In the market, thereare many types of investment opportunity such as real estates, commodities,bonds, mutual funds, equities and many others. One of the most popularinvestments are equities and bonds of companies, and within this category thereare numerous options. Investors normally carry out researches to find companiesthat suit their needs and preferences, in terms of future income flows, capitalappreciation, risk etc.
The most important documents that can provide relevantinformation to assist investors in their decision-making is the financialstatements published by companies. From these statements, investors can extractinformation concerning the company’s current and past earnings, and could to acertain extent gauge its future performance. At the same time, information onthe board members such as their experiences and qualifications can helpinvestors to form opinions on the quality of the board. In this essay, I amgoing to discuss how information published in the financial statements areregulated by the current accounting standards to ensure that they truly reflectthe performance of the company, as well as the roles of the board in relationto corporate governance. Before these, I shall look briefly into the relevantaccounting standards conceived under the IASB Conceptual Framework. According to the International AccountingStandards Board (IASB), the primary objective of financial statements is toprovide information about the financial position, performance and capability ofan enterprise. To achieve this objective, the financial statements must provideinformation regarding an entity’s analysis of balance sheet assets andliabilities, income and expenses, cash flows, equity, profitability etc. (Pepi2016).
This information assist users of financial statements in predicting the entity’sfuture cash flows, their timing and certainty (Deloitte 2017). The IASBConceptual Framework provides the foundations for the development of standardsthat are principle-based, consistent, and internationally convergent forfinancial statements to provide information needed for investment and othersimilar decisions (Mala & Chand 2015). The relevant standard assistsauditors in preparing financial statements in conformity with the frameworkprinciples and eases the concerns of stakeholders when interpreting them (Elliot& Elliot 2011). Consistent with the IASB standards, the content shouldcarry the fundamental characteristics of relevant, faithful representation,verifiable, comparable, understandable etc. to be useful to its users (E2010).
Financial statements play a critical role inproviding information relating to its past years’ performances and anindication to users of what to expect in the future. Users such as investors,shareholders, stakeholders and creditors rely on this information for theirdecision-makings. Thus, poor financial reporting that lacks honesty can lead toconfusions and significant financial losses to users. For instance, to increasepersonal gains, upper management in a company might carry out financialstatements manipulation.
One of the most well-known cases of dishonestsituation is the Enron case in 2001. The company hid billions of dollars fromfailed projects by deliberating using accounting manipulation techniques. Theconsequences were that not only users were misled by the financial reportinginformation and suffered losses, Enron eventually went bankrupt and itsauditors were charged of fraud offences (The Economist 2002). Thereal-life situation mentioned above shows that not only financial statements haveto be reported with honesty reflecting a true and fair view of the company’sfinancial situation, preparers must also be mindful about the rules stipulatedby IASB under the conceptual framework. One of its important components is IAS37 Provisions, Contingent Liabilities and Contingent Assets. Its primaryobjective is to provide regulations to curb potential manipulation of reportedearnings by managers (Deloitte 2017).
IAS 37 is mainly concerned with Provisionsand the distorting effects they can have on profit, income and capital gearing.Consequently, full recognition in monetary term is required. RegardingContingent Liabilities, it is mandatory for companies to provide fulldisclosure on potential liabilities to alert financial report users, though no recognition is required.The same principle is applicable to Contingent Asset where only full disclosureis needed and that no recognition would be allowed regarding potential income, toprevent users from being misled. The regulations of Provision areessential to provide a true and fair view of financial statements. According toPWC, provision is best measuredat present value of the expected cash outflows where the effects of time valueof money is material, and that the estimation are based on reliable method.
(PWC 2017). Theimportance of applying IAS 37 correctly could be better highlighted in the caseSociete Generale. It is one of the largest banks in Europe and was accused offraudulent practices in 2008. The company did an unauthorised and falsetransaction that cost more than $7 billion, the biggest loss ever recorded in thefinancial industry (Clark & Jolly 2008).
According to the article ‘TheImportance of Being Fair’, Societe Generale misused the IAS 37 rule, and made aprovision in the 2007 balance sheet even though there was no clear liability toanyone at that date. The provision made a huge impact on the firm’s reportedearning that year and consequently its shareholders suffered losses (Nobes2009). The adoption of the principle IAS 37 isto limit accounting manipulation such as big bath accounting, cookie jar reserves,income smoothing and other manipulative practices. The rules spell out in clear and definite termswhen and how provision should be made, and the disclosure of potentialliabilities and incomes without recognition. Strict adherence to the rules willlead to greater transparency and accounting prudence (Felegea et al 2010),giving its users a good basis for decision making. Bigbath accounting mentioned above involves the acceleration of certain expensesand losses into a single year with the goal of making the financial results ofthe following years look much improved.
