Journal of Business Finance & Accounting, 36(1) & (2), 1–30, January/March 2009, 0306-686X

doi: 10.1111/j.1468-5957.2008.02112.x

An Empirical Investigation of the True

and Fair Override in the United Kingdom

Gilad Livne and Maureen McNichols∗

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.
Keywords: principles- vs. rules-based accounting, earnings quality, informativeness of financial
statements, true and fair override

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

∗ 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. (Paper received December 2006, revised version accepted July 2008)
Address for correspondence: Maureen McNichols, Graduate School of Business, Stanford University,
Stanford CA 94305, USA.
e-mail: fmcnich@stanford.edu

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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

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

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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 pronounce-
ments. 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.

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.


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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 posi-
tion, 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
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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. 5 Benston 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:

1. Accounting standards, or similar pronouncements, prescribe one method, which

contradicts the Companies Act (CA) and thus requires an override.
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 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).


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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.
4. Accounting 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

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.

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(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:
H 1 : Firms that invoke more costly overrides experience similar financial perfor-
mance and debt contracts to otherwise similar firms that do not invoke an override.
We supplement our primary investigation with evidence on the valuation implica-
tions 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:
H 2 : 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.

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.


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

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 4 50 54
purchase accounting (MER)
Stepwise calculation of goodwill 32 2 34
(GDW)
Current assets presented at market 25 4 29
value and not cost (MVA)
Grants and contributions not shown 24 24
in deferred income (GRT)
Unrealized gains and losses taken to 27 27
the P&L (UGL)
Not recognizing diminution in value 23 23
of investment in parent company’s
accounts (ITG)
Other (OTH) 11 9 46 66
3
Total 413 104 57 133 707
% of total 58.4 14.7 8.1 18.8 100
Num. of quantified overrides 65 39 13 26 143
(% of category) (15.8) (37.5) (22.8) (19.4) (20.2)
S19 by Real Estate firms 385 385
GRT by Water firms 49 49
Overrides excluded from sample 434
above
Notes:
1 Category Description:

1. Accounting standards, or similar pronouncements, prescribe one method, which contradicts the
Companies Act (CA) and thus require an override.
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.
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.
4. Accounting standards or similar pronouncements require a certain method, which is overridden.
2 In case of multiple overrides for any given firm-year the table classifies the highest category override.
3The 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.

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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

12 An alternative matching procedure could involve identification of control firms facing similar cir-
cumstances 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.


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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

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 . . .

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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.
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

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 Repor-
ting, 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 Table1 due to lack of availability
of profit or equity data or negative values for these amounts.


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 12

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
TFV Sample Control Sample
1
Variable Name N Mean Median Std. Dev N Mean Median Std. Dev Z Value

Override Effects
% EQUITY 44 0.059 0.012 0.137 2.31
% INCOME 47 0.096 0.023 0.182 0.90
Descriptive Variables
SALES (£M) 578 1776.561 169.824 4604.421 578 1146.695 143.299 2639.330 0.45
INCOME(£M) 600 90.397 5.992 322.277 600 84.755 6.354 308.040 0.07
ASSETS (£M) 600 8605.769 164.920 36726.069 600 5740.361 166.423 32112.978 0.67
EQUITY (£M) 600 861.450 66.140 2114.679 600 650.053 57.133 1756.891 0.26
Performance Measures
NETPRO 539 0.022 0.045 0.230 539 −0.032 0.046 0.517 −0.72
DTOS 538 0.038 0.026 0.048 538 0.047 0.029 0.071 −1.69
LIVNE AND McNICHOLS

NETROE 580 0.059 0.102 0.352 580 0.058 0.109 0.342 0.32
TURNOVER 569 1.092 0.926 0.873 569 1.122 1.024 0.871 −1.28
CFOTOS 484 0.095 0.089 0.186 484 0.063 0.108 0.475 −1.24
OPINC 463 0.113 0.104 0.165 463 0.118 0.120 0.172 0.62

Journal compilation 
Contracting
DETOFIX 556 0.900 0.420 1.525 556 1.084 0.380 2.277 1.92
INTCV 440 9.607 5.196 44.509 439 13.791 5.029 89.866 −1.45


