Transition to Management by dffhrtcv3


									     BACCT2102 • Corporate Reporting

                TOPIC 1A
Financial Reporting Regulation
                       Suhaimi Bin Ismail
      Faculty of Business Management and Globalization
                Tel : 603 8317 8833 (Ext 8408)
    In this chapter we will discuss:

•   Mandatory regulations
•   Arguments for and against standards
•   The structure of the UK regulatory framework
•   The Operating and Financial Review
•   The Combined Code on Corporate Governance
•   The FRSSE
•   Interim reports.

       BACCT2102        Corporate Reporting        2
  Role of accounting numbers in
  defining contractual entitlements
Contracting parties frequently define the rights between
themselves in terms of accounting numbers.

For example, the remuneration of directors and managers
might be expressed in terms of a salary plus a bonus based
on an agreed performance measure, e.g. Interbrew’s 2002
Annual Report states:

An annual bonus plan is approved each year. Payment levels
are linked to audited consolidated earnings before interest
and taxes, and to year over year changes, both positive and
negative, in return on cash capital employed and/or market
      BACCT2102            Corporate Reporting                3
Role of accounting numbers in defining
contractual entitlements – temptation to manage
the numbers
If risk earnings will not grow at a rate attractive to directors THEN
temptation to take measures not in the interest of the shareholders.
Typical measures include:
• deferring discretionary expenditure, e.g. research, advertising,
  training expenditure;
• deferring amortisation, e.g. making optimistic sales projections in
  order to classify research as development expenditure which can be
  capitalised; and
• reclassifying deteriorating current assets as fixed assets to avoid the
  need to recognise a loss under the lower of cost and net realisable
  value rule applicable to current assets.

       BACCT2102                Corporate Reporting                         4
Role of accounting numbers in defining
contractual entitlements – temptation to manage
the numbers
 If risk earnings will not grow at a rate attractive to directors
 THEN temptation to take measures not in the interest of the
 Mandatory standards change management’s ability to adopt
 such measures
 This affects wealth distribution within the firm.
 For example, IF managers are unable to delay the amortisation
 of development expenditure, THEN bonuses related to profit
 will be lower and there will effectively have been a transfer of
 wealth from managers to shareholders.

     BACCT2102              Corporate Reporting                     5
Role of accounting numbers in defining
contractual entitlements – temptation to manage
the numbers
 The effect of changes in mandatory standards on wealth
 distribution is a major reason why

 (a) standards are required, and
 (b) also why it is difficult to obtain a consensus.

 Each party considers the economic consequences, real or
 imagined, on their personal position.

     BACCT2102            Corporate Reporting              6
Why there is a need for mandatory
Mandatory standards needed to define the way in which
accounting numbers are presented in financial statements.

Aim is that their measurement and presentation are less

Until the 1960s thought that the accountancy profession could
obtain uniformity of disclosure by persuasion BUT difficult to
resist management pressures.

During the 1960s confidence in the accountancy profession lost
when internationally known UK-based companies were seen to
have published financial data that were materially incorrect.
    BACCT2102            Corporate Reporting                     7
  Shareholders are in the dark
• Shareholders normally unaware that financial statements are
• Only aware in restricted circumstances
   – when a third party has a vested interest in revealing adverse facts
     following a takeover, or
   – when a company falls into the hands of an administrator, inspector
     or liquidator, whose duty it is to enquire and report on
     shortcomings in the management of a company.
• Two scandals which disturbed the public at the time,
  GEC/AEI and Pergamon Press, were both made public in the
  restricted circumstances referred to above, when financial
  reports prepared from the same basic information disclosed a
  materially different picture.
      BACCT2102               Corporate Reporting                          8
GEC takeover of AEI in 1967 –
AEI Story
• the pre-takeover accounts prepared by the old AEI directors differed
  materially from the post-takeover accounts prepared by the new AEI
• AEI profit forecast for 1967 as determined by the old AEI directors
• AEI Ltd produced a profit forecast of £10 million in November
  1967 and recommended its shareholders to reject the GEC bid.
• The forecast had the blessing of the auditors, in as much as they said
  that it had been prepared on a fair and reasonable basis and in a
  manner consistent with the principles followed in preparing the
  annual accounts. The investing public would normally have been
  quite satisfied with the forecast figure and the process by which it
  was produced.
• AEI would not subsequently have produced other information to
  show that the picture was materially different from that forecast.
    BACCT2102               Corporate Reporting                            9
GEC takeover of AEI in 1967 –
GEC Story

