A report on the regulation of financial reports

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Financial statements are the records that summarise the financial performance of a company for a specified period of time. The reports contain information such as profit and loss made in that fiscal year, the company's assets and liabilities, etc…The Companies Act 85 ( CA85) dictates that all companies have a duty to keep accounting records showing true and fair view of performance and financial position. The main objectives of financial statements are to

Provide reports to shareholders about how directors managed the company

Control the business

Provide the shareholders and prospective investors with necessary information so that they make the investment decisions accordingly.

Since 2005, all listed companies registered in UK are required to keep financial records that comply with the International Financial Reporting Standards (IFRS) and International Accounting Standards. (IAS)

Due to the fact that the financial report is more than the accounting information, the accuracy of its information is of vital importance for the stakeholders of the company. Some of the stakeholders with direct interest and the impact of the financial statements on their decision making process are;

Creditors: Decide whether or not to provide loan

Investors: Obtain information about the standing of the company and determine the scope of their investments

Management: Decide on how to develop their business.

Government: Designate the tax incomes; make relevant governing decisions

Employees and Labour Unions: Know how profitable the business is and ask for their rights

Owners: Decide whether to make additional investments or to refrain from investment.

Who is the Regulator and How is the Regulation Done?

In the UK, the Financial Reporting Council (FRC) regulates the whole financial reporting system. This body is an independent regulator tasked with the responsibility of promoting confidence in corporate governance and reporting. It represents and involves six operating parties with different responsibilities in the standard setting process.

Each country has its own regulatory body for accounting standard setting. In the UK, this has been done through the agency of the Accounting Standards Board (ASB), a subsidiary of FRC, which came to existence in 1990. It was formed with the aim of regulating the substance and format of the company reports by issuing Financial Reporting Standards (FRS). (CEM, 2009) Despite the different regulatory bodies in each country, there has been a great effort for the harmonisation of the accounting practises across national boundaries. In 2005, the International Accounting Standards Board (IASB) was instituted with the aim of developing "in the public interest, a single set of high quality, understandable and international financial reporting standards (IFRS) for general purpose financial statements."(IASB, undated)

The Companies Act of 1985 requires the company directors to be responsible for the regulation of financial statements and the annual report for each financial year. The directors are not only responsible for keeping the accurate accounting records, but also to prepare the consolidated financial statements that comply with International Financial Reporting Standards (IFRS) as adopted by EU, and the company financial statements and Director's Remuneration Report in accordance with law and the United Kingdom Accounting Standards.(United Kingdom Generally Accepted Accounting Practise, UK GAAP) The overriding principle is that, the financial statements should be prepared on going concern basis and should give a true and fair view of the affairs of the company.

Most annual reports for listed companies include the following ( Mills et al.(1999: 84);

Chairman's Statement

The Director's Report

The Auditor's Report

Accounting Policies

A Profit and Loss Account

A Balance Sheet

A Cash Flow Statement

Notes to the Accounts

The Director's Report, the Profit & Loss Account, the Balance Sheet, the Notes to the Accounts and the Auditor's Report are all required by law. The aim of the Director's Report is to give further information about the financial statements. It can be summarised as the report detailing principal activities and the performance of the business with a fair review. It's important to keep in mind that the auditor doesn't accept responsibility for the efficiency of the business.

The Companies Act also requires the companies to appoint an independent qualified auditor to audit the financial statements in accordance with relevant regulatory, legal requirements and International Standards on Auditing (UK and Ireland) issued by Auditing Practises Board (APB). In the Auditor's Report they should provide the shareholders with an objective opinion on the Director's Statements, stating whether they present a true and fair view of the company. The auditors accept no responsibility for the efficiency of the business.

The board of directors should be committed to Corporate Governance as they are accountable to the Company's shareholders. Corporate Governance can be described as "The system by which companies are directed and controlled."(The Cadbury Report, 1992)

UK companies listed in UK Stock Exchange are subject to the Combined Code on Corporate Governance. Though the Code is voluntary, if a company refrains from complying with one or more provisions; it must give a specific explanation and this should be reviewed and reported by the auditor.

