The Use of Financial Statements Essay
- October 06, 2021/
The use of financial statements to show the states of affairs of an undertaking is crucial in the quest of satisfying many a stakeholder. The government expects tax payments whose calculation depends on an accurate statement, while shareholders await for dividends declared on the basis of the results of the financial statements and potential investors also view this as a document that provides guidance as to when, how and where to invest their money. The accuracy of the statement is therefore paramount to the success not only of the company but also of all the other stakeholders.
This paper evaluates how the regulatory policies of financial statements have been effective by providing a critique analysis of the same. The writer will use examples of companies, to demonstrate situations where the regulations have been effective and where the regulations have failed.
We will evaluate various reports related to this topic in order to ascertain their applicability and effectiveness. These are; Greenbury 1995 , Hampel 1997, Townbull report 1999, Walker’s 2009, Cadbury’s 1992, Myner’s 2001, Higgs report 2003, The Smith report 2003.
The financial statements and the regulations
At this juncture, it is important to look at the books which fall under the category of financial statement as the basis for analysing the regulations thereof. The financial statements compose of four main books of accounting, including;
The income statement
The balance sheet or statement of balances
The statement of the retained earnings and
The statement of cash flow.
Eliot B., and Eliot J. (2005: 168-171), presented a levelled discussion by looking at the various stakeholders whose interests should be served in different ways when there is proper presentation of financial statement. These stakeholders include;
The customers, who will get value for the products which they buy because, as the company uses good practice to write their accounts, there are all chances that benefits will be passed on to the customers. The customers also want to be assured that they are dealing with a company that adheres to the legal requirements of the country, and so this is a matter of corporate social responsibility.
Workers, who expect to be paid adequately, when they put their honest efforts to serving in the company,. Workers will also feel proud on knowing that the company which they deal with respects the law and does what is right in the law.
Shareholders, who are the owners of the company and of whose interests, the board exists and should serve. It is important for the management to understand that wealth maximisation depends on accurately presented financial information. Failure to do this may result in shareholders taking punishing steps. Granted, shareholders, by the virtue impossibility of all of them working to run the company, they expect to be given a fair statement at the Annual General Meeting which reflects all that has been happening. The financial regulations are meant to protect their interest, and so regulations should be such that makes the directors to consider working in Ubarrimae Fidei with regards to the shareholders.
Government; the government expects to get taxes at the end of the year, if not for anything else, for sustaining a viable environment for the business to operate. It is important for the board therefore to present a true picture of the financial position. On personal view, loss or profits are acceptable to the government as long as they are just. Unfair representation of the statement to influence a certain outcome is less objective and if the current legislations cannot discourage such, then it has failed.
And society, which expects to accommodate a business that operates in utmost good faith.
Therefore on personal view, the effectiveness of financial statement can be judged by how well the financial statements serve the interests of these stakeholders. Eliot B., and Eliot J. (2005: 168) noted that there is therefore need to have regulations to ensure that the managers run the company in the best possible way, hence the need for the regulations.
Their work has been impressive by their discussion of what makes the financial statement to be useful or of good quality, which include;
The relevance of the statement
However, one striking piece of their discussion is the admission that the Directors and Accountants in the UK are often restricted by a multitude of regulations which come from three sources, which are; the Legislations of parliament, the professional accounting bodies and from the FSA – Financial services authority. In view of this, it can be objective to claim that the multitude of regulations may obviously make the directors to fail to present the true satisfying statements not because they do not want but because they are striving to meet so many conditions and someone a failure to meet on may be the beginning of problems for the organisation hence the ineffectiveness of the regulations.
If we consider the case of Lehman brothers, the failure came as a result of among others, the downgrading of its credit status, and when Barclays bank had offered to acquire the profitable assets of the company, which they explicitly said would be acquired along the pre-set rules by the Financial services Authority, the deal failed to work out because, as put by Barclays, the time had run out for the shareholders approval for this take over, this is because, the approval could be acquired before the duration needed as required by the regulations (New York Times 2008). However, it was disclosed that actually the regulator had discouraged the bank from acquiring Lehman Brothers, on personal view, probably because, this would have had negative effect on Barclays banks financial position which would be reflected on its financial statement and in this time of crisis, it could destabilise Barclays bank, which is one of the stable companies in the banking sector. Here is an instance where we can view the dependence on the guidance of the financial regulations before any move is made. Therefore, we can say that, the impact here, however indirect it appears to be, has been quite effective in shaping companies’ financial reporting.
The review work conducted by Walker (2009: 13-15) highlights 39 important recommendations in the management of companies under four specific heading, including the governance of the institution, the duties of the board of directors including their performance, the role of the company’s shareholders and finally, the governance of risk and remunerations. Of particular interest is the governance of risk and remunerations, where among the recommendations included, the need to have a risk committee responsible for advising the board, the committee should also advise about current risks and their advise should be taken into account. With relations to remunerations where the remuneration committee is responsible for overseeing that the company’s policy on pay is clear and fair, also, the there must be a way to monitor how the high end employee are paid and if the pay does not result in risky undertakings in their job roles.
