GGSR Lecture 4

8/6/2019 GGSR Lecture 4

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Lecture 4

GGSR

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Assignment (due Wed next wk)

Read pp. 1-18 of Financial Reporting & Corporate Governance

by ThomasA. Lee (LIBRARY)Call number:

HG4028

B2

L44

2006

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

A. Compare & contrast the case of Enron & FBW.

B. Explain the advantages & disadvantages of limited liability companies.C. Compare & contrast corporate management executives & directorsin terms

of the nature & purpose of their roles.

D. Given corporate managers are responsible for company operations, why isitnecessary to have corporate directors?

E. What are the advantages & disadvantages of representing corporate activities

in the form of accountingnumbers?F. Enumerate the stakeholdersin corporate activity.

G. What is the difference betweenshareholders & stakeholders?

H. Explainingeneral terms the nature & purpose of the auditor in a corporateactivity (in the context of corporate governance)?

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Assignment (due Sat next wk)

1. What is principal-agent relationship?

2. What is creative accounting?

3. How is audit used as an effective governance

mechanism?4. Why isinternal control such animportant

issue in the general area of corporategovernance?

5. Read about MiniScribe on p. 34. Be able todiscussin class why this case isnot a goodmodel of corporate governance

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Read Chapters2 & 3 of Financial Reporting & Corporate Governance by ThomasA. Lee


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The Company

A company represents a deliberate collaborationbetweeninvestors with funds to invest inbusiness & managers with skills to operate

that business on behalf ofinvestors. Thecollaboration exists within a legal structurethat issubject to legislative requirementsconcerningitsgovernance. The success of thisgovernance depends on a flow of regular &reliable financial information frommanagersto investors.

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Principal-agent relationship

Thisis fundamental to the corporate system ofbusiness & should be beneficial to both shareholders &managers. The relationship ismonitored & directed by

the BOD. Because the principal-agent relationship in corporate

business can be abused by senior managers, thecorporate audit by anindependent public accountancyfirmis a vital means of protectingshareholders from

potentially misleading accountingnumbers. Theauditor is therefore a significant means of providingconfidence & stability in financial markets.

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The state in the form of legislators & govt

departmentsisinterested in a company e.g.

for purposes of levying tax or monitoringcorporate regulations. Financial informationis

used to determine corporate tax liabilities. It

can also be used to assesssuch commercialmatters as product pricing & inflation, &

monopoly profits.

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Financial Statement Users

Investors

Lenders

Creditors Customers

Employees

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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 orprofit & loss account) reports the net gain & losses earnedby the company fromits operating activities. Profitsin thissense are the residue of an accounting process ofmatching

sales revenues with their associated expenses.

2. Cash Flow Statement thisstatement reports the net cashflows from operating,investing, & financing activities of thecompany. The aggregation of cash flows reconciles to theperiodic change in the companys cash resources.

3. Balance sheet thisstatement reports the companysassets at the end of the reporting period, & the variousshort-term & long-term obligations of the company(including debt & shareholders capital.)

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Subsidiary Financial Statements

These support the mainstatements. They are audited & somainly numerical in content. They include:

1. Statement of total recognized gains & losses. Thisstatementreports all profits & losses earned by the reporting companyduring the period i.e. trading profits & losses, & other gains& lossesnot reported in the income statement or profit &

loss account (e.g. on foreign currency transactions).

2. Statement on historical cost profits & losses. Thisstatementexplains accountingnumbersin the mainstatements that arenot based on the original cost of the transactions e.g. when

an asset is revalued.

3. Movementsinshareholders funds it reconciles the fundsofshareholders at the beginning & close of the reportingperiod e.g.in terms of undistributed profits & new capital

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Explanatory Statements

1. Accounting policies particularly for expert users offinancial statements,it isimportant to disclose themain accounting the main accounting conventions &practices (as contained in prescribed standards) that

have been applied to the preparation of theaccountingnumbersin the main financial statements.

