Regulatory Authorities

Publicly traded issuers are required to prepare financial reports in accordance with specific securities laws, regulations, and accounting standards set by regulatory authorities. Since corporate reporting standards and securities regulations can vary across jurisdictions, there is a need for global uniformity. Establishing regulatory authorities helps promote consistency and strengthens financial markets worldwide.

International Organization of Securities Commissions

While not technically a regulatory body, IOSCO oversees a substantial portion of the world’s financial capital markets. Established in 1983, IOSCO consists of ordinary, associate, and affiliate members.

Specifically, ordinary members are the securities commissions or equivalent governmental regulatory bodies responsible for securities regulation in their respective countries. These bodies oversee over 95 percent of the world’s financial capital markets across over 115 jurisdictions. Emerging markets make up 75% of IOSCO’s ordinary membership.

IOSCO’s comprehensive Objectives and Principles of Securities Regulation, updated as needed, serve as an international benchmark for all markets. The principles are built on three core objectives:

• Protecting investors.
• Ensuring that markets are fair, efficient, and transparent.
• Reducing systemic risk.

IOSCO’s principles are categorized into 10 groups, covering areas such as principles for the Regulator, Self-Regulation, Enforcement of Securities Regulation, Cooperation in Regulation, Issuers, Auditing, Collective Investment Schemes, Market Intermediaries, Secondary and Other Markets, and Principles Relating to Clearing and Settlement.

In the “Principles for Issuers” category, two principles are specifically related to financial reporting:

• Full, accurate, and timely disclosure of financial results, risks, and other material information for investors’ decisions.
• High-quality, internationally acceptable accounting standards for preparing financial statements.

US Securities and Exchange Commission (SEC)

The US SEC, an ordinary member of IOSCO, regulates securities and capital markets within the United States. Companies issuing securities or participating in US capital markets must comply with SEC rules and regulations.

The SEC was established in response to the 1929 stock market crash and subsequent Great Depression.

Key statutes enforced by the SEC from a financial reporting and analysis perspective include:

• Securities Act of 1933: Mandates that investors receive essential financial and other significant information during securities sales, prohibits misrepresentations, and requires initial registration of public securities issuances.
• Securities Exchange Act of 1934: This act created the SEC, granted it authority over the securities industry, and empowered it to require periodic reporting by companies with publicly traded securities.
• Sarbanes–Oxley Act of 2002: This act established the Public Company Accounting Oversight Board (PCAOB) to oversee auditors, mandated auditor independence, enhanced corporate responsibility for financial reports, and required management to report on the effectiveness of internal controls over financial reporting. The SEC enacts Sarbanes–Oxley requirements and oversees the PCAOB.

Companies comply with these laws primarily by filing standardized forms created by the SEC and replying to specific comments from SEC staff.

Most SEC filings must be submitted electronically, making them accessible online for analysts on various websites, such as the issuer’s investor relations site and the SEC’s official website.

Over 50 different SEC forms meet various reporting requirements, but the most relevant for financial analysts are highlighted here:

• Securities Offerings Registration Statement: Required by the 1933 Act for companies offering securities, detailing disclosures about the securities, their relationship to the issuer’s other capital securities, annual filing information, recent audited financial statements, and risk factors.
• Forms 10-K, 20-F, and 40-F: These are the Annual forms required from companies. Form 10-K is for US registrants, Form 40-F for certain Canadian registrants, and Form 20-F for all other non-US registrants. The forms require a comprehensive overview of the company, touching on its business, risk factors, financial disclosures, legal proceedings, and information related to management.
  Specifically, financial disclosures include audited financial statements, MD&A, and auditors’ reports.
• Annual Report: While not required by the SEC, many companies prepare an annual report to shareholders, presenting financial data, market segment information, research and development activities, and future goals.
  The annual report is often a meticulously crafted marketing document featuring photographs and an introductory letter from the CEO. In contrast, form 10-K is more legal in nature and less focused on marketing.
• Proxy Statement/Form DEF-14A: The SEC mandates that a proxy statement be given to shareholders before shareholder meetings. It contains information useful to financial analysts, such as proposals requiring shareholder votes, security ownership details, director biographies, and executive compensation disclosures.
• Forms 10-Q and 6-K: Filed for interim periods, with Form 10-Q for US companies (quarterly) and Form 6-K for many non-US companies (semiannually). The filings require unaudited financial statements, an MD&A for the interim period, and certain types of non-recurring events, such as the adoption of an accounting policy that occurred during the period covered by the report.

