An Empirical Investigation of the True and Fair Override in the United Kingdom

Authors

  • Gilad Livne,

    1. The authors are respectively from Cass Business School, London and the Graduate School of Business, Stanford University. They thank an anonymous referee, Stefan Ost, Sanjay Pareek, David Parkington, Amit Shanker and Mike Staunton of London Share Price Database for their help with data collection, and Qintao Fan and Yulin Long for their excellent research assistance. They also thank Mary Barth, Bill Beaver, Robert Bushman, Elroy Dimson, Chris Higson, Steve Monahan, Dennis Oswald, Peter Pope, L. Shivakumar, Martin Walker (editor) and Terry Warfield, as well as seminar participants at the American Accounting Association 2002 Annual Meeting, 2nd ESRC/CAIR Conference Manchester University, HKUST Summer Symposium, INSEAD, London Business School, Summer Camp of Stanford University, Tel Aviv University, University of California, at Berkeley, University of Wisconsin, Madison and Warwick University, for many helpful comments. Gilad Livne gratefully acknowledges the financial support of the Leverhulme Trust, UK, and the London Business School, and the Accounting faculty of Stanford University for their kind hospitality during summer of 2002. Maureen McNichols gratefully acknowledges the support of the Stanford Graduate School of Business.
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  • Maureen McNichols

    Corresponding author
    1. The authors are respectively from Cass Business School, London and the Graduate School of Business, Stanford University. They thank an anonymous referee, Stefan Ost, Sanjay Pareek, David Parkington, Amit Shanker and Mike Staunton of London Share Price Database for their help with data collection, and Qintao Fan and Yulin Long for their excellent research assistance. They also thank Mary Barth, Bill Beaver, Robert Bushman, Elroy Dimson, Chris Higson, Steve Monahan, Dennis Oswald, Peter Pope, L. Shivakumar, Martin Walker (editor) and Terry Warfield, as well as seminar participants at the American Accounting Association 2002 Annual Meeting, 2nd ESRC/CAIR Conference Manchester University, HKUST Summer Symposium, INSEAD, London Business School, Summer Camp of Stanford University, Tel Aviv University, University of California, at Berkeley, University of Wisconsin, Madison and Warwick University, for many helpful comments. Gilad Livne gratefully acknowledges the financial support of the Leverhulme Trust, UK, and the London Business School, and the Accounting faculty of Stanford University for their kind hospitality during summer of 2002. Maureen McNichols gratefully acknowledges the support of the Stanford Graduate School of Business.
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* Address for correspondence: Maureen McNichols, Graduate School of Business, Stanford University, Stanford CA 94305, USA.
e-mail: fmcnich@stanford.edu

Abstract

Abstract:  The True and Fair View concept requires companies to depart from GAAP or the law if necessary to present a true and fair view of the corporation's financial affairs. We analyze UK public companies invoking a true and fair override to assess whether overrides are associated with weakened performance, earnings quality and informativeness. We find quantified overrides increase income and equity significantly, and firms that invoke more costly overrides report weaker performance. We also find that firms invoking the most costly overrides have less informative financial statements than control firms, and lower earnings quality. In contrast, firms invoking less costly overrides do not exhibit weaker performance, less informative financial statements or weaker earnings quality. These findings are relevant for the debate on principle- vs. rules-based accounting.

1. INTRODUCTION

This paper provides evidence on the use of the true and fair view (hereafter TFV) override by UK companies. UK rules, the first International Accounting Standards (IAS 1, 2003) and legal requirements in the European Union require that public companies provide a true and fair view of their financial affairs in the financial statements. Conceptually the notion of TFV goes beyond conformity with GAAP in that it provides a reporting entity the option to depart from the letter of the law or a promulgated accounting standard in certain circumstances. Availing this option to firms entails the risk that increasing the set of accounting reporting choices applied reduces the comparability and quality of corporate financial reports. On the other hand, this option could enhance financial reporting if application of existing rules leads to misleading financial reports. The use of broad principles to grant managers considerable reporting flexibility has been advocated by some as superior to the philosophy of creating a dense web of rigid and highly detailed reporting requirements. However, not all agree with that view, especially US regulators and standard setters.

The debate on principles-based vs. rules-based accounting systems has come recently to the fore in the wake of Enron and other well-known accounting scandals. Against this background, the FASB and the SEC studied the issue of principles vs. rules-based reporting (e.g., FASB, 2002). The SEC has long questioned overrides of accounting standards, as is evident from its policy to ‘challenge the basis on which such an override has been used and the basis on which the auditors have given an unqualified report’ in the case of UK firms listed in the US (see SEC, 2001). The SEC objects to the possibility of an override due to the concern that the override requirement may lead to reduced comparability and transparency, and may be used to mask poor financial performance or deteriorating asset quality.1

Our study provides evidence pertaining to this debate because it examines the nature of overrides in a more principles-based accounting system, the UK. We postulate that invoking an override is a result of cost-benefit analysis carried out by managers of reporting entities. Specifically, we argue that there may be costs associated with an override, which are increasing in the authoritative support for the accounting treatment subject to override. For example, a departure from UK GAAP likely involves considerable costs because it increases the probability of conflict with auditors and directors, potential intervention of regulatory bodies, and litigation as well as criticism by various market participants (e.g., Jack, 1994; Brandt et al., 1997; and Hines et al., 2001). The benefits to reporting managers may include attaining certain reporting objectives, such as satisfying debt covenants. Therefore, overrides of GAAP are likely to be invoked only when the resulting net benefits are sufficiently high.

We use data from the UK to examine this issue, given its long history with the true and fair view requirement and the influence of UK standard-setters on shaping IAS. We find that the vast majority of our sample involves overrides of lesser authoritative rules, such as an override of the Companies Act to invoke GAAP. However, 19% of our sample observations involve an override of UK GAAP. This relatively small number of cases suggests that either UK firms are discouraged to override principles with more authoritative support, that circumstances giving rise to GAAP overrides that are solely aimed at providing better information to investors are rare, and/or that UK GAAP already provides sufficient flexibility.

Our primary goal is to investigate whether more costly overrides are associated with weaker financial performance. We find that firms invoking what we hypothesize are more costly overrides tend to exhibit weaker financial performance and lower interest coverage. Moreover, firms overriding GAAP exhibit a decline in performance in the first year of the override. If overrides are invoked to present a true and fair view, one would expect them to be invoked by successful firms as well as firms experiencing financial difficulties. These findings suggest that the more costly overrides are not consistent with the spirit of true and fair presentation. On the other hand, for firms invoking more ‘mechanical’ and less costly overrides, such as non-depreciation of investment properties we do not find evidence of weaker earnings or greater debt.

A secondary goal of this paper is to assess the valuation implications of earnings and book values of override firms. Prior research (e.g., Ohlson, 1995) suggests that greater earnings persistence should lead to higher coefficients on earnings and lower coefficients on book value of equity in valuation models. If overrides represent manipulations that are transitory in nature, we would expect to find lower (higher) coefficients on earnings (book value) for override firms than control firms. We provide evidence that the earnings persistence of override firms is lower than that of control firms for some costly overrides. We also find that companies that choose to override GAAP with the most costly overrides provide less informative financial statements.

Taken as a whole, the evidence provided in this paper indicates that UK companies have used the TFV override in well-defined circumstances. However, overrides that require considerable managerial discretion tend to be invoked in less favorable circumstances, suggesting the possibility that some firms invoke an override to mask weaker financial performance. Consistent with this, the earnings of override firms are not more persistent than the earnings of control firms.

The plan of the paper is as follows. Section 2 provides some background information on the practice of true and fair override in the UK and European Union that is useful for the debate about its admissibility. Section 3 develops the theory and main hypotheses examined in the paper. Section 4 describes the data and procedures used in data collection. Section 5 reports the main empirical findings and Section 6 concludes.

2. BACKGROUND TO THE DEBATE ON THE TRUE AND FAIR OVERRIDE

The concept of true and fair view first appeared in the United Kingdom in the Joint Stock Companies Registration and Regulation Act of 1844 (McGregor, 1992).2 The UK Companies Act (1985) requires that financial statements ‘give a true and fair view.’ Specifically, the Companies Act (1985) requires that if, owing to special circumstances, compliance with the Act would prevent compliance with true and fair presentation, the directors shall depart from the requirement of the Act and quantify the effect of the departure.3

The concept of true and fair also shows up in a number of professional pronouncements. At the broadest level, the ASB's (1993) Forward to Accounting Standards states that ‘the Board envisages that only in exceptional circumstances will departure from the requirements of an accounting standard be necessary in order for financial statements to give a true and fair view.’ The specific disclosure requirements first appeared in UITF Abstract 7 (ASB, 1992) and later incorporated into FRS 18 (ASB, 2000). In contrast to the Act, FRS 18 allows for the possibility that some departures cannot be quantified.