2. Notes to financial statements many if theaccountingnumbersin the main financial statementsare complex calculations & require further

explanation as to their nature & composition. Thisstatement provides this explanation & thereforeprevents the main financial statements frombecoming unreadable due to excessive detail.

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Explanatory Statements

3. Statement of principal subsidiaries the financialresults reported by a company are often a combinationofseveral companies i.e. typically when the reportingcompany owns50% or more of the voting capital of the

other companies. In these situations thisstatementlists these share ownerships. Thisstatement also listsinvestments of between20% & 50%. The financialresults of these associated companies are notcombined into the mainstatements but nevertheless,

may represent interestsin considerable amount ofprofits, cash flows, & financial positions thatshareholders ought to be aware of.

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Other statements

These provide support & amplification to the mainfinancial statement. They are typically unaudited& predominantly narrative instyle.

Statement of the Chairman thisis a voluntarystatement, often called the chairmans report. Itis used by the chairman of the BOD to provide abroad review of the reporting companysfinancial resultsin the context ofits trading &related activities.

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Directors report thisis a legally requiredstatement by the BOD & includes a mixture ofprescribed & voluntary information.

Operational & Financial Review thisis avoluntary statement & explains the main featuresof the financial results disclosed in the mainfinancial statementsin a narrative style. It has

two sections. The first deals with operatingmatters relating to profits & cash flows. Thesecond concerns financial funding activitiessuchasshare capital & long-term loans.

Review of trading activities. Thisis a statementthat expands on the broad review typically givenin the chairmansstatement. Thisis contained inthe Operational & Financial Review.

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Corporate Governance Statement in recent

years, companies have published thisstatementas a condition ofstock 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 directorsreport.

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Auditors report here the directorsresponsibility for the main financial statements &

the basis for the audit are broadly described, &the audit opinion on the quality of the mainfinancial statementsisgiven.

Statement of Directors responsibility although

the responsibility of the board of directors for themain financial statementsisidentified in theauditors report, companies are also required tomake a more detailed statement separately

usually in the directors report. The statementincludesmaintenance of adequate accountingrecorf & use of appropriate accountingstandards.

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Investment DecisionsInvestors are defined as2groups.

1. Existingshareholders- these include private individuals & commercial

organizationssuch as pension funds &investment fund managers.

- They ownsharesin the company becausethey either invested directly init (e.g. onitsformation or initial market listing) or bought

sharesinit through a recognized stockexchange (i.e. second-hand shares).

2. Potential shareholders

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Investment Decisions

Their use of financial statementsis variedaccording to their degree ofinterest & level ofexpertise in accounting & financial matters. A

small minority ofinvestorsmake considerable,expert, & direct use of financial statements.The large majority, however,make little or nodirect use of them, preferring to rely on

professional analyses of reported accountingnumbers that appear innewspapers & similarpublications.

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Financial Information Needs of Investors relate to 2separate but

related functions:

Managerial Stewardship financial info incorporate reports provides knowledge of thesenior managers & board of directors

effectivenessingoverning the company. Forexample, poor profits cansignal poor operationaldecisions & actions by senior managers &inadequate internal controls of operating

activities. Investment Decision-making refers to the

buying, holding, or selling ofsharesin a company.

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The most fundamental characteristic of theinvestment decisionisits comparison of thecurrent market value of a share unit (not always

known unless there is an established market for it& a stock market quotation) & the value theinvestor believesit to be worth (itsintrinsic orpresent value).

If the perceived present value of a share isgreaterthan or equal to itsmarket value thenit would berational for aninvestor to decide to buy the shareor hold it (ifit is currently owned).

On the other hand,if the shares present value isless thanitsmarket value, then a rationaldecision would be to refrain from buyingit or tosell it (ifit is currently held).

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Present Value

In a rational economic world, a marketable objectsuch as a share unitshould only be held by itsowner or bought by a potential owner ifitsintrinsic or present value is believed to be at leastequal to the price that is being asked for it. Only

in these circumstances can the investor avoidmaking an economic loss.

