By Nishan Fernando
Bushman, Piotroski and Smith (2003) identified that the availability of information was considered to be a key determinant of the efficiency of resource allocation decisions and growth in an economy. Availability of information is linked to corporate transparency, defined as the widespread availability of firm-specific information to those stakeholders outside the firm. Corporate reporting plays a significant role in facilitating corporate transparency.
Corporate reporting involves periodic dissemination of firm-specific information. This could be either voluntary or mandatory or a combination of both. Three broad aspects can be identified with regard to corporate reporting: (1) financial disclosures; (2) governance disclosures; and (3) the audit quality of these disclosures. This article will address the financial disclosure aspect of transparency and considers its drivers: the accounting principles used to recognize and measure financial disclosures; and its timeliness together with the audit quality pertaining to financial disclosures.
Transparency and GAAP
Financial statements have got the highest importance for any sort of business. In fact one could say that the financial statement is the summary of the whole year’s performance. A financial statement is prepared in the transparent way as it’s a source which will attract the investor and create desire among them for making an investment in that company.
Transparency in financial statements means that the statements should be user-friendly and clear, and everything should properly be disclosed. Companies that understand the importance of transparency and financial reporting, are also well informed about the psychology of the investors. A complex and opaque financial report gives little understanding about the true risks involved and real fundamentals of the company. One main concern while preparing the transparent financial statements, therefore, is that it should be interesting and easily understandable. The use of hidden entries and complex accounting and financial terms should be minimised and both favourable and unfavourable sides should properly be elaborated.
While making the financial statements transparent, one also have to ensure whether they are in compliance with Generally Accepted Accounting Principles (GAAP). In the Sri Lankan context GAAP comprise the Sri Lanka Financial Reporting Standards (SLFRS) promulgated by the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka) which are virtually the same as International Financial Reporting Standards (IFRS). Consequently, compliance with SLFRS makes the financial statements easily understandable internationally.
Agency Problems and Financial Reporting
Resolving agency problems is integral to corporate governance and transparency. Two types of agency problems can be typically identified in the corporate world. The first is that the interests of the board of directors and shareholders are aligned but the interests of management are not. The second type is that the interests of the board and management are aligned with each other but their interests are not completely aligned with the interests of sharehold¬ers.
These agency conflicts are reduced through both formal and informal measures. Formal measures include corporate charters, employment contracts, listing require¬ments and other regulations whereas many important governance functions are carried out via informal measures.
According to research findings by Verrecchia (2001), managers typically have better firm-specific information than non-executive directors and shareholders, but they may not always truthfully report information that is detrimen¬tal to their personal interests, such as information about poor performance or their consumption of private benefits. Boards, which largely consist of non-executive directors, and shareholders, are therefore typically assumed to be at an infor¬mational disadvantage when monitoring managers.
Thus, one important role for financial reporting is to provide non-executive directors and shareholders with relevant and reliable infor¬mation to facilitate their mutual monitoring of management and, in the case of shareholders, their monitoring of directors.
Qualitative Characteristics in Financial Reporting
The Conceptual Framework for SLFRS identifies qualitative characteristics which enhance the usefulness in financial reporting to ensure high level of transparency in the above context.
Relevance (the need to disclose all material information) and faithful representation (the need to provide complete information which are neutral and free from error) are considered fundamental to the quality of financial statements.
The Conceptual Framework further identifies four other characteristics which are considered to enhance the usefulness of financial information: (1) Comparability (ability to compare with the past information of the company and with the information of the other companies in the industry); (2) Verifiability (Ability of different knowledgeable and independent observers to reach consensus); (3) Timeliness (provision of information at the right point in time to influence decision making); (4) Understandability (Ability to understand information with reasonable effort).
The above characteristics will support the users to mitigate the agency conflicts thus increase the degree of transparency of the activities taking place in the company. Other than making the financial statement with proper elaborations and making it reader friendly, it is necessary to ensure completeness of the transactions leading to each of the figures and they are truly recorded in making the financial statement transparent. An independent audit will add value by improving the process as high level of auditing and cross checking ensures compliance with GAAP and true and fair presentation of the financial statements. The recent addition to the Auditor’s report requiring disclosure of key audit matters and mitigation of audit risks arising therefrom can be considered as another step forward to enhance transparency of financial reporting.
(The author is the Managing Director of BDO Consulting (Pvt) Ltd and a Past President of CA Sri Lanka.)