While there is ambiguity regarding the exact meaning of the words ‘true’ and ‘fair’, the legal view is that:

the courts will treat compliance with accepted accounting principles as prima facie evidence that the accounts are true and fair. Equally, deviation from accepted principles will be prima facie evidence that they are not. Accounts which depart from the standard without adequate justification or explanation may be held not to be true and fair' (Lord Justice Hoffmann (1983) and Hon. Mrs. Justice Arden (1984), as cited by Davies et al. (1999) p. 8).

IAS 1, issued by the International Accounting Standards Board and amended in December 2003, contains similar requirements for an override to those in the UK, though it requires that financial statements ‘present fairly’ a company's financial position, financial performance and cash flows (paragraph 13). The Financial Reporting Council (the UK regulator overseeing the ASB) has confirmed that following the adoption of IAS and ‘fair presentation’ in the EU, the concept of ‘true and fair view’ remains a cornerstone of financial reporting and auditing in the UK (FRC, 2005).

3. THEORY AND HYPOTHESES DEVELOPMENT

(i) Flexible vs. Rigid Reporting Requirements

Generally, a more flexible accounting system may be superior to a system in which the set of accounting procedures is restricted if managers use the flexibility to provide better information to investors or to improve contracting. For example, allowing non-GAAP reporting can increase the value of the firm while reducing contract-negotiating and duplicate bookkeeping costs (Leftwich, 1983). On the other hand, a flexible approach may be abused by self-interested managers, resulting in dead-weight costs (Watts and Zimmerman, 1990). In particular, allowing flexibility may allow opportunistic managers to portray the firm's financial performance as stronger than would be shown with less flexible reporting, leading to lower earnings quality and lessened informativeness of the financial statements.

(ii) Deterrents to the Abuse of Flexible Reporting Rules

Three forces can deter managers from abusing reporting flexibility available to them. First, anticipating potential abuse on the part of managers, shareholders and other contracting parties can include clauses that impose penalties for invoking undesired TFV overrides. However, such contracts may not be available in firms where management can set self-serving terms in the contracts (Bebchuk et al., 2002), and contract terms may be incomplete because it is not possible to anticipate all possibilities for self-serving behavior (Watts and Zimmerman, 1990).

Second, a country's enforcement mechanisms and legal framework can deter opportunistic reporting. Flexible accounting coupled with incomplete contracts may result in many disputes between the reporting entity and third parties being referred to regulators or a court of law. However, to paraphrase La Porta et al. (1998, p. 1121), in an environment of perfect judicial enforcement, reporting flexibility may be advantageous to investors because they can appeal to a court if they fear being misled by managers. In contrast, when the courts have limited discretion and enforcement power or litigation is costly, simple and restrictive sets of rules also known as bright-line rules, for which violations are easy to judge, may be superior.

Third, the firm's governance system, including its directors and auditors, can deter managers from abusing reporting rules. In the presence of strong oversight by the audit committee and a professional body of auditors, managers face the requirement that any departure from GAAP or the Act is either required or approved by the external auditor. An override may be required if the auditor believes that following form will contrast with the need to follow substance. Alternatively, in cases where the management-initiated override is not warranted, the directors and auditors should deter managers from misreporting.

In summary, when recognition or disclosure rules are very flexible and deterrence mechanisms are weak, opportunistic reporting can emerge. On the other hand, if rules are too rigid and deviation from promulgated rules is very costly, firms may be unwilling to depart from rules to provide financial statements that give a true and fair view.

(iii) Specific Costs Associated with TFV Overrides in the United Kingdom

When a company invokes an override, it is likely to draw attention from various interested parties, which in turn may involve costs. In particular, the company may be investigated by the Financial Reporting Review Panel (FRRP), an affiliate of the ASB, which has statutory powers to investigate whether annual reports comply with the Companies Act and GAAP.4 It has been widely perceived in the UK that the FRRP has been an effective deterrent mechanism against unreasonable violations of GAAP and the CA.5Benston et al. (2006) report that about 20–30 per cent of cases before the FRRP arose from a TFV override, and that the majority of these overrides were rejected because they were not compelling. Additional costs may involve conflicts with auditors, scrutiny by analysts and institutional investors. It is important to note, however, that such costs may not be present in other jurisdictions.6

In what follows we develop and order four categories of TFV overrides according to the relation between the type of override and potential costs that the TFV firm may incur. The four categories are as follows:

  • 1Accounting standards, or similar pronouncements, prescribe one method, which contradicts the Companies Act (CA) and thus requires an override.
  • 2Accounting standards, or similar pronouncements, allow some choice but effectively prefer a particular method in most cases. The preferred choice is consistent with the CA. Thus, not following the preferred method also contradicts the CA, and hence requires an override.
  • 3Accounting standards, or similar pronouncements, are silent on a particular issue, but not the CA. Not following the CA requires an override. Note that in the absence of a promulgated standard, the CA may be regarded as GAAP.
  • 4Accounting standards or similar pronouncements require a certain method, which is overridden.

All else equal, the first category is expected to occur most frequently, because the presumed superiority of GAAP triggers a ‘mechanical’ override of the Companies Act, suggesting little cost to invoking the override. In fact, due to the presumed supremacy of GAAP over the CA, mechanical overrides may be costly to avoid.

The fourth category regards departures from generally accepted accounting rules. Under the maintained presumption that following accounting standards is consistent with TFV, any departure from GAAP is likely to be regarded as the most costly. This is particularly true if the override is opportunistic and hence less defensible. Thus, a departure under this category is expected to occur in a small number of cases in which managers deem the benefits from the departure to be quite high and in excess of costs.

We expect that the second and third categories have greater cost than the first category and less than the fourth category but their relative ordering is ambiguous. Thus, our numbering of these categories is for convenience in reference and is not ordinal. The second category involves situations where an accounting standard offers a choice, but expresses some preference for one choice over the others. If not following the preferred option given in the standard involves some kind of penalty, or unwarranted exposure, firms may be hesitant to depart from the preferred choice unless the benefits outweigh the costs.

The third category involves cases where there are no specific rules except those required by the CA. In the absence of promulgated standards, one can argue that the CA effectively becomes GAAP. We do not expect this to occur at a high rate because accounting standards are more comprehensive than the CA. Furthermore, to the extent that the CA is regarded as authoritative, firms are less likely to depart from its requirements for opportunistic purposes due to potential cost.7

(iv) Hypotheses Development

Our primary hypothesis is motivated by the previous discussion of costs and benefits of invoking an override. Experience with the TFV override in Australia and New Zealand suggests that management may exploit greater flexibility in financial reporting to influence the perceptions of various parties as to the firms' status and performance. Relatedly, firms experiencing weaker financial performance may be more likely to use the TFV override option to avoid covenant violations, as suggested by the debt covenant hypothesis.8 Thus, in a reporting system featuring an override, firms may exercise this discretion to improve reported performance and thereby avoid violating debt covenants. A competing alternative, which represents the view in the UK (Cook, 1997), is that firms are motivated to override, and auditors provide approval, to achieve better accounting treatment (e.g., the override is ‘corrective’).9 Implicit in this view is the high regard paid to specific UK institutions, such as the FRRP and the audit profession. Such institutions may have played a smaller role in other jurisdictions with the resulting abuse of the TFV requirement. In such a case, we would not expect weaker performance for UK override firms. We expect that our ability to discriminate between these hypotheses is greatest for the most costly overrides, where the offsetting benefits are the greatest. However, the extent to which institutional forces deter firms from invoking an override to avoid a valid standard is an empirical question, so our first hypothesis is two-sided. Stated in null form:

  • H1: Firms that invoke more costly overrides experience similar financial performance and debt contracts to otherwise similar firms that do not invoke an override.

We supplement our primary investigation with evidence on the valuation implications of overrides. While it is possible that an override is invoked solely to increase reported income or influence contract outcomes, such as violation of debt covenants, it is not clear how the exercise of such discretion will affect earnings quality. Moreover, firms may want to use an override as a means of providing better information absent any other motivation. For example, an override may result in greater earnings persistence (i.e., greater quality).10 Managers may be motivated to do so because of the beneficial effect on the firm's cost of capital (Botosan, 1997).

