Important financial information by company to its stakeholders
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Published: Mon, 5 Dec 2016
Financial statement is a tool that provided important financial information by a company to its stakeholders about whether to invest in that particular company. However, recently, an increased frequency of restated financial statements in many high-profile cases such as Enron, WorldCom, Royal Ahold, HealthSouth and others have drawn far greater attention on the failures of businesses in which defection of financial reporting and corporate disclosure. This will affect the users’ view toward the financial reporting’s credibility and this loss of credibility has been spreading across capital markets. The rising in global nature of businesses and market has resulted in crossing of national boundaries. Thus, this report had been discussed about the grounds of 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
First of all, the loss of credibility in financial reporting is caused by the failure of government structures to prevent or detect the incentive of failure businesses from distorting their financial reporting. This means that there is a close relationship between business failure and reporting failure as well as the government structure. There are few origins cases in 1980s and 1990s that reflects this relationship such as Maxwell in UK, Credit Lyonnais in France, AWA in Australia, Canadian Commercial Bank in Canada, Wedtech in US and so forth. Besides that, 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 are resulted from a highly leveraged corporate sector, growing private sector reliance on foreign currency borrowings, and lack of integrity and accountability which indirectly contributed to the ineffectiveness in internal controls.
Understand the reasons for loss of credibility in financial statement
The participants of their roles
When the number of participants increases in the financial reporting process and they understand their roles for the discussion, that may make us understand more on the reasons of 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 are also playing their roles in setting and enforcing the rules respectively.
(a) Corporate management and the board of director
The management is responsible for preparing the financial statement; establish the process and the system of control so as to provide reliable and available statements for the necessary information on timely basis. For the board of director, they have the responsible for approving the nomination of other senior members of management. Audit committee will perform the supervisory roles. As for the financial statements, it needs to reflect economy reality and comply with accounting and reporting standards.
(b) The independent auditor
The independent auditor will provide an independent opinion with competence and integrity in the financial statement, whether it has material mistatement or not. In addition to that, they assure that all the international auditing standard will be complied with. Because of that, it can add credibility of the financial statement so that the shareholders will get benefits in making decisions by interpreting the financial statement.
(c) The standard setters
The effectiveness of standard depend on whether the language used for reporting is comprehensive, comparable and responsive to users’ needs. Besides that , the standards can restrict the people from misleading them.
(d) The regulators
There are two ways that regulators can give impact on the financial reporting process, those include through the financial statement and regulations of the capital market as well as regulation on auditors. Effective regulators should comply the standards and avoid any breaches of the standard in order to make shareholders feel trust on the financial statement.
(e) Credit rating agencies
Credit rating agencies need to have well quality and timely on the business by looking at the business circumstances and risk faced in order to make the best business decision.
(f) Financial Analysts
Financial Analysts evaluate the individual companies and provide additional information to help the investors to make decisions.
(g) Investment bank
Investment banks provide advice to companies by providing information to support companies in major transactions. Investment banks will be useful when there are segregation of activities which can prevent conflicts of interest.
(h) Internal and external lawyer
They give detailed advice on the appropriateness and structuring of individual business transactions in order perform a fair financial reporting and disclosure.
(i) The media
Media can provide information on the financial information and it is a communication tool to help shareholders to assist in the decision making.
(j) Investors and potential investor
They should have the capacity to be actively informed in the effective operation market. They need to use the information athat is available
The environment pressures
The preparers of information have the pressure of meeting performance and profit expectation. As for standard setters, they have political pressures. That is because some of the standard setters are lobbied by some politicians to avoid some standards to be effective implemented. In addition to that, they are under pressure for not having sufficient funding. As for auditors, they are facing the problem of being independent, timing of completion of work, fees and retention of the audit assignments. They are having conflict of interest, whether sell or maintain both audit and non-audit services. For credit rating agencies, analysts, lawyers and investment bank will provide information and assessments may face the problem of conflict of interest as well. The most important reason that gives pressure on participants is that they are unable to respond to market expectations effectively to such an extent that there is an expectation gap exists.
The key weaknesses
By having a number of participants, there will be lots of different types of pressures imposed to them. Because of that, some weaknesses have been identified.
