LOS F requires us to:
describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms
If left completely to the management discretion, there would be very high chances of low-quality reports being produced. There must exist, certain mechanisms or regulation that controls the reporting requirement. Some of the mechanisms that discipline the financial reporting quality are:
a. Markets. Markets are usually very efficient in ‘pricing-in’ risk. The higher the risk faced by the business, the higher would be its cost of capital and vice-versa. A better quality reporting lowers the perceived risk of the business thus reducing the cost of its capital in return.
b. Regulatory Authorities. There are certain government-established regulatory authorities as well as self-regulatory authorities, such as SEC, FCA, ISOCO, etc. that controls the financial reporting environment. These authorities:
i. have registration requirements to comply before the initial public offerings (IPO),
ii. have disclosure requirements for the ongoing issue of shares and post initial offer,
iii. have periodic audit requirements (usually annual),
iv. the requirement to prepare a statement of management commentaries giving a description of the risk and review of the business,
v. the requirement to prepare responsibility statement of management and board of directors, explicitly acknowledging their respective responsibilities,
vi. requiring regulatory review of fillings, and
vii. enforcement mechanisms having penalties and prosecution in case of deviation from fair reporting.
c. Auditors. The public companies are compulsorily required, and private companies may (in case, it is a condition of obtaining finance) have periodic (usually annual) audits. The auditors, as a result of a process of audit, are required to express an opinion on the true and fair view of the statements of affairs of the corporations as presented in the financial reports. There are, however, certain limitations to the credibility of audit as a mechanism to control the quality of financial reports. Some of these limitations are:
i. The auditor’s opinion is based upon the information prepared by the companies, which may already be biased or incomplete, to begin with.
ii. The audits are based on the samples and not all transactions are verified individually, thus not eliminating all risks.
iii. There may be an expectation gap, as the auditor may completely ignore the fraud angle and may only look for the fairness of the presentation.
iv. The auditor may not have enough power to control and enforce fair reporting, in a competitive market for clients.
d. Private Contracting. The covenants of certain contracts (especially in the case of debt financing), may motivate manipulations, which in turn motivates greater monitoring.