Mechanisms that Discipline Financial Reporting Quality

Mechanisms That Discipline Financial Reporting Quality

Market forces can discipline poor financial reporting quality. Companies and nations compete for capital, and the cost of capital is influenced by perceived risk, including the risk that financial statements may mislead investors. Therefore, to minimize long-term capital costs, a company should aim to provide high-quality financial reports, assuming no conflicting economic incentives are present.

Mechanisms that discipline financial reporting quality include market regulatory authorities, auditors, and private contracts.

Market Regulatory Authorities

While companies aiming to minimize the cost of capital should prioritize high-quality financial reporting, conflicting incentives often exist. Thus, national regulations and the regulators who establish and enforce these rules significantly ensure financial reporting quality.

International Organization of Securities Commissions (IOSCO) is recognized as the “global standard setter for the securities sector.” It establishes objectives and principles to guide securities and capital market regulation but does not set specific standards. IOSCO has over 120 securities regulators and 80 other securities market participants, including stock exchanges.

Many of the world’s securities regulators are members of the International Organization of Securities Commissions (IOSCO). Such members include The European Securities and Markets Authority (ESMA) and the Securities and Exchange Commission (SEC).

ESMA is an independent EU authority aiming to protect investors and ensure stable financial markets in the EU. It coordinates financial reporting enforcement through a forum of European enforcers. National bodies, like the UK’s Financial Conduct Authority (FCA), handle direct supervision.

The SEC oversees about 9,100 US public companies, reviewing their disclosures at least once every three years.

Other regulatory bodies include the Financial Services Agency in Japan, the China Securities Regulatory Commission, and Comisión Nacional de Valores in Argentina.

Key Features of Regulatory Regimes

Market regulatory authorities play a crucial role in promoting high-quality financial reporting through various mechanisms, which include:

1. Registration Requirements: Publicly traded companies must register securities before offering them for sale, providing current financial statements and relevant information about risks and prospects.
2. Disclosure Requirements: Companies must make periodic reports public, including financial reports and management comments. Standard-setting bodies like IASB and FASB establish standards that regulatory authorities enforce.
3. Auditing Requirements: Financial statements must include an audit opinion verifying conformity to relevant standards. Some regulators, like the SEC, require an additional audit opinion on internal controls over financial reporting.
4. Management Commentaries: Regulations require financial reports to include management statements reviewing the business and describing principal risks and uncertainties.
5. Responsibility Statements: Responsible individuals must acknowledge responsibility and attest to the correctness of financial reports. Some regulators require formal certifications with legal penalties for false certifications.
6. Regulatory Review of Filings: Regulators review initial registrations and a sample of subsequent financial reports to ensure compliance with rules.
7. Enforcement Mechanisms: Regulators can assess fines, suspend or bar market participants, and bring criminal prosecutions. Public announcements of disciplinary actions also serve as enforcement.

Auditors

Regulatory authorities typically require publicly traded companies’ financial statements to be audited by an independent auditor. Private companies also often seek audit opinions for their financial statements, either voluntarily or due to requirements from external parties such as debt or equity providers.

Audit opinions provide assurance to financial statement users that the information complies with relevant accounting standards and fairly represents the company’s performance. There are four types of audit opinions:

• Unqualified Opinion (Clean Opinion): This is the most favorable type of audit opinion. It indicates that the financial statements present a true and fair view of the company’s financial position and performance in accordance with the applicable financial reporting framework (e.g., GAAP, IFRS).
• Qualified Opinion: A qualified opinion is issued when the auditor encounters a specific issue that does not pervasively affect the financial statements. This issue may be a material misstatement or a scope limitation.
• Adverse Opinion: An adverse opinion is given when the auditor concludes that the financial statements do not present a true and fair view due to material and pervasive misstatements. This type of opinion indicates that the financial statements are not reliable and should not be relied upon for decision-making purposes.
• Disclaimer of Opinion: A disclaimer of opinion is issued when the auditor is unable to obtain sufficient appropriate audit evidence to form an opinion on the financial statements. This could result from significant uncertainties or scope limitations, where the potential effects could be both material and pervasive. In such cases, the auditor refrains from expressing an opinion on the financial statements.

Inherent Limitations of Audit Opinions

1. Reliance on Company-Provided Information: Auditors review financial information and documents prepared by the company they are auditing. This means that the data they examine is initially compiled and presented by the company’s management. If a company intentionally provides misleading or false information, the audit may not detect these misstatements because the audit is based on what the company presents.
2. Sampling Basis: Audits typically involve examining a sample of transactions and balances rather than reviewing every single transaction. This sampling approach is used to make the audit process efficient and cost-effective, but it means that not all errors or irregularities may be identified.
3. Expectations Gap: There is often a misunderstanding between what the public expects auditors to do and what audits are designed to accomplish. Auditors aim to provide reasonable assurance that the financial statements are free of material misstatement and fairly presented. However, they are not specifically tasked with detecting fraud.
4. Fee Structures and Potential Conflicts of Interest: The company being audited pays the auditors’ fees, which could potentially influence the auditors’ objectivity and independence. As such, auditors may be tempted to avoid conflict with the company to retain the business, especially if the audit firm also provides other consulting services to the company.

Private Contracting

Private contracts, such as loan agreements or investment contracts, play a significant role in maintaining high-quality financial reporting. Various parties involved in these contracts have a vested interest in monitoring the company’s performance and ensuring the accuracy and reliability of its financial reports.

Loan Agreements

Loan agreements often include covenants, which are legally binding conditions that the borrowing company must meet. These covenants may require the company to maintain certain financial ratios, such as debt-to-equity or interest coverage ratios. By imposing these conditions, lenders can ensure that the company remains financially healthy and capable of repaying the loan.

Moreover, lenders monitor the company’s financial reports to verify compliance with the covenants. Failure to comply with these covenants can result in penalties, such as increased interest rates, demands for early repayment, or even loan default. This creates a strong incentive for companies to produce accurate and high-quality financial reports to avoid breaching loan covenants.

Consequently, to avoid violating covenants, managers might feel pressured to manipulate earnings. Such actions can mislead lenders, but stringent monitoring by lenders can help detect and discourage such practices.

Investment Contracts

Investment contracts may include clauses that allow investors to withdraw or recover their investment if certain financial conditions are met. These triggers might be based on specific financial metrics or performance indicators.

Investors closely monitor the company’s financial statements to ensure that their investments are secure. If the company’s performance deteriorates and triggers these provisions, investors can act to protect their interests.

To avoid triggering these provisions, managers might be tempted to manipulate financial results. Investors, aware of this risk, are likely to scrutinize financial reports more carefully and demand high-quality and transparent reporting.

In conclusion, since financial reports directly impact contractual outcomes, both investors and lenders have strong incentives to ensure these reports are accurate and reliable. Their monitoring efforts act as a check on the company’s financial reporting practices, helping to maintain high standards and reduce the risk of misreporting.

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 primary 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 a company’s financial reports 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.