Alternatively, depending on the principle adopted, an override could result in less information to investors, as some regulators fear and consistent with Ewert and Wagenhofer (2005). Similar to our first hypothesis, the second hypothesis is two-sided. Stated in null form:

  • H2: The financial statements of TFV firms are as informative as the financial statements of otherwise similar firms that do not invoke an override.

4. DATA

To identify firms invoking an override during the 1998–2002 period, we searched the Lexis-Nexis UK annual reports database using key words ‘true and fair view,’‘override’ and ‘departure.’11 As reported in Table 1, this search resulted in a sample of 1,141 firm-year observations over the five years. Since in any given year, multiple overrides can be invoked by a single company, we include in Table 1 only the highest override category in any given year. As discussed below, we exclude 434 observations because they represent industry-wide practice, which prevents us from finding a suitable control sample. The final sample thus involves 707 firm-year observations that represent overrides invoked by 307 firms.

Table 1. 
Classification of Firm-year Overrides by Expected Cost Categories 1998–20021
Types of TFV Overrides2Category 1Category 2Category 3Category 4Total Number of TFV Obs.
  1. Notes:
    1 Category Description:

  2. 1. Accounting standards, or similar pronouncements, prescribe one method, which contradicts the Companies Act (CA) and thus require an override.

  3. 2. Accounting standards, or similar pronouncements, allow some choice but effectively prefer a particular method in most cases. The preferred choice is consistent with the CA. Thus, not following the preferred method also contradicts the CA, and hence requires an override.

  4. 3. Accounting standards, or similar pronouncements, are silent on a particular issue, but not the CA. Not following the CA requires an override. Note that in the absence of a promulgated standard, the CA may be regarded as GAAP.

  5. 4. Accounting standards or similar pronouncements require a certain method, which is overridden.

  6. 2 In case of multiple overrides for any given firm-year the table classifies the highest category override.

  7. 3 The total number of overrides identified is 1,441 (707 + 434). However, the 434 industry-wide observations were not included in the main analyses due to the lack of a control sample.

No depreciation provided for:
 Investment properties (S19)339   339
 Fixed assets (S12)     7  7
No amortization of goodwill (NOG) 104  104
Merger accounting used instead of purchase accounting (MER)  4   50 54
Stepwise calculation of goodwill (GDW) 32    2 34
Current assets presented at market value and not cost (MVA)   25  4 29
Grants and contributions not shown in deferred income (GRT)    24 24
Unrealized gains and losses taken to the P&L (UGL) 27    27
Not recognizing diminution in value of investment in parent company's accounts (ITG)   23  23
Other (OTH) 11   9 46 66
Total3413104 57133707
% of total58.414.7 8.118.8100
Num. of quantified overrides 65 39 13 26143
(% of category)(15.8)(37.5)(22.8)(19.4)(20.2)
S19 by Real Estate firms385   385
GRT by Water firms    49 49
Overrides excluded from sample above    434

Financial data were obtained from Datastream whereas share price data and market values of equity were obtained from the London Share Price Database (LSPD). Auditor identity and auditor's opinion were collected from Worldscope. We collected a control sample of industry and size-matched firms for all override firms except those in the real estate and water industries invoking industry-wide overrides. That is, the sample of 707 firm-year observations excludes 434 overrides that are industry-wide practice (e.g., depreciation in the real-estate industry) and hence no matched sample could be constructed. More specifically, we matched each TFV firm with a firm from the same three digit SIC code with the closest market value at the beginning of the TFV firm's fiscal year. Whenever the closest market value differed by more than 20%, a new search was conducted at the two digit SIC code and, if necessary, at the one digit SIC code. A control firm is used only for one TFV firm in any given year.12

We also require availability of share price data in the fourth month after the end of the fiscal year because public firms are required to file preliminary reports with the London Stock Exchange within 120 days from the fiscal year-end and many file the full report within three months. To verify the adequacy of the matching procedure, we verified that the difference in the mean and median market value is not significantly different from zero. The use of a matched sample provides assurance that our comparisons are not affected by cross-sectional variations in industry-specific factors or firm size, which may capture political cost considerations or other factors that are not central to our analysis. In addition, within-industry matching works to mitigate the possibility that a TFV firm and a control firm face fundamentally different circumstances, which prompt one company to invoke an override because existing rules are inappropriate for these circumstances.13

5. EMPIRICAL PROCEDURES AND FINDINGS

(i) Types of Overrides

All the override disclosures identified in our search were carefully read and analyzed and then classified into nine major types of overrides according to the underlying accounting treatment affected by the override. We then further assign each of the override types to one of the four cost categories discussed above. Table 1 presents these override types, classified by cost category, in descending order of frequency. It also shows how many overrides were quantified in each cost category. The Appendix presents further details regarding the expected effect of each override type on the financial statements. As can be seen from Table 1, Category 1 overrides comprise the majority of the sample, and the rate of occurrence is substantially lower for Category 4 than for Category 1. Also, the total number of overrides under Categories 2 and 3 (161 observations) is lower than that under Category 1, but higher than that for Category 4. The most common override type is non-depreciation of investment properties, which is required by GAAP but disallowed by the Companies Act. Hence this type is a Category 1 override. The second most frequent override type is non-amortization of goodwill. While UK GAAP allows for non-amortization, the relevant standard (FRS 10, ASB, 1997) does not favor it and, furthermore, requires annual impairment reviews that have been perceived as costly.14 As non-amortization of goodwill also stands in contrast to the CA, it is classified as Category 2.

As Table 1 indicates, seemingly similar override types may relate to more than one category. This is because each case is individually analyzed to determine the rule that was departed from. Thus, for example, in the case of piecemeal calculation of goodwill, two cases were found to violate GAAP while the other 32 cases were consistent with GAAP, but inconsistent with the CA.

The findings in Table 1 show that Category 1 overrides are the most common, and Category 4 overrides (outright departures from UK GAAP) are much less common. However, Category 4 includes 133 firm-year observations invoked by 68 firms in our 5-year sample period, suggesting that overriding GAAP is a non-negligible phenomenon.

(ii) Firm Performance by Type of Override

In this section, we describe several analyses that provide evidence on whether firms that invoke TFV overrides are doing so to report more favorable performance (hypothesis 1). If firms invoke overrides solely because they want to increase their reported income, or avoid violation of debt covenants, we would expect to see significant differences in pre-override performance or debt-related financial indicators between override and control sample firms. On the other hand, if firms invoke overrides to increase the informativeness of their financial statements, we would not expect TFV firms to exhibit weaker indicators before the effect of the override.

First, we examine the annual effect of overrides on income and the cumulative effect on equity for the subsample of firms that disclose these amounts. The Companies Act and UK GAAP require that firms invoking a TFV override disclose the particulars of any departure, the reasons for it and its effect, where the effect is quantified if possible. As reported in Table 1, only a small number of companies actually quantify the effect of their override. In some cases, this occurs because a firm would not be able to characterize what number it would have reported, as in the case of adopting merger (pooling) accounting instead of purchase accounting in acquisition of a subsidiary. In other cases, such as non-depreciation of investment properties, quantification would require that the firm calculate the depreciation amount it would have recorded, which is arbitrary if the firm views the asset as having an indefinite life.15 We expect that the median income and equity effects of an override are significantly positive if firms invoke overrides opportunistically. If overrides are not income and equity-increasing, on average, it seems less likely that they are invoked for opportunistic reasons. However, we note that because only a fraction of firms quantify their override effects, the median for the sample as a whole may differ from the median for the sample that disclosed the magnitude of the effects on income and equity. Furthermore, our tests that the median effect is positive are less powerful than they would be if based on a larger sample.

Second, we compare the characteristics of TFV firms to a control sample of industry and size-matched firms. We test whether firms that invoke overrides are less profitable and financially weaker than firms that do not. It should be noted that to the extent an override is successful in masking poor performance or financial position, we are less likely to find evidence supporting opportunistic behavior in measures based on net income. To mitigate potential effects of overrides on profits, assets and equity, we use two measures to assess underlying performance before the effect of an override: OPINC, the ratio of operating income before depreciation and amortization to sales, and CFOTOS, the ratio of cash from operations to sales. In addition, to assess the tightness of debt covenants before the effect of overrides, we use DETOFIX, debt to gross book value of tangible fixed assets, and INTCV, the interest coverage ratio.16 Note that if contracts regularly contain clauses to undo the effect of overrides, we would not expect to find an association between debt levels and the occurrence of overrides. Thus, finding such an association would suggest either contracting parties agree not to undo overrides or did not originally anticipate them.

