revenue managers exploit the weak points existing between cash-in and cash-out scenarios (Lapsley, Miller & Panozzo 2010). For example, expenses are only viable after they have been transacted either in or out across the counter. However, the case is different in accrual accounting. Under such circumstances, expenditures and revenues are only confirmed after a particular cost has been incurred. The revenue earned in the current year (but which is stated in the incoming session) is filed in the tax statements for the next trading period. In other words, the expenses incurred in the current financial period (but which are balanced in the following year) will interfere with the tax statements for the ‘proceeding’ period. In this context, tax incomes will go down in the current year due to forwarded expenses (Dean 2009).

Financial experts have questioned how two companies operating in the same market can mislead the public by reporting that they achieved true and fair audit statements after employing different accounting principles. Such were the questions directed at Associated Electric Industries (AEI) when it was taken over by General Electric (GE). In this transaction, AEI projected a $10 million profit. However, after one year of operations, GE announced losses of $4.5 million. The scenario prompted the formation of the UK Standard Accounting Steering Committee. The committee found that the company took advantage of the transaction. There were ambiguities with regards to merging and takeover regulations. The company exploited these discrepancies. Various issues were noted in relation to the merger. They included, among others, off-balance sheet financing, fictitious income, and misreported cash flows (Gwilliam & Jackson 2008).

Creative Accounting: The Flexible Nature of UK’s Financial Regulations

According to Flavio and Paes (2013, p. 189), there are four phenomena arising from flexibilities in accounting regulations. The four include fair presentation and effective management of public image. The others are fraud and creative accounting. Ding, Jeanjean and Stolowy (2005, p. 330) provide a working definition of fair presentation in this context. They view it as the application of ‘elasticity’ within the accounting framework in relation to the provision of a true and fair auditing report to serve the interests of the users. Many auditors argue that the major objective of companies is to impress the end user through the reports. As such, accounting firms will do anything under this flexibility to please the consumers (Kausa et al. 2011).

Impression management is another important aspect of creative accounting and exploitation of loopholes. It involves the application of accounting flexibility, especially through narratives and graphs, to portray a favourable interpretation of financial reports. The aim of such measures is to impress the consumers of financial reports. Improvement of image is more common in some situations compared to others. For example, it is reported in cases of a decrease in regulatory visibility, mergers and acquisitions (like in the case of AEI and GE), and in the formation of new management teams. Emergence of new issues has also necessitated impression management. For instance, Deustsche Bank applied this flexibility for the purposes of increasing the profits (in the reports) to meet the expectations of the analysts (Loughran and Ritter 2004).

Fraud involves the act of operating outside the legal provisions. Various accounting firms engage in fictitious transactions by inventing sales and subsidiaries (Loughran and Ritter 2004). In general, creative accounting involves exploiting the flexibility of the regulatory framework. The objective is to manage the presentation of financial reports to serve predetermined interests. In most cases, this act is characterised by increased incomes after the approval of premature sales. Some incidences are characterised by decreased expenses where provision of accounting and capitalisation of interest prevail. Creative accounting also involves decreased liabilities due to off-balance sheet financing and reclassification of debt into equity shares (Kausa et al. 2011).

Parmalat is an example of a company involved in this practice. The accounting committee noted that the organisation was engaged in a number of accounting frauds. They included fictitious sales, double billing, and failure to record debts. In addition, the bank was involved in the fabrication of sales made in operating subsidiaries. The frauds were committed with the aim of preserving the interests of the company (Gwilliam and Jackson 2008).

Exploitation of Loopholes and Accounting Scandals in the UK

Loopholes have resulted in what Gough, Josiah, Haslam and Sha (2014) refer to as accounting scandals. Such developments are caused by a number of factors. They include information asymmetry, off balance sheets, and window dressing. As a result of the powers wielded by the top management team, auditors can opt to reduce or increase the cost of shares. They do this after obtaining information that is not accessible to other parties.

In a reduced share price scenario, the company becomes a potential target for a takeover. Takeover means that the organisation can be bought or privatised due to the falling share prices. In the process, the agent makes profits as a result of the actions of the management team. During the takeover, a lot of money is involved. A scandal may arise in instances where members of the public raise queries about the money used. An example of this is the transaction cited earlier between AEI and GE (Ding et al. 2005). After executing a “fire sale”, the managers of the acquired firm are rewarded with a golden handshake worth millions of dollars. The rewards affect the operations of the new organisation.

