2.5 Challenges and Opportunities in Financial Reporting

Recall that financial accounting focuses on communicating information to external users. That information is communicated using financial statements. There are four financial statements: the income statement, statement of changes in equity, balance sheet, and statement of cash flows. Also be aware that the notes to the financial statements are an integral part of any financial statement package.

An essential part of financial statements are the notes that accompany them. These notes are generally located at the end of a set of financial statements. The notes provide greater detail about various amounts shown in the financial statements, or provide non-quantitative information that is useful to users. For example, a note may indicate the estimated useful lives of long-lived assets, or loan repayment terms. Examples of note disclosures will be provided later.

As noted in the introduction to this chapter, confidence in financial markets and the accounting profession were shaken in the early 2000s. A series of accounting scandals, perhaps most notably Enron Corporation’s, resulted in questioning the role of the information providers and the need for further regulation. One response, indeed, to these problems was the introduction of further regulation. In the United States, the Sarbanes-Oxley Act (SOX) was introduced in 2002 to restore the confidence in financial markets that had been so badly shaken after the accounting scandals. This legislation tightened up auditor independence rules, introduced new levels of oversight, created additional penalties for company executives engaged in fraudulent reporting, and improved other disclosure requirements.

There have been improvements observed in disclosure practices since the introduction of SOX, but these improvements have come with a cost. Some estimates have put the cost of SOX compliance at $6 billion per year. This is significant, but in assessing this cost, it is also important to consider the benefits. The major benefit that results from legislation like SOX is the potential reduction of market failures. When scandals such as the one at Enron occur, the loss is borne not only by shareholders but also by employees, other companies, and the general public, who will feel the effect of any recession or economic slowing that results from reduced confidence in the markets. But although the nature of the benefit is clear, the quantification of it is not. It is very difficult to measure the reduction of market failures that has occurred due to legislation, because if the legislation worked, there would be nothing to measure.

It would be unrealistic to suggest that regulation could completely eliminate any problem as complex as information asymmetry. Although SOX did appear to be effective in improving financial practices and disclosures, it did not prevent the 2008 financial crisis and subsequent market meltdown.

This is likely because the causes of this crisis were not primarily matters of accounting and reporting – rather, they were related to the regulation and practices of the investment-banking industry. So the argument can be made that further regulations are required. But the regulator faces the challenge to determine the appropriate amount of regulation. Too little regulation can allow fraudulent practices to continue, but too much can stifle business initiative and growth.

The Canadian government passed Bill 198, which essentially accomplishes the same thing as SOX in the United States – in fact, it’s frequently referred to as the Canadian SOX (C-SOX). This bill came out as a result of corporate scandals that shook investor confidence. It increased scrutiny of corporate governance amid growing concern about auditor independence and the disclosure of internal controls over financial reporting, a Price Waterhouse Coopers report notes. The Provincial Government of Ontario introduced the bill in a piece of legislation called “Keeping the Promise for a Strong Economy Act,” and it was approved on December 9, 2002. In reality, the bill dealt broadly with a number of different government operation procedures and only a small part dealt with financial reporting.

The Three Regulations For Bill 198

Shortly after the bill was passed, Canadian securities commissions issued three additional regulations for companies and auditors to talk about:

• Multilateral Instrument (MI) 52-108,
• MI 52-109 and
• MI 52-110.1.

1. MI 52-108:
   This bill requires securities issuers to use the services of auditors who participate in the Canadian Public Accountability Board’s independent oversight program.
2. MI 52-109:
   Under this regulation, chief executive officers and chief financial officers would need to verify their filings (both annual and interim) are accurate representations of their company’s current financial status. MI 52-109 is similar to basic components of SOX 404 and requires companies to disclose policy and develop procedures for collection, capturing, evaluation and disclosing information.
3. MI 52-110:
   Finally, this bill regulates the role of audit committees in any business or organization that issues securities.

Canadian businesses must comply with C-SOX. Much like the American SOX Act, Bill 198 requires companies both big and small to spend a great deal of money on compliance with the legislation. That being said, there are certain steps they can take to help them develop procedures and policies necessary for meeting the stipulations of the bill.

