Regulatory Authorities

Publicly traded issuers must prepare financial reports per specific securities laws and regulations and accounting standards as prescribed by regulatory authorities. Corporate reporting standards and securities regulations may differ in different jurisdictions. For this reason, the International Organization of Securities Commissions (IOSCO’s) member jurisdictions oversee more than 95 percent of the world’s financial markets, enabling global uniformity and promoting financial markets.

International Organization of Securities Commissions

The IOSCO was founded in 1983 and consists of affiliates, associates, and ordinary members. As mentioned, the IOSCO is technically not a regulatory authority but regulates more than 95 percent of the global financial capital markets. The International Organization of Securities Commission (IOSCO) consists of ordinary members, associate members, and affiliate members.

Specifically, the ordinary members are the securities commission tasked with securities regulations in the member countries. Some examples of ordinary members include the China Securities Regulatory Commission, the US Securities and Exchange Commission, the Egyptian Financial Supervisory Authority, the Securities and the Kingdom of Saudi Arabia Capital Market Authority. The ordinary member regulates 95 percent of the global financial capital markets in more than 115 countries.

IOSCO contains clearly defined Objectives and Principles of Securities Regulation, which are appropriately updated and act as the international benchmark for all markets. The securities regulation principles are based on three core objectives:

• Systemic risk reduction.
• Investor protection.
• Ensuring a fair, efficient, and transparent markets.

There are ten categories of IOSCO’s principles, consisting of principles for regulators, for enforcement, for market integrity and efficiency, for collective investment schemes, for issuers, and others.

Regarding the principle for issuers, it is a category that contains two principles that are of interest in this topic and related to financial reporting:

1. Investors should have access to complete, accurate, and timely disclosures of financial results, risk, and other relevant information.
2. The quality of accounting standards issuers use to prepare financial statements should be high and internationally accepted.

Another IOSCO principle pertains to self-regulatory organizations (SROs), which directly oversee their competence areas. These organizations should be subject to oversight by the relevant regulator and adhere to principles of fairness and confidentiality.

US Securities and Exchange Commission

As an ordinary member of IOSCO, the US SEC oversees US securities markets and securities. The Securities and Exchange Commission was established in response to reforms after the 1929 stock market crash preceding the Great Depression.

Key statutes enforced by the SEC, such as the Securities Acts of 1933 and 1934 and the 2002 Sarbanes-Oxley Act, play a crucial role in financial reporting and analysis.

The 1933 Securities Act mandates the disclosure of financial and other essential information to investors during the sale of securities, forbids false statements, and necessitates the initial registration of all public securities offerings.

The 1934 Securities Exchange Act established the Securities and Exchange Commission (SEC), granted the SEC regulatory authority over the entire securities industry, and authorized the SEC to mandate regular reporting from companies with publicly traded securities.

The 2002 Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB) to supervise auditors. The SEC implements the act’s provisions and oversees the PCAOB. The act focuses on auditor independence by restricting auditors from providing specific non-audit services to their audit clients, enhances corporate accountability for financial reporting by requiring top management to affirm that the company’s financial statements accurately represent its financial condition, and mandates management to evaluate and report on the effectiveness of the company’s internal controls over financial reporting, including obtaining external auditor verification of the effectiveness of internal controls.

SEC regulations are primarily enforced by filing standardized forms and responding to SEC staff comments on company filings. Since SEC filings are typically made electronically, analysts can access filings online, such as those on an issuer’s investor relations website or the SEC’s website. The following are some filings commonly used by analysts:

• Securities Offering Registration Statement: Companies offering securities must file a registration statement. Previously registered companies and new issuers issuing new securities must file these statements. The specific form and information required vary by size and nature.
• Forms 10-K, 20-F, and 40-F: These forms have to be filed annually. US registrants file Form 10-K, some Canadian registrants file Form 40-F, and all other registrants file Form 20-F. Information on these forms must include the company’s business, risks, financial disclosures, legal proceedings, and management.
• Annual Report: Annual reports are usually prepared by companies. The SEC does not require this. A company’s annual report is one of the best ways to present itself to shareholders and other stakeholders.
• Proxy Statement/Form DEF-14A: Proxy voting involves a shareholder authorizing another party to vote on their behalf. Before a shareholder meeting, the SEC requires a proxy statement to be sent to shareholders.
• Forms 10-Q and 6-K: US companies must file these forms quarterly on Form 10-Q, and non-US companies must file them semiannually on Form 6-K. The required information includes some financial information, such as unaudited financial statements and MD&A for the interim period covered by the report. Moreover, Form 10-Q  should include certain non-recurring events, such as the start of significant litigation or adopting a new accounting policy.

