Mechanisms that Discipline Financial Reporting Quality

Given the negative implications of low financial reporting quality, 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 because 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 high-quality financial reports.

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

Market Regulatory Authorities

Regulations and the regulatory authorities that administer them and establish and enforce rules play a vital role in regulating financial reporting quality. A regulatory regime that most directly affects financial reporting quality includes the following:

• Registration requirements: Before offering securities for sale to the public, a publicly traded company must usually 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.
• Enforcement mechanisms: Regulators usually have powers to enforce their rules, 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 voluntarily or if required by an external party, such as a bank.

Private Contracting

Mechanisms to discipline financial reporting quality may come from 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 allow investors to recover all or part of their investment if specific financial triggers occur.

Limitations of Mechanisms

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

• If a company deliberately intends to deceive its auditors, reviewing information might not uncover misstatements.
• It is quite possible that the sample on which an audit is based does not reveal misstatements.
• Whereas an audit is intended to assure users of financial statements that they are fairly presented, the public may expect it to detect fraud.
• An auditor may be incentivized to show leniency to a company being audited, especially if the auditor provides additional services.

Limitations also exist in using private contracting to discipline financial reporting quality. For example, since the financial reports prepared by a borrower or investee will directly affect the contractual outcomes, this potentially creates a motivation for 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.