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Important Financial Information by a Company to its Stakeholders

Financial statements are a tool that provide important financial information about a company to its stakeholders. However, recently there have been an increased frequency of restated financial statements in many high-profile cases such as Enron, WorldCom, Royal Ahold and HealthSouth, that have drawn far greater attention to the failures of businesses in which defection of financial reporting and corporate disclosure have been missed. This will affect the users’ view toward financial reporting’s credibility as the loss of credibility has been spreading across capital markets. The rise in the global nature of businesses and market has resulted in the crossing of national boundaries. Thus, this report has been complied with reference to the loss of credibility in financial reporting and corporate disclosure from an international perspective; as well as approaches to resolve this problem.

The origin of loss of credibility:

The loss of credibility in financial reporting is caused by the failure of government structures to prevent or detect the incentive that failure businesses have to distort their financial reporting. This means there is a close relationship between business failure, reporting failure and government structure. There are a few cases in 1980s and 1990s that reflects this relationship such as Maxwell in the UK, Credit Lyonnais in France, AWA in Australia, the Canadian Commercial Bank in Canada, Wedtech in US and so forth. The East Asian financial crisis in 1997 also raised concerns about the reliability of financial statements. According to United Nations Conference on Trade and Development (UNCTAD) in March 1999, this failure resulted from a highly leveraged corporate sector, growing private sector reliance on foreign currency borrowings, and a lack of integrity and accountability; which indirectly contributed to the ineffectiveness in internal controls.

Understanding the reasons for loss of credibility in financial statements-The participants and their roles:

 

When the number of participants increase in the financial reporting process, they help to provide a better understanding of the reasons for a loss of credibility and find the solutions for them. Those participants include the corporate management, shareholders, auditors, mass media, and other stakeholders. The standard setters and regulators also play their role in setting and enforcing the rules respectively.

Corporate management and the board of directors:

The management are responsible for preparing the financial statements and establishing the process and system of control that provide reliable and available statements of the necessary information on a timely basis. The board of directors have the responsibility for approving the nomination of other senior members of management. The audit committee perform the supervisory roles.

The independent auditor:

An independent auditor provides an independent opinion in the financial statement, and highlights whether there are material misstatements or not. In addition to this, they assure that all the international auditing standards are complied with. This adds credibility to the financial statement so the business looks more appealing to shareholders.

The standard setters:

The effectiveness of the standards depend on whether the language used for reporting is comprehensive, comparable and responsive to the user's needs.

The regulators:

There are two ways that regulators can impact the financial reporting process: through the financial statement and through regulations of the capital market and auditors. Effective regulators comply with the standard and avoid any breaches of the standard.

Credit rating agencies:

Credit rating agencies look at the circumstances surrounding a business and examine the risk faced in order to make the best business decision.

Financial analysts:

Financial analysts evaluate individual companies and provide additional information to help investors make decisions.

Investment bank:

Investment banks give advice to companies by providing information to support in major transactions. Investment banks are useful when there are a segregation of activities, which can prevent conflicts of interest.

Internal and external lawyer:

Internal and external lawyers give detailed advice on the appropriateness and structuring of individual business transactions in order to perform a fair financial reporting and disclosure.

The media:

The media can be a communication tool that help to assist shareholders in decision making.

Investors and potential investors:

Investors and potential investors should have the capacity to be actively informed in the effective operation market.

Environment pressures:

The preparers of information have the pressure of meeting performance and profit expectations. Standard setters on the other hand have political pressures. This is because some standard setters are lobbied by politicians in an attempt to avoid standards becoming effectively implemented. In addition, they are under pressure for not having sufficient funding. Differing from this, auditors are faced with the problem of being independent, as having their own time-scale for the completion of work, fees and retention of audit assignments can bear problems. Also, having a larger number of participants means that there will be lots of different types of pressures imposed to them. The following weaknesses to this approach have been identified:

The incentives provided to management:

The management level have direct remuneration and share options. In addition to this, they have the power to influence the share price. Therefore, their income can influence the share price, which may lead to unacceptable behaviour.

