What high quality financial reporting and auditing mean to the investor community? - SIAS President | Securities Investors Association (Singapore)

Date: July 10, 2008

By David Gerald, President/CEO, SIAS, delivered at Public Accountants Conference 10 July 2008

Evolution of Financial Reporting

A sole proprietor is only accountable to God and himself. He keeps his own books as he pleases and others, except the taxman, have no business to know how much he made or lost. If he is kind enough, he would let his wife know. There is no supervision of his accounts or finances.

When he needs more capital to expand his business, he looks for partners to inject capital or expertise. He needs to keep more accurate accounts but still more for the curiosity of his partners only. Partners keep internal accounts and still no external supervision is required. Whilst a sole proprietorship or partnership has little or no accountability to others, the liability to third parties is unlimited.

Hence, the evolution of the limited liability company called “Private Limited”. The constitution of the Company limits the number of shareholders in the company. The financial reporting and governance has to improve and the Board of Directors are responsible for the accurate keeping of accounts and the supervision of the financials of the Company.

Now the responsibility becomes larger and more demanding when a Private Limited Company cast it’s net wider to raise capital from the public and creditors. Hence the need to list the Company on the Stock exchange. Man on the street buying shares in such a Company has to be protected and politically and morally it becomes necessary to regulate such companies requiring high quality financial reporting and the requirement for greater supervision through external auditing. Rules are drawn to require timely disclosure of financial information to help investors make an informed decision on their investment. Listed Companies must prepare and table their Annual reports with financial statements for consideration and approval by shareholders annually. Hence, the need for high quality reporting and auditing.

Definition of “High Quality Reporting”

By “high quality” reporting, we take it to mean relevant, meaningful, reliable, accurate and comprehensive reporting of management stewardship whether in the form of numbers or other operating data.

Why High Quality Reporting?

A set of accounts prepared and audited with high quality financial reporting and auditing is of the utmost importance to the investor community as that indeed is the expectation.

Without high quality financial reporting and auditing, it is like asking a blind man to cross an extremely busy street without any aid at all!”

By giving out ambiguous / incomplete information, it will:

		destroy the investor community’s trusts; and shrink demand for the company’s securities and driving value down, not up
		For example, if a listed company owns a property that it acquired in 1969 for S$1 million and if the company did not report that its value is now worth S$100 million, how will the market react to this incomplete information? Worse, if it is the other way round Incomplete information promote uncertainty and uncertainty creates risk

–	As such, high quality financial reporting and auditing provides reliable financial information to guide the investor community in their investments decision making process. The general perception in the market place is that retail investors do not care about financial statements of Companies and are only interested in market gossips and the elaborate food that’s spread out for them at meetings. That’s only partially true. That only Institutional and high net worth investors pay attention to financial statements is no longer true. Nowadays, small investors do read the Annual Reports and attend AGMs and are quite prepared to seek clarifications and accountability from the Board based on financial reports. They are relying more and more on financial reports for selecting stocks. However, small investors are the last to know when a Company’s financial report is fraught with errors or even falsehoods. They accept the reports in good faith as the reports go through a three tier supervision process. Internally, the CFO and the Board including the Audit Committee and externally the Auditors. The integrity of the professionals involved in the preparation of the financial reports and the auditing is the basis of their acceptance of the financial reports per se. Therefore, the acronym “SIAS” stands for “Small Investors Always Suffer”

A. Evolution of the accounting standards

–	There are different sets of standards being issued by different accounting bodies, such as:

	In the United Kingdom (“UK”):

		The Accounting Standards Board (“ASB”) issues standards called Financial Reporting Standards (“FRS”) From 2005, this framework changed as a result of European law requiring that all listed European companies report under International Financial Reporting Standards (“IFRS”)
	In the United States (“US”):

		Generally accepted accounting principles, or US GAAP, are accounting rules used to prepare, present and report financial statements in the US The Financial Accounting Standards Board (“FASB”) is the highest authority in establishing US GAAP The US GAAP provisions differ from the IFRS, though efforts are underway to converge standards. Hopefully in time to come, US would follow IFRS.
	In Singapore:

		With the enactment of the Accounting Standards Act in 2007, the Accounting Standards Council (“ASC”) took over the task of prescribing accounting standards from the Council on Corporate Disclosure and Governance (“CCDG”) Singapore closely models its Financial Reporting Standards (“FRS”) according to the IFRS, with minor changes made to suit the Singapore context

B. Developments in the accounting and auditing professions today

– – – – – –	The globalization of markets and companies has increased the demand for internationally comparable high quality accounting information resulting from a common set of accounting rules As a result of that, the financial reporting standards is evolving towards one set of global accounting standards which would make it easier for the investor community to compare the financial performance of companies across different countries In addition, development in accounting profession today is seemed towards having more quality accounting and auditing standards to provide more informative reports which would eventually make stockholders and everyone else better off The last 12 months have seen acceleration in the convergence of financial reporting globally The globalisation of business and finance has already led to the successful mass adoption of IFRS by more than 12,000 companies over 100 countries India will converge fully with IFRS by 2011 with other countries joining them soon, such as Korea, Japan, Brazil, Canada and Russia. China has embarked on this part although India may, I believe, reach the finishing line earlier.