The Hampel Report requires that, for good Corporate Governance the Board should include a balance of executive and non-executive directors (especially independent non-executive directors) in order to prevent individuals from dominating the Board's decision. According to the Turnball Report (1999) the Board is also responsible for the reliability of the financial statements, and should assure that they have relied on a system of internal control, compromising organisational procedural controls and internal accounting controls. The company's internal auditors review and evaluate the effectiveness of internal control.

Discussion- Is the Current System of Regulation Accurate and Effective?

An effective financial reporting system is the one that serves the purpose. The purpose of the financial reporting is to give a true and fair view of the financial situation of a company to all readers of the reports. However, currently it can not be said that anyone who reads the financial reports of a company will be able to have a true view of the company's financial standing. Financial reports have to be based on reliable and accurate recordings of transactions. Today, the accuracy of the financial reports prepared by companies is very much under question. This is because the current financial reporting system is beset with many problems. Some of the problems plaguing the current system are; non-uniform standards across geographical regions, earnings management, auditor's independence, political lobbying, etc…

International Accounting Standards

Currently, the IFRS are being developed and increasingly widely accepted in different countries. However, not all the countries require the set of standards, allowing the room to manoeuvre around. For example, consider that a company exists in 3 countries, A, B and C. A and B both use the IFRS but C doesn't. If the company wants to get around any particular rule of the IFRS, it will attempt to use its subsidiary in country C to get around the restriction. This renders the company's financial statements in the countries A and B inaccurate. Globalisation means that today, business that's conducted in different countries is almost the same. However, the national accounting standards are very different. Alexander and Archer (2000:539) point out that there is a great difference between the accounting standards of even in the UK and US. The differences arise from the different semantic interpretations of the concepts "true and fair" and "fair presentation in accordance with generally accepted accounting principles." Although both concepts appear to be very similar in theory, in practise a large difference is seen.

Earnings Management

According to Mc Nichols (2000), earnings management occur when the actors in the process take some steps in order to obtain a set of earnings objectives. These actors (typically within the company) manage the company's accruals such that the financial standing of the company in the financial report is changed to meet the target. The problem of earnings management is tightly bounded to the types of remuneration contracts that give hefty incentives to the directors. For example, if a director is told that he is entitled to get a reward if his department makes a profit of X; then he will try his utmost to make sure that his department reports a profit of X. Reporting and actually making that profit are two different things. The director may use the room for judgement given in the current accounting standards to report a better earning. The opposite may also hold true; if for example a company that makes an income of above Y will fall in a higher tax band, the company may do its best to declare an income that's just below Y.

Irrelevance, Lobbying and Other Influences

The way business is done today is dramatically different from just even ten years ago. As the way business is done has changed, the laws and legislation of countries have also changed to reflect this change. However, when one looks at the field of accounting, it is clear that over the last two decades at least, very little change has taken place. Watts (2003) suggests that the field of accounting is very conservative; he further opines that this conservativeness appears to have increased in the last thirty years, as there has been very little change in accounting standards during this period. Although it may seem that some major changes have occurred with the setting-up of new regulatory bodies such as the FRC and ASB, the changes are merely superficial. Although the ASB is a new body, it adopted all former accounting standards in the form of SSAPs, and is attempting to make slow and incremental changes. The argument that has been put forward to make the case against a radical change is that a sudden change to new accounting standards would have made it difficult for companies to follow the new standards and costing them a lot. However, this is a very one-sided argument that only takes into consideration the point of view of companies. The investors, the government, the general public all have stake in the accuracy of financial statements and they would all stand to benefit if the accounting standards were tightened up so as to make the financial reports more accurate. Hence the inevitable question that arises is; why are the regulatory bodies not keen on changing the accounting standards so that it serves the interest of the other stakeholders better? The answer to this may be in the findings of Fogarty et al (1994) study. They found that the political lobbying in the standard setting organisations is a significant factor. Although the leaders of profession hold the public view that accounting standard setting should not be effected by politics, this is definitely not the case on the ground. Lobbying to influence the accounting standards is a well researched phenomenon in current literature, e.g (Sutton 2002; Tuitticci et al. 1994; Gavens et al.1989; Zeff, 2002,) all study this issue.