To give a comprehensive overview of the results of these tests, we begin by presenting the findings for the entire sample of firm-years invoking any category of override. Table 2 presents descriptive statistics on several variables for both the TFV and the control samples.17 We calculate the Wilcoxon matched pair signed rank Z-statistic for the median difference in the firm-specific means of the TFV and control samples, and report the results under the Z heading. The advantage of this approach is that it is less susceptible to cross-sectional dependence in the TFV sample. It also mitigates the influence of outliers.

Table 2. 
Comparison of Override, Descriptive, Performance, Contracting and Market-based Variables for the Full Sample of TFV Overrides 1998–2002 and Size and Industry-matched Control Sample, Excluding Real Estate Firms
Variable Name1TFV SampleControl SampleZ Value
NMeanMedianStd. DevNMeanMedianStd. Dev
  1. Notes:
    1 Variable definitions:

  2. Override Effects

  3. %EQUITY– Cumulative effect of override on equity/total equity

  4. %INCOME – Effect of override on income/income, for firm-years with positive income

  5. Performance Measures

  6. NETPRO – Net profit/sales

  7. DTOS – Depreciation expense/sales

  8. NETROE – Net profit/total equity

  9. TURNOVER – Sales/total assets

  10. CFOTOS – Cash flow from operations/sales

  11. OPINC – Pretax income from operations before depreciation and amortization/sales

  12. Contracting

  13. DETOFIX – Total debt/gross tangible fixed assets

  14. INTCV- Interest coverage ratio, measured as pretax income before interest/(capitalized interest + interest expense)

  15. Goodwill Related

  16. GWTOASS – Goodwill and other intangibles/total assets

  17. AMTOSALE – Amortization expense/sales

  18. PGWTOASS – Goodwill capitalized during the year

  19. Market-based Variables

  20. BM4M – Book value of equity-to-market value of equity, at four months after end-of-year

  21. EP4M – Earnings-price ratio based on the share price four months after year-end

  22. The z-statistics indicate whether the median override effect is greater than zero, and whether the median of all other variables is greater for the override sample than for the control sample. Z is based on the mean value of all observations available for any individual firm. A z-statistic is printed in bold type if it is significant with a probability value less than 0.05.

Override Effects
% EQUITY440.0590.0120.137    2.31
% INCOME470.0960.0230.182    0.90
Descriptive Variables
SALES (£M)5781776.561169.8244604.4215781146.695143.2992639.3300.45
INCOME(£M)60090.3975.992322.27760084.7556.354308.0400.07
ASSETS (£M)6008605.769164.92036726.0696005740.361166.42332112.9780.67
EQUITY (£M)600861.45066.1402114.679600650.05357.1331756.8910.26
Performance Measures
NETPRO5390.0220.0450.230539−0.0320.0460.517−0.72
DTOS5380.0380.0260.0485380.0470.0290.071−1.69
NETROE5800.0590.1020.3525800.0580.1090.3420.32
TURNOVER5691.0920.9260.8735691.1221.0240.871−1.28
CFOTOS4840.0950.0890.1864840.0630.1080.475−1.24
OPINC4630.1130.1040.1654630.1180.1200.1720.62
Contracting
DETOFIX5560.9000.4201.5255561.0840.3802.2771.92
INTCV4409.6075.19644.50943913.7915.02989.866−1.45
Market-based Variables
BM4M5230.7670.6070.6135220.7190.503   5231.86
EP4M5210.0250.0570.183520−0.0160.054   5210.44

Consistent with the theoretical considerations discussed earlier in the paper, we group the variables into five categories: override effects, descriptive measures, performance measures, debt contracting and market-related variables.18 The first category includes the override effects on equity and income, on a percentage basis, for the subsample of firm-years in which the amount of the effect was disclosed.19 The mean (median) increase in equity is 5.9% (1.2%) and the mean (median) effect on income is 9.6% (2.3%). However, only the median effect for equity is significantly positive with probability value less than 0.001. These findings thus provide some support for the notion that firms invoking overrides tend to adopt income- and equity-increasing accounting choices.

The second category includes descriptive measures, and indicates that TFV firms report SALES (total turnover), INCOME (net income), ASSETS (total assets) and EQUITY (total shareholders' funds) that are not significantly greater than those of the control group. Turning to performance measures, we observe that the net profit margin, NETPRO, is not significantly different for the TFV and control samples. However, TFV firms have significantly lower depreciation to sales, DTOS, which is not surprising given the large frequency of overrides that result in non-depreciation of investment properties. The difference in the two measures of pre-override profitability, CFOTOS and OPINC, are insignificant.

Under the hypothesis that TFV firms are motivated to override accounting rules to avoid violating a debt covenant, one might expect DETOFIX to be higher for TFV firms. We find that the median debt to gross fixed assets is indeed greater for TFV firms, suggesting that for the sample as a whole, concern over leverage ratios may have motivated them to override asset-reducing standards. Because we measure DETOFIX using gross fixed assets, this measure is not affected by non-depreciation overrides. Alternatively, INTCV likely reflects the effects of any income-increasing overrides and here we do not find a significant difference between TFV and control firms for the entire sample.

Market-based variables comprise the final category of variables in Table 2. The ratio of book to market value as measured four months after fiscal year-end, BM4M, is significantly greater for override firms. The ratio of earnings to price, again measured four months after fiscal year-end, EP4M, is not significantly different. These findings suggest that the market discounts the equity of TFV firms relative to that of control firms and therefore that investors at least partially adjust for the financial statement effects of the override.20

In summary, we do not find a significant difference between the pre-override profitability of TFV firms and those of a size- and industry-matched sample. This may be due, at least in part, to the fact that most of the overrides in Table 2 are mechanical. Nonetheless, we do find that TFV firms have higher debt to fixed assets, suggesting that a motive for override may be related to debt contracts.

It is important to recognize that the findings presented in Table 2 reflect the aggregation of diverse override types. We therefore examine three subsamples, with an aim to understanding whether differences in performance and debt contracting are observed where the overrides involve the greatest discretion and are most costly.

The first subsample we examine is that of firms invoking an override to avoid amortizing goodwill, which we also refer to as the nonamortization of goodwill (NOG) subsample. This override is conjectured to be costly because it is not the preferred method in FRS 10 and its implementation involves real costs to review for impairment. As such, it is a Category 2 override, implying that we expect differences in financial performance or position to be more pronounced than the overall sample. Put differently, firms overriding the principle of amortizing goodwill may be exercising greater discretion than firms who override the depreciation of investment property, as FRS 10 indicates that goodwill may have an indefinite useful life in exceptional cases.

The second subsample we examine is Category 4 overrides, firms that override UK GAAP, which we refer to as the true GAAP override sample. We expect these to be the most costly overrides and to involve the greatest discretion. The third subsample we examine, the S19 subsample, includes Category 1 overrides of the Companies Act requirement that all fixed assets of finite life be depreciated, in order to follow the UK GAAP (SSAP 19) requirement that investment assets be carried at fair value. Because the override is invoked to follow a more authoritative standard, we would not expect to see differences in performance, debt contracts or governance between firms invoking this override and the control sample.

The results for the non-amortization of goodwill subsample, reported in Table 3, indicate that firms quantifying the magnitude of their override significantly increase reported income and shareholders' equity by not amortizing goodwill. They also exhibit weaker performance than that of industry- and size-matched control sample firms. Specifically, OPINC, the ratio of operating income before depreciation and amortization to sales, and CFOTOS, the ratio of cash from operations to sales are significantly lower for non-amortizing TFV firms than for control firms. However, reported net income, net margin, return on equity and return on assets are not significantly lower, consistent with the income-increasing effect of the override. Second, these TFV firms have recognized significantly more goodwill than control firms, and due to the override, report lower amortization as a percent of sales than control firms. This is clearly reflected in the ratio of ending balance of goodwill and intangible assets to total assets, GWTOASS, and in new goodwill capitalized during the year, PGWTOASS.21 The picture that emerges for firms not amortizing goodwill is that they experience profitability before the override that is lower than the control sample, and which may further deteriorate in the future should they amortize the large amount of newly recognized goodwill. Third, these firms have a significantly lower interest coverage ratio. Bearing in mind the lower cash generation, this suggests that potential concern for violating debt covenants may have motivated the choice not to amortize goodwill. Finally, investors do not appear to discount the book value or earnings of these firms relative to the control sample, suggesting that investors view the reported numbers as comparable to those of firms that did not invoke an override.