Apart from the forms mentioned above, companies are required to make additional SEC filings if significant transactions or events have occurred between periodic filings. They include:

• Form 8-K: SEC registrants must report material and corporate events more frequently in addition to annual and interim reports. SEC Form 8-K (6-K for non-US registrants) is used to announce significant events and is referred to as the “current report.”
• Forms 3, 4,5, and 144: Beneficial ownership of securities must be reported on Forms 3, 4, and 5. Those who own more than 10 percent of a class of registered equity securities, including directors and officers, are required to file these documents. Initial statements are on Form 3, changes are reported on Form 4, and annual reports are on Form 5. Form 144 is a notice of proposed sales of securities held by affiliates of the issuer and restricted securities. Analysts can use these forms to examine purchases and sales of securities to corporate insiders.
• Form 11-K: This is an annual stock purchase and savings report for employees. Those analysts interested in companies with significant employee benefit plans may find it helpful since it includes more information about these plans than disclosed by the company.

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 reflects a balance between the autonomy of member states and the need for cooperation and convergence. When the International Accounting Standards Board (IASB) issues a new standard, the European Financial Reporting Advisory Group provides advice to the European Commission, which is then reviewed by the Standards Advice Review Group. Based on their input, the Commission drafts an endorsement regulation, which is voted on by the Accounting Regulatory Committee. If the vote is favorable, the proposal advances 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 representatives from member states, advises the European Commission on securities policy issues. On the other hand, ESMA 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

The financial statement notes, often referred to as footnotes, are a crucial component of regulatory filings, providing 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).

Furthermore, the notes disclose the accounting policies, methods, and estimates employed in preparing the financial statements. Both IFRS and US GAAP offer flexibility in choosing among alternative policies and methods for accounting for certain items, aiming to accommodate the diverse needs of businesses in reporting various economic transactions. This flexibility, while necessary for companies to select the most relevant and fair policies, methods, and estimates for their unique economic environment, poses challenges for analysts due to reduced comparability across different companies’ financial statements.

Additionally, notes disclosures include information on segment reporting, business acquisitions and disposals, contractual obligations (including both on- and off-balance sheet debt), financial instruments and risks arising from financial instruments, 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 often consist of multiple businesses, and while IFRS and US GAAP do not mandate the provision of disaggregated full financial statements for all subsidiaries or businesses, they do require some disaggregated information in the financial statement notes 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.
• its results are regularly reviewed by the company’s senior management.
• 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.
• proportion of an investment’s net profit or loss is accounted for under the equity method.

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) mandates that publicly traded companies must supply a Management Discussion and Analysis (MD&A), which outlines the specifics of what this should include. It is incumbent upon the management to underscore any positive or negative trends and pinpoint crucial events and uncertainties that have an impact on the company’s liquidity, capital resources, and operational outcomes.

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 necessitate them to exercise subjective judgments and that 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. Financial statement audits are often mandated by contractual agreements, laws, or regulations.

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

When an independent auditor provides a written opinion on a company’s financial statements, it is called an audit report.

The standard independent audit report usually has several paragraphs. To begin with, 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.
• The adverse audit opinion indicates that the independent auditor has determined that are the financial statements not fairly presented and materially depart 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 auditing standards. 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.

Key Audit Matters

For listed companies, the audit report includes a discussion of Key Audit Matters (international) or Critical Audit Matters (United States).

Key Audit Matters refer to issues that the auditor considers to be most important, such as those that have a higher risk of misstatement, involve significant management judgment, or report the effects of significant transactions during the period.

Critical Audit Matters refer issues that involve “especially challenging, subjective, or complex auditor judgment” and similarly include areas with a higher risk of misstatement or that involve significant management judgment and estimates.

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.