Company internal control:

Some companies have neglected the importance of having effective internal control as they focus more on growth and share price. Senior management focus on strategic issues rather than operations and control functions in the financial statement. If the CFO is not involved in the reporting process then it may cause the processing of financial reporting to be more difficult.

Oversight of management by board of directors:

Some boards of directors do not understand the importance of building a healthy governance structure. Independence, skills, resources, information and adequate time are needed by the director and audit committees in order to build a healthy governance structure.

Audit independence:

The auditors may not be independent at some point in time due to the pressure of the self-review threat, the audit fees and the audit relationship with management. Therefore, safeguards are needed to protect against this.

Auditors’ quality control mechanisms and audit work in relation to fraud:

The incompetence of auditors, weak independence and ineffective consultation can cause the audit quality to be questioned.

Accounting standards:

The insufficiency of standards and the significant variation of standards between countries are a key weakness. More often than not the standard setters are under political pressures, lack resources and are under financial difficulties. As a result, the credibility of the financial report may be affected.

Regulation:

Self regulation lacks effective self monitoring, and can cause a lack of credibility and reliability. Therefore, effective and worthy activities are unable to be carried out. The effectiveness of regulations in terms of independent monitoring of regulations vary among countries.

Behaviour of investment banks, lawyers and other advisers:

Investment banks can try and conceal fraud in the financial statement. The lawyer (and others), are unable to detect them as they just give an opinion based on technicalities.

Ethical behaviour:

Although auditors are members of professional bodies, they can still neglect professional ethical guidance.

Provision of non-audit services:

If auditors want to provide non-audit services, they need to provide them with effective safeguards. Non-audit clients may destroy the auditor's independence because of the existence of conflict of interest among shareholders in relation to the audit and the relationship with management. As a result of this, further restrictions may be imposed to avoid conflict of interest and protect the public interest. The audit firm argue that they may not be able to provide quality audit work if they do not understand the client’s procedure and controls. This is due to that fact that performing non-audit work gives additional information so the audit firm know the client’s business.

The alternative approach:

The auditor should only provide non-audit services which are clearly related to the audit role. However, audit firms may argue that by doing so, it may impact the audit quality. Therefore, they need to consider the potential conflicts and pressures, and how they might be able to counter these in other ways. Auditor independence may still be threatened because of the pressure given by the clients in terms of the continuation of the overall relationship and the level of audit fees.

The international dimension:

Credibility of financial reporting is a critical international issue. Nowadays most of the markets are global. The securities of companies are not limited in the entity’s country, but are traded on exchanges in many other countries. A national problem occurred when it was passed that the financial statement presented must follow the international standard. This meant that companies which traded securities in more than one country had to follow both the rules in their own country and in the country where the securities were listed. Each set of rules to follow were different, thus spoiling the credibility of each set and increasing inefficiency in the market, as well as adding avoidable costs. Of course, asking every country to adopt one country’s standards is not the only solution, the alternative is to adopt or incorporate a 'neutral' set of standards which can be accepted by every country.

Another problem are the standards that are followed by auditors in large firms. The auditors’ work is designed in accordance with the corporation; therefore when it comes to multinational companies auditors perform the audit in line with the home country. As a result of this the financial report may be compromised for not following international standards. Many countries are now moving parallel with the international standards in order to combat this issue.

Even with international standards being adopted by every country, conflict can still occur. The first conflict is the translation of the standards into different national languages. This can cause different interpretations of the standard to be used. Secondly, the differences between those who believe that detailed rules are required and those who believe that only principals should be applied are also a cause of potential conflict. If both views stick then this means that different accounting methods are still being produced event though they both successfully incorporate the international standards. This conflict can be solved by adopting the international standards in isolation and not adapting respective standards to international standards.

U.S. Public Company Accounting Oversight Board (PCAOB) offers support for those who claim that a system of mutual recognition of regulatory government that complies with the international standard is needed. This gives a certain level of confidence internationally, without having the problem of duplicating regulation and monitoring.

Corporate management and governance:

Increase emphasis on controls and financial management:

Recent corporate failure cases suggest that there is a need to focus on the responsibility of management and the board of director for information, financial management and internal control in order to produce trustworthy information.

