Financial Reporting
Introduction
Since 2006, a steady stream of financial scandals has shocked the business world, and as a result, financial information regulation, and more importantly detection and prosecution of fraud and gross misconduct by the directors of large organisations, is now the focus in the legal and media world. Two of the most famous examples of such wrongdoings are that of Enron and Parmalat. Both of these are briefly described as follows:
Enron: Enron Corporation (now renamed Enron Creditors Recovery Corporation) was a Houston-based American Energy giant which, before its bankruptcy in 2001, had over 22,000 employees and was considered a leading player in global electricity, natural gas, pulp and paper and communications industries with approximate revenue of $100 billion in 2000. For six consecutive years before its demise, Enron was named America’s Most Innovative Company by Fortune magazine. In 2001, it emerged that the company had, through an institutionalised, systematic and creatively planned accounting fraud, sustained its strong financial condition. This fraudulent financial reporting is sometimes called the ‘Enron scandal’. It has since become one of the most popular symbols of corporate fraud and corruption and is considered a landmark case in the field of business fraud because it raised fundamental questions about accounting practices in many corporations throughout the world (Fusaro and Miller, 2002).
Parmalat: Parmalat SpA is an Italy based multinational dairy and food corporation that became a market leader in the Ultra High Temperature (UHT) milk production. In 2003 however, the company collapsed when a fraud of $20bn was exposed in its financial reporting. Many new divisions of the company started producing losses and the company stated making use of derivatives, apparently to hide the extent of its losses and debt. This remains Europe’s biggest bankruptcy (Gumbel, 2008).
This report attempts to advise the top management of the company on the actions required to avoid the situations Enron and Parmalat found themselves in. The report is divided into 5 sections. The next section describes the regulatory bodies in Ireland and a brief history of regulation concerned with financial reporting; the third section notes the impacts of financial regulations in key stakeholders; the fourth section discusses global harmonisation in financial regulation; the fifth section considers the implications for financial reporting if a board decides on a public offering of the company; and the last section concludes the report by proposing some practical recommendations.
- Historical Regulatory Developments
The Financial Regulator of Ireland officially known as the Irish Financial Services Regulatory Authority is the single regulator in the Republic of Ireland. It controls all financial institutions including those which were previously regulated by the Irish Central Bank, the Office of the Director of Consumer Affairs (ODCA), the Department of Enterprise, Trade and Employment (DETE), and the Registrar of Friendly Societies. It is part of the Central Bank and the Financial Services Authority of Ireland. Historically the Central Bank and the Financial Services Authority of Ireland were one body. However, on 1st May 2003 a separate division of the Central Bank was established. The key purpose was to keep a balance and a compromise for those who believed that the Central bank should have full control of regulation of the financial service industry and those who wanted a fully independent regulator (IFSRA, 2008).
Another important body which assists the FSRA is the Accounting Standard Board (ASB). The key purpose of this institution is to issue accounting standards. It is now an autonomous body which operates under the Companies Act 1985. ASB collaborates with the Financial Reporting Council (FRC), the International Accounting Standard Board (IASB) and the accounting standard boards of all other EU countries. This collaboration ensures that their accounting standards stay aligned with international development (FRC, 2008).
ASB started its operations in 1990 when it took over the tasks of setting accounting standards from the Accounting Standards Committee (ASC). All accounting standards developed by the ASB are contained in the Financial Reporting Standards (FRSs). When the ASB took over the ASC, it discarded some standards of ASC accounting standards and adopted most them. These adopted standards fall within the legal definition of accounting standards and are elected ‘Statements of Standard Accounting Practices’ (SSAPs). Accounting standards are applicable to all the companies and entities tasked with preparing accounts and which aim to provide a true, disinterested view (FRC, 2008).
On 1st July 2005 the Prospectus Regulations came into operation. On 6th July 2005 and 13th June 2007 respectively the Market Abuse Regulations and the Transparency Regulations came into force. The Irish Stock Exchange was delegated certain responsibilities to investigate the instances of market abuse including that of insider trading. Also, under Part V of the Companies Act, 1990, the stock exchange is responsible for reporting any suspected market abuse to the Financial Regulator with respect to any securities admitted to trading on its markets.
