Financial Reporting

PART ONE – Corporate Governance

In the early 2000s, many concerns were shown regarding the transparency of the accounting information including the complexity of rule based accounting. The Sarbanes-Oxley act criticised rules-based accounting standards and highlighted a number of issues regarding the effectiveness of using principles-based accounting system in 2002 (Schroeder, Clark and Cathey, 2011). In 2003, the SEC report concluded that the rule-based accounting encouraged financial engineering, consequential to less informative and/or misleading financial statement. Therefore the report proposed principle-based accounting system (Benston, Bromwich and Wagenhofer, 2006) however the shortfalls of the principles based system were also highlighted.

According to ICAS (2006), rules provide specific and clear-cut instructions to eliminate the doubts (if any).  A rule based approach to accounting provides thorough and specific guidance with amplification; this however de-skills the profession in the sense that professional judgement is not required. A rule relates to developing an unmistakeable method for decision making. These rules are very authoritative and enforceable but cannot avert dishonesty. Instead, it fosters creative accounting and leads to financial engineering by distracting the focus away from the underlying reality. ICAEW (2009) states: “Rules create a roadmap for avoidance and divert the attention from the need of true and fair view”.  Rules can result in complex practices and difficulty in coping with the changing business environment; however this complexity depends on the complexity of the underlying situation. I believe that rule based approach is similar to pursue a problem after its occurrence. For example, if a set of rules is regulated, financial engineers may find a way around them; that’s when a new set of rules would be introduced to prevent that newly introduced practice.  This is because one can say ‘show me where it says that?’. It is possible that the rules are subjective and that they do not reflect the underlying principles.

A principle is referred to a general statement with broad support to decision making. It acts as a guide to actions with intending to promote truth and fairness (ICAS, 2006). On the other hand, Principle based accounting approach offers a system with a faithful representation of the financial substance of transactions. This type of system enables effective communication with the stakeholders. As it is not very specific, I can easily cope with the complex and changing business environments. However, SEC (2003) states that this system is inconsistent as it need considerable guidance for the management judgement.   

Therefore I believe that it won’t be wrong to conclude that both approaches have their respective benefits and limitations. Principles based approach encourages professional judgement with a putting ‘truth and fairness’ at the centre of attention; this discourages the financial engineering.  Agoglia, Doupnik and Tsakumis (2010) concluded that financial statement preparers are likely to report aggressively when applying precise standards.  Rules approach instead provides instruction for more practical implementation with a lesser need for justification in financial statements (Schroeder, Clark and Cathey, 2011). According to ICAS (2006), Rules cannot replace the principles. The rules can however be in place in order to observe the principles. Judgement would be needed to assess whether the rules actually support the principles or not.

The US GAAP was more rule-based whereas many countries, including the UK, adopted principles based approach to enforce the corporate governance codes (ACCA, 2008). The classic model of shareholder wealth maximisation yielded declining results and the dominance of shareholder began o be challenged.  The British’s share in the global economy had declined from 25% to 5.6% between 1900 and 2000. During this time; most British companies operating in major market like vehicle manufacture and investment banking for instance were driven out by competition. Additionally, many of the major companies collapsed after about 1970s. A series of corporate collapses such as BCCI bank, and scandals such as Robert Maxwell pension funds in the 1980’s and 1990s rouse concerns in the International business community. Davies (2006) state that The British businesses were not only weakening to compete globally, but it was also at a severe risk of internal decay. Apart from the damage to the British economy, the situation posed a threat to the credibility of London as a market for investors. The UK business community recognised the desperate need to put the practices in order.  

The stock exchange launched the Cadbury enquiry by the committee on financial aspects of corporate governance in 1991, chaired by Sir Adam Cadbury. The committee highlighted the issues, and discussed the recommendations and suggestion in the Cadburys report (FRC, 2006). Shareholders are considered as the Principals of an organisation who employ the managers as their agents to control the assets. Shareholder wealth maximisation is seen as the ultimate goal for all Principals. Managers are employed to achieve this goal, however, managers may have their personal objectives or interest that they may prioritise such as job security, increased pay or increased managerial power. This situation is known as Agency problem which leads to increasing agency costs to the principals (Jager, 2008). The Cadbury report addressed all these issues including the relationship and roles of non-executive directors and reporting on internal control on the company’s position.  LSE added the rule (comply or explain) that companies should report whether they followed the recommendations or give explanations (FRC, 2006).  

Govern can typically be defined as ruling by authority. However corporate governance can be used universally in a less strict sense of controlling (Lee, 2006). Financial markets and investors now associate good governance with prosperous companies.  It is as important for small companies as for the large ones. It helps to prevent corporate scandals and potential civil and criminal liability to the organisation. It also improves the reputation of the organisation, resulting in making it more attractive to customers, suppliers and investors (Lipman and Lipman, 2006).

The UK has adapted an approach to corporate governance which has high standards but relatively lower associated costs when compared with other countries. 94% of the UK pension funds agreed that these standards in UK companies have been consistently improving. London Stock Exchange found that companies gave most importance to the corporate governance requirements when choosing between UK and US listing. It had been concluded that UK was in advantage in this situation due to its higher standards than the US (FRC, 2006). One of the main differences between UK and US approach is that principles based approach is commonly used in the UK but rule based in the US which leaves it with no option to explain deviation.