There should be a formal reporting process to the shareholder, laying out the responsibility for financial reporting and internal control; as well as regular assessments by the audit committee. The internal audit function should report the result of the audit to the Chief Executive Officer (CEO). If the company does not have their own internal audit department, then they would have to outsource the audit duties to ensure that key activities can be handled effectively.

Knowledge of reporting and controls should be the core competence of a Chief Financial Officer (CFO), despite the fact that there is an expansion of the role to include issues such as strategic planning etc. These core competences have to be assessed by the CEO and the audit committee before their appointment.

Reduce incentive to misstate financials:

Companies are advised to avoid providing the market with the forecast of profits. The forecast of profit assumes an unrealistic level of precision and such a disclosure could create incentives for a misstatement of financial information. To avoid a misstatement of financial information it is suggested that companies have a competent board; that is independent of management; to determine the terms and conditions of employment and the level and form of remuneration of senior management. In addition to this, companies have to implement the corporate ethical code and provide ethical training for employee to enable them to face difficult ethical dilemmas.

Board oversight of management:

A regular evaluation of the CEO performance on governance and financial reporting as well as company performance should be carried out by supervisory board and audit committees in order to enhance the effectiveness of the oversight role of the board of directors. Additionally, the performance of the board and its individual members should be assessed regularly.

The power and functioning of the audit committee:

It is argued that audit committees have poorly defined their responsibilities with agendas controlled by management and have devoted inadequate time and effort to their role. It is recommended that all public-listed entities define clearly the responsibilities of the audit committee or a similar governance body; that is agreed by the board and communicated to the shareholders. The responsibilities should include:

  • Monitoring the integrity of the financial reporting of the company
  • Reviewing the company’s internal financial control and risk management systems
  • Monitoring and reviewing the company’s internal audit function
  • Recommending the appointment, remuneration and terms of engagement of external auditors and reviewing their independence, objectivity and effectiveness
  • To meet more regularly, allocate sufficient time to perform their roles effectively and have the power to access appropriate resources to help with decision-making

The effectiveness of the audit committee:

In order to be effective, the auditor needs to have an open and constructive relationship with the management teams and the external auditors. In addition, the auditor committee also have to be objective and independent from those they oversee. It is recommended that each member of the committee should be financially literate and at least one of them should have substantive financial experience. It would be beneficial if the company can provide the background of committee members to its shareholders through the disclosure of qualifications, experience and a director’s remuneration and shareholding.

Private or executive sessions:

Most private or 'executive' sessions should be held with the audit committee, the head of the internal audit and the CFO respectively without the presence of the management team. This allows any matters concerning management or constrained by their presence to be discussed freely.

The audit function:

Reduce threats to auditor independence:

Traditionally, the relationship between the company and its auditor was with the management. However, the auditor’s primary relationship with the company should be with the board through its audit committee rather than with management. The change in this relationship will keep the independence of auditors.

There are three elements used to determine the provision of a non-audit service:

  • A framework to determine what is or is not acceptable
  • An approval process
  • Transparency

It is recommended that a policy for the approval of non-audit service provisions should be established. The total fee should be broken down into categories with the impact of these fees on auditor independence being disclosed as part of the committee’s reporting to shareholders.

Familiarity is recognised as one of the threats to auditor independence by the IFAC Ethical Code. In order to reduce this threat, a rotation of key audit personnel is required after a period of either five or seven years. Furthermore, to reduce the threat, it is recommended to have a two year 'cooling-off' period for key individuals on the audit team before they can join a client company in a director or key management position. Appointment of such a key individual should be approved by the audit committee and disclosed in the committee report.

Economic or career-related pressure may threaten the auditor independence. Thus, the auditor's firm need to review their consultation process to ensure that they are robust enough to deal with client pressure. It is also important for the firm to review their profit distribution and counselling process to ensure that they have a positive effect on audit quality. It is inappropriate for a firm to remunerate their partners based on the sales of non-audit services to the client as this will increase the incentive to misstate financial information.