On 01 November 2007 the Markets in Financial Instruments Directive (‘MiFID’) was implemented which is relevant legislation governing the Exchange and its markets. The Rules of this plays a key role in measuring the relationship of member firms on the Irish Stock Exchange and are set by the Exchange. While deciding about a public offering, considering these rules is of utmost importance for the board. Trading in the Irish market has several taxation implications. These include the application of capital gains tax, dividend withholding tax and stamp duty. Within the Financial Regulator, the Markets Supervision Department is responsible for carrying out competent authority obligations provided by any financial Regulations.
The following are the three major types of financial regulations that affect the financial reporting in a company:
Prospectus Regulations: Directive 2003/71/EC of the European Parliament is transposed by prospect regulation. On 4th November 2003 the prospectus was published when securities were offered to the public or admitted to trading and amending Directive 2001/34/EC. The key purpose of this directive is to make sure that the investors are protected in the market place and market is efficient and is running in accordance with high regulatory standards.
Market Abuse Regulations: The Irish Council implemented the European Parliament directives on insider dealing and market abuse. The objective of the market abuse directive is to guarantee the integrity of the financial community and markets and enhance investor confidence in the markets.
Transparency Regulation: Similarly, the Transparency Regulation Directive of the European Parliament was implemented on 8 March 2007. This is aimed at enhancing the availability of information about issues whose securities are admitted to trading on a regulated market situated or operating within a member state.
- Impact & Relevance to Stakeholders
The key stakeholders which are affected by financial regulations include consumers, investors, various financial institutes and service providers, and government etc. The regulation impact assessment is periodically done to help consumers make informed decisions and provide them with support so that they can better manage their financial affairs. It ‘keeps an eye’ on financial institutions, fosters them so that they can provide sound products to their consumers which they can trust and thereby have confidence that their investments, deposits and insurance policies etc are safe FS (2007). It also helps policy makers make a systematic, well-informed and transparent decision when considering how to address a perceived regulatory problem. The financial regulations in the country including securities laws, legal/judicial system, and the political economy create incentives that influence the behaviour of corporate executives, investors, regulators and other market participants (Bushman and Piotroski, 2006). The financial reporting regulations and its practice affects the investor confidence, for example. In countries where judicial systems are strong and contracts are rigorously enforced, investors’ confidence in the market is high. Ireland also enjoys reasonably high confidence of investors in the market and the laws and regulations governing it. The regulations also affect the management as it is their responsibility to establish and monitor processes responsible to make sure that the company conforms to the regulations (Pineiro Chousa et al., 2003). Along with maintaining market confidence, regulation is also aimed at increasing public awareness and understanding of the financial system. The most important reason for regulation, however, is consumer protection. Financial regulation aims to ensure the appropriate degree of protection for consumers and strives to reduce financial crime. The regulators therefore face a delicate situation where they have to balance consumer protection with the interests of the businesses, which may at times be in conflict. It does so by placing certain obligations on both businesses and the consumers and tries to keep a fine balance between them both in the process (Lunt and Livingstone, 2007).
- Impact & Effectiveness of Global Harmonisation
Some of the key concerns created by the internationalisation of banks and globalisation of finance are the international harmonisation of financial regulations and standards to improve the operational environment of banks. Generally, it is believed that such harmonisation has brought additional discipline to local regulatory structure, removed regulatory arbitrage and thus has promoted supervisory effectiveness which has brought stability in financial institutes. Globalisation has thus promoted the convergence of financial regulatory and has helped the emergence of international institute structure.
Many international financial institutes and non government organizations have played an important role in the international efforts of regulatory harmonization in the financial sector and towards supervisory cooperation. Some of the key NGOs include the Basel Committee of Banking Supervision (BCBS) and institutions like the International Monitory Fund, the World Bank, and OECD.