But the above case shows the dependence and a form of respect to the regulations by the buyers of the failed company, but, we surely should be asking ourselves, what happened to the failed company. Some of the examples that the writer shall use to explain this scenario, these are the cases of Enron and the Northern Rock.
The case of Enron is even more interesting because, it touches on two main issues, one was the failure to follow the regulatory procedures by the accountants who were to oversee the pricing of the mark-to-market shares and secondly, in the UK, there were claims of political interference with the enforcement of regulations. In the first instance, as discussed by Peter C., and Ross M., (2002: 12-14), the accountants worldwide are often torn between using accurate prices or conservative prices (where depreciation is considered) when valuing the shares. The accountants of Enron did not follow the regulations in this valuation which made them to hide company’s debts from stakeholders for several years. Anyone would questions where the regulator was to enforce the regulations or was there just no regulation on such valuation? Obviously, if the accountants have all along been in this dilemma, there, well defined regulations touching on this matter should have been given.
Secondly, in the UK, the labour government was accused of aiding Enron to succeed in the UK market by changing the energy policy. This could have affected the regulations effectiveness.
The Northern Rock
The last case is that of Northern Rock, which continued to lend huge sums of money to fist time investors, the loans were given at 125% of the value of the property, for a company that depended on short term borrowing to fund long term loans. It was noted that in this case, the Treasury admitted that the regulations for dealing with the company’s financial affairs especially at the time of trouble were very weak and that action had to be taken. This is a case of the failure of the regulation to consider the future happening (Willem H. 2008: 137). Failure to have plans for dealing embattled companies is in itself a weakness of the regulations since it shows lack of foresight.
There is a need to consider the harmonisation of the working objectives of the tripartite bodies in the UK which deal with financial matters of the organisations. These are; the Treasury, the Bank of England and the Financial Services Authority, with much of the problems facing companies in their financial statement reporting comes from the failure by the FSA to have clear regulations (Willem H. 2008: 137-142)
All the above mentioned cases present us with a desire to seek more about the nature of corporate governance especially in the UK. On the surface of it, while, directors have a duty to run the affairs of the company for the stakeholders especially the shareholders, often the problem of interest occurs.
In their study of International Corporate Governance, Diane K., and John J., (2003) blamed the agency problem (often occasioned by the selfish desires of the directors to keep their jobs and benefits), for all the problems facing the corporate world. They further stated that since corporate governance involves seeking to run the company on behalf and for the benefit of others, if the managers do what is wrong, the company fails, because, corporate governance advocates, transparency and accountability.
But could we then conclude that failure which has been occasioned by the directors’ disregard for the rules is the failure of the financial regulations or failure of adherence to the corporate Memorandum of association?, the blame on the former still persists, this because, the regulations should guide the creation of the Memorandum of Association, hence the composition of the board members who run the organisation.
David S., et al (2000: 12- 17), termed their research work, Some cost benefit issues in Financial Regulation, where they noted that there are more benefits than costs in having a regulator to guide and oversee the preparation of financial statements. however, on the negative side, they noted that the existence of financial regulations have not prevented the management of the company from manipulating the figures and presenting to the ignorant shareholders, a ‘good’ state of affairs of the organisation, which may involve, misappropriating the shareholder’s funds to create profits and pay dividends thereof. This view is in line with the agency problem meaning that the regulations are not effective.
If we consider the issue of supervision, we are immediately drawn to the Cadbury’s report (1992) which was commissioned after the Death of Robert Maxwell, the owner of Mirror group where it was found that the company had taken untold risks which resulted in huge debts. Sir Adrian Cadbury, did a report whose main recommendations included, first, having clearly defined responsibilities to diffuse power in the company, to have many independent non executive directors, and at in the audit committee there should be at least three, there should be some non executive directors in the salaries committee and that these non executives must be picked by the entire board (Boyd C., 2004: 167-182). But is this feasible? Obviously, no, because, this report was commissioned to deal with a specific scenario, but, it can be credited with providing a framework for operation which has obviously set governance precedence for companies.
