11

Corporate Financial Corporate Financial Reporting IReporting I

Lecture 1Lecture 1

Development of Financial Development of Financial ReportingReporting

22

Aims and OutcomesAims and Outcomes Aims:Aims: This lecture aims to introduce students to the corporate governance This lecture aims to introduce students to the corporate governance

framework of UK financial reporting and the historical context of framework of UK financial reporting and the historical context of current financial reporting requirements.current financial reporting requirements.

Learning outcomes:Learning outcomes: After the lecture and recommended reading students should be able After the lecture and recommended reading students should be able

to:to: Describe the UK system of corporate governance and the discuss Describe the UK system of corporate governance and the discuss

the role of financial reporting thereinthe role of financial reporting therein State and discuss various arguments in favour and against the State and discuss various arguments in favour and against the

regulation of this system and of financial reportingregulation of this system and of financial reporting Outline problems that the UK system of corporate governance has Outline problems that the UK system of corporate governance has

facedfaced Discuss generally the development of financial reporting from 1844 Discuss generally the development of financial reporting from 1844

to the 1990sto the 1990s

33

The Art of Practical AccountingThe Art of Practical Accounting Accounting or Financial Reporting is a practical Accounting or Financial Reporting is a practical

disciplinediscipline It has developed in response to practical It has developed in response to practical

problemsproblems Napier – Napier – History of Financial Reporting in the History of Financial Reporting in the

United KingdomUnited Kingdom Development of commerceDevelopment of commerce Need to attract investmentNeed to attract investment Pre-requisites:Pre-requisites:

Security of investmentSecurity of investment Income stream from investmentIncome stream from investment

44

Stimulus and ResponseStimulus and Response Prior to 1844 formation of companies via Royal Charter or Act of Prior to 1844 formation of companies via Royal Charter or Act of

ParliamentParliament Growth of huge infrastructure projects of 1700s and 1800sGrowth of huge infrastructure projects of 1700s and 1800s Growth of “Deed of settlement companies”Growth of “Deed of settlement companies” Unregulated until 1844 Joint Stock Companies ActUnregulated until 1844 Joint Stock Companies Act Companies required to register with Registrar of CompaniesCompanies required to register with Registrar of Companies New companies could be incorporated by registrationNew companies could be incorporated by registration Legal requirements to:Legal requirements to:

Keep proper books of accountKeep proper books of account Balance them periodicallyBalance them periodically Present balance sheet to shareholders at each meetingPresent balance sheet to shareholders at each meeting Auditors appointed by shareholders to report on balance sheetAuditors appointed by shareholders to report on balance sheet Accounts filed with RegistrarAccounts filed with Registrar

55

Making it upMaking it up

No limited liability: shareholders = No limited liability: shareholders = creditorscreditors

Purpose:Purpose: To assess solvencyTo assess solvency Maintain capitalMaintain capital

Drawback:Drawback: No proper accounting policiesNo proper accounting policies Very flexible approach to drafting balance Very flexible approach to drafting balance

sheetssheets

66

The modern corporationThe modern corporation

Limited liability Act 1855Limited liability Act 1855 Companies could incorporate with limited liabilityCompanies could incorporate with limited liability Needed to make public the fact by “Limited”Needed to make public the fact by “Limited” Further legal movesFurther legal moves 1856 Joint Stock Companies Act1856 Joint Stock Companies Act Repealed accounting requirements of 1844 ActRepealed accounting requirements of 1844 Act But introduced:But introduced:

Articles of associationArticles of association Requirements of internal accounting recordsRequirements of internal accounting records Format for balance sheetFormat for balance sheet Audit requirements – true & fair viewAudit requirements – true & fair view Consolidated into first Companies Act 1862.Consolidated into first Companies Act 1862.

77

OutcomesOutcomes

These Acts established a particular These Acts established a particular system of corporate governancesystem of corporate governance in the UK.in the UK.

Agency theory can be adopted to explain Agency theory can be adopted to explain the development of this system.the development of this system.

88

DefinitionDefinition Agency problems arise whenever a division of labour results in one Agency problems arise whenever a division of labour results in one

party (the principal) delegating decision-making authority or control party (the principal) delegating decision-making authority or control over resources to another (the agent). over resources to another (the agent).

The agency problem occurs whenever The agency problem occurs whenever (a) it is difficult or expensive for one party to evaluate the (a) it is difficult or expensive for one party to evaluate the

performance of the other, and performance of the other, and (b) the motives of the parties to an exchange may be different, such (b) the motives of the parties to an exchange may be different, such

that each has an incentive to act in a different or incompatible way. that each has an incentive to act in a different or incompatible way. The factors that make it difficult or expensive to evaluate the The factors that make it difficult or expensive to evaluate the

performance of the other party are due to the existence of performance of the other party are due to the existence of uncertainty in environmental, organizational, or task conditions. uncertainty in environmental, organizational, or task conditions.