Strengthen audit quality control processes:

Attention should be given to the 'tone at the top' within the audit firm as well as within the company in order to raise audit effectiveness. Firms have to reinforce the importance of audit practice within the firm and ensure that there is a high quality entrance into the auditing profession. Post-qualification training given by both professional bodies and individual firms will also increase the competency of auditors.

Moreover, audit firms have to be more rigorous in client acceptance and retention processes as publicly available evidence indicates that most audit failure cases were identified as high risk clients. A review of the financial statement by an independent partner prior to the firm signing the audit report on a timely basis is an effective element in a firm’s overall quality control system. However, this report recommends that the review process should be strengthened by focusing on identified risk, disputes with management and clarifying the procedure of handling disagreement. In addition to this, audit firms need to review their post-audit review processes to identify whether any improvements are needed.

It is argued that increased transparency on the part of the audit firm could significantly raise the credibility of the firm and then contribute to the increased credibility of the financial information reported by them. Thus, this report recommends firms disclose details of their quality control system and the procedures they follow. It is also suggested for firms to disclose the relationship between the network member and any related entity.

Other stakeholders:

To restore the credibility of the financial statement among users; transparency, code of conduct and active involvement need to be implemented by stakeholders. For example, for financial analyst and legal advisers, code of conduct should be publicised and monitored both within the firm and externally. Legal advisers and investment banks should also disclose the details of the fees, summary of alternative resolutions and relevant issues. Such information can help the audit committee in their evaluation of the company's financial status and in making a decision. It is also recommended that investors are actively involved in the corporate governance of corporations such as voting.

Regulation and standard setting:

This report suggests that audit standards should be improved and that international standards on auditing should be set as the fundamental of worldwide standards. The report also supports International Financial Reporting Standards to replace the national standard and be used widely in all countries. Some recommendations for audit and accounting bodies are:

  • IAASB is an independent international audit standard setter within IFAC. The recommendation is that an active role should be played in establishing the program between international standards and national standards to achieve convergence as soon as possible. It is also recommended that IAASB complete the upgrade of ISAs promptly. On the other hand, it is advised that IAASB revise the literature on fraud to reduce the expectation gap between auditors and other users of the financial statement. Regarding the internal controls issues, the report proposes that IAASB should work out a new measurement of risk and audit procedures with other standard setters. The resources such as funding, HR and the composition of members in the body should also be evaluated and solved to ensure it can always react to all the stakeholders’ needs
  • IFAC is a global organisation for accountancy which protects the public interest. The report urged IFAC to finish the discussions with stakeholders for the financial statement as soon as possible in order to gain acceptance of ISA in issues relating to membership, financing and public interest in all countries. In addition, the report proposes that IFAC provide more detail and consistent guidance on the external quality assurance review of auditors
  • The report holds the belief that enhancing corporate governance, regulation of auditors and related parties can strengthen the environment for financial reporting and disclosure. Thus there is a recommendation on early execution of regulations in line with the principles of securities regulation outlined by the IOSCO revised version of 'Objectives and Principles of Securities Regulation' so that it can be set as national benchmark
  • During the convergence of the accounting standards, IASB and other regulation setters should help the users of the financial statement to understand the differences between national and international standards. The report also suggests that the company should add some information such as a review of the company or the effect of a new accounting policy. IASB and IAASB should identify standards that can be adopted in developing countries. IFAC are recommended to help the member bodies in developing countries to implement the convergence standard
  • The report also highlights the importance of self regulating and standards for public interest activities in addition to the importance of corporate governance. Professional bodies have to review their activities. The operation and structure of the process should also be reviewed by each country to ensure the compliance with what was outlined by IOSCO, Forum of Firms and IFAC regarding the external quality assurance review. However, self regulating should be blended with the monitoring of public interest to improve audit regulation in order to enhance the knowledge and the responsiveness to all the circumstances
  • Recent development show that all parties related, regardless of international level or national level, are trying to work on the issue of credibility of the financial statement. The best example is the introduction of Sarbanes-Oxley Act in 2002 in US. This act enforces stronger rules in corporate governance, management of listed companies and the auditors. Most recommendations surround the independence of auditors, the role and rules imposed on corporate governance, and the non audit activities issues, but rarely talk about the role of other stakeholders such as the lawyers

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