Another factor involved in accounting scandal involves managerial opportunism. According to Loughran and Ritter (2004), this phenomenon occurs where policy makers try to take advantage of the prevailing situation. For example, a highly paid manager on a short term performance contract may be tempted to alter the accounting information without paying attention to financial principles. The executives involved in such acts are convinced that they will not suffer from the consequences of their undertakings. The reason is that they will be working in the firm for a short duration. Financial regulations in the UK do not address these issues. In most cases, accounting firms exploit this loophole to serve their interests. For example, the accounting scandal revolving around Barlow Clowes involved taking advantage of such opportunities. A new management team inherited financial reports where more than $110 million was missing (Lapsley et al. 2010).

Due to information asymmetry, regulators, the government, and the public at large witness the ‘miraculous’ rise of a firm that was in a crisis before a takeover. Such suspicions prompted investigations into the operations of Polly Peck International (PPI), a British textile company. It was realised that the firm was involved in scandalous accounting before the merger. The investigations led to a review of UK’s Company Law Code of Ethics. However, in spite of this, the issue of information asymmetry persists today (Ding et al. 2005). Firms have taken advantage of this reality.

Conclusion

In this paper, the author analysed the implications of the various loopholes characterising financial markets in the UK. From this analysis, it is apparent that companies take advantage of ambiguities in the various financial legislations to impress members of the public and potential investors. To address this situation, it is important to review the rules on a regular basis. For example, the UTIF, which is expected to react to urgent accounting issues, should have access to information on probable accounting malpractices.

The introduction of various international bodies like IFRSs should minimise unethical accounting practices. Mechanisms should be put in place to ensure that deviations from the rules are punished. Creative accounting may be technically legal, but the government should play an active role to control it.

References

Dean, D 2009, ‘Auditing Santa’, Accounting, Auditing & Accountability Journal, vol. 22 no. 8, pp. 1311-1314.

Ding, Y, Jeanjean, T & Stolowy, H 2005, ‘Why do national GAAP differ from IAS? the role of culture’, The International Journal of Accounting, vol. 40, pp. 325-350.

Flavio, A & Paes, N 2013, ‘The influence of interest on net equity and interest rates on tax neutrality’, Economia, vol. 14 no. 1, pp. 185-198.

Gough, O, Josiah, J, Haslam, J, & Sha, N 2014, ‘Corporate reporting implication in migrating from defined benefit to defined contribution pension schemes: a focus on the UK’, Accounting Forum, vol.38 no. 1, pp. 18-37.

Gwilliam, D & Jackson, R 2008, ‘Fair value in financial reporting: problems and pitfalls in practice: a case study analysis of the use of fair valuation at Enron’, Accounting Forum, vol. 32 no. 3, pp. 240-259.

Kausa, A, Humphrey, C, Loft, A, & Woods, M. 2011. ‘Regulating audit beyond the crisis: a critical discussion of the EU Green Paper’, European Accounting Review, vol. 20 no. 3, pp. 431-457.

Lapsley, I, Miller, P & Panozzo, F 2010, ‘Accounting for the city’, Accounting, Auditing & Accountability Journal, vol. 23 no. 3, pp. 305-324.

Lehman, G 2010, ‘Perspectives on accounting, commonalities and the public sphere’, Critical Perspectives on Accounting, vol. 21 no. 8, pp. 724-738.

Loughran, T & Ritter, J 2004, ‘Why has IPO under pricing changed over time?’, Financial Management, vol. 33 no. 3, pp. 5-37.

Milne, M, Guthrie, J & Parker, L 2008, ‘Into the light and engagement: two decades of interdisciplinary perspectives on accounting, auditing and accountability research’, Accounting, Auditing & Accountability Journal, vol. 21 no. 2, pp. 117-128.

Peecher, M, Ira, S & Trotman, K 2013, ‘An accountability framework for financial statement auditors and related research questions’, Accounting, Organizations and Society, vol. 38 no. 8, pp. 596-620.

Soderstrom, N & Sun, K 2007, ‘IFRS adoption and accounting quality’, European Accounting Review, vol. 16 no. 4, pp. 675-702.

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