In the development of standards that are principle-based,

  In the market, there are many types of
investment opportunity such as real estates, commodities, bonds, mutual funds,
equities and many others. One of the most popular investments are equities and
bonds of companies, and within this category there are numerous options. Investors
normally carry out researches to find companies that suit their needs and
preferences, in terms of future income flows, capital appreciation, risk etc.

The most important documents that can provide relevant information to assist
investors in their decision-making is the financial statements published by
companies. From these statements, investors can extract information concerning
the company’s current and past earnings, and could to a certain extent gauge its
future performance. At the same time, information on the board members such as
their experiences and qualifications can help investors to form opinions on the
quality of the board. In this essay, I am going to discuss how information
published in the financial statements are regulated by the current accounting standards
to ensure that they truly reflect the performance of the company, as well as
the roles of the board in relation to corporate governance. Before these, I
shall look briefly into the relevant accounting standards conceived under the
IASB Conceptual Framework.

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   According to the International Accounting
Standards Board (IASB), the primary objective of financial statements is to
provide information about the financial position, performance and capability of
an enterprise. To achieve this objective, the financial statements must provide
information regarding an entity’s analysis of balance sheet assets and
liabilities, income and expenses, cash flows, equity, profitability etc. (Pepi
2016). This information assist users of financial statements in predicting the entity’s
future cash flows, their timing and certainty (Deloitte 2017).

 

  The IASB
Conceptual Framework provides the foundations for the development of standards
that are principle-based, consistent, and internationally convergent for
financial statements to provide information needed for investment and other
similar decisions (Mala & Chand 2015). The relevant standard assists
auditors in preparing financial statements in conformity with the framework
principles and eases the concerns of stakeholders when interpreting them (Elliot
& Elliot 2011). Consistent with the IASB standards, the content should
carry the fundamental characteristics of relevant, faithful representation,
verifiable, comparable, understandable etc. to be useful to its users (E
2010).

 

  Financial statements play a critical role in
providing information relating to its past years’ performances and an
indication to users of what to expect in the future. Users such as investors,
shareholders, stakeholders and creditors rely on this information for their
decision-makings. Thus, poor financial reporting that lacks honesty can lead to
confusions and significant financial losses to users. For instance, to increase
personal gains, upper management in a company might carry out financial
statements manipulation. One of the most well-known cases of dishonest
situation is the Enron case in 2001. The company could hide billions of dollars
from failed projects by deliberating using accounting manipulation techniques.

The consequences were that not only users were misled by the financial
reporting information and suffered losses, Enron eventually went bankrupt and
its auditors were charged of fraud offences (The Economist 2002).

 

  The
real-life situation mentioned above shows that not only financial statements have
to be reported with honesty reflecting a true and fair view of the company’s
financial situation, preparers must also be mindful about the rules stipulated
by IASB under the conceptual framework. One of its important components is IAS
37 Provisions, Contingent Liabilities and Contingent Assets. Its primary
objective is to provide regulations to curb potential manipulation of reported
earnings by managers (Deloitte 2017). IAS 37 is mainly concerned with Provisions
and the distorting effects they can have on profit, income and capital gearing.

Consequently, full recognition in monetary term is required. Regarding
Contingent Liabilities, it is mandatory for companies to provide full
disclosure on potential liabilities to alert financial report users, though no recognition is required.

The same principle is applicable to Contingent Asset where only full disclosure
is needed and that no recognition would be allowed regarding potential income, to
prevent users from being misled. The regulations of Provision are
essential to provide a true and fair view of financial statements. According to
PWC, provision is best measured
at present value of the expected cash outflows where the effects of time value
of money is material and that the estimation must be based on reliable method.

(PWC 2017).

 

  The
importance of applying IAS 37 correctly could be better highlighted in the case
Societe Generale. It is one of the largest banks in Europe and was accused of
fraudulent practices in 2008. The company did an unauthorised and ‘fictitious
transaction’, that cost more than $7 billion, the biggest loss ever recorded in
the financial industry (Clark & Jolly 2008). According to the article ‘The
Importance of Being Fair’, Societe Generale misused the IAS 37 rule, and made a
provision in the 2007 balance sheet even though there was no clear liability to
anyone at that date. The provision made a huge impact on the firm’s reported
earning that year and consequently its shareholders suffered losses (Nobes
2009).

 

  The adoption of the principle IAS 37 is to
limit accounting manipulation such as big bath accounting, cookie jar reserves,
income smoothing and other manipulative practices. The rules spell out in clear and definite terms
when and how provision should be made, and the disclosure of potential
liabilities and incomes without recognition. Strict adherence to the rules will
lead to greater transparency and accounting prudence (Felegea et al 2010),
giving its users a good basis for decision making.