Hodges and Mellet (2002: 126) for example find that documentation about accounting standard setting that is in the public domain reveals the presence of significant influences such as economic considerations and political lobbying. This is because the accounting standard setting function doesn't wholly reside with the so-called independent regulatory bodies. These bodies rely on the government of the day to make and enhance the relevant laws. The government of the day in turn is subject to the economic pressures of running a political party, and hence the line between political party donor and stakeholder with vested lobbying may become blurred in practise.

Auditor's Independence

One of the main problems arises from the fact that the auditors are responsible for the verification of the accuracy of financial statements of a company. Johnstone et al (2001) state that the auditor report adds value to the financial statements provided by the managers to the shareholders. As a result, integrity, independence and objectivity play a vital role in the supervisory process. But the latest corporate scandals of Enron and Worldcom and the demise of Arthur Anderson have eroded the trust in audit business and have caused the concern on the auditor's independence. According to a survey by the magazine Financial Director, the income generated from audit clients through non-audit services is more than the income derived through auditing. Bazerman et al (1997) elucidate the point very well, stating that in as long as the company is a client of auditors; the auditors can not achieve psychological independence.

Other Issues

Myner (2001) points out some problems with accounting in the savings industry. Many objectives set by the accounting standards for this sector actually have the practical effect of giving the managers unnecessary and artificial incentives on herd. The use of peer group benchmarks puts unnecessary pressure on an organisation to copy other forms in order to remain normal. This actually has the effect of increasing risk to the entire industry due to the reduction of diversity.

Creative accounting is another problem which has been pointed out in the current literature. Here the accountant use his knowledge of accounting rules to manipulate the accounting figures of a company such that it complies with the rules contained in the law and regulations. This is unethical.

Mills and Robertson (1999) define that: in the financial statements, many significant assets, especially the intangible assets like know how, goodwill and the value of people are excluded. Due to that, what is reflected on the balance sheet as the net book value differs form the market value of a company. There are also some specific issues with regards to financial reporting in the real estate industry as well. (CEM, 2009)

Conclusions and Recommendations

Despite the attempts to ensure that the financial reporting system serves the interest of all stakeholders, it is not likely to talk about hundred percent accuracy, thus the system can not be considered effective. The whole system is largely self-regulated in practise as can be seen in the non-compliances discovered, such as BCCI and Maxwell cases highlighted by the Committee on The Financial Aspects of Corporate Governance and Gee and Co. Ltd (1992) in what's called the Cadbury Report. Additionally, the regulators are highly susceptible to pressure from stakeholders with vested interests.

In order to develop the system, the following can be done:

- Though it's not been academically proved, the external auditors of a company may compromise their independence if they get paid for non-audit services as well. In that sense, the auditors would not give non-audit services to the companies where they are paid for audit purposes.

-On the other hand, the complexity of the reports should be reduced to prevent the confusion of readers. The companies should have the culture of good corporate governance in terms of effective board and audit practises for proper internal and external reporting and accounting, developing control systems, performance metrics, etc…It should always be kept in mind that, maintaining good corporate governance is not only the role of the director, it's a matter of the whole community.

-It is the time of "Fast Fish Eats Slow Fish", not the "Big Fish Eats Small Fish", so reaching an instant data with relevant information is of vital importance in the decision making process. With this in mind, a regulation; which requires all public limited companies in UK to publish their financial reports on the internet can be developed. The data should be updated 24/7, so the stakeholder can access the data instantly. This, not only speeds up the decision process, but also improves the control mechanism of the financial reports. The more the data is exposed to more people; there is always a change of less fraudulent activities as the control of the data can be made by any parties.