(a) The incentives provided to management
The management level will have direct remuneration and share option. Besides that, they have the power to influence the share price. Therefore, if their income can influence the share price, it may cause the management to produce unacceptable behavior.
(b) Company internal control
Some companies have neglected the importance of having effective internal control by having internal control because they focus on growth and share price. The senior management focuses on the strategic issues rather than operations and control function in the financial statement. If CFO is not the one who involve in the reporting process that may cause the processing of financial reporting to be more difficult.
(c) Oversight of Management by Board of Directors
Some boards do not understand the importance of building the healthy governance structure. The independence, skills, resources, information and adequate time need to be fulfilled by the director and audit committees to build healthy governance structure.
(d) Audit independence
The auditors may not be independent in some point of time because of the pressure of self-review threat, the audit fees and audit relationship with management. Therefore, safeguards are needed.
(e) Auditors’ quality control mechanisms and audit work in relation to fraud
The incompetence of auditors, weak independence and ineffective consultation processes of auditors which cause audit quality to be questioned because the auditors fail to set an appropriate environment. Auditors is not doing in line with market expectation whereby they can detect all the fraud created . Collusion issues also occur while doing audit
(f) Accounting standards
The insufficiency of the standards and the the significant variation of the standards between countries are key weaknesses. More often than not, the standard setters are under political pressures, lack of resources and financial difficulties. As a result, the credibility of the financial reporting may be affected.
Self regulation lacks effective self monitoring, it cause lack credibility and reliability. Therefore, effective and worthy activities are unable to be carried out. The effectivess of regulations in terms of independent monitoring of regulations are varies among the countries.
(h) Behavior of investment banks, lawyers and other advisers
Behaviour of investment banks tries to conceal fraud in the financial statement while the lawyer and others are unable to detect them because they just give an opinion based on the technicalities.
(i) Ethical Behavior
Although auditors are the members of the professional bodies, they neglect the professional ethical guidance.
Audit firms will provide services for audit and non-audit clients.
Provision of non-audit services
If auditors want to provide non-audit services, they need to provide them with effective safeguards .The non-audit clients may destroy the auditors independence because of the existence of the conflict of interest among the shareholders in relation to the audit and the relationship with management. Because of that, further restrictions may be imposed to avoid conflict of interest and protect the public interest. Yet, 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 control because performing non-audit work gives additional information for the audit firm to know the client’s business. That is because lots of expertise skills are needed to provide quality audit report. Besides that, they claim that the restriction imposed may indirectly affect the quality of personnel within the organization.
The alternative approach
The auditor should only provide the non-audit services which are clearly related to the audit role. However, audit firms may argue that by doing so, that may impact the audit quality. Therefore, they need to consider the potential conflicts and pressures might be able to counter in other ways. However, 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 government may take place to eliminate this problem.
The International Dimension
Credibility of the financial reporting is a critical international issue. Nowadays, most of the markets go globalization. For example 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 where the financial statement presented must follow the national standard. However, the company which traded the securities in more than one country had to follow both the rules in its own country and in the country where the securities were listed. Each of the set of information was different, where each of the set claimed that they were in the fair presentation. This would thus spoil the credibility of each of the set and increase inefficiency of the market, as well as adding avoidable costs. Of course, asking every country to adopt one country’s standards is not the only solution can do. The alternative is to adopt or incorporate a “neutral” set of standards which can be accepted by every country.
If national changes moves national standard to the international benchmark standards, international prerequisites are most likely to be met. Comparing to national standards, international standards are mostly principles-based rather than rules-based. It is possible to have national standards which are parallel to the international standards, but its detailed rules limited the application of the international standards, and in the end it is not compliance with the international standards. However, this difference is only mattered to the companies which are listed in more than a country.
The another problem is that the position of the large firm of auditors. The auditors’ work is designed according to the corporation; therefore, when it comes to multinational companies, they will perform the audit work in line with the home country, Therefore, the financial report may be presented by wide range of national standards. If the financial report of the corporation is complied with those standards, then it will show a clean opinion on the financial statements.