 

  Big
bath accounting mentioned above involves the acceleration of certain expenses
and losses into a single bad year with the aim of making the financial results
of the following and subsequent years look much better. There is always an
ulterior motive associated with such practice, to the disadvantage of
investors. In 2008, Samsung Electronics posted a record operating loss of 937
billion won but the actual loss was only 400 billion won back then. The
management took advantage of the year’s slow growth and worsen it by taking a
large non-recurring loss. Such action could lessen the burden of achieving
future earnings expectations, so that if the following year does not perform
well, it will still appear profitable (Kim 2009).

 

  Another
accounting manipulation technique is income smoothing which is defined as ‘an
attempt on the part of the firm’s management to reduce abnormal variations in
earnings to the extent allowed under sound accounting and management
principles’. To do so, managers intentionally reduce the fluctuations of their
firm’s earnings realization. Its ultimate aim is to show a steady revenue and
profit growth that will give the company a positive image, to attract investors
or creditors for investments and borrowings (Tucker & Zarowin 2005). However,
opportunistic income smoothing which is further elaborated below, only benefit
the insiders.

 

  The examples
above show activities which are not consistent with the concept of accounting
prudence. The Accounting Standards Board’s 1995 draft statement describes
prudence as a component of
reliability in financial statements as ‘uncertainties are recognised’. It is an
inclusion of a degree of caution
in the exercise of the judgements, such that income or assets are not
overstated and expenses or liabilities are not understated (Maltby 2000). The
principle of prudence is applied to provide a faithful representation, true and
fair view of the company, safeguarding the interest of its users.

 

  In addition to
the roles play by accounting rules in ensuring reliable financial reports,
board of directors of an organization also has an important role to play in
upholding good corporate governance. It is suggested that there is a direct
correlation between good corporate governance and long term shareholder value,
and good corporate governance is dependent on the board which is the main agent
in the reforming of the practices of corporate governance (Mclnnes Cooper 2014).

Investors and other users alike will therefore be very much interested in the
composition and qualification of the board in their analysis of earning
potential.

 

  One of the best corporate governance
practices suggested by Mclnnes Cooper is for the board to place great emphasis
on integrity and ethical dealing to rid the organization of dealings involved
conflict of interest, and to have respect and compliance with laws and policies
without fear. Opportunistic earnings management, a shady technique deployed to
increase the prosperity of the management insiders, as well as controlling
shareholders and to the detriment of outsiders could be eliminated by a strong
ethical policy (Surifah 2017). According to a study regarding banks in
Indonesia, strong corporate governance is essential to ensure efficient
deployment of the company’ resources leading to maximization of profit inflow.

A weak corporate governance would allow manipulations and abuse of power in
firms, such as the case in Indonesia where controlling shareholders took
advantage of the firms in 1988. Consequently, 16 banks were closed and 7 banks
were suspended by the authority.

 

  Moreover, a research from
Nalukenge et al finds that the inclusion of outside members on the board
increases effectiveness of preventing financial statements fraud. This is
because they are able to provide an independent view on corporate strategy and
standards of conduct. The existence of these independent directors also acts as
a monitoring and check and balance mechanism and are able to give positive
influence over board’s decisions (Nalukenge 2017). It is suggested that ‘no
fraud’ companies consist of a higher proportion of outside directors, implying
that board independence is associated with fraud prevention.

 

  A study by Yang and Zhao opines that the
combination of CEO and chairperson in a single person can lead to concentration
of power thus weakening the level of monitoring. As a CEO becomes too powerful
and dominant, he/she is able to use the firm for his own interests rather than
that of the shareholders (Yang & Zhao 2014). It is further implied that the
duality of these two roles is associated to financial statements fraud as the
concentration of power give CEO the ability to override the company’s internal
control structure (Nalukenge 2017). Mclnnes Cooper also suggests the separation
of the roles of the chair and CEO, allowing the Chairman to lead the board and
ensuring the long term interest of the firm is safeguarded while the CEO could
concentrate on leading the management and ensuring the plans and strategies are
effectively implemented (McInnes Cooper 2014).

 

  As users of financial report will be keen to
learn how strong is the board, it is a good governance practice to build a
strong and qualified board. Mclnnes Cooper suggests that the members must be
knowledgeable of the relevant field, qualified and competent, strong ethics and
of diverse backgrounds and skillsets. A strong board will go a long way to
ensure good governance and efficient utilisation of the firm’s resources for
long term earning growth.

 

  In conclusion, I wish to summarize that
financial statement of an entity is the most important document for decision
makers in their analysis of the firm’s future income flows. The information
provided in the report must therefore be truly representative of the company’s
assets, liabilities, earnings etc. To ensure the interests of the users are
safeguarded, there are accounting standards in place to regulate the
preparation of financial reports. Notwithstanding this, frauds related to
financial statements are still common. Board of directors is also of great
interest to users of financial report in their analysis of the future prospects
of the entity. A strong board who put in place some of the best practices of
corporate governance will be a good source of comfort to users as they could
expect greater transparency and accountability, as well as greater efficiency
and effectiveness in the utilisation of the company’s resources.