Even though the implementation of international financial standards are in many instances voluntary and optional since it relies on a soft law approach, several national governments perceive compliance with international standards as signalling reputational device. Moreover, given that the assessments of compliance with major codes and standards performed by the IMF and World Bank is part of the Financial Sector Assessment Programme (FSAP), there is a general worldwide interest in aligning national supervisory and regulatory frameworks with international standards.
In such an attempt to observe international standards and codes, the Regulatory Authority of Ireland has created many several new domestic laws, rules, regulations and institutions which have merely transplanted foreign legal concepts into the national legal systems GD (2008).
- Implications on financial reporting of a Board decision to proceed with a public offering
For any company going public this is a major milestone and a major transition. When a company goes public it gives others the chance to invest in it and to share in its market potential. Doing this thus requires several changes in the way a company is managed. It requires different and more frequent reports for both investors and regulatory agencies. The company is also required to provide announcements and press releases which can generate visibility and attention. And, above all, it has to meet the high expectations of shareholders, regulatory agencies, investment banks, stock exchanges, management, employees, the media and the board of directors.
Some of the accounting standards followed by the company going public include: FRS 29 (IFRS 7) Financial Instruments: Disclosures, FRS 28-Corresponding Amounts, FRS 25 (IAS 32) – Financial Instruments: Disclosure and Presentation, , FRS 16 – Current Tax, FRS 15 – Tangible Fixed Assets, FRS 3 – Reporting Financial Performance, FRS 22 (IAS 33) – Earnings per share, FRS 1 – Cash Flow Statements and FRS 20 (IFRS2) – Share-based Payment FRS 9 – Associates and Joint Ventures,
FRS 8 – Related Party Disclosures, SSAP 9 – Stocks and long-term contracts., SSAP 5 – Accounting for value added tax and SSAP 17 – Accounting for post balance sheet events (FSRC, 2008).
In this section, the report focuses particularly on the Accounting and Disclosure Issues and obligations for a public company as these are most relevant to financial reporting. Many standards have been issued in recent years in this regard and they are receiving increased attention by the standard setting bodies. However, the following issues are particularly problematic:
Revenue Recognition: It has been problematic to accurately report revenue, partially due to the complex revenue gathering arrangements that exist in the market and also due to multiple deliverables, bill and hold transactions, recognition of up-front fees, software recognition and service contracts. It is, however, essential for organisations to report revenue as accurately as possible as this has been one source of fraudulent financial reporting.
Segment Reporting: It is important to clearly identify and adequately disclose the company’s business segments and reporting of their individual financial figures as there have been instances of inconsistent aggregation of multiple segments. As a public limited company, this is something company would need to avoid.
Consolidation Issues: Consolidation now needs to conform to new guidelines from standard setters that include changes in the criteria to consider when determining whether to consolidate an entity. Accounting for special purpose entities such as risks and rewards of ownership must be addressed before considering voting interests.
Compensation Issues: The company must review its option pricing history when preparing for IPO before initial filing because granting stock options shortly before an IPO may create a compensation charge issue due to regulation in cheap stock. The regulators closely scrutinise circumstances in which options prices are significantly less that the IPO price may challenge that the exercise price was below market value at the time of grant. One way of avoiding this issue is to obtain independent valuations from experienced professionals at the time of issuing the stock options.
Stock Options and other forms of stock-based compensation: There has been continuing demand by the investors and regulators to improve the accounting for share-based payment arrangements with employees. According to the guidelines issued by the regulator, PLCs are required to expense the fair value of all forms of stock based compensation including employee stock options. The senior management should consider the implications of these obligations for financial accounting, income tax and internal control procedures and make sure that the company’s stock based compensation plans reflect a reasonable cost-benefit relationship.
- Conclusion and Recommendations
There is a need for the law to protect shareholders against possible malpractice by their company’s directors. At the same time, it is also important for top management in a company to avoid cases of fraud in financial reporting as witnessed in many companies over the last decade or so.