The conclusion here was that the problem of the UK regulator is not the lack of regulations to regulate the industry, but the problem has been lack of supervision which makes managers and directors to either take unnecessary risks or flout the rules. The issue of supervision was also raised in the House of Lords by Baroness Cohen of Pimlico on 10th Nov, 2009, who noted that while the process of harmonising the European Union financial regulations is necessary, the need to strengthen the UK regulator’s management and supervisory authority cannot be any greater, in view of the financial crisis that has plagued the world (The Daily Hansard 2009). Greenbury R., (1995: 19) produced a report in which dealt with the directors remunerations considered the issues of bonus payment to the directors as part of their package to work hard, but, many especially in the recent past, bonus payment has been the cause of unnecessary risks leading to economic crisis, yet the regulations in place cannot do anything about it, because it is an acceptable practice for the directors especially in the banking sector. The potential of the European Union financial regulations to have overriding powers over the UK’s Financial services regulations has made most members of parliament in UK to cry foul with Lord Myners noting that this goes beyond Ecofin agreement and must be reconsidered because it gives ESA immense power to control UKs regulations and render them in-effective in dealing with specific national situations
The Turnbull report (2005: 4-26), seem to agree with the verdict given by the ACCA by stating that above all the financial regulation needs to be supervised to sustain enforceability. The report touched on four main areas of regulations which must be followed by the corporate managers when presenting their financial statements, these include;
The relevance of having an internal control in the organisation for risk management.
The sustenance of a reliable internal control system.
Having a periodic review on how effective the internal control system is.
Having the board to present a statement to the stakeholders on the current position of the internal control.
But Turnbull Report looks at the wholesome role of the regulations and its verdict stands, yet we may also need to consider Sir Robert Smith’s Report (2005) on the audit committees, on which he states the role of committees as that of monitoring and reviewing the financial statements and providing the necessary recommendations to the directors of the company.
This report suggests that there should be deliberations regarding the nature of risks in the company, categories, the likelihood of such risks becoming real and the company’s ability to mitigate them.
Turnbull further states that an internal control system should;
Be integrated in the organisation and be part of its culture
Should be able to respond quickly to risky scenarios
Have steps for indicating any form of control failure to the right persons and as soon as possible.
But this report has been found to have several loopholes, for instance;
Boards view issues of risk management as not within their concern
Most companies are still concerned with matters of internal financial controls,
There may be lack common objectives among directors
Normally, internal control issues are regarded as matters of regulations for the sake of public relations. On these issues, Turnbull opines that a good audit system should be able to provide the board with sufficient assurance about its effectiveness, help in process improvement for risk identification and lastly, help board members to make viable decisions.
But the critics of this report note that this report has not offered a real solution on how to ensure that external audit system complements the internal system. Therefore, the co-ordinating function of this report goes missing (John I., 2003: 11-12).
But Sir Robert Smith’s Report (2003: 8-11) gave a more comprehensive detail on the role of audit committees among which include;
See that there is integrity in financial statement
Review internal control process.
Advise the board about who to appoint as external auditor and to monitor their independence
Take part in process of setting policies in case external auditor will be given other tasks to undertake.
However, anyone may raise the issue of collusion however remote, between the internal auditors and the potential external auditors which may lead to compromise in preparation of the financial statements.
But these reports explicitly provides guidance to the bigger organisations and not the medium and smaller ones with just a few directors, therefore, should the smaller and medium organisations flout their financial statements, the regulation takes the blame.
Lastly, according to the research conducted by Kern A., (2004) on the nature of International financial regulations, the UK regulations have been a product, partly, of the informal practices of the Bank of England, which relates to the activities of the banks and other companies, but, that these regulations on their own cannot guarantee fair representation of the financial statement by organisations and that there is a need to involve private participation in this process. Private participants here mean the other stakeholders who should work with the regulator and keep directors on check. However, he has not stated how this can be feasible, or / and practical.
From the discussion presented above, we can say that the financial regulations have been less than effective in determining the accuracy of the financial statement and by extension in guiding the actions of the corporate managers.
Financial regulations need to be;
Reviewed on periodic basis in order to make them compatibles with the changes in the corporate world, this is not only affected by the national factors but by global conditions.
The financial regulation allow for more supervisory role in order to ensure that from time to time the activities of the corporate directors are checked.
The financial services authority and other regulatory bodies must work together by sharing information within appropriate legal framework in a way that will guarantee effectiveness in the preparation and presentation of financial statements.
It is also, not possible to have general regulations touching on all the sectors, because this may give some sectors i.e the Manufacturing sector, undue leeway and advantage at the expense of other sectors like the banking industry.
In this discussion, we have seen how the financial regulations, have, however well intended, have failed to stop bankruptcy or failure by the banks. There is a cross sectional agreement that unless the supervisory duties of the regulators are strengthened, it is impossible to see the regulations being effective.
It is also worth noting that with European Union becoming active, most decisions are not country specific, because they are being made in Brussels, the, country specific regulations cannot be effective anymore if the rules require trading and financial representation in a way that reflects the corporate sector within the Union.
Effectiveness can only be achieved, if not guaranteed, by there being drastic changes and multi agency working to create harmony and enforce the rules, thereby benefit the stakeholders.