Features

Changing face of financial reporting

29 Apr 2014 - {{hitsCtrl.values.hits}}

By Cathrine Weerakkody

Financial reporting is a language that companies (public or private, non profit organizations, state or local governments) use to communicate to users of financial statements about their financial position.

Accounting rules are set up to help entities produce meaningful financial statements that can be relied upon for decision making. These rules and accounting practices ensures that financial statements can be compared across markets and protects the integrity of the financial information published in the set of accounts.

Accounting standards differ from country to country. For example, US GAAP which applies to financial reporting in the United States lists a set of detailed rules that must be followed (rules based accounting).

IFRS applies to most countries such as the United Kingdom which lists a set of objectives to be followed (principle based accounting). To ensure companies focus on high quality reporting and to ensure consistency, statutory bodies have been set up to regulate and to set standards for financial reporting. For example, SEC regulates financial markets and accounting bodies that set Accounting standards in the United States. Each country has their own form of regulation. There is generally now a requirement for accounting bodies to follow a standard set of procedures across regions. However considerable differences still exist across countries in the accounting treatment of many items due to varying accounting standards. Differences in accounting treatment can result in significantly different amounts being reported in the Profit and Loss Account statement and on the balance sheet. Research suggests that financial reporting practices differ across countries due to; (1) the prevailing legal system, (2) taxation, (3) providers of financing, (4) inflation, and (5) political and economic ties.

Developed, emerging and frontier markets
As McGowan states, Emerging markets (a term coined by the IFC in 1980) are countries with economies and stock markets showing signs that they are in the early phases of economies and stock markets in developed, industrialized countries. The frontier markets are a subset of these emerging markets that are smaller and less liquid than the more advanced emerging markets.”

A frontier market is a type of country that is not a developed market. The term is an economic term which was coined by International Finance Corporation’s Farida Khambata in 1992. Frontier markets (FMs) are investable but have lower market capitalization and liquidity than the more developed emerging markets. The frontier equity markets are typically pursued by investors seeking high, long term returns and low correlations with other markets. The implication of a country being labeled as frontier is that, over time, the market will become more liquid and exhibit similar risk and return characteristics as the larger, more liquid developed emerging markets.
According to the IMF, “Well-developed Markets are characterized by a large and continuous volume of trading by a variety of participants, including government, financial institutions, and other businesses.” Market depth in emerging and frontier market stocks are generally lower than developed stock markets. This refers to the markets ability to ensure that large market orders do not have an impact on price of a particular stock. Given the low trading volume, developing stock markets face higher volatility than developed stock markets such as the U.S. Deep markets means there is high level of liquidity moreover the existence of developed secondary markets.
Several companies in emerging markets have smaller capitalization compared to companies in mature markets. According to Market Realist,” in many cases the percentage of publicly available shares can be as low as 10 percent.”We could expect several investors using financial statements to make decisions. For example, FASB directly speaks to investors to find out what kind of information they need. The output from this discussion will help FASB to set standards that result in better information and other users of financial reports.

The constant improvement of standards and responsiveness of accounting boards to change will lead to differences between countries. Low trading volume and few shares floating would to accounting rules being less precise compared to mature markets. Furthermore it will not be practical for emerging markets to develop strict standards when there is no appetite within the market for rules. On the other hand Developing markets have a relative low complexity of financial instruments compared to developed markets. With reference to Mathieson ( 2004 ),in emerging economies, local derivatives differ in their sizes, both in absolute terms and relative to cash markets compared to mature markets. Financial instruments can be in the form of equity or debt or foreign exchange based.

Governance standards
Most frontier markets suffer from high risks arising from political instability and volatile currency movements. According to Swedroe (2011), “Before investing in a country, I want to be sure that it has well-defined property rights, enforces strict accounting standards and is fair to foreign investors. Emerging markets countries sometimes have problems in these areas, but the risk is even greater with frontier markets”. Public capital markets are underdeveloped for financial instruments and they are very small in developing markets. High risks, poor liquidity, weak regulatory system, inadequate legal system, poor market infrastructure and other restrictions would lead to a limited range of financial instruments being available in stock markets.

Therefore accounting rules in developed economies will be different as they do not need to incorporate very complex instruments. In addition, there is a high concentration of ownership and involvement in the hands of few high worth individuals in emerging markets. For example, Dallas (2011) notes that “In many emerging economies, controlling families occupy managerial positions in listed firms, and succession planning is often focused on family members and not on professional managers. In some countries where relationships matter more and the business elite are tightly connected, such as in Thailand, family run companies are likely to prepare their financial reports based on their needs.