The high standards of corporate governance in the UK are achieved by a combination of governance features. The role and composition of the board is very important. The company is lead by a single board with the members being accountable. It is the board’s responsibility to maintain an effective internal control and reveal the company’s position with a balanced assessment. Adequately experienced directors of the audit committee should monitor and evaluate the practices.  There is a separate chair man and chief executive who divide the responsibilities clearly for the board members. Large companies need a 50-50 balance of executive and independent non-executive directors while smaller companies should have at least two independent directors.  The procedures of appointing directors should be transparent and be approved by the Shareholders.  Additionally, the effectiveness of the board should be regularly evaluated. The effectiveness of the board, based on the performance of the members should be remunerated transparently by the remuneration committee. Importantly, the shareholders should maintain effective communication with the board to ensure s good level of understanding (FRC, 2006).

PART TWO – Professional Ethics

Ethics branches out from the philosophy of morality which relates to concepts related to good and bad or right and wrong. It is a very controversial issue with no universally accepted approach to it. Some practices may not be forbidden by law, but can be classified as unethical (Ferrell, Fraedrich and Ferrell 2009). The concerns for ethics have been growing, therefore businesses and professionals find it important to take the interest and perceptions of the stakeholders into considerations.

Accountancy, like every profession, requires special knowledge, skills and qualities. An accountant not only serves the employer, whose accounts are being prepared, but also many other stakeholder groups such as the government bodies, competitor companies and the general public. The stakeholders perceive the accountants as extremely competent, dependable and objective. Each stakeholder may have a unique interest in the work done by the accountant. The shareholders use the accounts to evaluate the performance of the business as they are primarily interested in profits.  The government bodies would need the accounts to determine the tax liability of the firm. The accounts may also determine the decision of potential investors and bankers (Carey, 1980).

Therefore Accountants should practice professionally and consider the interest of teh stakeholders. Professional ethics adopted by accountants would help maintain the trust and reputation of the occupation (ICAEW, 2011. However, the accountants may be in guidance of seniors to prepare false image of the business by manipulation of the accounts. Cardebat and Sirven (2010) concluded that CSR policies adopted by firm do not improve their financial performance. Still, I believe that professional ethics may help the business to sustain in the future.

ICAEW’s provide the accountants with the Code of Ethics, which provides guidance to maintain the ethical practice.  The code sets out five principles which should not be threatened by the accountant’s practice. The first fundamental principle is ‘Integrity’; which relates to being straight forward and truthful in the practise. The accountants should not provide false information or mislead the user in any way. I believe that this principle is equally important for all professions therefore this requirement by code is very important.  The second principle of ‘objectivity’ requires the accountants to not be biased towards a decision. The accountants should be neutral and not just make decisions on the basis of own preference. Additionally, the decision should be in the best interest of the business and the stakeholders. As the third principle ‘Professional competence and due care’ requires the accountants to uphold a high level of professional knowledge and skills to apply the most suitable techniques and standards for their practise. . These two principles are very significant because the clients, who the accountants serve, may perceive the accountant as dependable and objective so base the decision on their work.   The fourth principle ‘confidentiality’ demands the respect for the client or business’s level of requirements regarding confidentiality of the data. The accountants are not allowed to use any information for personal use or disclose any confidential information to anyone who is not authorised, unless it is legally required. Misuse of confidential information can potentially be disastrous for a business, therefore this principle is considered. The fifth principle ‘professional behaviour’ relates to complying with the laws and regulations. As mentioned, accountants should practice in the favour of the business and should consider the interest of the stakeholder, but that should not be achieved by violating any laws.

ICEAW has also identified threats to these principles that should be safeguarded. ‘Self-interest’ of accountants may influence the judgements, decisions or behaviour. An appropriate ‘self-review’ may not be conducted, resulting in judgements based on the previous ones which may not be accurate. An accountant may ’advocate’ the client to an extent that the objectivity of the profession is compromised. ‘Familiarity’ with the client may also influence the practice in the favour of the client. Similarly, the accountant may be ‘intimidated’ and pressurised to not practise objectively.    

To minimise these threats, the ICEAW provides safeguards to maintain the principles. The perceptions and judgements of a third party (who is well informed of all details including the threats and safeguards) should be considered when concluding  whether the practise is threatening the principles or not. The circumstances may determine the nature of safeguards to be applied. I totally support the principles and safeguards to threats provided by ICAEW because conventional regulation cannot cure moral blindness. Additionally, I suggest that accountants should sign an oath, similar to that adhered by doctors, as Dr Barry Morgan suggested for executives (BBC, 2011).

References

ACCA, 2008. Rules, Principles and Sarbanes-Oxley: Corporate Governance Codes. [Online] Available at: <http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_apr08_campbell.pdf> [Accessed 12 March 2011].