The present value of a share is based oninvestmentperiods, future receipts, and rates of return. The

problem for the buyer or seller (ofstock shares) isone of trying to estimate the present value. Moreoften thannot, this boils down to a gut feelingabout the worth of the good or service.

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Investment Decision-making

When buying, holding or sellingsharesin companies,investors require financial information to makepredictions about future returns that determine formalor informal present values. The corporate financial

report provides financial information about the past ofthe company & is a basis for these predictions.Companies rarely disclose predicted financialinformation other thanmanagerial expectations ofincreased sales & profitability in the most general form

e.g. the CEO informing professional financial analysts& journalists that his company hopes profitsnext yearwill continue to rise.

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Assignment

Differentiate commonstockholders from

preferred stockholders.

What must a diligent shareholder do to monitorthe financial progress & health of the

company he invested into?

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Financial reportingis a significant part ofeffective governance.

Corporate senior managers act as agents forshareholder principalsin a businessstructuregoverned by legislation. The situationis one ofpotential hazard to shareholders & requires

variousmechanisms to be in place in order toensure that the managerial agents performinways that are compatible & consistent with theinterests ofshareholder principals.

Financial reporting

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Financial reporting

Financial reports are anintegral part ofcorporate governance as they contain a set of

audited financial statements to shareholders.

These statements comprise accountingnumbers

describing the financial results of businessactivity supervised by a team ofsenior

managers and a board of directors.

The accountingnumbers are prepared usingmandatory procedures contained in a regulated

process of accounting standards.

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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 isgoverned by

prescribed rules of accounting, & they aresupported by a variety of other explanatory &

review statements.

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Financial reporting

Corporate Financial reporting & auditingprovisions have typically beengovernment

responses to corporate scandal involving

fraudulent activity. In order to protect the

public interest in a capitalist economy,govthas from time to time felt the need to

interfere in capital markets.

Audited accountinginformationin financialstatements has been a principal tool of

governance for more than 160 years.

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Financial reporting

It is a mandatory requirement for aprofessionally qualified accountant to reportan opinion on the quality of the financial

statements reported by senior managers toshareholders.

The value of the corporate audit is directlyrelated to the independence of the auditor.The lessindependence the auditor has, theless value can be associated with the audit.

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The Audit

The corporate audit isnot intended by publicaccountants to be a fraud detection audit. This

can lead to different expectations of the

auditors & its beneficiaries. Such differencesare called expectationgaps.

The corporate audit comprisesseveral stages

involving examinations, assessments, &

reports. Each of these stagesinvolves the use

of relevant expertise & professional judgment

in evaluating audit evidence.

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Corporate governance

To governis defined as ruling by authority;

The organizationismanaged on behalf of a varietyofstakeholdersincludingitsshareholders.

Corporate governance consists of the formalmechanisms of direction,supervision & control putin place within a company in order to monitor thedecisions & actions ofitssenior managers &

ensure these are compatible & consistent with thespecific interest ofshareholders & the variousother interests ofstakeholders who contribute tothe operations of the company.

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Accountability

It means that these managers are expected toprovide a regular reckoning or account of theirdecisions & actions.

Within a company, there are variousconnected lines of responsibility, fromemployees & staff to junior managers tosenior managers to the Board of Directors tothe shareholders and,more indirectly, toother stakeholders.

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Accountability

It is a modern equivalent of the centuries oldnotion ofstewardship.

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.

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BOARD INDEPENDENCE

The guiding principle underlying the BOD & its

subcommitteesis 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 ofmakingsenior

managers accountable to owners.

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Government regulation

There is evidence in recent times, particularly in

the US after a number of financial scandals, of

govt becomingmore 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 governancebetween the roles of corporate senior

management & the auditor.

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Creative Accounting

Thisgenerates accountingnumbersintended to

deceive shareholders & other users. It

damages the credibility of the company and

itsmanagers, & can financially damage

shareholders and other users who rely on

themin their decisions. Creative accounting

effectively destroys the trust on which theprincipal-agent relationship needs to be based

and can de-stabilize capital markets.

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GGSR Lecture 4