INTRODUCTION

Media are not shy at reporting corporate frauds, be they debt concealment, false announcements
of good results, and manipulation of all kinds of information, which often coincides with the end
of financial fads or the bursting of bubbles. These malpractices have been considered as proof of
the failure of the then prevailing models of corporate governance, and of the dangers of a lack of
disclosure. Since then, regulation, in Europe and across the Atlantic, has responded by
attempting to impose new mechanisms of governance and by requesting from firms more
information obligations, and better controls of information, notably through the Sarbanes-Oxley
Act in 2002 in the United States. Transparency has in particular been put forward in the banking
sector: the pillar 3 of Basel II requires disclosure to enhance market discipline. Lack of
disclosure is once again considered as lying at the heart of the current crisis, with opacity
affecting above all investment banks. And, from the very beginning of the crisis, increased
transparency has been seen as one of the main elements of an improved financial regulation. G20
major economies have notably highlighted the dominant role of transparency in measures to fight
the crisis and avoid a potential repetition. The manipulation of information, via the complexity of
structured products resold in the markets, and plain fraud, are again being investigated.
Moreover, the mandate of the new Financial Stability Board, created by G20 countries in April
2009, contains a requirement for its members to maintain the transparency of the financial sector.

Information asymmetry between the firm or the bank and third parties, whether these are
investors, creditors, employees or the public authorities, can thus safely be considered as one of
the main culprits of financial and economic crises and, as such, lies at the heart of actors’
concerns. Disclosure, whether voluntary or mandatory, would have the virtue of reducing
information asymmetries and of allowing effective control of managers, and reestablishing good
governance. In sum, though the problem is not new, the current crisis has installed transparency,
and thus disclosure, as a one-stop shopping solution. Is such a position justified?

The problems of information asymmetry have long been highlighted in the literature, in
particular in the corporate finance literature. These information asymmetries oppose the manager
and the shareholders, or, following a broader view, they oppose on the one hand those who are
commonly called insiders (managers and majority shareholders) and, on the other hand, the
outsiders (minority shareholders, creditors, and other stakeholders). One could also include the
regulatory authorities among these outsiders, as well as information professionals - the rating
agencies and financial analysts. As part of a separation between the ownership of capital and
control, information asymmetries pose the problem of the ex post control of the choices of
managers by shareholders. The response provided by the traditional literature related to corporate
governance was the definition and implementation of incentive contracts. These were supposed
to solve the following two problems: first, the cost of perfect information and, second, the
inability of shareholders to process information correctly (which is the major reason for
delegating power). However, incentive mechanisms, whose objectives are to make manager’s
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interests coincide with those of shareholders, have shown their pernicious effects. Since the
1990s and the first decade of the 21st century, then, the solution to the problem of information
asymmetry seems to be disclosure, supported by an apparent consensus between economic
actors, public authorities and the media. However, the academic literature is more qualified. The
costs of establishing disclosure are well known, and are the justification of the existence of a
second-best equilibrium: the first best, in perfect information, has long been assumed
unattainable. The drawbacks of perfect information, or, at the least, of information disclosure,
have been enlightened. For instance reducing informational asymmetries between an agent and a
principal does not necessary improve the principal’s utility or profit. Knowledge reduces the
principal’s will to punish the agent even though it would be necessary to increase efficiency. The
disclosure of information to third parties reduces the incentive of agents to behave for the
principal’s sake. So, quite logically, the costs of establishing corporate disclosure on financial
markets, and the pernicious effects of it, have increasingly been highlighted by the modifications
of regulation, laws, rules and behaviors.

Defining corporate disclosure

Corporate disclosure can be defined as the communication of information by people inside the
public firms towards people outside. The main aim of corporate disclosure is “to communicate
firm performance and governance to outside investors”. This communication is not only called
for by shareholders and investors to analyze the relevance of their investments, but also by the
other stakeholders, particularly for information about corporate social and environmental
policies.

Limitations

The limitations of financial statements are those factors that a user should be aware of before
relying on them to an excessive extent. Knowledge of these factors could result in a reduction of
invested funds in a business, or actions taken to investigate further. The following are all
limitations of financial statements:

Dependence on historical costs

Transactions are initially recorded at their cost. This is a concern when reviewing the balance
sheet, where the values of assets and liabilities may change over time. Some items, such as
marketable securities, are altered to match changes in their market values, but other items, such
as fixed assets, do not change. Thus, the balance sheet could be misleading if a large part of the
amount presented is based on historical costs.