Financial statements are unlikely to be detailed and precise compared to companies located in developed markets. However as all companies are subjected to tax, they will be expected to follow a set of accounting rules based on their country. There are difficulties in obtaining a fair valuation in emerging markets. Augusto de la Torre et al observes that in highly illiquid markets, fair value accounting becomes inherently difficult. Market prices are the best measure to value assets and it is common practice to use secondary markets to value assets. As these markets have low liquidity and transparency, it would be difficult to obtain an accurate market price. Furthermore, due to low trade volume, authorities are forced to depend on “price vendors”. As these vendors use various types of methods and models leads to several assumptions and high level of subjectivity when valuing assets. This will make it difficult for standard setters to develop suitable rules for financial reports. Furthermore, the accounting standards and regulation of financial reporting would differ from developed countries. Generally, emerging markets are less correlated with developed markets. Growth in most emerging markets are driven by domestic demand and existence of natural resources. Therefore, countries will develop their own set of rules and regulation of financial reporting based on their individual environments.

Compliance and regulatory requirements
Monitoring of financial statements to ensure compliance with the standards is the responsibility of auditors. However if auditors fail to detect fraud and it may subsequently lead to a stock market crash. For example, stock market crash of 1929 (Bealing JR 1994) and the creation of the UK Financial Reporting Review Panel (FRRP) after UK accounting scandals of the 1980s (Peel 1999). Developed markets continue to add more strict rules to ensure such events do not take place again.
A strong legal enforcement is said to ensure that companies comply with the rules. Furthermore external oversight by auditors is said to improve the quality and integrity of financial reports. Quantity and quality of financial information in emerging markets can be lacking and governance structures can generally be weak. Weak legal system, limited set of accounting rules would lead to poor regulation of financial reports. In addition if the market is underdeveloped and have very few investors, auditors are unlikely to be required.

Globalization
However due to globalization, financial reporting in South East Asian countries are affected by US legislation. It appears that SOX is adopted in these countries. There is today a global reform movements towards greater corporate responsibility and better financial reporting. Developed markets have a strong functioning judicial system in place to regulate financial statements. They impose penalties such as fines to any company that violates any rules.

Many developing countries however do not have a strong regulatory system or good accounting standards. It is the responsibility of the government and Central Bank of each country to create the conditions for investors feel secure enough to invest and ensure there is transparency in all activities. Inland Revenue will also monitor the financial statements of firms as they need it for tax purposes.

The lack of regulation makes it more difficult to develop strict accounting standards and stakeholders are unlikely to place trust in financial statements. Emerging countries borrowing from the UK or US need to improve their accounting standards and the regulation of financial reporting. As emerging economies open their doors to the global market to benefit from a greater flow of capital. According to HSBC, Government debt markets are growing, and many frontier markets now support well-functioning stock markets (although they remain small in terms of total capitalization).

According to Bekaert (2014) “Currently, emerging markets account for more than 30% of world GDP. However, they only account for 12.6 percent of world equity capitalization.” International investors would like to invest in such economies as they can experience high growth, and also spread their risk, however to attract that capital, financial information reported should be reliable and in line with international standards. However, many developing markets are yet to adopt International Financial Accounting standards and their national accounting frameworks do not open the door for investment decisions based on financial information.

Building technical expertise
Therefore there is a need for Capacity building in developing markets to promote a common accounting language across different countries . The best way to sustain the development of the accountancy profession is through the creation of accounting bodies. These accounting bodies set professional standards including the code of conduct for their members,

Their main objective would be to protect the general public on all matters relating to the profession. These bodies will ensure that students study, train and gain experience in order to qualify as a member and continue to learn , develop and acquire knowledge in order to maintain the required level of skill to carry out their professional work. For example, the Chartered Institute of Management is a UK based accounting body and has established itself in several countries. This allows professionals to promote the accountancy profession in the country where the accounting body operates.

These accounting bodies also have had a positive impact on the accounting rules and regulation of financial reporting standards in many developing markets. Furthermore the integrity and quality of financial reporting would improve in developing markets because of the influence of these accounting bodies. In the UK and other developed markets, accounting standards are very comprehensive. Every transaction is recorded in a specified way (or one of a few ways), and financial reports are presented according to a very strict set of rules. Therefore the presence of these global accounting bodies in developing markets is key for the emergence of a common set of accounting rules and practices.

Conclusion
With an increasing integration of markets, there has been pressure on a number of countries to develop a global set of accounting standards. For example, from 2002 onwards there was an agreement made to eliminate the gap between International Financial Reporting Standards (IFRS) and the U.S. Generally Accepted Accounting Principles (GAAP). The convergence of these standards will have an impact on governments, public and private companies, investors, accounting bodies, accounting standards and stock markets. However both standards need improvement individually. Herz (2013) suggests that, “The forthcoming end to the convergence program and IASB’s new ASAF usher in a new era for international accounting standard setting and for FASB as it considers how best to improve U.S. GAAP while also continuing to fulfill the requirement to promote convergence to international standards and the SEC may still weigh in on all of this. How all this finally develops, will no doubt be very important to both the United States and the international capital markets.” In conclusion , a common accounting language across different countries would certainly facilitate a free flow of funds and the movement of talent across countries on account of the familiarity with a common reporting language across different countries. However there is a definite need for the body of accounting rules not be too cumbersome and difficult to apply and in the process become a slave to ticking off the application of the rules rather than representing the true state of affairs of the company.

(The writer is a CIMA finalist and final year undergraduate student in the UK)

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Changing face of financial reporting

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