OTHMAN YEOP ABDULLAH GRADUATE SCHOOL OF BUSINESS

BDAK8033
ACCOUNTING PRACTICE AND REGULATION

Corporate governance in an accounting context

 Purpose of Modern Accounting Regulation

• Ensuring Business Transparency

A primary purpose of modern accounting regulations is
to ensure the transparency of financial management for
both public companies and private businesses.
Transparency is necessary for government agencies to
easily determine if public companies and private
businesses are paying taxes appropriately and paying
dividends to investors in a legal manner. Companies
operating with open financial books also have an easier
time showing revenue streams to potential investors and
illustrating the allocation of capital versus the cost of
doing business.
 Purpose of Modern Accounting Regulation

• Ensuring Investor Confidence

Companies that are hiding losses through creative accounting
may be in violation of several regulatory laws. This regulation
will require the filing of quarterly and yearly financial disclosure
forms for publicly traded companies. Regulation in accounting is
necessary to ensure investors can make informed decisions on
what companies are doing well and what companies are making
unwise business decisions. Without these regulations, consumer
confidence in investment markets may drop dramatically, leading
to a stagnation of business development.
 Purpose of Modern Accounting Regulation

• Providing Meaningful Assessment

Without a form of regulation, business accounting would have no
meaning, since every company could just use a different method to
paint financial numbers in the best possible light. Regulation
streamlines the accounting process, giving every business the same
framework to determine finances. This allows for easier comparing
and contrasting of business performance and allows other companies
to more easily determine where individual performance ranks amidst
the competition in a given sector of the market. Without regulation,
no business really has a clear definition of what a successful business
looks like in terms of financial numbers.
 Purpose of Modern Accounting Regulation

• Accountability and Fraud Detection

The modern digital world has a variety of ways for individuals
within a company to move business capital through different
accounts in an attempt to defraud a company or hide losses.
Accounting regulation is necessary to detect these illegal practices
and to hold those guilty of committing such crimes responsible.
Effective accounting regulation can detect trends in money
movement early in the fraud process, which can both lessen a
company's financial losses and preserve the company's public
reputation. This way the guilty party takes the blame for the fraud
and not the entire company.
 Accounting regulation framework
Accounting standards

Accounting
regulation

Stock
Legislation exchanged
requirement
 Legislation

Through the Companies Acts.

1. Companies are defined as having Limited
Liability. Shareholders are limited to losing their
capital invested in the firm.
2. There are two types of company. Private, (Ltd) &
Public (Plc).
3. Companies must present P&L accounts and a
Balance Sheet once a year to their shareholders.
 Legislation

4. These must be audited (inspected) by a

statutory, independent auditor who attaches a
report to the accounts. Note; it is not the role of
the auditor to inform the shareholders of how
well, (or not) their firm has been run for them by
the management. Only to confirm to the
shareholders that the accounts do give a true &
honest picture of the current state of the business.
 Legislation

5. Some companies must separately file their

annual accounts with the Register of Companies.
 Stock exchanged requirement

• 1. Only Public Companies (Plc’s) are listed on

the stock exchange.
• 2. As part of the process of becoming a Plc,
companies must agree to comply with all the
listing rules that will apply to them once they
are listed.
• 3. Public companies must publish both Final
Accounts and Balance Sheet in full.
 Accounting standard

1. US Generally Accepted Accounting

Principles(GAAP)
2. International Financial Reporting Standards
(IFRS)
3. China Accounting Standards (CAS)
 Financial reporting quality VS.
quality of reported results

Financial Reporting Quality Quality of Reported Results

• Decision-useful information
• Faithful representation of
economic reality
• Compliant with standards
“Earnings Quality”)
• Sustainable activity
• Adequate returns
• Increases the company’s
value

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 Financial Reporting Quality and
Earnings Quality are interrelated

High Quality:
Earnings quality
• Sustainable
• Returns ≥ Cost
of capital

Low Quality:
• Non-recurring
• Returns < Cost
of capital

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Quality Spectrum of Financial Reports

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 Potential Problems That Affect
the Quality of Financial Reports

1. Reported amounts and timing

of recognition on the income statement.
2. Classification on statement of cash flows.
3. Biased choices based on measurement of
assets and liabilities on the balance sheet.
4. Fraud

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 1. Reported amounts and timing
of recognition: revenue

Aggressive, Overstated
premature, and Overstated equity and
fictitious revenue income overstated net
recognition assets

Conservative Understated
Understated equity and
revenue income understated net
recognition assets

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 1. Reported amounts and timing
of recognition: Expenses

Understatement Overstated
Overstatement equity and
of bad debt of income overstated net
expense receivables

Understatement Overstated
Overstatement equity and
of depreciation of income overstated net
or amortization PPE