C. Future developments

– –	More quality accounting standards will be the focus of the accounting profession The IASB has a number of topics for amendments or new IFRSs on its active agenda. A number of these are expected to have an impact on preparation of financial statements from 2009 onwards, which include inter alia:

		Fair value measurement guidance; Accounting for equity (share capital) Employees’ benefits Financial Instruments
–	Investors” interest in non-financial information such as:

		The companies’ product quality and customers’ satisfaction; The number of projects the companies have in the pipeline that indicate where the companies are heading; and How companies attract, retain and develop the best talent
– – – –	The need for real corporate transparency is passing from a luxury embraced by a few to a necessity of business survival It is no longer good enough to comply with minimum regulatory requirements, but the successful companies of the future are rethinking the set of information that they need to underpin their corporate reputation, to maintain their license to operate and to improve the public’s trust in them In years to come, companies may be required to report their macro-economic strategies together with the impacts on the environment, the supply chain and society at large Change in the future will be driven by market forces and by smart management who pride themselves on staying one step ahead of the pack


D. A single set of global auditing standards

– – – – – –	Auditing standards are important in sustaining healthy capital markets because they are one of the supporting pillars for high-quality audits that strengthen public confidence in financial reporting Investors would prefer that the quality of audits is the same everywhere so that they can rely on financial information to make decisions But at the moment, the standards and the enforcement of these auditing standards vary in quality internationally As a result, investors and lenders will inevitably demand a ‘risk premium’ before they will be induced to lend to or purchase a security from companies in countries that have demonstrably weaker auditing standards or, perhaps worse still, where the quality of audits is unknown However, the path to a single set of global audit standards is likely to be staged. In recent years, the International Auditing and Assurance Standards Board (“IAASB”) has made substantial progress in the development and enhancement of International Standards on Auditing (“ISA”) Harmonisation of auditing standards among international and national standard setters is essential to provide investors and lenders with consistently high quality financial information in order to make investing and lending decisions across capital markets


E. Standard Setters (LASB) are also dealing with ambiguous issues, such as:

–	Lease accounting model

		Many leasing transactions are not reported on balance sheets. Investors have to use incomplete footnote disclosures for their analysis, which raises questions about the usefulness of the current lease accounting model
–	Fair value

		Fair value is considered the most relevant measurement objective as financial statements are designed to help users estimate future cashflows. A measure that reflects current economic conditions is likely to better reflect those cashflows than an asset or liability measured at historical cost However, illiquidity in some markets has led to difficulties in establishing whether fair values are indeed fair. A valuation technique must be in place to incorporate all factors that market participants would consider in setting a price, including the current market conditions i.e. the relative liquidity of the market and the choice of discount rate, for example.

F. Consequences for companies not practising the highest standard of financial reporting and auditing standards

–	Enron Corporation (“Enron”)

		Enron was an American energy company based in Houston, Texas Before its bankruptcy in late 2001, Enron employed around 22,000 people and was one of the world”s leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues of $111 billion in 2000. Fortune named Enron “America”s Most Innovative Company” for six consecutive years As was later discovered, many of Enron”s recorded assets and profits were inflated Debts and losses were put into entities formed “offshore” that were not included in the firm”s financial statements, and other sophisticated financial transactions between Enron and related companies were used to take unprofitable entities off the company”s books Enron’s share price hit US$84.87 in early 2001 but slumped to just US$4.55 in late 2001
–	WorldCom

		For a time, WorldCom (“WCOM”) was the United States” second largest long distance phone company WorldCom grew largely by acquiring other telecommunications companies, most notably MCI Communications The fraud was accomplished primarily by under reporting ‘line costs’ (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them off WorldCom also inflated its revenues with bogus accounting entries from ‘corporate unallocated revenue accounts’ WorldCom’s shares once traded near US$64 in 1999 tumbled to US$0.21 in June 2002
–	Barings PLC (“Barings”)

		The collapse of Barings Bank in 1995 is a clear example of accounting fraud Nick Leeson, an employee of Baring Futures (Singapore) Pte. Ltd. (“BFS”), speculated on futures contract and manipulated the records Nick Leeson operated BFS without supervision from London headquarters. He was the floor manager for Barings’ trading and also the head of settlement operations, in-charge with ensuring accurate accounting for the unit The fall of BFS was predominantly due to lack of internal controls within Barings, which include, inter alia:
			– No clear reporting lines with the organisational structure – Incompetency in various departments – Certain departments failed to understand its business
–	Informatics Holdings Limited (“Informatics”)