Table 3. 
Comparison of Override, Descriptive, Performance, Contracting and Market-based Variables for the Subsample of Non-amortization of Goodwill Overrides, 1998–2002, and Industry and Size-matched Control Firms
Variable NameNon-amortization of Goodwill Override SampleControl SampleZ Value
NMeanMedianStd. DevNMeanMedianStd. Dev
  1. Note:
    Variable definitions are included in Table 2.

Override Effects
% EQUITY60.0170.0130.011    2.53
% INCOME210.1780.0980.213    3.31
Descriptive Variables
SALES (£M)891947.083487.3663313.353891272.840283.4422404.6580.59
INCOME (£M)92136.44916.692440.44492105.68612.162436.7300.00
ASSETS (£M)928347.317392.95933761.9369212731.626233.20962764.1160.44
EQUITY (£M)92824.726110.1461855.30492870.44895.3512629.0710.03
Performance Measures
NETPRO850.0610.0470.104850.0510.0600.201−0.88
DTOS870.0310.0230.038870.0450.0280.061−1.96
NETROE900.0890.1280.414900.0310.1351.165−0.38
TURNOVER871.2501.0800.856871.1921.0830.8130.24
CFOTOS820.1130.0890.104820.1280.1360.158−1.69
OPINC800.1140.1050.122800.1380.1480.158−1.81
Goodwill-related
GWTOASS890.2660.2300.210890.1810.0540.2342.25
AMTOSALE810.0040.0010.008810.0250.0020.063−1.29
PGWTOASS670.1260.0740.155670.0640.0170.1152.31
Contracting
DETOFIX861.1730.7281.444862.0810.4454.7310.84
INTCV689.9875.94715.2356836.6448.121112.154−2.56
Market-based Variables
BM4M800.5200.4100.506800.4110.3350.4070.77
EP4M800.0250.0530.151800.0350.0460.0820.02

Our third analysis focuses on overrides of GAAP (Category 4), which we hypothesize involve the highest cost. We expect to see significant differences in performance relative to control firms if the higher cost of these departures is offset by greater benefits from reporting the alternative financial statement amounts. As noted in Table 1, during 1998–2002 we find 133 firm-year observations of GAAP overrides. Given the considerable concern that the SEC and various commentators have expressed regarding granting managers the ability to depart from GAAP as well as the lack of sufficient evidence on such departures, we augmented our search to encompass the nine-year period of 1994–2002. This procedure gives us a larger sample and longer time series to examine factors associated with GAAP overrides: the resulting subsample has 203 firm-years.22

Table 4 provides the comparison that pertains to the augmented subsample of GAAP overrides. Due to limits on data availability, the number of observations for variables other than override effects varies from 91 to 151 depending on the specific variable. For the subset of firms that quantified the effect of their override, we find that the equity and income effects are not significantly different from zero. Firms overriding GAAP are significantly less profitable after the override than their respective control firms, as reflected in lower net margin and return on equity, though cash from operations to sales and operating income to sales are not significantly lower. Consistent with the lower level of reported profitability, interest coverage is also significantly lower. However, we do not find a higher level of debt to fixed assets for TFV firms. These findings provide support for the hypothesis that firms overriding GAAP are experiencing weaker performance or have a greater incentive to raise earnings for debt contracts.

Table 4. 
Comparison of Override, Descriptive, Performance, Contracting and Market-based Variables for the Subsample of True GAAP Overrides, 1994–2002, and Industry and Size-matched Control Firms
Variable nameTrue GAAP Override Sample 1994–2002Control SampleZ Value
NMeanMedianStd. DevNMeanMedianStd. Dev
  1. Note:
    Variable definitions are included in Table 2.

Override Effects
% EQUITY180.0380.0190.066    1.36
% INCOME8−0.0530.0550.253    −0.92
Descriptive Variables
SALES (£M)1374447.736372.0009702.8721371829.578382.1003453.5320.37
INCOME (£M)151193.5668.239526.249151117.07815.354263.971−0.89
ASSETS (£M)15110183.506575.71635488.6651515144.959524.25121099.1460.40
EQUITY (£M)1511643.086214.3003781.199151968.729183.5281713.0500.24
Performance Measures
NETPRO130−0.0460.0280.4591300.0280.0460.378−2.77
DTOS1300.0380.0300.0361300.0450.0270.0621.80
NETROE1480.0160.0710.4021480.1070.1080.348−2.69
TURNOVER1360.9580.8550.6651361.2221.0981.136−0.80
CFOTOS1070.0830.1090.2231070.1050.1170.156−0.48
OPINC1090.0770.1100.2331090.1570.1230.170−0.37
Contracting
DETOFIX1430.9790.4401.9281431.0630.4343.028−0.57
INTCV117−7.9262.77764.21011712.2374.58998.484−2.17
Market-based Variables
BM4M1350.8370.6300.6971350.6960.5310.8950.97
EP4M910.0700.0570.063910.0730.0650.074−0.72

In our next subsample analysis, we examine overrides that can be regarded as ‘mechanical’ in that they represent an accounting treatment that is consistent with GAAP but is in contrast to the requirements of the Companies Act (i.e., Category 1). This subsample comprises non-depreciation of investment properties (by non real-estate firms) and is presented in Table 5. We are interested in this subsample as a benchmark to the analysis of the more costly overrides, since we do not expect to find significant differences for mechanical overrides. The median income effect of this override is significantly positive for the subset of firms that quantified their effects, though none of these overriding firms quantified the equity effect. However, the net profit margin for TFV firms is not greater than that of control firms. Consistent with the override, TFV firms report significantly lower depreciation to sales relative to control firms. Adjusting for depreciation however, the profitability of TFV and control firms seems to be similar, as OPINC and CFOTOS are not significantly different between TFV and control firms. The interest coverage ratio is insignificantly different for TFV firms and the debt to fixed assets ratio, DETOFIX, is significantly lower, suggesting that debt covenants are not tighter for TFV firms. Lastly, earnings to price, EP4M, is significantly higher for the override sample than the control sample, indicating that the market at least partially adjusts for the difference in depreciation and its implications for reported income and book value of equity. The overall evidence thus seems to support the claim that non-depreciation of investment properties is mechanical in nature and not an opportunistic accounting choice, consistent with our prediction for a Category 1 override.23

Table 5. 
Comparison of Override, Descriptive, Performance, Contracting and Market Variables for the Sample of S19 (non-depreciation of investment properties) 1998–2002, and Control Firms
Variable NameNon-depreciation Override SampleControl SampleZ Value
NMeanMedianStd. DevNMeanMedianStd. Dev
  1. Note:
    Variable definitions are in Table 2.

Override Effects
% EQUITY0        
% INCOME90.0750.0600.053    2.76
Descriptive Variables
SALES (£M)3081376.046129.6463406.5743081020.496110.7132448.198−0.08
INCOME (£M)32558.1565.360209.50832572.4144.169272.1050.43
ASSETS (£M)32510922.544118.43643032.8803255842.223115.34527530.7790.25
EQUITY (£M)325706.31946.3491619.934325581.77244.0851576.6730.04
Performance Measures
NETPRO2890.0590.0490.149289−0.0540.0380.6780.66
DTOS2880.0290.0190.0342880.0420.0290.066−2.80
NETROE3130.0810.1000.2563130.0280.1050.3481.31
TURNOVER3031.1861.0261.0103031.1421.0530.853−0.68
CFOTOS2540.1020.0810.130254−0.1250.0901.8590.00
OPINC2430.1200.0960.1132430.0730.0970.2021.13
Contracting
DETOFIX2960.9250.3602.1762960.9770.3541.940−1.70
INTCV24719.5026.47657.23724615.7314.50687.8340.16
Market-based Variables
BM4M2880.8560.7460.5862870.8430.6210.8871.23
EP4M2850.0460.0730.170284−0.0370.0560.3972.16

The previously reported tests are based on a comparison of the TFV firms to industry and size-matched control firms. The next set of tests examines the change in performance of TFV firms in the year they first adopted an override relative to the prior year. To the extent that overrides are undertaken to increase income or equity, we would expect to find first-time adoptions associated with worsening financial conditions. We therefore use the TFV firm in the year prior to the first override as the control. We present results on the descriptive and performance-related variables for the sample as a whole, and for the subsample of GAAP overrides.