There is always an ulterior motiveassociated with such practice, to the disadvantage of investors. In 2008, SamsungElectronics posted a record operating loss of 937 billion won but the actualloss was only 400 billion won back then. The management took advantage of theyear’s slow growth and worsen it by taking a large non-recurring loss.
Suchaction could lessen the burden of achieving future earnings expectations, sothat if the following year does not perform well, it will still appearprofitable (Kim 2009). Anotheraccounting manipulation technique is income smoothing which is defined as ‘anattempt on the part of the firm’s management to reduce abnormal variations inearnings to the extent allowed under sound accounting and managementprinciples’ (Tucker & Zarowin 2005). To do so, managers intentionally reducethe fluctuations of their firm’s earnings realization. Its ultimate aim is toshow a steady revenue and profit growth that will give the company a positiveimage, to attract investors or creditors for investments and borrowings (Tucker& Zarowin 2005). However, opportunistic income smoothing which is furtherelaborated below, only benefit the insiders. The examplesabove show activities which are not consistent with the concept of accountingprudence.
The Accounting Standards Board’s 1995 draft statement describesprudence as a component ofreliability in financial statements as ‘uncertainties are recognised’. It is aninclusion of a degree of cautionin the exercise of the judgements, such that income or assets are notoverstated and expenses or liabilities are not understated (Maltby 2000). Theprinciple of prudence is applied to provide a faithful representation, true andfair view of the company, safeguarding the interest of its users. In addition tothe roles play by accounting rules in ensuring reliable financial reports,board of directors of an organization also has an important role to play inupholding good corporate governance. It is suggested that there is a directcorrelation between good corporate governance and long term shareholder value,and good corporate governance is dependent on the board which is the main agentin the reforming of the practices of corporate governance (Mclnnes Cooper 2014).Investors and other users alike will therefore be very much interested in thecomposition and qualification of the board in their analysis of earningpotential. One of the best corporate governancepractices suggested by Mclnnes Cooper is for the board to place great emphasison integrity and ethical dealing to rid the organization of dealings involvedconflict of interest, and to have respect and compliance with laws and policieswithout fear. Opportunistic earnings management, a shady technique deployed toincrease the prosperity of the management insiders, as well as controllingshareholders and to the detriment of outsiders could be eliminated by a strongethical policy (Surifah 2017).
According to a study regarding banks inIndonesia, strong corporate governance is essential to ensure efficient utilizationof the company’ resources leading to maximization of profit inflow. A weakcorporate governance would allow manipulations and abuse of power in firms,such as the case in Indonesia where controlling shareholders took advantage ofthe firms in 1988. Consequently, 16 banks were closed and 7 banks weresuspended by the authority. Moreover, a research fromNalukenge et al finds that the inclusion of outside members on the boardincreases effectiveness of preventing financial statements fraud.
This isbecause they are able to provide an independent view on corporate strategy andstandards of conduct. The existence of these independent directors also acts asa monitoring and check and balance mechanism and are able to give positiveinfluence over board’s decisions (Nalukenge 2017). It is suggested that ‘nofraud’ companies consist of a higher proportion of outside directors, implyingthat board independence is associated with fraud prevention. A study by Yang and Zhao opines that thecombination of CEO and chairperson in a single person can lead to concentrationof power thus weakening the level of monitoring. As a CEO becomes too powerfuland dominant, he/she is able to use the firm for his own interests rather thanthat of the shareholders (Yang & Zhao 2014). It is further implied that theduality of these two roles is associated to financial statements fraud as theconcentration of power give CEO the ability to override the company’s internalcontrol structure (Nalukenge 2017). Mclnnes Cooper also suggests the separationof the roles of the chair and CEO, allowing the Chairman to lead the board andensuring the long term interest of the firm is safeguarded while the CEO couldconcentrate on leading the management and ensuring the plans and strategies areeffectively implemented (McInnes Cooper 2014). As users of financial report will be keen tolearn how strong is the board, it is a good governance practice to build astrong and qualified board.
Mclnnes Cooper suggests that the members must beknowledgeable of the relevant field, qualified and competent, strong ethics andof diverse backgrounds and skillsets. A strong board will go a long way toensure good governance and efficient utilisation of the firm’s resources forlong term earning growth. In conclusion, I wish to summarize thatfinancial statement of an entity is the most important document for decisionmakers in their analysis of the firm’s future income flows. The informationprovided in the report must therefore be truly representative of the company’sassets, liabilities, earnings etc. To ensure the interests of the users aresafeguarded, there are accounting standards in place to regulate thepreparation of financial statements.
Notwithstanding this, frauds related tofinancial statements are still common. Board of directors is also of greatinterest to users of financial statement in their analysis of the futureprospects of the entity. A strong board who put in place some of the bestpractices of corporate governance will be a good source of comfort to users asthey could expect greater transparency and accountability, as well as greaterefficiency and effectiveness in the utilisation of the company’s resources.