Market-based Variables
BM4M 523 0.767 0.607 0.613 522 0.719 0.503 523 1.86
EP4M 521 0.025 0.057 0.183 520 −0.016 0.054 521 0.44

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Table 2 (Continued)

2008 The Authors

Journal compilation 
Notes:
1 Variable definitions:
Override Effects
%EQUITY– Cumulative effect of override on equity/total equity
%INCOME – Effect of override on income/income, for firm-years with positive income
Performance Measures
NETPRO – Net profit/sales
DTOS – Depreciation expense/sales
NETROE – Net profit/total equity
TURNOVER – Sales/total assets

C Blackwell Publishing Ltd. 2008

CFOTOS – Cash flow from operations/sales
OPINC – Pretax income from operations before depreciation and amortization/sales
Contracting
DETOFIX – Total debt/gross tangible fixed assets
INTCV- Interest coverage ratio, measured as pretax income before interest/ (capitalized interest + interest expense)
Goodwill Related
GWTOASS – Goodwill and other intangibles/total assets
AMTOSALE – Amortization expense/sales
PGWTOASS – Goodwill capitalized during the year
Market-based Variables
BM4M – Book value of equity-to-market value of equity, at four months after end-of-year
EP4M – Earnings-price ratio based on the share price four months after year-end
INVESTIGATION OF THE TRUE AND FAIR OVERRIDE

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.
13
14 LIVNE AND McNICHOLS

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.

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.

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 INVESTIGATION OF THE TRUE AND FAIR OVERRIDE 15

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.
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

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.


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 Table 3
16

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
Non-amortization of Goodwill Override Sample Control Sample
Variable Name N Mean Median Std. Dev N Mean Median Std. Dev Z Value

Override Effects
% EQUITY 6 0.017 0.013 0.011 2.53
% INCOME 21 0.178 0.098 0.213 3.31
Descriptive Variables
SALES (£M) 89 1947.083 487.366 3313.353 89 1272.840 283.442 2404.658 0.59
INCOME (£M) 92 136.449 16.692 440.444 92 105.686 12.162 436.730 0.00
ASSETS (£M) 92 8347.317 392.959 33761.936 92 12731.626 233.209 62764.116 0.44
EQUITY (£M) 92 824.726 110.146 1855.304 92 870.448 95.351 2629.071 0.03
Performance Measures
NETPRO 85 0.061 0.047 0.104 85 0.051 0.060 0.201 −0.88
DTOS 87 0.031 0.023 0.038 87 0.045 0.028 0.061 −1.96
NETROE 90 0.089 0.128 0.414 90 0.031 0.135 1.165 −0.38
TURNOVER 87 1.250 1.080 0.856 87 1.192 1.083 0.813 0.24
CFOTOS 82 0.113 0.089 0.104 82 0.128 0.136 0.158 −1.69
OPINC 80 0.114 0.105 0.122 80 0.138 0.148 0.158 −1.81
LIVNE AND McNICHOLS

Goodwill-related
GWTOASS 89 0.266 0.230 0.210 89 0.181 0.054 0.234 2.25
AMTOSALE 81 0.004 0.001 0.008 81 0.025 0.002 0.063 −1.29

Journal compilation 
PGWTOASS 67 0.126 0.074 0.155 67 0.064 0.017 0.115 2.31
Contracting
DETOFIX 86 1.173 0.728 1.444 86 2.081 0.445 4.731 0.84


INTCV 68 9.987 5.947 15.235 68 36.644 8.121 112.154 −2.56
Market-based Variables
BM4M 80 0.520 0.410 0.506 80 0.411 0.335 0.407 0.77
EP4M 80 0.025 0.053 0.151 80 0.035 0.046 0.082 0.02
Note:

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Variable definitions are included in Table 2.
 INVESTIGATION OF THE TRUE AND FAIR OVERRIDE 17

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.
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
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

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.