“Well-designed, documented and monitored disclosure controls and procedures and internal controls over financial reports, including all relevant policies, procedures and operating principles at significant locations” are necessities, the PwC report notes. PwC also advocates an internal control infrastructure that “facilitates communication, reporting, training, incident identification and issues management, enables ongoing monitoring of the system of internal control and completion of applicable control procedures and ultimately provides management with confidence that internal control structure is effective and can be evaluated and tested on an ongoing basis.”

For companies considering going public, compliance may seem like a pain at first, but costs will eventually decline as reporting standards and internal controls are established.

One response by the accounting profession to the need for the further regulation has been the development of IFRS. These standards were introduced at the time that financial crises were shaking the financial world in the early 2000s. IFRS are viewed as being more principles based relative to other standards, such as the United States’ Generally Accepted Accounting Principles (GAAP), which has historically been more rules based. Principles-based standards present a series of basic concepts that can be used by professional accountants to make decisions about the appropriate accounting treatment of individual transactions. These concepts are often intentionally broad and often do not provide specific, detailed guidance to the accountant. Rules-based standards, on the other hand, are more prescriptive and detailed. These standards attempt to create a rule for any situation that may be encountered by the accountant. Accordingly, the body of knowledge is much larger, with much more specific detail regarding accounting treatments.

Principles-based standards are usually considered to have the advantage of being more flexible, as they allow for more interpretation and judgment by the accountant. This can be particularly useful when unusual or unique business transactions are presented to the accountant. However, this flexibility is one of the weaknesses of this approach. Some fear that giving too much freedom to the accountant to interpret the accounting standards may result in financial statements that are less comparable to those of other entities or that could be subject to increased earnings management or other manipulations.

Because rules-based systems have far greater detailed guidance, some have argued that this is better for the accountant, as the accountant can defend the treatment of a particular transaction by simply pointing to compliance with the rule. As well, it is thought that rules-based systems can also lead to greater comparability, as much of the format and content of disclosure are tightly prescribed. Unfortunately, overly detailed rules can still allow for a different type of misrepresentation called financial engineering. When an accounting treatment relies on specific and detailed rules, creative managers can simply invent a new type of transaction that works around the existing rules. They will argue that the rule does not specifically prohibit them from doing what they are doing, but the engineered transaction may, in fact, be violating the spirit of the rule. Interpretations that focus more on the form of the transaction than on the substance can lead to inappropriate and ultimately misleading accounting. As a practical matter, all systems of accounting regulation contain both broadly based principles and detailed rules. The challenge for accounting standard setters is to find the right balance of rules and principles.

It should be apparent that many of the problems faced by the accounting profession stem from the questionable application of ethical principles. As noted before, the broad purpose of accounting information is to reduce information asymmetry.

Information asymmetry can never be eliminated, but if accountants can communicate sufficient, useful information, then the asymmetry can be mitigated. Although it is a normal business practice to try to take advantage of an information imbalance, if this is done in a misleading or deceitful way that unfairly disadvantages certain parties, confidence in capital markets will be damaged. The accountant, in trying to provide as much information as possible to clients, will face pressure from those vested interests that stand to gain from the information imbalance. The accountant may be asked to withhold or distort the information to achieve certain results. Often, these pressures are subtle and not presented as a clear-cut violation of accounting standards. Business transactions can be complex, and the application of accounting standards to those transactions can involve significant judgment, estimation, and uncertainty. The answer to an accounting question may not be clear, and certain interested parties may view this state as an opportunity to try to influence the accountant.

The management of a company often has a particular interest in trying to influence financial reports. Managers are given the task by the shareholders of managing the business in the most efficient and profitable way possible. Managers face great pressures in the task and will at times look at the financial reporting as one tool to be used to deal with these pressures. Managers may be motivated to influence or bias the reported financial results for a number of reasons, including the following:

