Sunday, October 28, 2012

Financial reporting and taxation a zero sum game?

As a qualified chartered accountant, the above may sound heresy when I'm questioning the two pillars of the profession(atleast in India!). However, I am NOT saying that they do not have any utility, just that the utility to the overall economic system might be doubtful-this is not the fault of the people involved, but just a consequence of the rules of the game.

For example, information asymmetry and stewardship are the two main theories for providing historical financial(and other) information to outsiders, which are usually audited as well. Now, auditors play a watchdog(but not a bloodhound!)'s role in ensuring that there are no material errors in the information. The auditor's role adds value to the extent financial reporting becomes reliable/internal controls become stronger. But for the financial reports themselves, lets think a bit. Usually, the recipient of those reports-be it investors, lenders, regulators, NGOs etc-have certain set expectations from the provider in terms of dividend/earnings expectations, lending covennants, fees/taxes and not earning beyond a reasonable profits. Some of these expectations can be met by reporting higher earnings, other by reporting lower earnings. Now, what many non accountants do not know is that most accounting numbers are estimates/approximations, best expressed as a range. Now, though global accounting standards are converging in form of IFRS which aims at eliminating choice to the extent possible, that elimination happens usually only when a particular choice has been overtly abused(merger accounting, leasing etc) and hardly proactively. Otherwise, principles based accounting gives management a wide discretion to report numbers aggressively, with only the auditors or alert active investors to rein them in. In this scenario, the financial reporting function may see its role as reducing tax payouts, meeting the earnings expectations etc. Those fringe benefits justify hours/days of detailed discussions on which accounting treatment to adopt for a transaction-the treatment per se does not add economic value to the decision once taken, but due to those other benefits like earnings management, time may be spent on this rather than on BP&A/other economically productive work like reporting fair numbers.

However, financial reporting does have consequences on a huge scale when messed up-value transferred to those to fudge their books-both in corporate sector(Enron, Worldcom, Satyam) and the public sector as exemplified in this (in)famous IMF working paper on public sector accounting.
* “Accounting Devices and Fiscal Illusions”, by Timothy Irwin, IMF Staff Discussion Note, March 2012

About taxation, one of India's most famous jurists(said to be the best Finance Minister India never had) Nani Palkiwala once deplored that thanks to India's complex tax code, the best brains in the country were wasting their talent working out loopholes in the code. This was said decades back, but the tax laws have become more complex since then, both in India and even in "developled" nations like the USA. In fact, this zero sum nature of taxation was what persuaded me not to take this up as a full time career, despite having topped the tax paper at the Chartered Accountancy exams, and loving the subject. I was not convinced on the value addition to society as a whole, in this.

 This has been a long blogpost/(rant?) and so I conclude by saying that besides financial reporting and taxation, there are plenty of overall zero sum games like 'active fund management'. The reason I singled out those two was lack of searchable writing on Google, and my own experience in the field. These fields are full of market imperfections, and can divide value between parties like Company-Investor, Tax Payer-Tax Officer etc-but does not create it in the long run. Hence, I described it as a zero sum game, in that sense, especially if done wrongly.