• GEC was successful with its bid
• GEC’s directors had control over the preparation
  of the AEI accounts for 1967.
• AEI profit for 1967 as determined by the new AEI
• the accounts of AEI were produced for 1967
  showing a loss of £4.5 million.
• From same basic information used by AEI when
  producing its profit forecast.
   BACCT2102        Corporate Reporting              10
  GEC takeover of AEI in 1967 –
  Reasons for difference
• Two possible reasons for the difference
   – Either the facts have changed; or
   – the judgements made by the directors have changed.
• In this case, it seems there was a change in the facts
   – to the extent of a post-acquisition closure of an AEI factory; this
     explained £5 million of the £14.5 million difference between the
     forecast profit and the actual loss.
• Also a change in judgement
• The remaining £9.5 million arose because of differences in
  judgement. For example, the new directors took a different
  view of the value of stock and work-in-progress.
      BACCT2102                Corporate Reporting                         11
Public view of the accounting
profession following these cases

• Known that that accountancy is not an exact science
• BUT not realized how much latitude there was for
  companies to produce vastly different results based on
  the same transactions.
• Given that the auditors were perfectly happy to sign
  that accounts showing either a £10 million profit or a
  £4.5 million loss were true and fair, the public felt the
  need for action if investors were to have any trust in
  the figures that were being published.
   BACCT2102           Corporate Reporting                12
Profession’s response
• Each firm of accountants tended to rely on precedents
  within its own firm in deciding what was true and fair.
• Fine until the public becomes aware that profits depend on
  the particular firm or partner who happens to be
  responsible for the audit.
• The auditors also under pressure to agree to practices that
  the directors wanted because there were no professional
  mandatory standards.
• An embarrassed profession announced in 1969, via the
  ICAEW, that there was a pressing need for the introduction
  of Statements of Standard Accounting Practice to
  supplement the legislation.

      BACCT2102           Corporate Reporting                   13
Creation of a standard-setting body
• Development from the ASSC, the ASC, the Dearing Committee,
•   the Dearing Report to the ASB.
• The Accounting Standards Steering Committee (ASSC)
   – Formed by the ICAEW in 1970
   – Later increased to include other professional accounting bodies.
• The objectives of the ASSC were as follows:
   – Damage limitation by narrowing the areas of difference in accounting
   – The development of a consensus by encouraging wider exposure and
     discussion of proposals for standards,
   – To encourage disclosure by requiring companies to disclose the
     accounting policies they have adopted, e.g. depreciation policy, and also
     to disclose if they change a policy,
   – To improve standards by developing a continuing programme.

      BACCT2102                  Corporate Reporting                             14
Creation of a standard-setting body
• The Accounting Standards Committee (ASC)
  By 1976 the procedure was for the ASSC (renamed the ASC) to
    – prepare a draft standard;
    – draft adopted if all six professional accountancy bodies were unanimous
    – each body then issued the Statement of Standard Accounting Practice
      (SSAP) to its own members.
• By 1982 accounting bodies had too great a control over the process.
    – terms of reference were widened, e.g. to consult representatives of finance,
      commerce, industry and government
    – membership reduced to twenty, including five users of financial reports who
      were not required to be accountants; and government officials could be co-
      opted as non-voting members.
    – The process organised to give users full opportunity to make their inputs to the
      standard setting.

       BACCT2102                     Corporate Reporting                                 15
Creation of a standard-setting body
• The ASC - aims of the process were:
  – Topics to be the subject of a standard were made
  – Consultation encouraged by issue of discussion
  – An exposure draft prepared by the ASC was
  – A draft standard was prepared by the ASC, taking
    into account reactions to the discussion documents
    and exposure drafts.