• The presence of performance-based compensation: Managers may be rewarded in bonuses or stock options that are directly or indirectly influenced by financial results. The manager clearly has an incentive to make the results look positive.
• Evaluation of management stewardship: Even if the manager is not directly compensated based on results, the manager’s value to the company will still be evaluated relative to the business’s performance.
• Meeting market expectations: Financial markets expect results and can be very punitive when expected results are not achieved. In order to meet the market’s expectations with respect to performance, the manager may feel pressure to “work the numbers.”
• Conditions of contracts: Some contracts, such as a loan agreement with a bank, may stipulate that certain financial ratios be maintained. If the ratios are not maintained, then some punitive consequence will likely be applied, such as a penalty or additional interest charges. As the financial ratio is based on reported results, the manager has an incentive to ensure the results keep the company onside.
• Political pressures: Sometimes a company may face pressures that are not directly related to the interests of the investors or lenders. A large, profitable company that enjoys a certain level of oligopolistic power may face additional public scrutiny if profits are too high. Public-interest groups may feel that the company is taking advantage of its position of power, and they may demand political action, such as increased taxes or other sanctions against the company. In order to avoid this type of political heat, the managers may have an incentive to deliberately reduce or smooth income.

In these examples, it should be apparent that the accountant could play a key role in the achievement of management’s objectives. The accountant must therefore always be aware of these motivations and apply sound judgment and ethical principles. But the application of ethics is not simply a matter of consulting an ethics handbook. An ethical sense is a personal characteristic that is inherent in each individual. It is very difficult to teach, as our personal ethics are formed long before we choose to become professional accountants. Ethical awareness and practice, however, is something for which the accounting profession has developed a significant framework.

All professional bodies contain codes of conduct for their members. In these codes, basic principles of ethical behaviour and discussions of how to deal with ethical conflicts are included. Some of the common principles that are included in these codes include the following:

• Integrity: The accountant should always act in an honest fashion and not be associated with any information that is false or misleading.
• Objectivity: The accountant should always be unbiased when applying judgment.
• Professional competence: The accountant should always maintain a level of professional knowledge that is current and sufficient for performing professional duties and should not engage in any work that is outside the scope of that accountant’s knowledge.
• Confidentiality: The accountant must not share privileged client information with other parties and must not use that information for his or her own personal gain.
• Professional behaviour: The accountant should not engage in any activity that discredits the profession.

Dealing with ethical conflicts and external pressures from stakeholders can be difficult at times, and accountants are often advised to seek advice from other professionals or their own professional association when the need arises. Accountants play a key role in the operation of capital markets and are essential to the financing of a business. The external stakeholders of the business expect ethical and professional conduct from the accountants, and it is important the profession continues to earn and maintain this trust.

Another area which provides both challenges and opportunities to professional accountants is the increasing use of information technology to perform accounting and reporting functions. Technology has allowed for the automation of routine bookkeeping tasks as well as the development of more advanced functions such as data mining and strategic analysis. The increased use of cloud computing and mobile devices has provided platforms for instant access to information, which could enhance the qualitative characteristic of timeliness. Sophisticated big data applications could improve the relevance of accounting information by targeting the specific needs of the user. Technologies such as eXtensible Business Reporting Language (XBRL) have been designed to improve the comparability of information by providing a standardized platform for financial statement delivery. Computer assisted audit tools and techniques allow auditors to more precisely identify key areas of audit risk and to analyze larger sample sizes, which could lead to improvements in the reliability of information and the efficiency of the process.

The emergence of blockchain technology may provide the biggest challenge and opportunity to the auditing profession. This type of decentralized, public ledger has the potential to allow for instant access and verification of transactions. Smart contract technology could use blockchain to automate and control many accounting and business processes. As blockchain has the potential to create unalterable, transparent accounting records, auditors will need to rethink the traditional, annual financial statement audit. Continuous auditing and verification of the structure of smart contracts may become the new role for audit professionals.

Recently, the growth of data analytics has begun to change the job of the accountant, and will likely continue to promote a profound alteration of the accounting and finance fields. The automation of routine and tedious tasks is only the beginning of the transformation of the role of financial professionals. Data analytics can be used to add value to an organization through descriptive, diagnostic, predictive, or prescriptive functions. The accountant of the future will need to be able to understand how to use both structured and unstructured data to solve business problems. Although accountants may not be experts in data analysis, they can provide valuable input and interpretation of the information created by data scientists. The accountant will need to work collaboratively with data scientists to ensure that the right questions are being asked, and the results are being deciphered in a meaningful way. Taking the results of data analysis and communicating them through data visualization techniques will provide value to the users of financial information.

