Making Financial Reporting Better: Strengthening the Financial Reporting Supply Chain
Is it sufficient to wait until the next crisis hits and ask only: “where were the auditors?”
Why financial reporting
Timely and meaningful information underpins the effective functioning of any organization. Organizational leadership use financial and non-financial information to manage and direct their operations, while external stakeholders—investors, suppliers, creditors, banks, and regulators—use it to make investment decisions, to undertake transactions with organizations with confidence, and to exercise regulatory oversight.
Financial statements capture much of the information that organizations prepare, publish, and use. And while it’s becoming more important to report other, non-financial information that stakeholders find relevant to their decision making, financial statements prepared in accordance with internationally accepted financial reporting standards are a crucial instrument for the effective functioning of markets.
Improving financial reporting
Given the critical role that financial statements play, it is imperative that efforts are made to examine ways to improve their quality, and to understand their purpose and limitations in providing a comprehensive view of an entity’s financial position.
Government and regulatory responses to the recent global financial crisis and corporate failures have focused primarily on the role of the auditor. There have been a multitude of regulatory reforms impacting the auditing profession, and financial reporting standard setting has been subject to vigorous debate. However, there has been considerably less focus on the roles of management teams and boards of directors, and the responsibilities and impact of regulators, in achieving high-quality financial reporting.
A more holistic view of financial reporting and assuring the needs of users is required; a view that recognizes, assesses, and explores the entire financial reporting supply chain—that is, all of the people and processes involved in the preparation, approval, audit, analysis, and use of financial reports.
It is a complex process with many components, many interactions, and many different actors. Roles, responsibilities, and interactions must be clearly identified and appropriate controls and safeguards must be implemented.
Components of the financial reporting supply chain:
Governing bodies. Governing bodies—often boards of directors—are responsible for publishing financial reports, and lie at the heart of the financial reporting supply chain. They must have effective corporate governance arrangements and clear ethical codes, and be competent to oversee high-quality financial reporting arrangements.
Are we doing enough to ensure that governing bodies (particularly audit committees) have the appropriate expertise and competency, and have in place (and comply with) appropriate governance arrangements and ethical codes? Many corporate governance principles and guidelines exist; however, should we consider improving this foundational aspect of financial reporting by setting corporate governance requirements as mandatory global standards?
Financial statement preparers and management. Those responsible for producing the information—financial preparers, management accountants, chief financial officers, and chief executive officers—should be bound by effective corporate governance arrangements and clear ethical codes.
Is enough being done to ensure that these groups are equipped to contribute to high-quality financial reporting? Should preparers be subject to similar registration, qualification, licensing, inspection, codes of conduct/ethics, and enforcement arrangements as auditors? Should they be required to sign their names to all financial statements to heighten the sense of accountability?
Financial reporting standard setters. Financial reporting standards are the principles and rules used to prepare financial statements. They provide the common language—used throughout the supply chain—to measure, describe, and evaluate the financial information.
Is standard setters’ almost exclusive focus on investors—and profit or loss, as measured by financial reporting standards—appropriate? Should they look more broadly at user groups, and recognize that, for today’s complex organizations, there are multiple measures of financial performance? Does the quest for a single measure of performance distort, rather than enhance, a full understanding of an organization’s financial performance?
External auditors. The external auditor provides an independent, skilled assessment of the reliability of the organization’s financial statements. Over recent years the external auditor, and the audit itself, have been subject to considerable scrutiny, and the auditor’s role and work have been further regulated and redefined, including in areas such as independence and reporting.
Is extended auditor reporting—on matters beyond the basic purpose of an audit (to express an opinion on the financial statements)—helpful, or simply contributing to information overload? Are the auditor’s incentives aligned with this extended mandate? Should the auditor prepare different reports for different user groups and stakeholders? Should these be part of the basic audit or commissioned as needed under separate terms of reference?
Regulators. Audit oversight, securities, and prudential regulators are important links between producers and users of financial information. They enforce various aspects of the auditors’ work, undertake inspections, oversee auditor registration, oversee the conduct and reporting of security issuers and banks, and ensure that the information exchanged between individuals and organizations is transparent and sound. Clearly, regulators have a marked impact of the quality of financial reporting.
Should all regulators, or at least those that oversee exchanges that permit foreign listings, be subject to high-quality, global standards for their operations and accountability, to ensure consistency of oversight across all jurisdictions?
Instead of placing excessive reliance on financial statements as offering the full range of the information necessary for a comprehensive understanding of an entity’s financial position, should regulators obtain supplemental financial disclosures, either through commissioning an agreed-upon procedures engagement by the auditors, or through other means, for particular organizations or sectors where their supervisory activities indicate that additional information and examination is warranted?
Analysts. Credit rating and investment analysts are responsible for evaluating organizations' financial reports (and other relevant data) and drawing conclusions about their creditworthiness and investment potential. These assessments are used by investors and others in decision making, and relied upon by regulators in their regulatory and oversight functions—and thus play a critical role in the movement of capital throughout markets and industries.
Should credit rating agencies be subject to greater levels of regulation, and be held liable for losses when investors relied on their ratings, which were shown to be deficient? Should analysts providing their services to the investing public be subject to similar registration, qualification and licensing arrangements as auditors, to ensure the highest standards of competence and performance?
Investors. Investors are individuals or entities that commit capital to organizations with the expectation of financial returns. They rely on financial reporting: reliable, accurate information that enables sound decision-making. Their investments ultimately result in economic activity, growth, employment, prosperity, and the creation of wealth—for investors as individuals, and for society as a whole.
Can investors distinguish high-quality, robust financial information from reporting that is deficient—so they can apply appropriate pressure and influence to improve reporting by organizations in which they invest? Should governments do more to promote financial literacy, to ensure that citizens have a more informed perspective about the financial decisions they make? Should they discourage citizens from becoming investors without having first become financially literate?
Financial reporting plays an integral role in the capital markets and economic stability and growth, and efforts to enhance its quality are vital. But it is a complex process with many components, interactions, and actors—and only a holistic, critical assessment of the entire financial reporting supply chain will be effective. Discussion, debate, and decisions must focus on all aspects of the supply chain, and the roles and responsibilities that all participants have in producing even better outcomes.
Everyone has an interest in achieving high quality financial reporting. We can’t wait until the next financial reporting scandal arises to debate, discuss, examine, and assess this important issue. We need to act now, with coordinated efforts, to achieve this goal.