Many countries are moving parallel with the international standards. However, the problem is the absence of the regulatory and compliance where the changed standards were not certain to be resulted in changed practice. This made not much different with those countries which are yet to incorporate with the international standards.
Nevertheless, even international standards are being used by every country, conflict still occurred. The first conflict is the translation of the standards into different national languages. Second, the differences between those who believed that detailed rules are required and those who believed that only principal should be allowed make the potential conflict. If both of the approaches remain to stick on their point of view, this means that different accounting is still being produced although they incorporate with the international standards. This conflict can be solved by adopting the international standards and not adapting respective standards to international standards.
U.S. Public Company Accounting Oversight Board (PCAOB) offers the support for those who claim that a system of mutual recognition of regulatory government which complies with the international standards is needed. This would give certain level of confidence which is required internationally, without having the problem of duplication of regulation and monitoring.
CORPORATE MANAGEMENT AND GOVERNANCE
Increase Emphasis on Controls and Financial Management
Recent corporate failure cases had 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 to shareholder laying out the responsibility for financial reporting and internal control as well as regular assessment by the audit committee of the appropriateness of the resources being devoted to the adequacy and effectiveness of internal control by the internal audit function. The internal audit function has to report their result of audit to Chief Executive Officer (CEO) and has unshackled access to the audit committee. If the company does not have their own internal audit department, they have to outsource the audit department 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 that there is an expansion of the role of CFO to includes some issues such as strategic planning and 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 advice to avoid from providing the market with having forecast of profits. The forecast of profit assumes an unrealistic level of precision because such disclosure might create incentives to misstatement of financial information. The report supports IASB and national standard setter’s plan to introduce an accounting standard requiring the expensing of the costs and greater transparency on the disclosure of the terms of granting share option. This is because it is likely to enable the board to consider the establishment of the performance hurdles more effectively.
To mitigate misstate of financial information, it is suggested for companies to have a competent board independent of management in determining the terms and condition of employment and the level and form of remuneration of senior management. In addition to that, companies have to implement the corporate ethic code and provide training in ethical aspect for employee to enable them to face difficult ethical dilemma. Besides that, we need strong monitoring tools for the code to establish the atmosphere in the organization.
Board Oversight of Management
This report also suggests that 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 oversight role of board of director. Beside, the performance of the board and its individual members should be assessed regularly.
The Power and functioning of the audit committee
It is said that audit committees have had poorly defined their responsibilities with agendas controlled by management and have devoted inadequate time and effort to their role. This report recommends that all public-listed entities to define clearly the responsibilities of audit committee or similar governance body that is agreed by the board and communicated to shareholders. The responsibilities should include:
Monitoring the integrity of the financial reporting of a company
Review a company’s internal financial control and risks management systems
Monitoring and reviewing a company’s internal audit function
Recommending the appointment, remuneration and terms of engagement of external auditors and reviewing their independence , objectivity and effectiveness
Beside, audit committees are advised to meet more regularly, allocate sufficient time to perform their roles effectively and have the power to access appropriate resource to help on their decision-making.
The effectiveness of the audit committee
In order to be effective, auditor needs to have open and constructive relationship with management teams and the external auditors. In addition, auditor committee also has to be objective and independent from those they oversee. This report also recommends 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 shareholdering. Besides that,
Private or executive sessions
Most private or “executive” session should be held with the audit committee, head of internal auditor and CFO respectively without the present of management team so that any matter concerning management or constrained by their present can be discuss freely.
The audit function
Reduce Threats to Auditor Independence
Traditionally, the relationship between the company and its auditor is with management. In fact, the auditor’s primary relationship with the company should be with the board through its audit committee but not management. The change of this relationship will maintain the independence of auditors.
There are three elements in determine the provision of non-audit service which are
A framework to determine what is or is not acceptable
An approval process
This report recommends that the IFAC Code of Ethics be the basic for national codes relating to independence because it included the three elements above in the code. In addition, a policy for approval of non-audit service provision should be established. The total fee should be broken down into categories and the assessment of audit committee toward the impact of these fees on auditor independence should be disclosed as part of the committee’s reporting to shareholders.