Although technology provides professional accountants with opportunities to improve the value of the information provided, it also poses challenges. XBRL has experienced problems with data-tagging errors, which has reduced its effectiveness. Cloud computing and mobile devices have increased concerns about data security and economic disruption. Data mining strategies have led to ethical questions about the privacy of personal information. Real-time reporting of financial results faces concerns about data reliability, and more significantly, the alteration of manager behaviour (i.e., earnings management). Professional accountants need to be aware of these challenges as they adapt to rapidly changing technologies that have the potential to both benefit and damage the reputation of the profession.

A summary of the foundation principles includes:

Brief definitions of the above principles include:

Economic Entity Assumption: This accounting principle treats the owner and the business as two different entities and they both have different legal liabilities. The transactions of the business should be kept and treated separately from the owners and other businesses.

Control: Control is related to the economic entity assumption. An investor will have control over another entity (investee) when it has power over the investee; when the investor has rights to variable returns from its involvement with the investee; and when the investor has the ability to use its power over the investee to affect the amount of the investors returns.

Revenue Recognition: The recognition of revenue should be on the accrual basis of accounting. In the accrual concept, one should record the business transactions in the time periods when they actually occur and not on the basis of the cash flows correlated with that. This is necessary for the preparation and formation of Financial Statements at the end of the year. Say there is a sale to a debtor of $2,000 on 5th August Y8. So, it’s recognition should be on 5th August only regardless of the debtor’s immediate payment or not.

Matching Concept: This accounting principle states that the company should go for Accrual Basis only. The revenues should match with the expenses. The recordation of the revenues and expenses should be at the same time only.

Periodicity (Time Period): This accounting principle states that there should be the standardized time period of reporting the financial statements. The time period is usually monthly, quarterly or annually. The header of the financial statements should cover the time period, the statement covers.

Monetary Unit: This accounting principle states that there should be the recordation of only those transactions that carry a monetary value. The transactions stated in terms of a currency (for example $ in Canada) should only be recorded. The monetary unit should be stable and dependable.

Going Concern: This accounting principle assumes that the business may continue forever. It will carry out its objectives and plans in the foreseeable future with no intention of liquidation.

Historical Cost: According to this accounting principle, the recordation of the assets in the financial statements should be on their purchased values. Then, may they be purchased today or twenty years ago. There may be a change in the value of the assets over time due to the depreciation or inflation. But one does not show this change in the financial statements due to the Historical Cost principle.

Fair Value Principle (value in use): IFRS has continued to request the use of standardized fair value measurements in the financial statements. Fair value can be more useful than historical cost for certain assets in some industries. Under IFRS, fair value is defined as “the price that would be received to sell an asset”.

Full Disclosure: There has to be a disclosure of all the necessary information that is important for the users, lenders or investors within the financial statements or as a footnote. One gets a clarity of a particular aspect if there is a proper mentioning of the required information. Without this accounting principle, the readers may not understand the full information and may not make a sound judgment.

Other very important principles to consider include:

Conservatism: If a situation arises where there are two acceptable options for reporting an item, an accountant tends to go for a less favourable alternative due to the conservatism concept. One should record the expenses, the earliest possible even if there is an uncertainty about the outcome and the incomes, the latest possible only if there is a certainty. This principle encourages the recordation of the expenses and liabilities earlier rather than later. Hence, this affects the overall financial position of the business by showing less net profits.

Consistency: This accounting principle states that one should be consistent enough in the usage of the methods and the principles once adopted until another outstanding method/principle come across. This means that one should follow the methods continuously until another method outstands the current one. One should prove the new method with a demonstration and then come up to the conclusion.

Materiality: This accounting principle states that the information which will have a material effect should form a part of the financial statements. The information that is not material and by which the users don’t get mislead can be avoided.

Reliability: This accounting principle states that only those transactions should be recorded that can be proven and has significant evidence. For example, in order to prove an expense, its invoice is enough. The auditors are constantly in search of evidence and hence, this principle is of prime interest for them.