Understatement Overstated
Overstatement equity and
of interest or of income understated
tax liability

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1. Reported amounts and timing
of recognition: Cash flow
Increases
Defer payment operating cash
of payables flow for the
period

Accelerate Increases
payments from operating cash
customers flow for the period

Increases
Defer purchases
operating cash
of inventory
flow for the period

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 2. Classification
– Reclassification of accounts receivable or inventory from current to
long-term favorably affects company metrics, such as turnover ratios.
– Classification of revenue items as being derived from core, continuing
operations favorably affects the apparent sustainability of revenues.
– Classification of expense items as non-operating favorably affects
reported operating income.
– Classification of expense items and losses as non-recurring in non-
GAAP/non-IFRS metrics favorably affects the apparent sustainability of
profits.
– Classifications that result in items being reported in other
comprehensive income can favorably affect comparability.
– Classification choices on the statement of cash flow can distort
operating cash flows.

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3. Biased Choice

• How?
 4. Fraud

Motivations potentially associated with low financial reporting

quality
• Mask poor performance (e.g., declining profitability or lower
profitability than competitors)
• Meet or beat market expectations (e.g., analysts’ forecasts
and/or management’s guidance)
– Increase stock price, if only temporarily
– Increase credibility with market participants
• Increase compensation that is linked to reported earnings
• Avoid violation of debt covenants

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 4. Fraud Con.
Conditions conducive to issuing low-quality financial
reports

Opportunity

Rationalization Motivation

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 Mechanisms that discipline
financial reporting quality

1. Regulatory authorities
- Registration requirements. Market regulators typically require
publicly traded companies to register securities before offering
the securities for sale to the public. A registration document
typically contains current financial statements, other relevant
information about the risks and prospects of the company
issuing the securities, and information about the securities being
offered.

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 Mechanisms that discipline
financial reporting quality

1. Regulatory authorities
- Disclosure requirements. Market regulators typically require
publicly traded companies to make public periodic reports,
including financial reports and management comments.
- Auditing requirements. Market regulators typically require a
company’s financial statements to be accompanied by an
audit opinion attesting that the financial statements conform
to the relevant set of accounting standards.

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 Mechanisms that discipline
financial reporting quality

1. Regulatory authorities
- Management commentaries. Regulations typically require a
publicly traded company’s financial reports to include
statements by management.
- Responsibility statements. Regulations typically require a
statement from the person or persons responsible for the
company’s filings. Such statements require the responsible
individuals to explicitly acknowledge responsibility and to
attest to the correctness of the financial reports.

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 Mechanisms that discipline
financial reporting quality

1. Regulatory authorities
- Regulatory review of filings. Regulators typically undertake a
review process to ensure that the rules have been followed.
The review process typically covers all initial registrations and
a sample of subsequent periodic financial reports.
- Enforcement mechanisms. Regulators are granted various
powers to enforce the securities market rules. Such powers
can include assessing fines, suspending or permanently
barring market participants, and bringing criminal
prosecutions. Public announcements of disciplinary actions
are also a type of enforcement mechanism.

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 Mechanisms that discipline
financial reporting quality
2. Auditors
Audit opinions provide financial statement users with some assurance
that the information complies with the relevant set of accounting
standards and presents the company’s information fairly.
To provide an audit opinion, the auditors must examine the company’s
financial controls and financial records. Auditors perform substantive
tests after assessing the risk of a material misstatement at the
company. The higher the auditor’s assessed risk, the more extensive
the substantive tests will be. Examples of substantive tests performed
by auditors include physical inventory counts, direct confirmations of
bank balances with the company’s banks, direct confirmation of the
company’s transactions with the company’s customers.
1. Info provided by company
2. Opinion based on sampling
3. Expectations gap
4. Company pays audit fees 27
 Mechanisms that discipline
financial reporting quality
3. Private Contracting
• Examples of private contracts include loan agreements or investment
contracts. When financial reports prepared by the investees or borrowers
directly affect the contractual outcomes—potentially creating a motivation
for misreporting—investors and lenders are motivated to monitor financial
reports and to ensure that they are high quality.

• For example, loan agreements often contain loan covenants, which create
specifically tailored financial reporting requirements that are legally
binding for the issuer. Avoiding a debt covenant violation is a potential
motivation for managers to inflate earnings or otherwise misreport.
Lenders are motivated to monitor financial reports and to ensure that they
are high quality.

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 Evaluating the Quality of Financial Reports

– an understanding of the company’s business and industry;

– comparison of the financial statements in the current
period and the previous period;
– evaluation of the company’s accounting policies compared
with those of other companies in the same industry;
– financial ratio analysis;
– examination of the statement of cash flows with particular
focus on differences between net income and operating
cash flows;
– perusal of risk disclosures; and
– review of management compensation and insider
transactions.
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