Disclosure and Financial Reporting - Essay Example

Disclosure and Financial Reporting Introduction The activities of a company and stakeholders are published in the financial ments which are formed by financial reporting in the form of Balance sheet, Income statement, cash-flow statement and accompanying notes. The disclosure of financial statements is secondary information given for review of the stakeholders of the company, its partners and external readers in support of any published financial information. The financial reporting and disclosure by organizations help the outsiders to take decisions on investment. It also helps the other market players to decide on mergers and acquisitions. Through disclosure of financial statements, the companies also endorse the financial information that has been sent to their regulating authorities like Securities and Exchange Commission (SEC). It is important to understand the key issues that affect the financial decisions of managers in disclosures and financial reporting. In this essay, the changes in regulations and standards that have improved the method of financial reporting and disclosure and the subsequent impacts on a company in terms of future cost, risk exposure and profits are being discussed. Several laws have been enacted and acts have been passed in different countries with the objective of making financial reporting and its disclosures more reliable and trustworthy. The objective of addressing the key issues is to ensure and protect the interest of the stakeholders and investors. One such act that addressed these issues is Sarbanes-Oxley Act. It was first implemented for companies listed in NYSE and has now been spread all over the world. Sarbanes-Oxley Act has redefined and changed the ways of Corporate Governance of companies leading to efficient and transparent operations (Ambler, Massaro and Stewart, 2005, p.38). Disclosures and financial reporting: Key issues addressed The recent changes in the Sarbanes-Oxley Act have redefined standards of disclosure and financial reporting for companies. The Sarbanes-Oxley legislation is a US federal law that was enacted in 2002 and was made applicable for all public limited companies of US. The Sarbanes Oxley Act or SOX is commonly referred as Public Company Investor Protection and Accounting Reform Act’ and ‘Auditing and Corporate Responsibility Accountability Act. Many investors had previously complained about the relevance and volume of financial information in their disclosures and were also unhappy of finding useful information in the disclosure and financial reporting by companies. In the above context, SOX was enacted in order to make it mandatory for companies to certify accuracy and relevance of the financial information disclosed by them. Non-adherence to SOX Act also earned penalties for the companies. The enactment of SOX has empowered the external auditors and has increased the role of oversight for the concerned Board of Directors. The change in role of the Board of directors has redefined corporate governance by making it stricter than earlier. Through efficient corporate governance, the companies were able to deal with the new system of laws and regulations and maintain healthy relationships with their stakeholders (Rao, 2000, p.42). The continuous monitoring of the board of directors helped in eliminating the misdeeds or misappropriations in the part of corporate officers. As a result of these changes in regulation, the following key issues were addressed. Proper system of accounting and financial reporting was put in place which enabled disclosure of only and only relevant information to the stakeholders of the company. Secondly, flexible requirements were put in place for the companies to report relevant information for some specific circumstances. Thirdly, a judgment panel or framework was instituted to decide which information is pertinent with respect to specific situation faced by the companies. Fourthly, suitable techniques were adopted in order to make information more user-friendly and easy to find for the readers. This was done by organizing the information and formatting the same in a proper manner. Finally, the requirement of disclosure of financial statements in interim periods and in a periodical manner was also addressed. Apart from these issues, the requirement of disclosure of risk exposure of companies namely liquidity risk, interest rate risk was also addressed. The Sarbanes-Oxley Act came into force on the background of large scale accounting frauds and scandals namely that of Enron. The transparency, reliability and periodicity of financial disclosures to the internal and external stakeholders were the concerned areas that have been focused by the Sarbanes-Oxley Act. In order to address the above-mentioned issues of financial disclosure and reporting, the following changes in the operational framework of the companies took place which resulted in effective and successful implementation for achieving the desired goals of relevance, reliability, periodicity and transparency of financial information. The SOX Act requires principal officer of the public limited companies to certify the authenticity of the financial information that is maintained with the Securities and Exchange Commission. The principal officer also has a principal duty to certify the effectiveness of the internal control systems of