Additionally, companies make other SEC filings as necessary for significant events or transactions between periodic reports. These include:

• Form 8-K: Used to report material corporate events on a current basis, including acquisitions, changes in securities and trading markets, and significant management changes. It is termed as form 6-K for non-US registrants.
• Forms 3, 4, 5, and 144: These forms are used to report beneficial ownership of securities by directors, officers, and significant shareholders. Form 3 is for initial statements, Form 4 is for changes, Form 5 is for annual reports, and Form 144 is for proposed sales of restricted securities.
• Form 11-K: Annual report for employee stock purchase, savings, and similar plans. Consequently, form 11-K helps analysts examine companies with substantial employee benefit plans, as it provides more detailed information about these plans than what is found in the company’s financial statements.

Note that similar legislation exists in other jurisdictions to regulate securities and capital markets, with regulatory authorities enforcing regulations consistent with IOSCO objectives.

Regulators typically recognize and adopt specific accounting standards and establish reporting and filing requirements, ensuring international cooperation in developing, implementing, and enforcing consistent regulatory standards.

Capital Markets Regulation in Europe

In the European Union (EU), capital markets are primarily regulated by individual member states. However, the EU has established specific overarching regulations. Notably, since 2005, the EU has mandated that consolidated financial statements of companies listed in the EU adhere to International Financial Reporting Standards (IFRS).

The process for endorsing new IFRS standards strikes a balance between member states’ autonomy and the need for cooperation and convergence. When the International Accounting Standards Board (IASB) issues a new standard, the European Financial Reporting Advisory Group advises the European Commission. The Standards Advice Review Group then reviews this advice. Based on their feedback, the Commission drafts an endorsement regulation, which the Accounting Regulatory Committee votes on. If the vote is favorable, the proposal moves forward to the European Parliament and the Council of the European Union for final approval.

Securities regulation within the EU is overseen by two key bodies established by the European Commission: the European Securities Committee (ESC) and the European Securities and Markets Authority (ESMA).

The ESC, composed of high-level member-state representatives, advises the European Commission on securities policy issues. ESMA, on the other hand, acts as a cross-border supervisor to coordinate the regulation of EU markets.

In conclusion, despite the presence of these EU-wide bodies, the responsibility for securities regulation largely remains with individual member states, leading to variations in requirements for share registration and periodic financial reporting across countries.

Financial Statement Notes and Supplementary schedules

Financial statement notes, often referred to as footnotes, are a crucial component of regulatory filings. They provide extensive disclosures that are essential for understanding the financial statements.

The footnotes detail the basis of preparation, including the fiscal year alignment with the calendar year, the type of accounting standards, the types of currency, the rounding of figures, and whether the financial statements are consolidated (aggregate the financial records of all controlled subsidiaries after eliminating intercompany balances and transactions).

The notes also reveal the accounting policies, methods, and estimates used in preparing the financial statements. Both IFRS and US GAAP allow flexibility in selecting among alternative policies and methods for certain items, accommodating the diverse needs of businesses in reporting various economic transactions. While this flexibility is essential for companies to choose the most relevant and fair policies, methods, and estimates for their unique economic circumstances, it creates challenges for analysts by reducing the comparability of financial statements across different companies.

The notes also provide disclosures on segment reporting, business acquisitions and disposals, contractual obligations (including both on- and off-balance sheet debt), financial instruments and the associated risks, legal proceedings, related-party transactions, and subsequent events (post-balance sheet events).

Generally, for most companies, financial notes and supplemental schedules typically provide explanatory information for every line item (or almost every line item) on the balance sheet and income statement.

Business and Geographic Segment Reporting

Most companies operate multiple businesses, and while IFRS and US GAAP do not require disaggregated financial statements for all subsidiaries or business units, they do mandate some disaggregated information in the financial statement notes, organized by operating segment.

An operating segment is defined as a component of a company:

• that engages in activities that generate revenue and incur expenses, including start-up segments that have yet to earn revenues.
• whose results are regularly reviewed by the company’s senior management.
• that has available discrete financial information.

A company must disclose separate information for any operating segment that meets specific quantitative criteria. Specifically, if the segment accounts for 10 percent or more of the combined operating segments’ revenue, assets, or profit.

If the combined revenue from external customers for all reportable segments is less than 75 percent of the total company revenue, additional reportable segments must be identified until the 75 percent threshold is reached.

Small segments may be aggregated if they share a significant number of factors that define a business or geographical segment, or they may be combined with a similar significant reportable segment. Information about operating segments and businesses that are not reportable is aggregated in an “all other segments” category.

Companies are required to disclose the factors used to identify reportable segments and the types of products and services sold by each reportable segment. For each reportable segment, the following information should also be disclosed in the notes to the financial statements:

• Revenue, distinguishing between revenue to external customers and revenue from other segments.
• A measure of profit or loss.
• A measure of assets and liabilities (if the company’s chief decision-making officer regularly reviews these amounts).
• Interest revenue and interest expense.
• Cost of property, plant, and equipment, and intangible assets acquired.
• Depreciation and amortization expense.
• Other non-cash expenses.
• Income tax expense or income.
• The equity method accounts for the proportion of an investment’s net profit or loss.

