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Lecture 4


Assignment (due Wed next wk)

Read pp. 1-18 of Financial Reporting & Corporate Governance by Thomas A. Lee (LIBRARY)
Call number: HG 4028 B2 L44 2006

Answer the following questions on one short bond paper (computerized):

A. B. C. D. E. F. G. H. Compare & contrast the case of Enron & FBW. Explain the advantages & disadvantages of limited liability companies. Compare & contrast corporate management executives & directors in terms of the nature & purpose of their roles. Given corporate managers are responsible for company operations, why is it necessary to have corporate directors? What are the advantages & disadvantages of representing corporate activities in the form of accounting numbers? Enumerate the stakeholders in corporate activity. What is the difference between shareholders & stakeholders? Explain in general terms the nature & purpose of the auditor in a corporate activity (in the context of corporate governance)?

Assignment (due Sat next wk) Read Chapters 2 & 3 of Financial Reporting & Corporate Governance by Thomas A. Lee

1. What is principal-agent relationship? 2. What is creative accounting? 3. How is audit used as an effective governance mechanism? 4. Why is internal control such an important issue in the general area of corporate governance? 5. Read about MiniScribe on p. 34. Be able to discuss in class why this case is not a good model of corporate governance

The Company
A company represents a deliberate collaboration between investors with funds to invest in business & managers with skills to operate that business on behalf of investors. The collaboration exists within a legal structure that is subject to legislative requirements concerning its governance. The success of this governance depends on a flow of regular & reliable financial information from managers to investors.

Principal-agent relationship
This is fundamental to the corporate system of business & should be beneficial to both shareholders & managers. The relationship is monitored & directed by the BOD. Because the principal-agent relationship in corporate business can be abused by senior managers, the corporate audit by an independent public accountancy firm is a vital means of protecting shareholders from potentially misleading accounting numbers. The auditor is therefore a significant means of providing confidence & stability in financial markets.

The state in the form of legislators & gov t departments is interested in a company e.g. for purposes of levying tax or monitoring corporate regulations. Financial information is used to determine corporate tax liabilities. It can also be used to assess such commercial matters as product pricing & inflation, & monopoly profits.

Financial Statement Users

Investors Lenders Creditors Customers Employees

Main Financial Statements These relate to profitability, cash flows, & financial position. They are audited & mainly numerical in content.

1. Statement of profitability (called the income statement or profit & loss account) reports the net gain & losses earned by the company from its operating activities. Profits in this sense are the residue of an accounting process of matching sales revenues with their associated expenses. 2. Cash Flow Statement this statement reports the net cash flows from operating, investing, & financing activities of the company. The aggregation of cash flows reconciles to the periodic change in the company s cash resources. 3. Balance sheet this statement reports the company s assets at the end of the reporting period, & the various short-term & long-term obligations of the company (including debt & shareholders capital.)

Subsidiary Financial Statements These support the main statements. They are audited & so mainly numerical in content. They include:

1. Statement of total recognized gains & losses. This statement reports all profits & losses earned by the reporting company during the period i.e. trading profits & losses, & other gains & losses not reported in the income statement or profit & loss account (e.g. on foreign currency transactions). 2. Statement on historical cost profits & losses. This statement explains accounting numbers in the main statements that are not based on the original cost of the transactions e.g. when an asset is revalued. 3. Movements in shareholders funds it reconciles the funds of shareholders at the beginning & close of the reporting period terms of undistributed profits & new capital received from shareholders. 9

Explanatory Statements
1. Accounting policies particularly for expert users of financial statements, it is important to disclose the main accounting the main accounting conventions & practices (as contained in prescribed standards) that have been applied to the preparation of the accounting numbers in the main financial statements. 2. Notes to financial statements many if the accounting numbers in the main financial statements are complex calculations & require further explanation as to their nature & composition. This statement provides this explanation & therefore prevents the main financial statements from becoming unreadable due to excessive detail.