Inflationary effects

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If the inflation rate is relatively high, the amounts associated with assets and liabilities in the
balance sheet will appear inordinately low, since they are not being adjusted for inflation. This
mostly applies to long-term assets.

Intangible assets not recorded

Many intangible assets are not recorded as assets. Instead, any expenditures made to create an
intangible asset are immediately charged to expense. This policy can drastically underestimate
the value of a business, especially one that has spent a large amount to build up a brand image or
to develop new products. It is a particular problem for startup companies that have created
intellectual property, but which have so far generated minimal sales.

Based on specific time period

A user of financial statements can gain an incorrect view of the financial results or cash flows of
a business by only looking at one reporting period. Any one period may vary from the normal
operating results of a business, perhaps due to a sudden spike in sales or seasonality effects. It is
better to view a large number of consecutive financial statements to gain a better view of
ongoing results.

Not always comparable across companies

If a user wants to compare the results of different companies, their financial statements are not
always comparable, because the entities use different accounting practices. These issues can be
located by examining the disclosures that accompany the financial statements.

Subject to fraud

The management team of a company may deliberately skew the results presented. This situation
can arise when there is undue pressure to report excellent results, such as when a bonus plan calls
for payouts only if the reported sales level increases. One might suspect the presence of this issue
when the reported results spike to a level exceeding the industry norm.

No discussion of non-financial issues

The financial statements do not address non-financial issues, such as the environmental
attentiveness of a company's operations, or how well it works with the local community. A
business reporting excellent financial results might be a failure in these other areas.

Not verified

If the financial statements have not been audited, this means that no one has examined the
accounting policies, practices, and controls of the issuer to ensure that it has created accurate
financial statements. An audit opinion that accompanies the financial statements is evidence of
such a review.

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NO PREDICTIVE VALUE

The information in a set of financial statements provides information about either historical
results or the financial status of a business as of a specific date. The statements do not necessarily
provide any value in predicting what will happen in the future. For example, a business could
report excellent results in one month, and no sales at all in the next month, because a contract on
which it was relying has ended.

Financial statements are normally quite useful documents, but it can pay to be aware of the
preceding issues before relying on them too much.

NEGLIGENCE

Negligence is the result of someone failing to act in a responsible manner and in accordance with
generally acceptable guidelines. Failure to act responsibly or ethically often causes injury to
another party and the injured party has a right to be compensated for injury sustained as a result
of the negligent act.

ACCOUNTING MALPRACTICE

Accounting malpractice is an accountant’s error, omission or deviation from Generally Accepted

Accounting Principles (GAAP) resulting in financial loss. Auditing malpractice, similarly, is an
auditor's error, omission or deviation from Generally Accepted Auditing Standards (GAAS)
resulting in financial loss.

There are two general categories of accounting malpractice: simple negligence and gross
negligence. Simple accounting negligence occurs when an accounting professional inadvertently
deviates from GAAS or GAAP or makes an accounting error. Gross negligence occurs when an
accounting professional intentionally deviates from GAAP or GAAS, manipulates accounts or
knowingly deviates to achieve a predetermined end result.

Accounting malpractice includes

 Billing clients fraudulently or inaccurately

 Committing tax errors, tax fraud, or tax evasion
 Committing violations of federal and state securities laws
 Conducting wrongful certification of financial statements
 Deviating from GAAP that result in fines
 Deviating from GAAS that result in inaccurate shareholder reports, lawsuits, or fines
 Failing to follow reasonable standards of care in accounting
 Failing to properly audit financial statements or detect defalcations
 Failing to provide accurate advice on financial aspects of corporate restructuring
 Failing to reasonably detect fraud

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 Giving erroneous advice regarding accounting matters, committing inventory errors, or

failing to provide correct tax advice
 Improper tax returns
 Keeping poor financial books
 Making misstatements on financial audits
 Manipulating reports to impact stock value
 Using improper accounting practices to enable or cover-up embezzlement or fraud,
including tax investment cases, securities fraud, and CPA license fraud

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