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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
True GAAP Override Sample 1994–2002 Control Sample
Variable name N Mean Median Std. Dev N Mean Median Std. Dev Z Value

Override Effects
% EQUITY 18 0.038 0.019 0.066 1.36
% INCOME 8 −0.053 0.055 0.253 −0.92
Descriptive Variables
SALES (£M) 137 4447.736 372.000 9702.872 137 1829.578 382.100 3453.532 0.37
INCOME (£M) 151 193.566 8.239 526.249 151 117.078 15.354 263.971 −0.89
ASSETS (£M) 151 10183.506 575.716 35488.665 151 5144.959 524.251 21099.146 0.40
EQUITY (£M) 151 1643.086 214.300 3781.199 151 968.729 183.528 1713.050 0.24
Performance Measures
NETPRO 130 −0.046 0.028 0.459 130 0.028 0.046 0.378 −2.77
DTOS 130 0.038 0.030 0.036 130 0.045 0.027 0.062 1.80
NETROE 148 0.016 0.071 0.402 148 0.107 0.108 0.348 −2.69
TURNOVER 136 0.958 0.855 0.665 136 1.222 1.098 1.136 −0.80
LIVNE AND McNICHOLS

CFOTOS 107 0.083 0.109 0.223 107 0.105 0.117 0.156 −0.48
OPINC 109 0.077 0.110 0.233 109 0.157 0.123 0.170 −0.37
Contracting

Journal compilation 
DETOFIX 143 0.979 0.440 1.928 143 1.063 0.434 3.028 −0.57
INTCV 117 −7.926 2.777 64.210 117 12.237 4.589 98.484 −2.17
Market-based Variables


BM4M 135 0.837 0.630 0.697 135 0.696 0.531 0.895 0.97
EP4M 91 0.070 0.057 0.063 91 0.073 0.065 0.074 −0.72
Note:
Variable definitions are included in Table 2.

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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

2008 The Authors

Non-depreciation Override Sample Control Sample

Journal compilation 
Variable Name N Mean Median Std. Dev N Mean Median Std. Dev Z Value

Override Effects
% EQUITY 0
% INCOME 9 0.075 0.060 0.053 2.76
Descriptive Variables
SALES (£M) 308 1376.046 129.646 3406.574 308 1020.496 110.713 2448.198 −0.08
INCOME (£M) 325 58.156 5.360 209.508 325 72.414 4.169 272.105 0.43
ASSETS (£M) 325 10922.544 118.436 43032.880 325 5842.223 115.345 27530.779 0.25

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EQUITY (£M) 325 706.319 46.349 1619.934 325 581.772 44.085 1576.673 0.04
Performance Measures
NETPRO 289 0.059 0.049 0.149 289 −0.054 0.038 0.678 0.66
DTOS 288 0.029 0.019 0.034 288 0.042 0.029 0.066 −2.80
NETROE 313 0.081 0.100 0.256 313 0.028 0.105 0.348 1.31
TURNOVER 303 1.186 1.026 1.010 303 1.142 1.053 0.853 −0.68
CFOTOS 254 0.102 0.081 0.130 254 −0.125 0.090 1.859 0.00
OPINC 243 0.120 0.096 0.113 243 0.073 0.097 0.202 1.13
Contracting
DETOFIX 296 0.925 0.360 2.176 296 0.977 0.354 1.940 −1.70
INTCV 247 19.502 6.476 57.237 246 15.731 4.506 87.834 0.16
INVESTIGATION OF THE TRUE AND FAIR OVERRIDE

Market-based Variables
BM4M 288 0.856 0.746 0.586 287 0.843 0.621 0.887 1.23
EP4M 285 0.046 0.073 0.170 284 −0.037 0.056 0.397 2.16
Note:
Variable definitions are in Table 2.
19
20 LIVNE AND McNICHOLS

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, SALES, ASSETS and EQUITY, respectively, are all significantly positive,
whereas the change in income, INCOME, is not significantly positive. Consistent
with this, the change in scaled profitability measures, NETPRO, NETROE and
TURNOVER are all significantly negative. However, the change in our measures
of profitability before the effect of the override, CFOTOS and OPINC, 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.
The right side of Table 6 presents the findings for the GAAP override subsample. Sim-
ilar to the sample as a whole, the change in scaled profitability measures, NETPRO,
and TURNOVER are significantly negative. In contrast to the entire sample, however,
CFOTOS and OPINC are negative, though CFOTOS 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

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.