     BACCT2102         Corporate Reporting               16
Arguments in support of standards

• Need to make valid inter-company comparisons of
  performance and trends
• Investors must be supplied with relevant and
  reliable data that have been standardised
• Comparisons distorted if companies permitted to
  select accounting policies with the intention of
  disguising changes in performance and trends.
   BACCT2102       Corporate Reporting           17
Arguments in support of standards

• Credibility lost if companies selected different
  accounting policies for similar events
• Uniformity essential if reports are to disclose a
  true and fair view
• However, not intended to be a comprehensive
  code of rigid rules
• Not to supersede informed judgement in
  determining what was a true and fair view.
   BACCT2102         Corporate Reporting              18
Arguments in support of standards
• The process has stimulated the development of a conceptual
• For example, the leasing standard considered the
  commercial substance of a transaction rather than simply the
  legal position.
• In 1970s no clear statement of accounting principles other
  than that accounts should be prudent, be consistent, follow
  accrual accounting procedures and be based on the initial
  assumption that the business would remain a going concern.
• By 1994, the ASB had produced its exposure drafts of
  Statement of Accounting Principles, which appeared in final
  form in December 1999.
   BACCT2102            Corporate Reporting                  19
Arguments against standards

Adverse allocative effects
• Could occur if standard setters did not take
  account of the economic consequences flowing
  from the standards they issued. For example
• additional costs could be imposed on preparers
• suboptimal managerial decisions might be taken to
  avoid any reduction in reported earnings
   BACCT2102        Corporate Reporting           20
  Arguments against standards
• Can lead to the issuing of standards that are over-
  influenced by those with easiest access to the
  standard setters as the subject matter becomes
  more complex e.g. capital instruments.
• ASB attempting to minimise such influences by
  basing its standards on the Statement of Principles,
  but is the Statement of Principles too general?

     BACCT2102         Corporate Reporting               21
 Arguments against standards

• Too many standards
• Too detailed
• Too general-purpose; fail to recognise the
  differences between large and small entities
• Too many standard setters with differing
  requirements, e.g. FASB, IASB, ASB, national
  Stock Exchange listing requirements.
    BACCT2102        Corporate Reporting         22
Developments for small companies
Importance to the economy
• Small firms are the main job creators.
• Statistics from the DTI in 1998 showed around 3.7
  million businesses in the UK.
• 2.5 million were sole traders or partners without
• There were 1.2 million companies on the Companies
  House register - around 12,000 (1%) were public
• Only about 2,450 listed on the Stock Exchange.
• Employees: 7,000 had more than 250 employees, 26,000
  had between 50 and 250 and 1.01 million had nine or less.
   BACCT2102           Corporate Reporting                23
Small companies - Statutory
• A small company satisfies two or more of the following
   – Turnover does not exceed £5.6m.
   – Assets do not exceed £2.8m.
   – Average number of employees does not exceed 50.

• provision for small companies to file abbreviated accounts
   – excused from filing a profit and loss account; and
   – the directors’ report and balance sheet need only be an abbreviated
     version disclosing major asset and liability headings.
   – privacy is protected by excusing disclosure of directors’
    BACCT2102               Corporate Reporting                            24
Small companies - Mandatory

• all companies to comply with SSAPs and FRSs to
  present a true and fair view.

• excused from full compliance provided such
  differences were justified on rational grounds.

   BACCT2102        Corporate Reporting             25
Small companies – rational
• How can rational grounds be established?
   If more negative responses than positive answers to 9
   questions then rational grounds exist. The nine are:
Generic relevance
1. Is the standard essential practice for all entities?
2. Is the standard likely to be widely relevant to small
Proprietary relevance
3. Would the treatment required by the standard be readily
   recognised by the proprietor or manager as corresponding
   to their understanding of the transaction?
   BACCT2102           Corporate Reporting                26
  Small companies – rational
  grounds (cont)

Relevant measurement requirements
4. Is the treatment compatible with that used by the Inland
   Revenue in computing tax?
5. Are the measurement methods in a standard reasonably
   practical for small entities?
6. Is the accounting treatment the least cumbersome?