		Informatics was involved in computer and commercial training centres and examination facilitators Founder Wong Tai and former CEO Ong Boon Kheng were charged for overstating the company’s profits by more than $15 million in the first three quarters of the financial year ended March 2004. The company had allegedly overstated its pre-tax profit by $5.452 million for the quarter ended June 2003; $8.78 million for the quarter ended September 2003; and $1.54 for the quarter ended December 2003
–	Citiraya Industries Limited (“Citiraya”)

		Citiraya was involved in the recycling of electronic waste In December 2004, the Corrupt Practices Investigation Bureau received information that certain members of Citiraya’s staff may have given bribes to staff of its customers to facilitate the diversion of rejected microprocessor chips for resale in black markets outside Singapore In January 2005, the Commercial Affairs Department received information that Citiraya may have inflated its sales through fictitious transactions There was a lack of transparency in the company Fraud perpetrated was extensive, pervasive and extended to all facets of operations
G. The lessons learnt from these companies are many. The importance of high-quality corporate financial reporting to the investor community cannot be underestimated.

– – –	Companies should have the right management and professionals in place who value integrity and exercise sound professional judgement Tighter Internal Controls Effective whistle blowing policy

Key considerations for management to focus on includes, inter alia:

–	Ease of preparation, easy to understand and access to information

		Reporting principles should be simple to apply and transparent disclosures should be written in plain language; External reporting should flow from relevant internal management information, with minimum configuration
–	Integration of financial, contextual and non-financial information

		Financial information only records short-term results; More attention is required on longer-term value on the company’s strategy, markets, executive remuneration, customers, innovation, people and environmental impacts. Companies should continue to give a 5 year summary of financial and operating figures instead of the 2 year period summary which is still in existence in some companies.
–	Principles-based reporting

		This approach requires a sound conceptual framework – recognising the value of reporting specific information This is critical to determine the scope and quality of information communicated around economic, environmental and social performance
–	User-centric focus

		The reporting framework should reflect the relevance and reliability of information, how it is used to assess performance and governance, and the cost/benefit of its preparation and audit
–	Element of transparency

		The necessity to explain companies’ strategies; What drives value and what are the key performance indicators for understanding their business and its success

H. Expectations from the investor community

– –	Corporate reporting remains vitally important to the investment community. These are the individuals who most closely read and analyse corporate reports. They are the hungriest for information and, in many respects, the most demanding Areas which the investor community commonly wants better information includes, inter alia:

		Investors place high importance on the income statement for accessing operating performance and would like to have more details. Areas investors are looking at include:
			– sources of growth, whether it comes from organic or acquired growth, from unit volume gains or price rises – more breakdown of costs would help investors better understand the operational leverage of the business – a standardised reporting and definition of EBITDA (broader definition, not just limited to cash flow)

		Investors value the balance sheet as a highly important element of the financial model. The recent controversial topic concerning the measurement of assets and liabilities at current value or historical cost had caused the investment community to demand for more transparency in terms of key assumptions Investors want more detail in the cash flow statement and in supporting notes to help them have better insight into the company’s actual performance over the period Segment reporting is highly important to investors as most of the intrinsic valuation models are built from the segment. A good understanding of performance by segment is fundamental to the investor community in assessing which areas of a business are more productive and where value is or is not being added Investors want to be able to piece together sufficient information to put financial numbers in context;
			– Market information and management’s strategy are the non-financial data useful for making investment decisions – Competitors’ data and market research reports are also relevant to an investor before making any investment decisions, as some form of benchmarking

		Investors want major risk factors to be highlighted especially in IPO prospectus. Investors would like to see all companies provide a longer term summary on their operating and financial data A mandate for modifying international standard to suit Singapore circumstances is needed. One must not forget the international standard setters are influenced by the state of development of the largest economy and are not mindful of the needs of the smaller economies
			– One example where Singapore has deviated from IFRS is in the treatment of Leasehold land whereas IAS does not allow capitalisation of Leasehold land as property, plant and equipment. Singapore allows it – There is also one school of thought that on the current treatment of investment property (now both international and Singapore standards deal with it under the fair value model) fair value gains or losses are recorded in the income statement. Whether this is desirable or not, is a judgement call as it introduces volatility in the reported earnings

		Given the creativity of the professionals involved, the investing community is at their mercy. To reiterate this point, in the light of the global credit crunch, one may still wonder whether adequate allowances for impairments have been made for mortgage backed securities and other assets Behind all the reporting, there should be a genuine desire on the part of management and the Board to inform shareholders as Warren Buffet does. He spends time writing at least 20 over pages as he believes in providing full information

I. Consequence of applying highest standard of accounting and auditing standards

–	High standard of accounting and auditing standards will result in:

		Better comparability globally; More efficient capital allocation; Reduced complexity and the risk of errors; Process and cost efficiencies; Boost investors’ confidence resulting in increase in market share price and higher PE
J. Conclusion

In 1994, Warren Buffet once told a student audience,

	“If I pick up an annual report and I can’t understand a footnote, I probably won’t – no, I won’t invest in that company because I know that they don’t want me to understand it.”

What high quality financial reporting and auditing mean to the investor community? – SIAS President