Explanatory Statements
3. Statement of principal subsidiaries the financial results reported by a company are often a combination of several companies i.e. typically when the reporting company owns 50% or more of the voting capital of the other companies. In these situations this statement lists these share ownerships. This statement also lists investments of between 20% & 50%. The financial results of these associated companies are not combined into the main statements but nevertheless, may represent interests in considerable amount of profits, cash flows, & financial positions that shareholders ought to be aware of.


Other statements
These provide support & amplification to the main financial statement. They are typically unaudited & predominantly narrative in style. Statement of the Chairman this is a voluntary statement, often called the chairman s report. It is used by the chairman of the BOD to provide a broad review of the reporting company s financial results in the context of its trading & related activities.

Directors report this is a legally required statement by the BOD & includes a mixture of prescribed & voluntary information. Operational & Financial Review this is a voluntary statement & explains the main features of the financial results disclosed in the main financial statements in a narrative style. It has two sections. The first deals with operating matters relating to profits & cash flows. The second concerns financial funding activities such as share capital & long-term loans. Review of trading activities. This is a statement that expands on the broad review typically given in the chairman s statement. This is contained in the Operational & Financial Review.

Corporate Governance Statement in recent years, companies have published this statement as a condition of stock market listing their shares. It attempts to explain the philosophy & mechanisms of corporate governance to shareholders & particularly addresses the issue of compensation for senior managers & members of the board of directors. The statement is typically contained in the directors report.


Auditor s report here the directors responsibility for the main financial statements & the basis for the audit are broadly described, & the audit opinion on the quality of the main financial statements is given. Statement of Directors responsibility although the responsibility of the board of directors for the main financial statements is identified in the auditor s report, companies are also required to make a more detailed statement separately usually in the directors report. The statement includes maintenance of adequate accounting recorf & use of appropriate accounting standards.

Investment Decisions
Investors are defined as 2 groups. 1. Existing shareholders - these include private individuals & commercial organizations such as pension funds & investment fund managers. - They own shares in the company because they either invested directly in it (e.g. on its formation or initial market listing) or bought shares in it through a recognized stock exchange (i.e. second-hand shares). 2. Potential shareholders

Investment Decisions
Their use of financial statements is varied according to their degree of interest & level of expertise in accounting & financial matters. A small minority of investors make considerable, expert, & direct use of financial statements. The large majority, however, make little or no direct use of them, preferring to rely on professional analyses of reported accounting numbers that appear in newspapers & similar publications.

Financial Information Needs of Investors relate to 2 separate but related functions:

Managerial Stewardship financial info in corporate reports provides knowledge of the senior managers & board of directors effectiveness in governing the company. For example, poor profits can signal poor operational decisions & actions by senior managers & inadequate internal controls of operating activities. Investment Decision-making refers to the buying, holding, or selling of shares in a company.

The most fundamental characteristic of the investment decision is its comparison of the current market value of a share unit (not always known unless there is an established market for it & a stock market quotation) & the value the investor believes it to be worth (its intrinsic or present value). If the perceived present value of a share is greater than or equal to its market value then it would be rational for an investor to decide to buy the share or hold it (if it is currently owned). On the other hand, if the share s present value is less than its market value, then a rational decision would be to refrain from buying it or to sell it (if it is currently held).

Present Value
In a rational economic world, a marketable object such as a share unit should only be held by its owner or bought by a potential owner if its intrinsic or present value is believed to be at least equal to the price that is being asked for it. Only in these circumstances can the investor avoid making an economic loss. The present value of a share is based on investment periods, future receipts, and rates of return. The problem for the buyer or seller (of stock shares) is one of trying to estimate the present value. More often than not, this boils down to a gut feeling about the worth of the good or service.

Investment Decision-making
When buying, holding or selling shares in companies, investors require financial information to make predictions about future returns that determine formal or informal present values. The corporate financial report provides financial information about the past of the company & is a basis for these predictions. Companies rarely disclose predicted financial information other than managerial expectations of increased sales & profitability in the most general form e.g. the CEO informing professional financial analysts & journalists that his company hopes profits next year will continue to rise.