The parties have incentives to act differently because they have The parties have incentives to act differently because they have different risk preferences, or because they may have different different risk preferences, or because they may have different propensities to act opportunisticallypropensities to act opportunistically

Managing internal corporate entrepreneurship: an agency theory perspectiveManaging internal corporate entrepreneurship: an agency theory perspective Jones & Butler, Journal of Management Dec. 1992Jones & Butler, Journal of Management Dec. 1992

99

Development of the SystemDevelopment of the System

Members/Members/ IndependentIndependent ShareholdersShareholders AuditorsAuditors

appoint

report

Board of Directors

report

delegatemonitor

1010

The rThe rôôle of Financial Reportingle of Financial Reporting

Financial Reporting is an important Financial Reporting is an important element of this system, being a key part of element of this system, being a key part of the process by which Directors meet its the process by which Directors meet its accountability requirements. accountability requirements.

Financial reporting is the means by which Financial reporting is the means by which the board of directors ‘reports’ to the the board of directors ‘reports’ to the owners, with independent auditing owners, with independent auditing ‘monitoring’ on the ‘truth and fairness’ of ‘monitoring’ on the ‘truth and fairness’ of those reports.those reports.

1111

Traditional mindsetTraditional mindset Traditionally (pre-1970s) this model of corporate governance Traditionally (pre-1970s) this model of corporate governance

supported a particular supported a particular stewardshipstewardship emphasis in financial reporting:emphasis in financial reporting: ‘‘the primary purpose of annual accounts of a business is to present the primary purpose of annual accounts of a business is to present

information to the proprietors showing how their funds have been information to the proprietors showing how their funds have been utilised, and the profits derived from such use’ (ICAEW, 1952).utilised, and the profits derived from such use’ (ICAEW, 1952).

This supported a This supported a traditional financial accounting frameworktraditional financial accounting framework, , which included:which included:

An early emphasis on the balance sheet An early emphasis on the balance sheet Asset measurement at historical cost Asset measurement at historical cost Prudence in the reporting of income and expenses Prudence in the reporting of income and expenses Realisation with respect to the recognition of income Realisation with respect to the recognition of income The calculation of profit (for capital maintenance purposes) via the The calculation of profit (for capital maintenance purposes) via the

matching of income and expenses matching of income and expenses Traditionally, also this system has been either lightly or self-Traditionally, also this system has been either lightly or self-

regulated.regulated.

1212

Not Not quitequite what it says on the tin what it says on the tin

There may, however, be some problems with a There may, however, be some problems with a stewardship emphasis to accounting:stewardship emphasis to accounting:

It does not help in assessing whether business It does not help in assessing whether business activities were appropriate (i.e. commercially activities were appropriate (i.e. commercially justifiable) justifiable)

It will not necessarily help in predicting the It will not necessarily help in predicting the future, andfuture, and

It provides no information with respect to the It provides no information with respect to the valuation of assets and the businessvaluation of assets and the business

1313

Stimulus & Response (again)Stimulus & Response (again)

These conflicts of interest are not a recent These conflicts of interest are not a recent occurrenceoccurrence

Two major classes of event shift the Two major classes of event shift the emphasis of the role of financial reporting emphasis of the role of financial reporting as an intermediaryas an intermediary Accounting Scandal/FailureAccounting Scandal/Failure Increasing shareholder basesIncreasing shareholder bases

1414

Newton –v- Birmingham Small Newton –v- Birmingham Small Arms Co (1906)Arms Co (1906)

At extraordinary meetings of the BSA shareholders in early At extraordinary meetings of the BSA shareholders in early 1906, the directors had passed a special resolution to allow 1906, the directors had passed a special resolution to allow them to create an "internal reserve fund" out of profits, them to create an "internal reserve fund" out of profits, which they could use for any purpose they thought fit. which they could use for any purpose they thought fit.

Transfers into the fund might be made in any year in which Transfers into the fund might be made in any year in which the company had paid a dividend of at least 10% on the the company had paid a dividend of at least 10% on the ordinary shares and had paid all preference dividends. ordinary shares and had paid all preference dividends.

The auditors were to be informed of this fund and any The auditors were to be informed of this fund and any transfers to or from it, but they were not to be permitted to transfers to or from it, but they were not to be permitted to disclose information about it to the shareholders, and it was disclose information about it to the shareholders, and it was not to be disclosed separately in the balance sheet. not to be disclosed separately in the balance sheet.

The result would be the creation of a fund about which the The result would be the creation of a fund about which the shareholders shareholders were not entitled to be informedwere not entitled to be informed..

1515

A shot across the directors’ bowsA shot across the directors’ bows

Challenged by Sir Arthur Newton (a shareholder) Challenged by Sir Arthur Newton (a shareholder) Upheld but on grounds that the directors might not Upheld but on grounds that the directors might not

prevent the auditors from making disclosures to prevent the auditors from making disclosures to shareholdersshareholders

LJ Buckley argued the permissibility of inner reserves on LJ Buckley argued the permissibility of inner reserves on grounds of prudencegrounds of prudence

Further impetus (examples)Further impetus (examples) 1925 Company Law Amendment Committee1925 Company Law Amendment Committee 1931 Royal Mail Case (Rex v Kylsant)1931 Royal Mail Case (Rex v Kylsant) 1967 GEC/AEI takeover1967 GEC/AEI takeover

Common denominator is lack of control of directors’ Common denominator is lack of control of directors’ activitiesactivities

Flaw in accounting regulation?Flaw in accounting regulation? Flaw in control mechanisms/accountability of directors?Flaw in control mechanisms/accountability of directors?