the company. The certification of effectiveness of disclosure controls has been enacted by Section 302 of Sarbanes – Oxley Act. The certifications submitted by the principal auditor of the company is subject to audit by the external auditors who forms an opinion on the effectiveness of the internal controls certified and the veracity of the financial information attested by the principal officer. Section 303 of Sarbanes – Oxley Act ensures that it would highly unlawful for any director or officer of a company to execute improper influence, mislead or pressurize to manipulate any financial information during the period of audit as may be conducted by external auditors. This helps in ensuring protection for the investors of the company. Section 401 of the Sarbanes – Oxley Act recommends of all off-balance sheet items in its periodic reports. The inclusion of material information from off-balance sheet into the main balance sheet inflates the financial position of a company which happened in the case when Lehmann Brothers went bankrupt. Thus with the help of this section, a new dimension of transparency and reliability of financial disclosure has been addressed. The periodicity of disclosure of financial reporting has already been addressed before. Section 404 of Sarbanes – Oxley Act ensures assessment of internal control systems of the companies. This was done with the help of ratings given by the management and the external auditors to find out the degree to which the management has fulfilled its responsibility in maintaining adequate control structure in their company for efficient financial disclosure and reporting. In order to do this, the companies assessed the performance of operating control structure against the set benchmarks to identify the areas of financial misstatements, risk exposure, provide flexibility of the judgment panel to decide on the relevance of financial reports, etc. As a technique, the companies are maintaining their internal control structure in accordance to the Committee of Sponsoring Organizations of Treadway Commission (COSO). Several other techniques adopted by companies involve evaluation of controls to detect and prevent fraud, control over periodic financial reporting and assessment of internal controls based on the complexity and size of the company. Section 802 of Sarbanes – Oxley Act imposes criminal penalties for exercising influence on US investigating or administrative authorities. Section 906 of Sarbanes – Oxley Act imposes criminal penalties to CEO/CFO for certification of improper financial statements and reports. Section 1107 also imposes criminal penalties for retaliation alongside whistle-blowers. Thus the implementation of the changes in regulation of financial disclosures and mandate of implementing internal controls has helped in addressing key issues and management assertions related to providing transparent, periodic and reliable financial information to all its stakeholders and external readers and thereby ensuring the safety of its investors. Financial disclosures and reporting has helped to put a strict corporate governance in place for the companies with due responsibilities of the Board of Directors to implement adequate internal controls (Gibson, 2010, p.118). Assessment of Strength and weakness in arguments accompanying disclosures Strengths The most significant area of strength arising out of the arguments of changed regulatory corporate environment is that it reinforced the principal that shareholders are basically the owners of the companies and that corporate managers should act on their behalf with their primary responsibility of allocating resources in optimal ways to maximize the returns. The enactment of Sarbanes – Oxley Act has received cross-sectional responses and admirations across the industry for being able to ensure investor protection through relevant and transparent as well as periodic financial disclosures. Various sections of the act bestow responsibility on the CEO and the CFO to ensure implementation of proper internal controls for financial reporting and disclosure. The act has not only ensured investor protection but also imposed penalties in cases of non-adherence. The role of external auditors and their opinion on company’s relevancy in financial reporting and disclosure has become extremely important. The Sarbanes – Oxley Act has been unique in enforcing transparency of the top management, responsibilities of employees towards their work and also protecting the whistle-blowers leading to the ultimate protection of the investors (Tricker, 2012, p.29). Weakness The changes in regulation, corporate governance, cost of operation, inclusion of Sarbanes – Oxley Act in the US federal law has some strengths and weakness as well. As a result of the Sarbanes-Oxley Act, the companies are having born extra cost of compliance, extra cost of risk management and corporate governance for which the operating profits are on the decline. This has provided incentive to many firms listed in New York Stock Exchange (NYSE) to deregister and move out of their establishments in US. This has led to the fall of capital markets in US. The US companies and businessmen have also found themselves in a costly and a competitively disadvantageous position with respect to their foreign counterparts. As a result, especially small and medium sized business is moving out of US to