The left side of Table 6 presents the findings for the overrides for which we could identify the first year of the override from the firm's financial statements and collect relevant data for the prior year. The findings indicate that the changes in sales, assets and equity, ΔSALES, ΔASSETS and ΔEQUITY, respectively, are all significantly positive, whereas the change in income, ΔINCOME, is not significantly positive. Consistent with this, the change in scaled profitability measures, ΔNETPRO, ΔNETROE and ΔTURNOVER are all significantly negative. However, the change in our measures of profitability before the effect of the override, ΔCFOTOS and ΔOPINC, are not significantly negative. The debt contracting variables indicate a marginally significant increase in debt to fixed assets and a statistically insignificant decline in interest coverage. Finally, the change in the book-to-market and earnings to price ratios are significantly positive, consistent with investors discounting book value of equity and earnings, respectively, in the year of the override, relative to the prior year.

Table 6. 
Analysis of Differences Between First Year of Override and the Prior Year for Descriptive, Performance, Contracting, and Market Variables. Positive (negative) value implies year of override higher (lower) than prior year
Variable Name1Entire Sample 1998–2002Z ValueGAAP Override Sample 1994–2002Z Value
NMeanMedianStd. DevNMeanMedianStd. Dev
  1. Notes:

  2. 1Variable definitions:

  3. Performance Measures

  4. ΔNETPRO – Change in net profit/sales in the first year of the override relative to the prior year.

  5. ΔDTOS – Change in depreciation expense/sales in the first year of the override relative to the prior year.

  6. ΔNETROE – Change in net profit/total equity in the first year of the override relative to the prior year.

  7. ΔTURNOVER – Change in sales/total assets in the first year of the override relative to the prior year.

  8. ΔCFOTOS – Change in cash flow from operations/sales in the first year of the override relative to the prior year.

  9. ΔOPINC – Change in pretax income from operations before depreciation and amortization/sales in the first year of the override relative to the prior year.

  10. Contracting

  11. ΔDETOFIX – Change in total debt/gross tangible fixed assets in the first year of the override relative to the prior year.

  12. ΔINTCV- Change in interest coverage ratio, measured as pretax income before interest/(capitalized interest + interest expense) relative to the prior year.

  13. Market-based Variables

  14. ΔBM4M – Change in the ratio of book value of equity-to-market value of equity (measured at four months after end-of-year), in the first year of the override relative to the prior year.

  15. ΔEP4M – Change in the earnings-price ratio based on the share price four months after year-end relative to the prior year.

  16. Each of the above measures is included only once for each firm. The z-statistic indicates whether the median of the variables is greater for the override sample than for the control sample. A z-statistic is printed in bold type if it is significant with a probability value less than 0.05.

Descriptive Variables
ΔSALES (£M)224185023.126539.501299122.723.8346225275.81925130000.03
ΔINCOME (£M))225−35424.28218.00461337.720.1746−63903.12−1094323494−1.01
ΔASSETS (£M))2251476257.4914212.0016431363.203.96464720054.874682356010562.04
ΔEQUITY (£M))225−15166.394458.002049770.244.2546−75410.834359.539028080.73
Performance Measures
ΔNETPRO207−0.022−0.0060.166−2.6241−0.125−0.0280.274−3.03
ΔDTOS2130.0420.0010.4293.30410.0270.010.0673.70
ΔNETROE196−0.047−0.0100.273−2.7337−0.025−0.0460.293−1.31
ΔTURNOVER224−0.106−0.0110.529−2.4746−0.154−0.0380.559−1.95
ΔCFOTOS199−0.028−0.0090.247−0.5143−0.071−0.0240.522−1.63
ΔOPINC166−0.0020.0010.0950.2137−0.082−0.0150.266−1.88
Contracting
ΔDETOFIX2210.4140.01313.2441.65250.005−0.0050.243−0.30
ΔINTCV173−0.343−0.14511.430 −0.97230.720−0.8046.149−0.42
Market-based Variables
ΔBM4M2060.1680.0570.5674.25420.1290.0310.4351.29
ΔEP4M155−0.0060.0080.2662.99250.007−0.0010.1390.02

The right side of Table 6 presents the findings for the GAAP override subsample. Similar to the sample as a whole, the change in scaled profitability measures, ΔNETPRO, and ΔTURNOVER are significantly negative. In contrast to the entire sample, however, ΔCFOTOS and ΔOPINC are negative, though ΔCFOTOS is marginally significant. The changes in the debt contracting variables and the market-based variables are not significantly different from zero. Taken along with the findings in Table 4, the findings suggest that eroding performance may have contributed to the decision to override GAAP.

Taken as a whole, the findings thus far suggest that firms invoking the more costly overrides are experiencing weaker profitability. Firms invoking an override to avoid amortizing goodwill have significantly lower pre-override profitability. Firms invoking an override of UK GAAP have lower post-override profitability and experienced a significant decline in profitability in the year of adoption.24 Such firms may also be concerned about violating debt covenants, such as those based on interest coverage. An interpretation of these results is that in the UK's environment, which is characterized by principles-based rules coupled with significant deterrents to abuse, some companies would nevertheless be motivated to take advantage of the TFV requirement. However, this in itself does not imply that with more rigid requirements (i.e., a rules-based environment) the frequency and magnitude of accounting manipulations in the UK would have been lower.

(iii) Implications of Overrides for Earnings Quality and Informativeness

Our next analysis examines whether investors view TFV firms' financial statements as less informative than those of control firms (hypothesis 2). In the first set of tests, we focus on one dimension of informativeness, the explanatory power of reported book value and earnings per share for share prices. Following Joos and Lang (1994), we assess informativeness by the adjusted R2 from the regression of share price on reported book value and earnings per share.25

Our tests use Ohlson's (1995) model relating stock prices to earnings and book values.26 He notes that his model can be interpreted as a weighted average of earnings and book value-based valuation models. In his model, lower persistence of earnings will be captured by a lower coefficient on income and a higher coefficient on book value of equity. We separately examine this relation for positive and negative earnings, given the prior evidence by Hayn (1995) that negative earnings are of lower persistence.

The estimation equation is:

image(1)

where P is the stock price per share measured 4 months after fiscal yearend; BV is the book value of equity per share; BV is the book value of equity per share times an indicator variable equal to 1 (0) if net earnings per share are negative (non-negative), NI is reported net earnings per share, and NI is reported net earnings per share times an indicator variable equal to 1 (0) if net earnings per share are negative (non-negative). We include BV and NI because the coefficient on net income is likely lower for reported losses, and the coefficient on book value of equity is likely higher.27 We expect that β1 > 0, β2 > 0, β3 > 0 and β4 < 0. We estimate equation (1) for the override and control samples separately, and test for differences in the R2 of the two subsamples.28

We examine whether more costly overrides (NOG and GAAP) involve a loss of informativeness. We compare these results to those of the mechanical override subsample, for which we would not expect less informative financial statements. The bottom two rows of Table 7 show the R2 for the override and control subsamples. For the full sample of overrides from 1998–2002, the R2 is 0.65 for the TFV firms, in contrast to 0.47 for the control firms. These findings indicate that earnings and book value do not have less explanatory power for the share prices of override firms than for those of control firms. In addition, the untabulated coefficient of variation is higher for the control sample, so the higher R2 is not due to scale. For the NOG subsample, we find that both the TFV and control sample regressions have R2's of 0.67. Because the coefficient of variation for the control sample is higher, these findings suggest that the explanatory power of book value of equity and income for share prices of the override sample is not less than for the control sample.

Table 7. 
Pooled Regression of Stock Price on Book Value of Equity per Share and Net Earnings per Share with Varying Coefficients for TFV and Control Firms. Coefficient Estimates with t-statistics Immediately Below inline image (2)
 Full SampleNOG OverridesGAAP OverridesS19 Overrides
  1. Notes:
    Price per share is calculated as market value of equity divided by the average number of shares that is used by the company to calculate its EPS. The average number of shares is also used to deflate the independent variables in the regression.

  2. P– Stock price per share measured in UK pounds 4 months after fiscal year end.

  3. TFV – An indicator variable set equal to one if a TFV firm, zero otherwise.

  4. BV – Book value of equity per share.

  5. BV– Book value of equity per share times an indicator variable equal to 1 (0) if net earnings per share are negative (non-negative).