      BACCT2102            Corporate Reporting                27
Small companies – rational
grounds (cont)
User relevance
7. Is the standard likely to meet information needs and
   legitimate expectations of the users?
8. Is the disclosure likely to be meaningful and
   comprehensible to users?
Expanding statutory provision
9. Do the requirements of the standard significantly augment
   the treatment required by statute?

   BACCT2102            Corporate Reporting                28
  How FRSSE deals with individual
Standards have been dealt with in seven ways
(1) Adopted without change
FRSSE adopted certain standards without change, e.g. SSAP17
(2) Not addressed
Certain standards were not addressed in the FRSSE, e.g. FRS 1
(3) Statements relating to groups are cross-referenced
If group accounts are to be prepared the FRSSE contains the
   cross-references required to FRS 2 Accounting for Subsidiary
   Undertakings, FRS 7 Fair Values in Acquisition Accounting.

      BACCT2102            Corporate Reporting                    29
How FRSSE deals with individual
standards (cont)
(4) Disclosure requirements removed
Certain standards apply but the disclosure requirement is
(5) Disclosure requirements reduced
Certain standards apply but there is a reduced disclosure
requirement, e.g. SSAP 9 Stocks and Long-Term Contracts
applies but there is no requirement to sub-classify stock nor to
disclose the accounting policy.

      BACCT2102             Corporate Reporting                    30
How FRSSE deals with individual
standards (cont)
 (6) Increased requirements
 Certain standards are included with certain of the requirements
 reduced and other requirements increased, e.g. under FRS 8
 Related Party Disclosures a new paragraph has been added,
 clarifying that the standard requires the disclosure of directors’
 personal guarantees for their company’s borrowings.
 (7) Main requirements included
 Certain standards have their main requirements included, e.g.
 FRS 16 Current Tax, FRS 18 Accounting Policies, FRS 19
 Deferred Tax.

     BACCT2102             Corporate Reporting                    31
  Small companies – IASB position
• IN 2004 the IASB issued a Discussion Paper ‘Preliminary
  Views on Accounting Standards for Small and Medium-sized
Public accountability criterion
• Move from size tests to a definition based on qualitative factors
  such as public accountability
• SME if it does not have public accountability.
Public accountability test
• Public accountability implied if
   – outside stakeholders have a high degree of either investment,
     commercial or social interest; and
   – the majority of stakeholders have no alternative to the external
     financial report for financial information.
      BACCT2102                 Corporate Reporting                     32
Review questions
1 Why is it necessary for financial reporting to be
  subject to (a) mandatory control and (b) statutory
2 How is it possible to make shareholders aware of the
  significance of the exercise of judgement by directors
  which can turn profits of £6m into losses of £2m?
3 Discuss the main arguments for dispensing with all
  SSAPs and FRSs.
5 To what extent do you think FRSs should take
  economic consequences into account?
   BACCT2102          Corporate Reporting                  33
Review questions
7 Explain the main changes to interim reports
  following the ASB Statement of Best Practice.
8 ‘The most favoured way to reduce information
  overload was to have the company filter the
  available information set based on users’
  specifications of their needs.’ Discuss how this
  can be achieved.
9 Review a SORP and discuss the reasons why
  existing FRSs need to be supplemented.
   BACCT2102        Corporate Reporting          34
Review questions
10 ‘Quarterly reporting is essential in the interest of
   transparency and can, therefore, only be beneficial
   for investors.’ Discuss.
11 ‘Every European company should be required to
   prepare their financial reports in accordance with an
   IFRSSE similar in content to the UK’s FRSSE.’
12 ‘Measurement criteria are more important than
   disclosure requirements for small entities.’ Discuss.

   BACCT2102          Corporate Reporting              35
            The End

            End of Topic 1A

BACCT2102       Corporate Reporting   36

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