Companies must also prepare a reconciliation between the information of reportable segments and the consolidated financial statements based on segment revenue, profit or loss, assets, and liabilities.

Management Commentary

The Management Discussion and Analysis (MD&A) section is critical to a public company’s annual report. A management commentary or management discussion and analysis report (MD&A) is usually included in a public company’s annual reports. It is referred to by various names, including management reports, management commentary, and operating and financial reviews.

While the information in the MD&A is crucial, it is typically unaudited, except in some countries like Germany, where management reporting has been mandated and audited since 1931.

It provides a platform for management to discuss various aspects of the company, including its business operations, risk management strategies, planned capital expenditures, and future outlook. The MD&A is a valuable tool for understanding the financial statements and offers insights into the company’s potential future performance.

The MD&A is a useful starting point for understanding the financial statements and can also provide critical insights into a company’s potential future performance.

Management Commentary and Regulations

In regulatory filings such as Form 10-K and 10-Q in the United States, the MD&A section covers topics such as the nature of the business, past performance, and future prospects.

In the US, the Securities and Exchange Commission (SEC) requires publicly traded companies to provide a Management Discussion and Analysis (MD&A), detailing what it should include. Management must highlight significant trends, both positive and negative, and identify key events and uncertainties that affect the company’s liquidity, capital resources, and operational results.

The MD&A should also offer insights into the repercussions of inflation, price fluctuations, and other significant events and uncertainties that could lead to a substantial divergence between future operational results and financial status from the currently reported financial data. Furthermore, the MD&A should include details about obligations not recorded on the balance sheet and about contractual commitments, such as obligations to make purchases.

Management is also expected to delve into the pivotal accounting policies that require subjective judgments and exert a considerable influence on the financial results reported.

To enhance the quality of the MD&A, the International Accounting Standards Board (IASB) issued an IFRS Practice Statement titled “Management Commentary.” This provides a framework for preparing and presenting management commentary, identifying five key content elements: the nature of the business, management’s objectives and strategies, significant resources, risks and relationships, results of operations, and critical performance measures.

Auditor’s Report

Companies’ annual reports typically include financial statements that must be audited by an independent accounting firm, following specific auditing standards. The auditor provides a written opinion, known as the audit report, which may vary across jurisdictions but generally includes a statement of the auditor’s opinion. Contractual agreements, laws, or regulations often mandate financial statement audits.

Objectives of an Audit

According to ISAs, the two primary objectives of an audit are:

• To provide reasonable (not absolute) assurance that financial statements are free from material misstatement. This, in essence, enables the independent auditor to express an opinion on whether or not the preparation of financial statements complied with a specified set of accounting standards.
• To report on the financial statements following the auditor’s findings as required by the International Standards for Auditing.

Types of Audit Reports

An independent auditor’s written opinion on a company’s financial statements is called an audit report.

The standard independent audit report usually has several paragraphs. The first, or “introductory,” paragraph describes the financial statements and the responsibilities of management and the auditor. The second, or “scope,” paragraph describes the nature of the audit process and gives the basis for the auditor’s expression about reasonable assurance. The third paragraph, “opinion,” gives the auditor’s assessment of the financial statements’ fairness.

The audit opinion can take any one of the following forms:

• The unqualified audit opinion indicates that the financial statements are fairly presented under accounting standards.
• The qualified audit opinion indicates some limitation to the audit’s scope or an exception to the accounting standards.
• An adverse audit opinion indicates that the independent auditor has determined the financial statements are not fairly presented and significantly deviate from accounting standards.
• The disclaimer of opinion indicates that the auditor cannot issue an audit opinion for one reason or another.

Audit Standards and Practices

Audits are conducted under the International Standards on Auditing (ISAs), developed by the International Auditing and Assurance Standards Board (IAASB). These standards are widely adopted, although some countries, like the United States, have their own. In the US, the Public Company Accounting Oversight Board (PCAOB) sets auditing standards for public companies following the Sarbanes–Oxley Act of 2002.

Audits are designed using sampling techniques and may involve estimates and assumptions. As a result, auditors provide reasonable, not absolute, assurance about the financial statements’ accuracy. This means there is a high probability that the audited financial statements are free from material error or fraud.

Question

Information on a company’s results of operations, planned capital expenditure, and future outlook is usually found in which of the following?

1. Auditor’s report.
2. Management commentary.
3. Notes to the financial statements.

Solution

The correct answer is B.

In a management commentary, a company’s management discusses matters of concern to the company, such as the results of its operations, risk strategies employed, planned capital expenditure, and future outlook.

A and C are incorrect because they typically do not report this information.