In the United States, the standard unqualified audit report states that the firm’s financial statements included in its annual report present fairly, in all material respects, the financial position of the company at the year end, the results of its operations, and its cash flows, in conformity with generally accepted accounting principles (GAAP). The standard unqualified audit report in the United Kingdom uses different language: such a report states that the company accounts give a true and fair view (TFV) of the state of affairs at the end of a given year.

The term “generally accepted accounting principles” has been used in US audit reports since 1939, and is an unfortunate, nebulous term, perhaps implying to non-accountants that these accounting principles are accepted by some parties but not by others (which in fact might be the actual case, but is not the intended meaning). Even the use of the word “principles” is flawed. When the Wheat Committee administered the 1973 transition of the Accounting Principles Board (APB) to the Financial Accounting Standard Board (FASB), it deliberately replaced “principles” to “standards” in the title of the successor organization. The Committee had studied the APB pronouncements and decided that they did not satisfy the normal definition of “principles”.

The true and fair view phrase also has limitations, which we will address in a later section of this paper. Rutherford, B., 1985. The true and fair view doctrine: A search for explication. Journal of Business Financial and Accounting 12 4, pp. 483–494. Full Text via CrossRefRutherford (1985), Houghton (1987), and Karan (2002), among others, have indicated that the concept lacks a precise meaning, both in the United Kingdom and in Australia. Rutherford (1985) states that TFV lacks a widely accepted definition and that it is unlikely to achieve one except by the adoption of adherence to GAAP as a technical definition. Houghton (1987) studied the meaning of TFV as perceived by accountants and shareholders. He found a significant difference to exist between the two groups and that the accountants could not accurately perceive the shareholders’ meaning. Karan (2002) (p. 50) states that it would be more meaningful to say that financial statements are “not misleading by reason of material statements or omissions” than it would be to say that they give a “true and fair view”.

The Public Company Accounting Oversight Board (PCAOB) is currently responsible for establishing US auditing standards. In 1992 the body who had previously promulgated auditing standards, the Auditing Standards Board (ASB) issued Statement on Auditing Standards No. 69 (SAS 69), which states that the phrase “generally accepted accounting principles is a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time”. SAS 69 goes on to state that the fairness of the overall presentation of the financial statements should be applied within the framework of GAAP, and that the auditor should determine if the accounting principles: (1) are GAAP, and (2) are appropriate. SAS 69 further states that GAAP originates from a variety of sources, including among others: (1) the pronouncements of various bodies composed of “expert accountants” who have the authority to issue accounting principles, (2) accounting literature, and (3) prevalent practice in an industry. A GAAP hierarchy is provided for guidance in the application of GAAP. A caveat is provided, however, that the determination as to whether a particular accounting principle is GAAP “may be difficult” since there is no single reference that provides a taxonomy of GAAP. SAS 69 also states that the employment of GAAP “almost always” results in the fair presentation of the financial statements. However, there is a possibility that the “literal application” of GAAP might, in unusual circumstances, result in misleading financial statements. In this case, the auditor should express a qualified or adverse rather than an unqualified audit opinion. The problem is that this latter dictum is rarely, if ever applied in practice.

It has been speculated that “true and fair” as used in the UK audit report is a hendiadys, a single concept denoted by two conjoined words. If this is the case, then the way is open to claim that “give a true and fair view” in the UK audit report means roughly the same as “present fairly” in the US audit report. Hence, the major difference between the US and the UK audit report is that the US audit report makes explicit reference to GAAP.

This explicit reference to GAAP in the US audit report is unfortunate. It allows auditors to eschew the “present fairly” in “present fairly in conformity with GAAP” and focus on “conformity with GAAP.” As many have observed, US auditing is rule-dominated, which in effect means that if the audited financial statements are prepared in accordance with GAAP, the auditor will deem them acceptable. This auditor mindset does not insure that the manner in which the entity’s economic transactions are recorded and presented (their form) portrays their economic reality (their substance). The FASB refers to this qualitative characteristic of accounting information as “reliability”. The FASB defines reliability as, “The quality of information that assures that information is reasonably free from error and bias and faithfully represents what it purports to represent”. Representational faithfulness, in turn, is the “correspondence or agreement between a measure or description and the phenomenon that it purports to represent” (p. 39).

A decade ago, the managing partner of the Chicago office of a Big Six firm remarked to one of us that it was his firm’s policy to issue unqualified audit opinions on financial statements in conformity with GAAP, even if the statements contained “creative” or “aggressive” accounting transactions and/or presentations that were designed to enhance their favorable portrayal. In order to gauge the prevalence of this stance among practicing auditors, we designed six cases of accounting treatments by management that were in accordance with the letter of GAAP, even though the motivation of management in engaging in those treatments was clearly to present results that were as favorable as possible. We surveyed audit partners of the then Big Six audit and several second tier accounting firms as our subjects and presented them with several cases employing creative accounting within the limits of GAAP. For each case we asked them two questions: (1) what they would judge as a risk of exposure to a lawsuit if they were to issue an unqualified opinion, and (2) the likelihood of issuing a qualified audit opinion on the financial statements. We found that the audit partners assigned a very low risk to the possibility of being exposed to a lawsuit, and that it would be very unlikely that they would issue a qualified opinion for each of the cases. We hypothesized that the auditors perceived GAAP as a “safe harbor” or aegis that protects them from litigation. We predicted that if such auditor behavior continued in such a rule-dominated practice, in which the substance of business transactions is ignored, auditors would eventually lose their legitimacy before society. With Arthur Levitt being named Securities Exchange Commission (SEC) Chairman in 1993 and his declaration of war on aggressive accounting in 1998, we were interested as to whether auditor opinions had changed. We ran a similar experiment in 1999 with different cases and found that the average responses indicated higher litigation risk and higher likelihood of using a qualified opinion, but that the average response was still on the low side of the risk/likelihood scale.

Given these findings, and the ever increasing use (abuse) of aggressive accounting as in the case of Enron and numerous other publicly-traded companies, we propose the following actions. First, the US audit report language should be modified in a manner similar to that of the United Kingdom. It might be changed to include the following language, “XYZ Company’s balance sheet, statements of earnings, stockholders’ equity, and cash flows provide a true and fair view, in all material respects, of the firm’s financial position and results of operations.