Differentiate common stockholders from preferred stockholders. What must a diligent shareholder do to monitor the financial progress & health of the company he invested into?


Financial reporting
Financial reporting is a significant part of effective governance. Corporate senior managers act as agents for shareholder principals in a business structure governed by legislation. The situation is one of potential hazard to shareholders & requires various mechanisms to be in place in order to ensure that the managerial agents perform in ways that are compatible & consistent with the interests of shareholder principals.

Financial reporting
Financial reports are an integral part of corporate governance as they contain a set of audited financial statements to shareholders. These statements comprise accounting numbers describing the financial results of business activity supervised by a team of senior managers and a board of directors. The accounting numbers are prepared using mandatory procedures contained in a regulated process of accounting standards.

Financial reporting
The principal components of a corporate financial report comprise several statements including the income statement or profit & loss account, the cash flow statement, & the balance sheet. These statements are mandatory, their content is governed by prescribed rules of accounting, & they are supported by a variety of other explanatory & review statements.

Financial reporting
Corporate Financial reporting & auditing provisions have typically been government responses to corporate scandal involving fraudulent activity. In order to protect the public interest in a capitalist economy, gov t has from time to time felt the need to interfere in capital markets. Audited accounting information in financial statements has been a principal tool of governance for more than 160 years.

Financial reporting
It is a mandatory requirement for a professionally qualified accountant to report an opinion on the quality of the financial statements reported by senior managers to shareholders. The value of the corporate audit is directly related to the independence of the auditor. The less independence the auditor has, the less value can be associated with the audit.

The Audit
The corporate audit is not intended by public accountants to be a fraud detection audit. This can lead to different expectations of the auditors & its beneficiaries. Such differences are called expectation gaps. The corporate audit comprises several stages involving examinations, assessments, & reports. Each of these stages involves the use of relevant expertise & professional judgment in evaluating audit evidence.

Corporate governance
To govern is defined as ruling by authority; The organization is managed on behalf of a variety of stakeholders including its shareholders. Corporate governance consists of the formal mechanisms of direction, supervision & control put in place within a company in order to monitor the decisions & actions of its senior managers & ensure these are compatible & consistent with the specific interest of shareholders & the various other interests of stakeholders who contribute to the operations of the company.

It means that these managers are expected to provide a regular reckoning or account of their decisions & actions. Within a company, there are various connected lines of responsibility, from employees & staff to junior managers to senior managers to the Board of Directors to the shareholders and, more indirectly, to other stakeholders.

It is a modern equivalent of the centuries old notion of stewardship. The practice of absentee owners delegating managerial duties to an agent is as old as the history of property ownership. Gradually, over several centuries, a complex structure of corporate governance regulation was formed with one consistent objective to hold senior corporate managers accountable to shareholders through the board of directors.

The guiding principle underlying the BOD & its subcommittees is the need for independence in order to bring objectivity to the tasks of directing, regulating & controlling the executive functions of company management, i.e. for the purpose of making senior managers accountable to owners.


Government regulation
There is evidence in recent times, particularly in the US after a number of financial scandals, of gov t becoming more involved in the oversight & control of the corporate audit function. There is a pronounced movement toward more independent auditors & a distinction with respect to corporate governance between the roles of corporate senior management & the auditor.

Internal Control
Corporate governance is assisted generally by an effective system of internal control. More specifically, it is enhanced by an internal function although the internal auditor may be constrained by the tasks set by senior managers & the need to report to the latter. External auditors should not undertake the provision of internal audit services for the same company client.

Creative Accounting
This generates accounting numbers intended to deceive shareholders & other users. It damages the credibility of the company and its managers, & can financially damage shareholders and other users who rely on them in their decisions. Creative accounting effectively destroys the trust on which the principal-agent relationship needs to be based and can de-stabilize capital markets.