free them from the changed legislative structure. The smaller international companies were ready to get listed in the stock exchange of UK rather than US thereby hitting the countries capital market. The change regulatory environment has also led to the decline of formation of new public companies. This was visible through the decline in the number of IPOs. From 2009 to 2012, the leading exchange for new stock offering was not in US but in Hong Kong. Thus the changes in regulation with the enactment of Sarbanes – Oxley Act had shown apparent weakness in sustaining the steadiness of US economy. Conclusion The enactment of Sarbanes – Oxley act was done to ensure tighter corporate governance in companies and also to restore confidence of the investors. Although an analysis of positive impacts of the changed regulations have decreased the investors’ concern on their financial stake, it also had negative impacts on increasing the companies’ costs of compliance and cost of implementation of controls and corporate governance standards. This resulted in average lower income of the companies thereby providing them the incentive to relocate their operation. This had an adverse impact on the economy of the country. An analysis of the above table shows that the expenditures on auditing as percentage of its revenue has increased by leaps and bounds irrespective of the size of the firm after the enactment of the Sarbanes Oxley Act (U.S Government Accountability Office, 2006, p.1). The table also shows that the firms with the lowest category of market capitalization up to $75 million had their cost of audit increase to highest percentage of 1.14% of their revenues in 2004. This cost is solely due to the maintenance of internal control standards in lieu of SOX. As a comparison, the companies not filing internal control reports had a much lesser increase in cost which is only 0.79% of their revenues. Thus it has been logically established the US companies are at a much disadvantageous position in comparison to their foreign counterparts. It was also found that companies averaging $21 million in market capitalization with managements having weaker internal controls on financial reporting performed more poorly as compared to same category of corporations having stronger internal control of reporting. The evidence of average stock returns of the companies after the enactment of Sarbanes – Oxley Act shows that there is not much difference between the average return of stocks post enactment of SOX and pre-SOX environment. Considering the overall impacts, the enactment of Sarbanes – Oxley Act would show encouraging signs of investors showing confidence on the disclosed financial statement of the companies. But at the same time, the impacts of Sarbanes-Oxley Act may be misleading for the investors looking at the future of capital market as the companies had to incur costly expenditures to sustain in the changed regulatory environment thereby decreasing their overall earnings. While looking from the other side, it is also possible that the companies exiting the market due to SOX may be more risk-prone to the investors and, therefore, Sarbanes – Oxley legislation has created an environment for fair market players where investor can rely on the disclosures and financial reporting made by the companies (Rezaee, 2007, p.37). It acted as a filter to the nation’s economy and added strength as well as purity and transparency of fund management. Also it is useful to note whether the effects of Sarbanes – Oxley Act had instant or recurring effects in the market and economy. Compliance cost and internal control costs had declined after the first post – SOX stage and would reduce further in the face of regulatory adjustments. Apart from this Sarbanes – Oxley Act stressed on tighter corporate governance aimed at ensuring corporate success and economic growth for the companies, lowering of capital cost by restoring confidence among investors, positive impact on share price, minimization of wastage, corruption, risk and mismanagement. The changed environment helped organization operate in a manner that would serve the best interest of all. However, the Sarbanes – Oxley Act helped in creating a transparent relation between the companies and its shareholders through timely and reliable financial disclosures which helped the investors in decision-making and realize the fairness of their returns (Ramos, 2008, p.90). References Ambler, D. E., Massaro, L. and Stewart, K. L. (2005). Sarbanes-Oxley Act: Planning & Compliance. USA; Aspen Publishers. Gibson, C. H. (2010). Financial Reporting and Analysis: Using Financial Accounting Information. USA; Cengage Learning. Ramos, M. J. (2008). How to Comply with Sarbanes-Oxley Section 404: Assessing the Effectiveness of Internal Control. USA; John Wiley & Sons. Rao, P. M. (2000). Financial Reporting and Disclosure Practices. India; Deep and Deep Publications. Rezaee, Z. (2007). Corporate Governance Post-Sarbanes-Oxley: Regulations, Requirements, and Integrated Processes. USA; John Wiley & Sons. Tricker, B. (2012). Corporate Governance: Principles, Policies and Practices. Great Britain; Oxford University Press. U.S Government Accountability Office. (2006). Sarbanes-Oxley Act: Consideration of Key Principles Needed in Addressing Implementation for Smaller Public Companies. Retrieved from: http://www.gao.gov/products/GAO-06-361. Read More