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

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:
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”):
In the United States (“US”):
In Singapore:
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:

Investors” interest in non-financial information such as:

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
Fair value
F. Consequences for companies not practising the highest standard of financial reporting and auditing standards
Enron Corporation (“Enron”)
Barings PLC (“Barings”)
– No clear reporting lines with the organisational structure
– Incompetency in various departments
– Certain departments failed to understand its business
Informatics Holdings Limited (“Informatics”)
Citiraya Industries Limited (“Citiraya”)
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
Integration of financial, contextual and non-financial information
Principles-based reporting
User-centric focus
Element of transparency
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:

– 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)

– 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

– 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

I. Consequence of applying highest standard of accounting and auditing standards
High standard of accounting and auditing standards will result in:
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.”