Familiarity is recognized as one of the threat to auditor independence by IFAC Ethnic 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 mitigate the threat, it is recommended to have a two years “cooling-off” period for key individuals on the audit joining the client company as a director or a key management position. Appointment of such 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, auditors’ firm needs to review their consultation process to ensure that they are robust enough to deal with client pressure that faced by partners and provide support needed by them. It is also important for firm to review their profit distribution and counseling 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 basis of sales of non-audit services to client as this will increase the incentive to misstate financial information.
Strengthen Audit Quality Control Processes
This report recommends that high attention is given to the “tone at the top” within the audit firm as well as within the companies in order to raise audit effectiveness. Firms have to reinforce the importance of audit practice within the total firm and ensure that there is a high quality of entrant into the auditing profession. The adequacy of post-qualification training given by both professional bodies and individual firm will also increase the competency of auditors.
Moreover, audit firm have to be more rigor 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 strengthen by focusing on identified risk, disputes with management and clarifying the procedure of handling disagreement. Beside, audit firm needs to review their post-audit review processes to identify whether any improvement is needed.
It is said that increased transparency on the part of audit firm could significantly raise the credibility of the firms and then contribute to the increased credibility of the financial information reported by them. Thus, this report recommends firms to disclose details of their quality control system and the procedure to ensure the effectiveness of the system such as the internal inspection program. The report also suggests firms to disclose the relationship between the network member and any related entity.
To restore the credibility of financial statement among the users, transparency, code of conduct, and active involvement are needed to be implemented by stakeholders. For examples, for financial analyst and legal advisors, code of conduct should be publicized and monitor within firm and externally. Legal advisors 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 financial status and in making decision. Besides, the report recommends the investors to involve actively in the corporate governance of corporations such as voting.
Regulation and standard setting
This report suggests that the audit standards should be improved and 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 used widely in all countries. Here are some recommendations for some audit and accounting bodies:
Roles of Audit and Accounting Bodies
IAASB is performing its role as an independent international audit standard setter within IFAC. The recommendation for it is an active role should be played in establishing program between international standards and national standards to achieve convergence as soon as possible. Besides that, IAASB is recommended to complete the upgrade of ISAs promptly. On the other hand, it is advised to revise standard on fraud to reduce the expectation gap between auditors and other users of financial statement. Regarding the internal controls issues, the report proposes that IAASB should work out the new measurement of risk and audit procedures with other standard setters. The resources such as funding and human resources 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 organization for accountancy profession to protect the public interest. The report urged IFAC to finish the discussions with stakeholders for financial statement as soon as possible to gain acceptance of ISA in issues of membership, financing and public interest from all countries. In addition, the report proposes that IFAC to provide more detail and consistent guidance on external quality assurance review of auditors. Other recommendations are the issuance of framework of the responsibility of the professional bodies and improve the level of members’ compliance to the constitution of IFAC through discussion and self assessment.
The report holds belief that enhancing corporate governance, regulation of auditors and related parties can strengthen the environment for financial reporting and disclosure. Thus there is 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.
On the other hand, the international conflicts should be solving to build confidence to public. During the convergence of the accounting standards, IASB and other regulation setters should help the users of financial statement to understand the differences between national and international standards by making the standards more understandable. The report also suggests that the company should add some information such as review of the company or effect of a new accounting policy. The regulation also needed to emphasis on the timely basis for the financial reporting. IASB and IAASB should identify standards that can be avoided to adopt in developing countries. IFAC is recommended to help the member bodies in developing country in implementing the convergence standard.
The report also highlights the importance of self regulating and standard for public interest activities besides the importance of corporate governance. The 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 had 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 shows that all the parties related, regardless of international level or national level is trying to working on the issue on the credibility of financial. The best example is the introduction of Sarbanes-Oxley Act in 2002 in US, whereby this act enforces stronger rules in corporate governance, management of listed companies, and the auditors. Most recommendation and actions are surrounded on the independence of auditors, the role and rules imposed on corporate governance, the non audit activities issues and rarely talk about the role of other stakeholders such as lawyer. The report concludes that enhancing the credibility of financial reporting and disclosure is international and national issues whereby action along the information chain that provides financial information to the market and commitment from both individual and institutional is crucial to contribute to the resolution.
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