  6. NI – Reported net earnings per share.

  7. NI– Reported net earnings per share times an indicator variable equal to 1 (0) if net earnings per share are negative (non-negative).

  8. *, **, *** - significant at 0.10, 0.05 and 0.01, respectively.

Intercept108.2695.0261.1167.75
9.44***3.14***2.67***5.05***
TFV−42.99−17.5036.00−60.93
−2.64***−0.381.05−3.21***
BV0.370.380.260.49
7.36***2.68***2.80***7.56***
BV0.430.851.39−0.03
3.36***1.86*5.82***−0.23
NI7.1212.4910.416.16
14.98***9.34***10.27***9.24***
NI−6.38−15.78−7.72−5.91
−6.74***−5.06***−3.76***−5.64***
BV * TFV−0.240.07−0.08−0.16
−3.19***0.24−0.62−1.79*
BV * TFV−0.04−0.55−1.170.25
−0.25−0.61−2.65***1.01
NI * TFV2.81−4.580.253.81
4.01***−2.06**0.164.22***
NI * TFV−4.608.92−3.21−6.58
−3.18***2.08**−1.23−3.44***
N992136244 508
Pooled R20.560.670.620.63
Override R20.650.670.520.73
Control R20.470.670.710.51

The results of the market-based tests for the GAAP overrides subsample are in contrast to the previous findings. They indicate that the explanatory power of the book value of equity and income for variation in GAAP override firm share prices is lower than for the control sample. The coefficient of variation is higher for the override sample however, so the scale effect is not inducing this finding. Given the findings in Tables 4 and 6, this is also consistent with the view that GAAP overrides are invoked to mask deteriorating performance in the financial statements.

Finally, we estimate equation (1) for the subsample of firms that do not depreciate investment properties, a treatment that is consistent with GAAP but inconsistent with the Companies Act. To the extent that these are merely mechanical overrides, we do not expect to find similar results to GAAP overrides. Indeed, for this sample, the R2 comparison suggests that the book value of equity and income reported by override firms have greater explanatory power for share prices than those reported by control firms. The coefficient of variation is greater for the control sample, again indicating that scale bias is not inducing this result. This finding may be explained, at least in part, by the fact that firms invoking S19 also annually revalue their investment properties. Prior literature (e.g., Aboody et al., 1999) suggests that revaluations are informative, implying that our results may reflect the greater informativeness of revalued properties.

Our second set of tests of H2 focus on the coefficients on earnings and book values, to examine whether TFV firms' earnings are perceived by investors as less persistent than those of control firms. This test pools the control and TFV samples, but allows the coefficients to vary between control and TFV firms. Specifically, we estimate an augmented version of equation (1):

image(2)

where TFV is an indicator variable assuming the value of one if the observation is for a TFV firm, and zero otherwise.29 We test whether the persistence of earnings, as reflected in stock prices, differs between TFV firms and control firms. Specifically, if the earnings of TFV firms are artificially increased by the override and therefore are less persistent, we would expect β7 < 0 and β5 > 0. By introducing the interaction variable NI * TFV in (2), we can also examine whether investors perceive differences in the persistence of negative income, and whether investors perceive differences in such persistence between TFV and control firms.

The results of this analysis are reported in Table 7. For the entire sample, the evidence indicates differential weights on income and book value of equity between profit and loss firms. Consistent with the prediction that losses are less persistent, the incremental coefficient on NI is negative and statistically significant (β4=−6.38, t=−6.74) and the incremental coefficient on BVE, book value of equity for loss firms, is positive and statistically significant (β2= 0.43, t= 3.36). This finding also largely holds for the coefficients on the three subsamples: the coefficient on negative net income is negative and significant for all three subsamples and the coefficient on book value for negative income firms is positive and significant for the NOG and GAAP override samples, though not for the S19 overrides.

As for the persistence of TFV firm earnings, we find that for profitable firms, the incremental coefficient on TFV earnings, β7, is positive and statistically significant (β7= 2.81, t= 4.01). This finding indicates that investors perceive these firms to have greater earnings quality than profitable control firms. Consistent with this, the incremental coefficient on book value of equity of TFV firms, β5, is negative and significant (β5=−0.24, t=−3.19), indicating a lower weight on equity in the valuation of TFV firms. For loss firms, the findings indicate an insignificant incremental coefficient on the book value of equity of TFV firms, (β5=−0.04, t=−0.25) and a significantly lower coefficient on the earnings of TFV loss firms, consistent with these TFV firms having less earnings persistence. A substantially similar pattern is observed for the S19 subsample as well.

In the GAAP override subsample, the findings do not indicate any difference in the persistence of profit between control and TFV firms. However, β6, the coefficient on book value for loss firms, BV, is significantly smaller for override firms than control firms, consistent with their financial statements being less informative overall. In addition, the coefficient on earnings for loss firms is marginally significantly negative, suggesting less persistent earnings for loss firms. These findings suggest that the lesser informativeness of GAAP override firms observed in the R2 test is due to the firms earning losses.

In contrast to the findings for the GAAP override sample, the NOG subsample exhibits offsetting effects on the persistence of profit and loss override firms, consistent with the finding of similar R2's overall for both the NOG and control samples. For the S19 sample, as mentioned above, we obtain qualitatively similar findings to those for the sample as a whole.

To summarize, the stock price-based tests indicate that the financial statements of firms invoking the most costly overrides, the GAAP overrides, have lower explanatory power than those of their control sample. This finding is in contrast to the findings for firms invoking the NOG or S19 overrides, and for the override sample as a whole. The coefficient estimates indicate that the weaker explanatory power of GAAP override firms is due to the market discounting both the book value and earnings of GAAP override firms with losses. Our findings therefore suggest investors at least partially discount earnings and book value of the override firms where strategic use of overrides is most likely. In contrast, for the S19 sample, consistent with our finding little support that firms invoke these opportunistically, investors view their earnings as more persistent.

6. CONCLUSIONS AND TFV UNDER IAS SO FAR

The true and fair view (TFV) concept allows companies to depart from the letter of the law or a promulgated accounting standard in certain circumstances. The true and fair override provides a rich and unexplored context for studying how firms exercise discretion over accounting principles and their motives for exercising this discretion. In addition, this context allows one to test whether such flexibility is informative and potentially provides insights into the decades-long debate regarding trade-offs between flexible (i.e., principles-based) and rigid accounting rules.

We postulate that the incidence of a particular override is negatively related to the strength of the authoritative support for the principle from which the reporting firm departs. This is because the greater the support for the standard, the larger the cost of the departure. Our findings are consistent with this conjecture in that overrides hypothesized to be costly are less frequent than those hypothesized to be less costly.

We find that firms overriding principles with greater authoritative standing to avoid amortizing goodwill have experienced weaker performance than industry and size-matched firms. We find that firms overriding UK GAAP exhibit weaker profitability and experienced a decline in pre-override profitability in the year the override was first adopted. The finding that more costly overrides are invoked by firms with weaker financial performance suggests that UK managers have used the flexibility available to them for reasons not intended by the rules. Additional evidence suggests firms invoking an override of GAAP provide less informative financial statements.

In conclusion, this paper contributes to the literature along several dimensions. The paper's analysis helps to assess whether UK companies have taken advantage of the TFV override to mask unfavorable performance or financial position. This evidence may be useful in the current debate on whether accounting rules in the US should be more flexible. It also provides evidence that may be useful to the ongoing deliberations by the SEC as to whether to allow US firms to follow IAS, and to international accounting researchers who are interested in the issue of harmonization and the effects of IAS.

In assessing the strength of our results and their applicability to other contexts, four caveats are in order. First, one should bear in mind that departures from UK GAAP may not be the same departures US firms or firms from any other country would take. Second, the reporting practices that result in any country are a consequence of their standards, legal environment and the manner in which standards are enforced, as the Australian experience demonstrated. Given that the UK is at the high end of the range of enforcement of accounting standards, override behavior in other countries might differ significantly from the behavior documented in the UK. Third, only a small fraction of the overrides in our sample are quantified. It is possible that with greater disclosures one could assess more accurately the effect on revenues, expenses, assets and liabilities. It remains an open question whether the effect we have documented is representative. If invoking firms tend to withhold information when the effect is large, our analysis may underestimate the average impact. Fourth and finally, since 2005, UK companies report under IAS rules. To the best of our knowledge, the TFV override has been used in only three cases, two involving an override of pension accounting and the third involving recognition of trading losses. It remains to be seen whether overrides of IAS GAAP will occur with any frequency, and if so, whether similar factors to those documented here will motivate them.