Agoglia, C,. Doupnik, T., and Tsakumis, G., 2010. Principles-Based versus Rules-Based Accounting Standards: The Influence of Standard Precision and Audit Committee Strength on Financial Reporting Decisions. The Accounting Review, Vol. 86, No. 3. [Online] Available at: <http://web.ebscohost.com/bsi/pdf?sid=e2878bb0-9301-4b49-baac-79a58a44f1c0%40sessionmgr10&vid=5&hid=105> [Accessed 19 March 2011].

BBC, 2011. Archbishop of Wales calls for ethical business code. [Online] Available at: <http://www.bbc.co.uk/news/uk-wales-12166032> [Accessed 19 March 2011].

Benston, G., Bromwich, M., and Wagenhofer, A., 2006. Principles- versus Rules-Based Accounting Standards: The FASB's Standard Setting Strategy. Abacus, Vol. 42, No. 2, [Online] Available at: <http://fisher.osu.edu/~schroeder_9/AMISH520/Benston2006.pdf> [Accessed 19 March 2011].

Cardebat, J. & Sirven, N., 2010. What corporate social responsibility reporting adds to financial return?. Journal of Economics and International Finance, Vol. 2.

Carey, J., 1980. Professional Ethics of Public Accounting.[Online] Available at: <http://books.google.co.uk/books?id=hWQ-J3gS9sQC&printsec=frontcover&dq=professional+ethics+in+accounting&hl=en&ei=t8-yTfekNc-p8QPauOWVDA&sa=X&oi=book_result&ct=result&resnum=2&ved=0CFoQ6AEwAQ#v=onepage&q&f=false> [Accessed 26 March 2011].

Davies, A., 2006. Best Practice in Corporate Governance. [Online] Available at: <http://books.google.co.uk/books?id=23sdpmOPsnEC&pg=PA4&dq=why+corporate+governance+important&hl=en&ei=Cl-xTf7WBpGyhAfU_tjrCg&sa=X&oi=book_result&ct=result&resnum=3&ved=0CEwQ6AEwAg#v=onepage&q=why%20corporate%20governance%20important&f=false> [Accessed 11 March 2011].

Financial Reporting Council, 2006. The UK approach to Corporate Governance. [Online] Available at: <http://www.frc.org.uk/documents/pagemanager/frc/FRC%20The%20Uk%20Approach%20to%20Corporate%20Governance%20final.pdf>  [Accessed 13 March 2011].

Ferrell, O., Fraedrich, J. and Ferrell, L., 2009, Business Ethics: Ethical Decision Making and Case. [Online] Available at: <http://books.google.co.uk/books?hl=en&lr=&id=f3jg2jhqfC8C&oi=fnd&pg=PR15&dq=Business+Ethics:+Ethical+Decision+Making+and+Cases&ots=edwXf0Ghlh&sig=HVc-TLsTi_nNP3DTKcOf72aK-6o#v=onepage&q&f=false> [Accessed 11 March 2011].

ICEAW, 2011. Code of Ethics Overview. [Online]. Available at: <http://www.icaew.com/en/technical/ethics/icaew-code-of-ethics/overview-of-the-icaew-code-of-ethics>  [Accessed 12 March 2011].

ICEAW, 2011. ICAEW advocates a principles based approach to regulatory reform. [Online] Available at: <http://www.icaew.com/en/about-icaew/newsroom/press-releases/2009-press-releases/icaew-advocates-a-principles-based-approach-to-regulatory-reform-166300> [Accessed 13 March 2009].

Jager, C., 2008. The Principal-Agent-Theory within the Context of Economic Sciences. [Online] Available at: <http://books.google.co.uk/books?id=pHM1V1h9otYC&printsec=frontcover&dq=principal+agent&hl=en&ei=OpexTc3GAo2KhQear9zrCg&sa=X&oi=book_result&ct=result&resnum=1&ved=0CCoQ6AEwAA#v=onepage&q&f=false>

Lipman, F. And Lipman, L., 2006. Corporate GovernanceBest Practices. [Online] Available at: <http://books.google.co.uk/books?id=emts4pFA-ooC&pg=PA3&dq=why+corporate+governance+important&hl=en&ei=ZbewTaDGCYig8QPemuTlCw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CDcQ6AEwAA#v=onepage&q=why%20corporate%20governance%20important&f=false> [Accessed 26 March 2011].

Lee, T., 2006. Financial Reporting &Corporate Governance. [Online]  Available at: <http://books.google.co.uk/books?id=OJDe8U3slekC&printsec=frontcover&dq=corporate+governance+financial+reporting&hl=en&ei=p5qxTa25LYmO8gOFn_iVDA&sa=X&oi=book_result&ct=result&resnum=1&ved=0CEMQ6AEwAA#v=onepage&q&f=false> [Accessed 11 March 2011].

Schroeder, R., Clark, M., and Cathey, M., 2011. Financial Accounting: Theory and Analysis. [Online] Available at: <http://books.google.co.uk/books?id=HTXzc5VjT4QC&pg=PA58&dq=principle+vs+rule+based+accounting&hl=en&ei=u6CtTa--B4XPhAeEupWoDA&sa=X&oi=book_result&ct=result&resnum=2&ved=0CDoQ6AEwAQ#v=onepage&q&f=false> [Accessed 27 March 2011].