Mechanisms that Discipline Financial Reporting Quality

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

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

More specifically, 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.

As such, 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.