Mechanisms That Discipline Financial Reporting Quality

Given the negative implications that low financial reporting quality can have, disciplinary mechanisms need to be established to promote high reporting quality. Even though several mechanisms exist, there are certain limitations to their effectiveness.

Mechanisms That Discipline Financial Reporting Quality

Financial markets provide a mechanism for disciplining financial reporting quality by the mere fact that the cost of raising capital is a function of perceived risk. Accordingly, if a company wishes to enjoy a low cost of capital, it should seek to consistently produce financial reports that are of high quality.

Other mechanisms which discipline financial reporting quality include market regulatory authorities, auditors, and private contracts.

Market Regulatory Authorities

Regulations, as well as the regulatory authorities which administer them and establish and enforce rules, play a vital role in the regulation of financial reporting quality. A regulatory regime that most directly affects financial reporting quality include the following:

• registration requirements: before offering securities for sale to the public, a publicly-traded company is usually required to have these securities registered with the securities regulator;
• disclosure requirements: publicly traded companies are usually required by market regulators to make periodic reports, including financial reports and management comments, public;
• auditing requirements: market regulators typically require the financial statements of licensees to be accompanied by an audit opinion attesting that the financial statements conform to the relevant set of accounting standards;
• management commentaries: market regulations typically require the financial reports of publicly traded companies to include management statements;
• responsibility statements: regulations usually require the person(s) responsible for filing a company’s returns to provide a statement indicating that the person(s) explicitly acknowledges responsibility and attests to the accuracy of the financial reports;
• regulatory review of filings: a review process is usually undertaken by market regulators to ensure that their rules have been followed; and
• enforcement mechanisms: regulators usually have powers to enforce their rules including powers to assess fines, suspend or permanently bar market participants, and institute criminal prosecutions.

Auditors

Audit opinions assure the users of financial statements that the information contained in the financial statements complies with relevant accounting standards and presents the company’s information objectively. Publicly traded companies are usually required by regulatory authorities to have their financial statements audited by an independent auditor. This leads to the production of an audit opinion. Private companies also obtain audit opinions of their financial statements, either voluntarily or if required by an external party, such as a bank.

Private Contracting

Mechanisms to discipline financial reporting quality may come in the form of elements of private contracts such as loan agreements or investment contracts. For example, a loan agreement may contain loan covenants, which create financial reporting requirements that are legally binding for the issuer. An investment contract may also contain provisions that give investors the option to recover all or part of their investment if certain financial triggers occur.

Limitations of Mechanisms

Certain limitations exist in the use of audit opinions to discipline financial reporting quality. These include the following:

• if a company deliberately intends to deceive its auditors, a review of information might not uncover misstatements;
• it is quite possible that the sample which an audit is based on, does not reveal misstatements;
• whereas an audit is intended to assure users of financial statements that the statements are fairly presented, the public may expect it to detect fraud; and
• an auditor may have an incentive to show leniency to a company being audited, especially if that company is provided with additional services by the auditor.

Limitations also exist in the use of private contracting as a mechanism for disciplining financial reporting quality. For example, since the financial reports that are prepared by a borrower or investee will directly affect the contractual outcomes, this potentially creates a motivation for misreporting to occur.

Question 1

Which of the following mechanisms used to discipline financial reporting quality directly involves a company having its financial statements audited by an independent auditor?

1. Auditors.
2. Private contracts.
3. Regulatory authorities.

Solution

The correct answer is A.

Auditors audit the financial statements of a company and produce audit reports.

Question 2

The main role of an auditor is to:

1. Detect fraud.
2. Reveal misstatements.
3. Assure that financial information is presented fairly.

Solution

The correct answer is C.

The goal of auditing the financial reports of a company is to confirm that these reports make a fair representation of the company’s economic reality. Since the auditing process is based on sampling, it doesn’t necessarily discover fraud or misstatement.