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A use of corporate governance and financial reporting

Viets, Associate Clinical Professor Systems and Accounting Graduate Programs, Kelley School of Business, Indiana University, Bloomington Overwhelmingly, company financial statements and tax returns are prepared with integrity by honest managers and audited by competent professionals with proper skepticism.

Fraud and misleading reporting barely impact economic projections. Confidence in financial statements has been damaged, though, because a few people took advantage of trust and position, supported by others who did not carefully guard company assets and the sanctity of financial reports. Unfortunately, examples have been prominent and the media properly made certain we did not miss any. Financial reporting is self-regulated.

Corporate Governance and Reporting

Managements prepare reports, interpreting how to report results. Reports are seldom immediately reviewed by regulators and may never be reviewed. Self-regulation will not change, and there is no need to change it. Notwithstanding this conclusion, we have learned, or have at least been reminded from recent experiences, that certain aspects of the financial reporting system need to be fixed.

Accountants are overwhelmed with the standards setting process. Financial statement readers want reports on assets and liabilities in a world that is trading elements of assets and liabilities. It is difficult to reduce business complexity to simple, transparent financial statements. Assets and liabilities today are carved into elements, dividing shared responsibility and ownership.

For example, engineered transactions like special purpose entities have never been dealt with effectively by those who decide GAAP. Today, two years after Enron, a debate continues over variable interest entities, as companies try to understand a proposed standard that is getting old before it is even implemented.

The standards setting process is emotional and political. Debate is less about accounting theory than the impact on financial position and capital allocation.

The SEC answered the question of principles-based versus rules-based by concluding that standards should really be objectives-based. Companies and auditors continue the journey without a good map.

Internal Controls Sarbanes-Oxley addressed a second problem: Internal controls are activities that assure companies achieve business objectives, not the least of which is good financial reporting. Some companies do not have good internal controls.

  • But with four firms auditing 99 percent of all public company sales, there is doubt about meaningful regulation;
  • When the board of directors reviews financial information, it should thoroughly question and probe the information presented and continue to do so until the board is satisfied with the answers to its questions;
  • In this case would be examined current assets and their relation to short-term liabilities to assess the short-term solvency of the company;
  • Shareholders, or potential, are also interested in many of the characteristics considered by a creditor in the long term.

But even if they do, bad managers can ignore the controls and initiate improper transactions in financial statements. Internal controls have never been well documented. They develop more from instinct, similar to the way a person dons a coat when it is cold.

Documenting instinct seems to add little value. But many risks needing controls are not as obvious as temperature changes. Formal development and documentation can help. Sarbanes-Oxley requires new reporting to investors on the effectiveness of internal controls. These new requirements exposed the truth about controls. Documentation does not support evaluations by managements and auditors. As a result, documentation of controls is now done on a crash basis by smart people lacking business school background on what constitutes good internal controls.

Required reporting has been delayed one year.

Centre de gouvernance d’entreprise

The requirement is controversial because compliance is expensive. Audit fees have increased dramatically and companies are investing heavily in compliance. Many managers wonder if we are preparing for the possible or the improbable. Auditors Auditors are a separate, complex problem. Auditors work from a risk model that weights costs of finding problems. The model accepts undiscovered reporting problems when the cost to find them is too high.

When the expectation gap becomes a problem, the argument is about auditor negligence, so difficult to defend in hindsight. Accounting firms manage this risk through contracting, legal defense, settlements, stop loss organizational structures, and insurance.

If these fail, partners melt into other firms, leaving the damage behind. Confidence in auditors has suffered. Auditors proudly proclaim their own self-regulation, administered through the American Institute of Certified Public Accountants. Firms use self-inspections and peer reviews. The past haunts the accounting profession. Investors are troubled by self-regulation and audit quality.

Large firms face huge litigation claims and their nonaudit practices are viewed with suspicion. Smaller firms do not want to assume the responsibility. Sarbanes-Oxley established the Public Company Accounting Oversight Board to qualify and register firms before they can audit public companies and to inspect the practices of firms.

But with four firms auditing 99 percent of all public company sales, there is doubt about meaningful regulation. Regulation is premised on fear that failure by any of the four will result in a use of corporate governance and financial reporting the profession and may require change in our assurance model.

Conclusion The problems are difficult, but not addressing them leaves open doors to those who will take advantage of any opening. The overwhelming majority of honest managers and competent professionals are embarrassed and maddened by the actions of those who caused the dramatic changes now being implemented. How can so few cause so much damage for all? Most business people can, and do, make decisions every day against temptation, greed, arrogance, and self-interest.

Knowing the great damage caused by a small minority, the majority must balance that harm with humble, generous service, recognizing that each decision leaves a trail showing a willingness to be open and honest. Also in this Issue….