1616

Shareholder changesShareholder changes

Type of shareholderType of shareholder Change in the dominant types of Change in the dominant types of

shareholdershareholder leading to a significant divorce of ownership leading to a significant divorce of ownership

and control for certain entities andand control for certain entities and change in the assumed information needs of change in the assumed information needs of

these users towards a decision-useful these users towards a decision-useful perspectiveperspective

1717

Corporate Governance as Control Corporate Governance as Control MechanismMechanism

Cadbury Report 1992Cadbury Report 1992 The majority of non-executive directors should be The majority of non-executive directors should be

independent of management and free from any business independent of management and free from any business or other relationshipor other relationship

Non-executive directors should be appointed for Non-executive directors should be appointed for specified termsspecified terms

Service contracts should not exceed three yearsService contracts should not exceed three years Executive remuneration should be subject to the Executive remuneration should be subject to the

recommendations of a Remuneration Committee made recommendations of a Remuneration Committee made up entirely or mainly of non-executive directorsup entirely or mainly of non-executive directors

An Audit Committee, comprising of at least three non-An Audit Committee, comprising of at least three non-executive’s, should be established executive’s, should be established

1818

Further DevelopmentsFurther Developments

Greenbury Report 1995Greenbury Report 1995 Outlined:Outlined: The role of a Remuneration Committee in setting the The role of a Remuneration Committee in setting the

remuneration packages for the CEO and other directorsremuneration packages for the CEO and other directors The required level of disclosure needed by shareholders The required level of disclosure needed by shareholders

regarding details of directors’ remuneration and whether regarding details of directors’ remuneration and whether there is the need to obtain shareholder approvalthere is the need to obtain shareholder approval

Specific guidelines for determining a remuneration policy Specific guidelines for determining a remuneration policy for directorsfor directors

Service contracts and provisions binding the Company to Service contracts and provisions binding the Company to pay compensation to a director, particularly in the event pay compensation to a director, particularly in the event of dismissal for unsatisfactory performanceof dismissal for unsatisfactory performance

1919

And more…And more… Hampel Report 1998Hampel Report 1998 Viewed governance from a strict principal/agent perspective Viewed governance from a strict principal/agent perspective

regarding corporate governance as an opportunity to regarding corporate governance as an opportunity to enhance long term shareholder valueenhance long term shareholder value

Asserted as the primary objective of the companyAsserted as the primary objective of the company Previous codes focused on preventing the abuse of the Previous codes focused on preventing the abuse of the

discretionary authority entrusted to managementdiscretionary authority entrusted to management Report favoured greater shareholder involvement in Report favoured greater shareholder involvement in

company affairscompany affairs The Board was identified as having responsibility to maintain The Board was identified as having responsibility to maintain

a sound system of internal control, thereby safeguarding a sound system of internal control, thereby safeguarding shareholders’ shareholders’

The Board was to be held accountable for all aspects of risk The Board was to be held accountable for all aspects of risk management, as opposed to just the financial controls as management, as opposed to just the financial controls as recommended by Cadbury.recommended by Cadbury.

2020

And more…And more… Combined Code 1998Combined Code 1998 Consolidation of Cadbury, Greenbury & Hampel ReportsConsolidation of Cadbury, Greenbury & Hampel Reports Higgs Report 2003Higgs Report 2003 Examined the role, independence and recruitment of non-executive Examined the role, independence and recruitment of non-executive

directors. directors. Viewed the non-executive director’s role as: Viewed the non-executive director’s role as:

making contributions to corporate strategy making contributions to corporate strategy monitoring the performance of executive management monitoring the performance of executive management satisfying themselves regarding the effectiveness of internal satisfying themselves regarding the effectiveness of internal

control control setting the remuneration of executive directorssetting the remuneration of executive directors being involved in the nomination, removal and succession being involved in the nomination, removal and succession

planning of senior managementplanning of senior management Revised Combined Code 2003Revised Combined Code 2003 Incorporates Higgs.Incorporates Higgs.

2121

Back to Financial ReportingBack to Financial Reporting Particular issues relating to financial reporting Particular issues relating to financial reporting

were:were: Content issues relating to Content issues relating to creative accountingcreative accounting

(the exercise of choice in accounting to improve (the exercise of choice in accounting to improve the performance and position of the business – the performance and position of the business – EPS and gearing ratio in particular), which EPS and gearing ratio in particular), which appeared not to be effectively addressed by the appeared not to be effectively addressed by the auditing function or the efficiency (ability to see auditing function or the efficiency (ability to see through) of the stock market.through) of the stock market.

Context issues relating to the Context issues relating to the nature and nature and effectiveness of the regulationeffectiveness of the regulation of financial of financial reporting in curtailing creative accountingreporting in curtailing creative accounting