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Cases like Enron, WorldCom, Global Crossing have cumulatively and negatively impact the credibility in financial reporting.
Loss of confidence in public towards financial reporting and corporate disclosure resulted in less investment from the investors and the incremental in cost of capital. The economy's productivity has reduced.
To improve the credibility in financial reporting, the companies are encouraged to reinforce governance and reporting practices. However, the action cannot abolish the business's failure, it will only reduce the likelihood of fraud.
Many reports said that the reason of the arising of fraud is the failure of corporate governance mechanisms. Other than that, the effectiveness of audit process is an issue.
Authorities in whole globe need to take corrective actions by reviewing and setting up special commission discussion. The loss of credibility in financial reporting seems less happenings in developing countries, however, there was a rise of limited visibility and loss of credibility in financial reporting.
The Participants and Their Roles in Financial Reporting
Top management is responsible to provide financial reporting that reflect the economic position and adhere to the accounting and reporting standards.
Board of Directors
Board of directors is responsible to ensure the management does their job well and ensure the financial statements can represent the company's activities and follow the accounting and reporting standards.
Shareholders and public will rely on the opinions of independent auditors because it can add value to the financial reports. Auditors need to give independent opinions towards the financial statements by following suitable audit standards and issue audit report with the supporting audit evidence.
The Standard Setters
Accounting Professional Bodies are responsible for standard setting. Some countries' government and independent bodies will help to set the standards. They are responsible to establish effective standards which make the user understand the reporting, make comparison and restrict the possibility of fraud.
Sometimes, regulatory role is combined with standard setter. The regulators need to assess company's compliance with standards and deal with counter of the standards. An effective regulatory framework will help to increase the trustworthy among the investors.
They are the intermediate between companies and banks or bond market lenders. They provide the banks or creditors the information based on their evaluation towards the business performance and financial reports of a company. Good quality and timely evaluations help for decision making.
Financial analysts should provide unbiased evaluation of company position to the investors and potential investors so that it can increase the reliability of financial reporting.
The investment banks provide advice to the public and information to support company's major decisions. Segregation of duties can eliminate the probability of interest conflict and banks can be a useful guidance to users.
Internal and External Lawyers
Internal and external lawyers are responsible to ensure the financial statements are reliable based on legal perspective. Meanwhile, they also need to protect the interest of the company.
The media need to further analyze the financial information before they report it to the public. Unbiased comments are useful to help investors and shareholders in decision making.
Investors and Potential Investors
They are the group of people will look at a company's financial reporting information and make decision whether to invest in that particular company.
Factors That Affect Credibility in Financial Reporting
The incentives such as direct remuneration and share options given to management based on the company's performance and share price may lead to higher audit risk. It rises up the credibility issue in the financial reports produced by the management.
Less attention on internal control given by senior management in a company may also lead to higher audit risk. This is because the senior management may focus more on strategic issues rather than on the operations and controls in preparation of financial reports.
Other than that, some boards of directors have oversight companies' management. The governance structure in some companies fails to give adequate attention to financial reporting matters.
Auditor's independence also gives rise to the need of safeguarded in financial reporting. Auditors' quality control instruments may be ineffective. The quality control system may fail to detect the weaknesses in controls or procedures.
Auditors claim that they can only provide reasonable assurance on the audit work. They cannot be expected to detect fraud, even though is material fraud. This is reflected in the auditing standards; however it does not fulfill the market's expectations.
The significant variations of accounting standards among countries have lead to difficulty in comparing financial statements between countries. The standard setters have political pressures and lack of resources and time in responding to market needs. Thus, the financial reporting may lack of credibility. The weaknesses in financial reporting give rise to the GAAP Convergence 2002. However, there were some difficulties in the process of adopting the convergence. The convergence of IFRS will only take place in 2012 by all the countries.
Regulations set by professional bodies may be ineffective. Public doubted the regulators' skills and resources and the political pressures they might face. The weaknesses of regulation rise up the question of credibility in financial reporting.
Behavior of investment banks and lawyers is also a factor that contributes to the losing of public confidence in financial reporting. Investment banks tend to mislead the financial statements and conceal the real transactions. Lawyers interpret the financial statements without consider whether the financial statements are fairly presented. Ethical cultural are not fully adhering to.
The Credibility Issue of Financial Reporting in International Dimension
National and international developments interaction in financial reporting is critical. It rises up the credibility issue in financial reporting. Many big companies are now trading across the nations. Each independent firm of the companies follows the national law and professional regulation of the host country in which it operates. Even though the independent firm applies national standards and there are different set of information in the market, they claim that the financial statement is fairly presented. The interaction also rises up the need to establish a 'neutral' set of standards which can be accepted by every country.
This report concluded that IFRSs and ISAs should be used as the standard in accounting and auditing areas. Regulators should encourage the use of international standards in nation while the standard of auditor independence should refer to IFAC Code of Ethics.