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Table 6

2008 The Authors

Analysis of Differences Between First Year of Override and the Prior Year for Descriptive, Performance, Contracting, and

Journal compilation 
Market Variables. Positive (negative) value implies year of override higher (lower) than prior year
Entire Sample 1998–2002 GAAP Override Sample 1994–2002
Variable Name 1 N Mean Median Std. Dev Z Value N Mean Median Std. Dev Z Value

Descriptive Variables
SALES (£M) 224 185023.12 6539.50 1299122.72 3.83 46 225275.81 9 2513000 0.03
INCOME (£M)) 225 −35424.28 218.00 461337.72 0.17 46 −63903.12 −1094 323494 −1.01
ASSETS (£M)) 225 1476257.49 14212.00 16431363.20 3.96 46 4720054.87 4682 35601056 2.04

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EQUITY (£M)) 225 −15166.39 4458.00 2049770.24 4.25 46 −75410.83 4359.5 3902808 0.73
Performance Measures
NETPRO 207 −0.022 −0.006 0.166 −2.62 41 −0.125 −0.028 0.274 −3.03
DTOS 213 0.042 0.001 0.429 3.30 41 0.027 0.01 0.067 3.70
NETROE 196 −0.047 −0.010 0.273 −2.73 37 −0.025 −0.046 0.293 −1.31
TURNOVER 224 −0.106 −0.011 0.529 −2.47 46 −0.154 −0.038 0.559 −1.95
CFOTOS 199 −0.028 −0.009 0.247 −0.51 43 −0.071 −0.024 0.522 −1.63
OPINC 166 −0.002 0.001 0.095 0.21 37 −0.082 −0.015 0.266 −1.88
Contracting
DETOFIX 221 0.414 0.013 13.244 1.65 25 0.005 −0.005 0.243 −0.30
INTCV 173 −0.343 −0.145 11.430 −0.97 23 0.720 −0.804 6.149 −0.42
INVESTIGATION OF THE TRUE AND FAIR OVERRIDE

Market-based Variables
BM4M 206 0.168 0.057 0.567 4.25 42 0.129 0.031 0.435 1.29
EP4M 155 −0.006 0.008 0.266 2.99 25 0.007 −0.001 0.139 0.02
21
 22

Table 6 (Continued)

Notes:
1 Variable definitions:

Performance Measures
NETPRO – Change in net profit/sales in the first year of the override relative to the prior year.
DTOS – Change in depreciation expense/sales in the first year of the override relative to the prior year.
NETROE – Change in net profit/total equity in the first year of the override relative to the prior year.
TURNOVER – Change in sales/total assets in the first year of the override relative to the prior year.
CFOTOS – Change in cash flow from operations/sales in the first year of the override relative to the prior year.
OPINC – Change in pretax income from operations before depreciation and amortization/sales in the first year of the override relative to the prior year.
Contracting
DETOFIX – Change in total debt/gross tangible fixed assets in the first year of the override relative to the prior year.
INTCV- Change in interest coverage ratio, measured as pretax income before interest/ (capitalized interest + interest expense) relative to the prior year.
LIVNE AND McNICHOLS

Market-based Variables
BM4M – 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.
EP4M – Change in the earnings-price ratio based on the share price four months after year-end relative to the prior year.

Journal compilation 
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.


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 INVESTIGATION OF THE TRUE AND FAIR OVERRIDE 23

informativeness by the adjusted R 2 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:

P = β0 + β1 BV + β2 BV− + β3 NI + β4 NI− + ε (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 β 1 > 0, β 2 > 0, β 3 > 0 and β 4 < 0. We estimate equation (1) for the
override and control samples separately, and test for differences in the R 2 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 R 2 for the override and control subsamples.
For the full sample of overrides from 1998–2002, the R 2 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 R 2 is not due to scale. For the NOG subsample,
we find that both the TFV and control sample regressions have R 2 ’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.

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 R 2 , and this effect increases in
the scale factor’s coefficient of variation. As a result, comparing R 2 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 R 2 s 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.