Two major steps are therefore recommended to avoid such mistakes by the company. These are outlined as follows:
- Timely disclosure of all relevant information; and
- Equal treatment of all shareholders.
These must be seen as continuing obligations by the company and continually apply even after the initial set of requirements has been complied with in the process of listing/public offering. This can be achieved by institutionalizing the following within the company.
Disclosure of Information: The top management is obliged to ensure the flow of information from the company to the shareholders and general public through the market. This includes all pieces of information that may affect the company’s share price. Moreover, any incident that has the potential to influence the share price of the company needs to be made public immediately, for example news of a proposed takeover bid, which almost certainly affects the price and value of listed shares instantaneously.
Transactions: The financial regulations applicable on public companies are designed to ensure that the shareholders are kept informed of all major transactions. The owners therefore are allowed and encouraged to exercise some degree of control despite delegation of power to professionals for the day to day running of the business. Thus, all major transactions that may affect the company’s standing must be disclosed for scrutiny by the shareholders and in some cases may be subjected to shareholder democracy. The rationale for this is to give shareholders an opportunity to accept or reject major transactions that may affect their company strategically.
Financial Information: Fraudulent use of financial information has resulted in many corporate scandals in large multinationals. Therefore, in order to avoid such situations, the production and dissemination of credible financial information by the company to its members is of utmost importance. The company’s financial strength determines its relative health or otherwise and is indicated by various financial indicators. However, the complex nature of accounting information makes it possible for professionals in the company to manipulate the standing and outlook of the company to a certain degree by using the figures in a propagandist way. In this regard, the role of auditors and compliance with the regulations becomes increasingly important for the company.
Communications with Shareholders: The company’s management can communicate with shareholders via various mechanisms: for example, giving notices in the national press and circulars sent directly to the shareholders. In a variety of circumstances, communications are essential e.g. an explanatory circular may be required to notify the shareholders about a meeting to deal with issues other than ordinary business at the company’s annual general meeting. It is obligatory for the company to treat all shareholders equally and disclose identical information to all of them simultaneously. A circular may therefore be an effective way of doing this.
In this way, and through effective monitoring and control of financial data and reports and providing transparent access to information to the shareholders and the general public, a public limited company can effectively reduce the chances of financial crises and instances of fraud that have plagued various firms over the last decade or so.
References
Bushman, R. and Piotroski, J. (2006) Financial reporting incentives for conservative accounting: The influence of legal and political institutions, Journal of Accounting and Economics, Volume 42, Issues 1-2, October 2006, Pages 107-148
FS(2007) Financial Regulator, Financial Regulatory Body, Ireland, Report available: http://www.financialregulator.ie/data/pub_files/Prelim%20Financial%20Capability%2016%20June.pdf (Accessed: 20/12/2008)
Fusaro, P. and Miller, R. (2002) What Went Wrong at Enron: Everyone’s Guide to the Largest Bankruptcy in U.S. History (Wiley)
GD(2008)http://www.gdnet.org/pdf2/gdn_library/awards_medals/2005/medals_cat5_second.pdf
Gumbel, P. (2008) How It All Went Sour, Time Magazine, http://www.time.com/time/magazine/article/0,9171,901041129-785318,00.html (Accessed: 22/12/2008)
IFSRA (2008) Irish Financial Services Regulatory Authority (Financial Regulator), http://www.ifsra.ie/ (Accessed: 23/12/2008)
ISE (2008) Irish Stock Exchange, http://www.ise.ie/ (Accessed: 23/12/2008)
Lunt, Peter and Livingstone, Sonia (2007) Regulating markets in the interest of consumers?: on the changing regime of governance in the financial service and communications sectors. In: Governance, consumers and citizens: agency and resistance in contemporary politics. Palgrave Macmillan, Basingstoke, UK, pp. 139-161.
Piñeiro Chousa, J., Tamazian, A., and Melikyan, D. (2003) Financial Markets Regulation – A Need to Protect Minority Shareholders. Capital Market in Armenia, No. 19, 20, Vol. 125,126, pp. 49-62, 2003.