Post-Enron, much of the reason for the sluggish performance of the stock market is investor lack of confidence in the credibility of financial reporting and disclosure. Restoring that magical ingredient – confidence – is now vital. But how will such a restoration be achieved?
Almost all the high-profile disasters were powered by a triple failure in business, governance and reporting. A reporting failure occurs when the governance structure fails to prevent or detect a business issue that should be communicated to the users of the financial statements.
As a business moves closer to a business failure, the management’s incentive to distort reporting increases and, therefore, so does the chance of reporting failure.
This latest wave of corporate collapses dented confidence harder than similar failures in previous decades because stock markets across the globe had seen stock prices rise rapidly to historically high levels, including notable surges in particular sectors such as telecoms and e-business. The pressures on management to deliver performance in line with the expectations of the market were correspondingly high and increasingly focused on maintaining share prices in the short term.
The International Federation of Accountants (IFAC) has published a report, Rebuilding Public Confidence in Financial Reporting, produced by a task force that identifies and analyses the causes of the loss of credibility, how to restore that credibility and best practice recommendations. It concludes that “extensive action” is required to raise credibility.
IFAC’s task force came up with recommendations which, it claimed, would start to repair the damage done by Enron et al. It wants a knowledge of reporting and controls to be considered a core competency of the chief financial officer – a sentiment that underlines how some companies were perceived to care more about financial engineering than financial management – and that the key role of the internal audit be emphasised by having it report to the chief executive officer and giving it unfettered access to the audit committee. It wants boards of directors to improve their oversight of management, including regularly evaluating the performance of the CEO examining his or her leadership role in ethics, governance and financial reporting, as well as the performance of the company.
The report admitted that incentives to misstate financial information need to be reduced. It wants companies to stop providing the market with forecasts of profits that assume an unrealistic level of precision and support the International Accounting Standards Board in expensing the costs (and the clear disclosure of the terms) of granting the options.
External advisers need to be brought more formally into the corporate governance net. The task force is demanding to see codes of conduct for other players in the financial reporting process: directors, auditors, financial analysts, lawyers and investment advisers helping the corporation on matters relevant to financial reporting. In addition, credit rating agencies should be required to disclose their criteria, their evaluation process and the quality mechanism they use. Finally, it calls on regulators to conduct post-issue reviews of financial statements for compliance with accounting standards.
It’s a sizeable shopping list and many will no doubt cry, ‘We’ve already done that’. Certainly in the UK, Higgs and Smith seem to have informed much of this report. All of the examples of reporting failure demonstrate a failure to act ethically by at least some of the participants who should have known and done better. As IFAC says: “The list is lengthy: misleading auditors, auditors looking the other way, disguising transactions, withholding information, providing unbalanced advice, abuse of trust and misusing insider information.”
Time and again, we come back to concepts that cannot be legislated for: trust, faith, confidence; in other words, fairly sophisticated issues of human morality and behaviour. Laws, regulations and standards can provide a framework, but they can’t provide the conscience.
This agenda set out by the IFAC, though by no means unique to it, points the way to restoring trust and confidence in the corporate world across the globe, protecting investors, employees and directors who play by the rules, thereby improving economic growth.