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24 LIVNE AND McNICHOLS

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
P = α0 + α1 TFV + β1 BV + β2 BV− + β3 NI + β4 NI− + β5 BV ∗ TFV
∗ ∗
+ β6 BV− TFV + β7 NI∗ TFV + β8 NI− TFV + ε (2)

Full Sample NOG Overrides GAAP Overrides S19 Overrides

Intercept 108.26 95.02 61.11 67.75

9.44∗∗∗ 3.14∗∗∗ 2.67∗∗∗ 5.05∗∗∗
TFV −42.99 −17.50 36.00 −60.93
−2.64∗∗∗ −0.38 1.05 −3.21∗∗∗
BV 0.37 0.38 0.26 0.49
7.36∗∗∗ 2.68∗∗∗ 2.80∗∗∗ 7.56∗∗∗
BV− 0.43 0.85 1.39 −0.03
3.36∗∗∗ 1.86∗ 5.82∗∗∗ −0.23
NI 7.12 12.49 10.41 6.16
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 −0.24 0.07 −0.08 −0.16
−3.19∗∗∗ 0.24 −0.62 −1.79∗
BV− ∗ TFV −0.04 −0.55 −1.17 0.25
−0.25 −0.61 −2.65∗∗∗ 1.01
NI ∗ TFV 2.81 −4.58 0.25 3.81
4.01∗∗∗ −2.06∗∗ 0.16 4.22∗∗∗
NI− ∗ TFV −4.60 8.92 −3.21 −6.58
−3.18∗∗∗ 2.08∗∗ −1.23 −3.44∗∗∗
N 992 136 244 508
2
Pooled R 0.56 0.67 0.62 0.63
Override R 2 0.65 0.67 0.52 0.73
Control R 2 0.47 0.67 0.71 0.51
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.
P – Stock price per share measured in UK pounds 4 months after fiscal year end.
TFV – An indicator variable set equal to one if a TFV firm, zero otherwise.
BV – Book value of equity per share.
BV− – Book value of equity per share times an indicator variable equal to 1 (0) if net earnings per share
are negative (non-negative).
NI – Reported net earnings per share.
NI− – Reported net earnings per share times an indicator variable equal to 1 (0) if net earnings per share
are negative (non-negative).
∗ , ∗∗ , ∗∗∗ - significant at 0.10, 0.05 and 0.01, respectively.

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 INVESTIGATION OF THE TRUE AND FAIR OVERRIDE 25

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 R 2 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 in-
formative, implying that our results may reflect the greater informativeness of revalued
properties.
Our second set of tests of H 2 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):

P = α0 + α1 TFV + β1 BV + β2 BV− + β3 NI + β4 NI− + β5 BV ∗ TFV

(2)
+ β6 BV−∗ TFV + β7 NI∗ TFV + β8 NI−∗ TFV + ε

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 β 7 < 0 and β 5 > 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 (β 4 = −6.38, t = −6.74) and
the incremental coefficient on BVE− , book value of equity for loss firms, is positive
and statistically significant (β 2 = 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

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.


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26 LIVNE AND McNICHOLS

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, β 7 , is positive and statistically significant (β 7 =
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, β 5 , is negative and significant (β 5 =
−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, (β 5 = −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, β 6 , 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 R 2 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 R 2 ’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.

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 INVESTIGATION OF THE TRUE AND FAIR OVERRIDE 27

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.


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28 LIVNE AND McNICHOLS

APPENDIX
Distribution of TFV Override Types and their Expected Effect on Reported
Numbers
Number Expected Effect on: Number of
Types of TFV Overrides of Quantified Obs.
TFV Obs. P&L Equity (and% of all
obs. in TFV 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 54 +/− +/− 3(5.6)
purchase accounting (MER)
Stepwise calculation of goodwill (GDW) 34 +/− +/− 29(85.3)
Current assets presented at market 29 +/− +/− 13(44.8)
value and not cost (MVA)
Grants and contributions not shown in 24 No No 0(0.0)
deferred income (GRT)
Unrealized gains and losses taken to the 27 + + 13(48.1)
P&L (UGL)
Not recognizing diminution in value of 23 No No 0(0.0)
investment in parent company’s
accounts (ITG)
Other (OTH) 66 +/− +/− 23(34.8)
Total 707 143(20.2)
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.

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