Appendix

Table APPENDIX. 
Distribution of TFV Override Types and their Expected Effect on Reported Numbers
Types of TFV OverridesNumber of TFV obs.Expected effect on:Number of quantified obs. (and% of all obs. in TFV type)1
P&LEquity
  1. Note:
    This table provides further detail on the nature of the override types and their expected effects on book value of equity and net profit. It also provides information regarding how many overrides were quantified within each override type.

No depreciation provided for:
 Investment properties (S19)339++23(6.8)
 Fixed assets (S12)  7++ 0(0.0)
No depreciation provided for:
 Investment properties (S19)339++ 23(6.8)
 Fixed assets (S12)  7++  0(0.0)
No amortization of goodwill (NOG)104++ 39(37.5)
Merger accounting used instead of purchase accounting (MER) 54+/−+/−  3(5.6)
Stepwise calculation of goodwill (GDW)34+/−+/− 29(85.3)
Current assets presented at market value and not cost (MVA) 29+/−+/− 13(44.8)
Grants and contributions not shown in deferred income (GRT) 24NoNo  0(0.0)
Unrealized gains and losses taken to the P&L (UGL) 27++ 13(48.1)
Not recognizing diminution in value of investment in parent company's accounts (ITG) 23NoNo  0(0.0)
Other (OTH) 66+/−+/− 23(34.8)
Total707  143(20.2)

Footnotes

  • 1

    See SEC Concept Release: International Accounting Standards 34-42430, Section IV.A.2 (dated 2/18/2000).

  • 2

    Given that the UK is a common law country, it is quite plausible that this concept was used in practice well before it was incorporated into this Act.

  • 3

    Nobes and Parker (1991) document that most of their sample directors were willing to depart from the details of the law or a standard. This requirement also exists, or used to exist, in Australia, New Zealand and Singapore, as well as in EU nations.

  • 4

    Peasnell et al. (2001) find that 43 firms judged by the Panel during 1990–1999 to have issued defective statements tend to exhibit weaker performance than size- industry- and time-matched control. They suggest that this may be attributable to the higher likelihood that weak firms are referred to the Panel by disaffected shareholders.

  • 5

    For example, see Sykes, as quoted by Quick (2001), and Alexander and Archer (2003).

  • 6

    In Australia and New Zealand, it was felt that the override was used to avoid complying with GAAP. As a result, the ability to invoke an override in these countries was removed in the 1990s (see McGregor, 1992; and Kirk, 2006; for a review of the TFV override in these countries). The recent case of Societé Generale in France raises this question as well. See Hughes (2008).

  • 7

    It is possible that matters that are not covered by UK GAAP are covered by IAS or US GAAP thus providing support for the override. However, TFV firms in our sample do not typically make reference to other GAAP. (We thank Mary Barth for pointing this out to us.)

  • 8

    See Dichev and Skinner (2002) for evidence from private lending in the US that firms manipulate earnings to avoid violating debt covenants.

  • 9

    Relatedly, Oswald (2008) finds evidence consistent with this view in the context of R&D. In contrast, Feltham et al. (2007) examine the relation between leverage and accounting choice and show that firms with poorer performance have incentives to lower the precision of accounting earnings to avoid violation of debt covenants and detection of bias.

  • 10

    Prior literature has viewed earnings persistence as an important aspect of earnings quality (e.g., Dechow and Schrand, 2004).

  • 11

    One limitation of this search procedure is that it is possible that an override occurred but the reporting company did not formulate it as such in the annual report (i.e., does not explicitly use any of the above terms). However, we take some assurance that our search was effective from the fact that we identified a large number of overrides that were separately provided to us by David Tonkin of Company Reporting.

  • 12

    An alternative matching procedure could involve identification of control firms facing similar circumstances that can potentially give rise to a specific override (e.g., acquisitions of subsidiaries involving recognition of similar goodwill). The primary reason we did not follow this procedure is that the heterogeneity of override types in the sample would require substantial judgment on the part of the researcher to identify similar circumstances for control firms. Second, matching beyond industry and market cap is likely to greatly constrain the size of the control sample.

  • 13

    Relatedly, the IASB now employs in IAS 1 the (rebuttable) presumption that compliance with GAAP would not be misleading if other firms in similar circumstances follow GAAP. In this context, firms within the same industry as the overriding firm may be presumed to be facing similar circumstances.

  • 14

    The intention of the ASB might have been to encourage non-amortization, but as Davies et al. (1999, p. 769) comment, ‘The implication of the ASB's definition [of goodwill] encourages the view that the life is normally indefinite, and not just in exceptional cases….In practice, the impairment test has been seen to be very onerous, and this has been a powerful disincentive for companies to argue that the life of the goodwill will exceed 20 years.’

  • 15

    This view is questioned by Company Reporting, a leading UK publication that critically focuses on reporting practices by listed companies:Claiming that the effect of an override is not quantifiable is common practice amongst companies not depreciating investment properties; although we have some difficulty in understanding why they are unable to calculate something like two per cent of the carrying value. In contrast, the remaining … companies tend to state the accounting treatment adopted and why, but often neglect to mention the requirement from which they are departing or the quantitative effect of that departure (Company Reporting, 2000).

  • 16

    Beneish and Press (1993) demonstrate that technical violation of accounting-based debt covenants is costly. In addition, most of the violations in their sample are with respect to tangible net worth. Our focus on fixed tangible assets in the calculation of DETOFIX thus captures lenders' preference for using tangible assets in debt covenants.

  • 17

    To ensure that the means reported are not unduly influenced by extreme observations, we exclude observations with ratios greater than the 99th percentile or less than the 1st percentile.

  • 18

    We also looked at corporate governance variables, such as the number of external directors and the size of the board. However, we did not find significant differences between TFV firms and control firms. Thus, for brevity, we do not tabulate the findings of these analyses.

  • 19

    The number of quantification observations in Table 2 is fewer than in Table 1 due to lack of availability of profit or equity data or negative values for these amounts.

  • 20

    It is interesting to note that the mean and median market-to-book ratios of override firms are closer to 1, which one would expect if their accounting more fully captured their value.

  • 21

    This finding is consistent with Aboody et al. (2000) who find that acquiring firms' tendency to use pooling methods increases in the step-ups to targets' net assets.

  • 22

    The main override types here are as follows: 57 overrides concern violation of requirements of FRS 6 merger accounting (MER), 21 departures from the requirements of SSAP 4 (GRT), 16 departures from the requirement of SSAP 12 to depreciate fixed assets (S12), 14 depart from FRS 9 accounting for associates and joint ventures, 13 overrides of SSAP 9 GAAP concerning current assets (MVA), 13 depart from GAAP concerning presentation matters, 12 of FRS 4, accounting of capital instruments and 10 of FRS 1 presentation of the cash flow statement.

  • 23

    Note that while the override itself is ‘mechanical’ (all investment properties should not be depreciated under GAAP), managers' identification of certain assets as investment properties may be opportunistic.

  • 24

    Peasnell et al. (2005) find that the likelihood of UK managers making income-increasing abnormal accruals during 1993–1996 to avoid reporting losses and earnings reductions is negatively related to the proportion of outsiders on the board.

  • 25

    Following Barth and Clinch (2001), we examine the sensitivity of our findings to level and deflated regressions. The untabulated findings are consistent with the estimation results for the deflated regressions we report.

  • 26

    For a related empirical application, see Ghosh et al. (2005).

  • 27

    We also estimated a specification permitting a different slope coefficient on book value of equity for loss vs. profitable firms. Although the coefficient on book value of equity changes, the overall explanatory power remains similar and the pattern of explanatory power across subsamples is unaffected. We therefore tabulate the simpler model.

  • 28

    Brown et al. (1999) argue that scale effects in levels regressions increase R2, and this effect increases in the scale factor's coefficient of variation. As a result, comparing R2 across samples is invalid unless the scale effect is accounted for. They propose calculating the regression coefficient of variation to assess the potential impact of scale effects. Because the control sample firms are matched to the TFV firms based on size and industry, we control directly for scale. However, to ensure that these controls are effective, we examine the coefficients of variation to draw inferences from R2s that are robust to the scale effect. We also applied the approach recommended by Gu (2007) and find that none of our conclusions are affected.

  • 29

    The coefficients for this model are equivalent to those obtained in equation (1) but this specification allows for direct tests of the difference in coefficients in earnings and book value between the override and control samples.

Ancillary