One of the topics that came up in last week’s Round Table on Alternative Conceptual Frameworks was a discussion of the true and fair override. It came up when we were talking about one difference between US GAAP and IFRS being that the FASB’s conceptual framework is not authoritative. Even though IFRS requires preparers to follow specific rules when there are specific rules that apply, the conceptual framework, under IFRS, can be appealed to as authoritative guidance in the absence of specific rules. This, to me, makes perfect sense, but is not currently the model we have in the US.

Where it gets more interesting is when there is a true and fair override condition, which requires companies to deviate from GAAP when following GAAP would materially misrepresent a firm’s position. Such guidance is the epitome of principles-based guidance. In contrast, the objective of preparers and auditors within the US is to ensure that financial statements are presented fairly in accordance with US GAAP, which reflects a more rules-based perspective. (If you followed the rules, the representation must be fair.)

During our Round Table discussion (which you can watch here), there was some uncertainty as to how often the true and fair view (TFV) gets invoked in practice. As it turns out, there is recent empirical evidence on this issue by Gilad Livne and Maureen McNichols. In their paper, they examine data from the UK (prior to the UK’s adoption of IFRS in 2005) and find that “the vast majority” of their 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.” They conclude from this data that the “relatively small number of cases suggests that either UK firms are discouraged [from overriding] 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.”

The aim of their research, however, is not just to document the frequency and type of override invoked, but rather to test the hypothesis that “more costly overrides are associated with weaker financial performance.” If you’re interested, you should read the paper for yourself, but they sum up their findings by saying:

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 authors end with a note of caution stating that their findings do not necessarily generalize to other settings, such as with the override of IFRS as opposed to UK GAAP. For example, they note that since the adoption of IFRS in 2005, the TFV override has only been invoked in the UK three times.

Nevertheless, one of the big questions in the debate over principles vs. rules is the question of whether auditors will, in exercising professional judgment, be able to enforce the underlying principles, rather than caving to the demands of preparers. The evidence presented in this paper, that firms overriding UK GAAP provide less informative financial statements, would seem to validate this concern.

How true or fair is “True and Fair” likely to be?  Perhaps only as true or fair as the auditor wants it to be.


Disclaimer: The views expressed here are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the FASB are arrived at only after extensive due process and deliberations.