Recommendations for Improving the Credibility of Financial Reporting
i) Corporate Management and Governance
Several recommendations proposed in this report. The report proposes that there is a need to improve the performance levels in developing countries and financial reporting's credibility in all countries.
The report commends that IAASB and IASB need to show clearly what standard that may not need to apply to developing countries. Besides, it will be very helpful if IFAC is able to assist developing countries in enhancing their financial reporting. This report also suggests the standards of accounting that are probable for worldwide application.
The governance and corporate management need to emphasis on financial management and control. The annual reporting should also be ample and the management reporting should be regularly reported for the purposes of internal control.
Members of board committees are responsible in determining and reviewing employees' conditions, terms and remuneration package. Internal and external information and professional advice should be provided to help them in decision making.
This report also recommends that companies should abstain from profit forecasting that can lead to create incentives to mistake earning. Board must make sure the every single member in the company is complying with the code of ethics. The ethnical policies should be set up and widely share out.
This report mentions that the chief executive officer's core competence should be financial controls and reporting. The CEO's evaluation and appointment is very important. The chief executive management should be assessed before their appointments are made. The board needs to regularly evaluate the performance of company especially the performance by CEO.
ii) The Audit Function
This report found that the client retention in audit process is ambiguous. Audit firm's client should have greater skepticism in the client acceptance and retention policies to improve the effectiveness of quality control processes.
The transparency of financial report should be enhanced to increase the report's credibility. Firms are required to disclose the details of the processes and publish the financial reports.
Audit committee plays an important role to ensure internal controls are in good condition by regularly assessing the internal audit function. For company that does not have internal audit function, the audit committee should directly deal with issues by reporting to the outsourced for example shareholders. Audit committee should supervise the integrity of the company's financial report.
A company needs to review its profit distribution and counseling process since they have direct effects on audit quality. Besides, the company needs to strengthen the importance of audit practice.
Firm should control its quality effectively in order to perform diligence and timely basis. This control can be enhanced by focusing on the procedures which identify risks, awareness of the disputes with management and ensure accounting is aligned with best practice.
Audit communities should be assessed before their appointments are made. In fact, the auditor should be appointed through the formal selection by shareholder but in reality, most of them are appointed by the management.
Besides, auditors will involve in judgments making. Auditors are expected to get information and advice from the firm's expertise. However, some audit failures show that the expertise's advice is not being used. This report recommends that written report is needed to record the result of consultation on expertise's judgment and advice. Any disagreement of the result should be documented and disclosed to the audit committees.
iii) Other Private Sector Participants
Conflicts are detected in credit-rating agencies and financial analysts. A code of conduct is necessary for the financial analysts. The code should be known by public and monitored within the firm and external users. Besides, sale-based incentive must be terminated otherwise misinformation will incur. Credit-rating agencies must disclose the valuation processes that they used in order to increase the transparency.
Conflicts took place to legal advisers and investment banks as the conflicts happened between their role as adviser to the management and their duty to the company. A code of conduct should be developed to the lawyers who provide relevant financial reporting information to the clients. The relevant information must be made publicly which can be monitored by firm and external users. Fees given to the lawyers must be disclosed to the audit committee and board. Besides that, it is vital for lawyers to provide independent view and best practice.
This report recommends the investors to participate actively in the companies which they invested. It recommends that the voting details and criteria should be published to the public.
iv) Regulation and Standard Setting
There are several ways to improve audit standards. This report recommends that International Standards on Auditing (ISAs) becomes the worldwide standards as well as national standards to increase the credibility of financial reporting.
International Auditing and Assurance Standard Board (IAASB) is required to establish a program to achieve the convergence by combining national standards and international standards. Furthermore, IAASB should concern the standard on fraud as the expectation gap existed between auditor and the financial reports users. This report also recommends that IAASB issues standards of risk assessment and audit procedures in order to eliminate personal and corporate bias.
International Federation of Automatic Control (IFAC) is required to discuss with the external stakeholders to confirm the legitimate of ISAs and IFAC in worldwide. Besides, IFAC have to evaluate the additional resources on timely basis.
To improve audit regulations, numerous of steps need to take place. In some extent, self-regulatory bodies play a vital role as their response on market condition is promptly compared to government. This report recommends that the professional body must review the public-interest self-regulatory activities to ensure that they comply with practice standard.
A part from that, a monitoring activity should be developed to the member bodies of IFAC as the initial assessment indicates that the compliance of IFAC regulations among the member bodies is insufficient. IFAC should allocate sufficient resources for further assessment.
Other than that, worldwide is looking forward to a convergence process where it requires the national standards corresponding with IASB.
The financial reporting should be prepared in understandable, short and simpler way for reference use. Additional interpretive information on operating, financial and accounting policies matters should be provided to the shareholders.
There are many dimensions that to be emphasized to improve the credibility of financial reporting in order to rebuild public confidence. Effective corporate codes need to be developed and monitored. Next, corporate management should focus more on financial management and controls. The issue of auditor's independence should be given greater attention. Code of conduct for participants in financial reporting need to be put in place and their compliance should be monitored.