Financial Reporting
- Introduction
Since 2006, a steady stream of financial scandals has shocked the business world, and as a result, financial information regulation, 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 as Enron Creditors Recovery Corporation) was Houston based American Energy giant that before its bankruptcy in 2001, employed over 22,000 employees and was considered a leading plays 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 the 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 ‘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 and raised questions about the 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 advice 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. Next sections describes the regulatory bodies in Ireland and a brief history of regulation concerned with financial reporting. Third section notes the impacts of financial regulations in key stakeholders, fourth section discusses the global harmonisation in financial regulation, fifth section considers the implications on financial reporting if board decides 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 Irish Financial Services Regulatory Authority (FSRA) is single regulator in Republic of Ireland which controls all financial institutes including those who were previously regulated by Irish Central Bank, Office of the Director of Consumer Affairs (ODCA), Department of Enterprise, Trade and Employment (DETE), and Registrar of Friendly Societies. It is part of Central Bank and Financial Services Authority of Ireland. Historically the Central Bank and 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 financial service industry and those who wanted a full independent regulator (IFSRA, 2008).
Another important body which assists FSRA is Accounting Standard Board (ASB). The key purpose of this institute is to issue accounting standards. It is now an autonomous body which operates under the Companies Act 1985. ASB has collaboration with Financial Reporting Council (FRC), International Accounting Standard Board (IASB) and 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 Accounting Standards Committee (ASC). All accounting standards which are developed by ASB are contained in Financial Reporting Standards (FRSs). When ASB took over 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 that prepare accounts which aim to provide a true 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 the 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 plays a key role to measure the relationship of member firms which Irish Stock Exchange and are set by Exchange. While deciding about public offering, considering these rules is utmost important for board. Trading in Irish market has several taxation implications. This include the application of capital gains tax, dividend withholding tax and stamp duty. Within Financial Regulator, the Markets Supervision Department is responsible for carrying out the competent authority obligations provided for any financial Regulations.
Following are the three major types of financial regulations that affect the financial reporting in a company:
Prospectus Regulations: The 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 efficent 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 market abuse directive is to guarantee the integrity of financial community and markets and enhance the investor confidence in the markets.
Transparency Regulation: Similarly the Transparency Regulation Directive of European Parliament was implemented in 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. Regulation impact assessment is periodically done to help consumers make informed decisions and provide them support so that they can better manage their financial affairs. It keeps an eye on financial institutes, fosters them so that they can provide sound products to their consumers, which they can trust and keep a 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 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 for example effects the investor confidence. In countries where judicial systems are strong and contracts are rigorously enforced, investor’s 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 the financial crime. The regulators therefore face a delicate situation where they have to balance the consumer protection with also keeping the interests of the businesses which may at times be conflicting. It does so by placing certain obligations on both businesses and the consumers and try to keep a fine balance between the 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 have brought stability in financial institutes. Globalisation has thus promoted the convergence of financial regulatory and has helped emergence of international institute structure.
Many international financial institutes and non government organizations have played 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 International Monitory Fund, World Bank, OECD.
Eventhough the implementation of the 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 signaling 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 the international standards.
In such an attempt to observe the 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 the public offering
For any company going public is a major milestone and a major transition. When a company goes public it gives others a chance to invest in it and to share in its market potential. Doing this thus require several changes in the way company is managed. It requires different and more frequent reports for both investors and regulatory agencies. Company is also required to do 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, media and 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 the financial reporting. Many standards have been issues in recent years in this regard and there are receiving increased focus by the standard setting bodies. However, following issues are particularly problematic:
Revenue Recognition: It has been problematic to accurately report the 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. This is however essential for organisations to report the 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 includes 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 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 the cases of fraud in the 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 applies even after the initial set of requirements have 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. Also 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 case 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 into many corporate scandals in large multinationals. Therefore in order to avoid such situation 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 the compliance to the regulations becomes increasingly important for the company.
Communications with Shareholders: Company’s management can communicate with shareholders via various mechanisms for example giving notices in the national press and the circulars sent directly to the shareholders. In a variety of circumstances, the communications is 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 equally treat all shareholders and disclose identical information to all shareholders at the same time. Circular may therefore be an effective way of doing this.
Thus through effective monitoring and control of financial data and reports and providing transparent access to information to the shareholders and general public, a public limited company can effectively reduce the chances of financial crises and instances of fraud that plagued various firms over the last decade or so.
Contribution Essay:
Reflection is a process of considering what one has learnt, how useful it is and how it may affect ones future personal and career development. It helps in relating what was already known and what has been newly learnt to the plans for the future. This study was aimed to get the grips on financial reporting especially in the context of a public limited company (as the decision regarding public offering was to be considered by the board of directors in the scenario provided). A report was required that discusses various issues related to the topic using the literature. Due to time and word limitations, only secondary sources could be used and the report draws heavily from the literature. Literature Review provides an overview of the key concepts, theories and work of various authors on the topic in question. Due to its nature, literature review provides secondary data, i.e. the data that is already analysed and summarised by other authors. This was thus collected using a host of sources including library (used to access books, printed journals, newspaper etc.) and electronic resources that include corporate websites and e-journals accessed through online databases such as ABI Inform and web of science using Athens login facility. A systematic reading of relevant literature accessed using key words and phrases related to the topic was done and notes were made along with references to maximise recall. The important information was re-phrased and included in the literature review section in a coherent and structured order. Two important techniques were used in this regard. One, the use of spider’s web to understand and paraphrase articles read. A spider’s web is drawn on paper while reading a piece of literature that starts from a central concept and then links further concepts to the central one, branching and sub-dividing these into further sets of theories and linking them all together, thus forming a spider’s web. Secondly, the references of the key articles on the topic were used to get more in depth information on certain key concepts, thus moving ‘forward’ and ‘backwards’ on the reference lists provided in key books and journal articles. Careful consideration was made of the fact that only reliable and academic sources of information are used, thus enhancing the validity and reliability of the research along with providing multiple sources of evidence. The findings were then triangulated by the primary research.
The study provided me an enormous opportunity to learn a variety of concepts not only related to the topic concerned but also with regards to the research methodologies, data collection methods and analysing and discussing the results in the form of a report. This project will therefore help my future assignments by making them more logical, better structured, coherent and based on multiple evidences from the literature. Especially, the knowledge gained from this study will inform the design and implementation of my dissertation plan and enable me to achieve better results.