ethics in corporate financial reporting

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Ethics in Corporate Financial Reporting

1, INTRODUCTION

Ethics assume importance in a society of interdependence. Ethical behaviour is one that conforms tomoral standards. Morality is concerned with the distinction between 'good and bad behaviour, in

accordance with conventionally accepted standards of conduct. Moral standards reflect the ethos of thesociety in which the individual or the organisation exists. For example, in some societies, the

shareholder theory of corporate governance is more acceptable, while in others the stakeholdertheory of corporate governance has wider acceptance. However, in spite of cultural differences amongsocieties, there are some fundamental principles of business ethics.

Peter F Drucker, the most influential management thinker of our time, argues that a society of

interdependence should adopt the essential concepts of Confucian ethics. Drucker summarises thoseconcepts as follows:

(a) Clear definition of the fundamental relationships.

(b) Universal and general rules of conduct that is, rules that are binding on any one person ororganisation, according to its rules, functions, and relationships.

(c) Focus on right behaviour rather than on avoiding wrongdoing, and on behaviour rather than on

motives or intentions, and finally

(d) An effective organisation ethic, indeed an organisation ethic that deserves to be seriouslyconsidered as ethics, will have to define right behaviour as the behaviour, which optimizeseach party's benefits and thus make the relationships harmonious, constructive, and mutually

beneficial.

(Source: - " The changing world of the ExecutiveTruman Talley Books, TimesBooks, New York, 1982.)

The following discusses ethics in corporate reporting in the light of the above concepts.


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2. FUNDAMENTAL RELATIONSHIPS

Fundamental relationships in a company structure of business are well defined. The Companies Actstipulates a system of corporate democracy in which the board of directors is accountable to

shareholders and the executive management is accountable to the board of directors. The board ofdirectors has ^fiduciary relationship with shareholders. It acts as a trustee for shareholders. The

relationship between the board of directors and the executive management is task oriented. Theexecutive management is accountable to the board of directors for the use of authorities delegated to itand for the proper execution of tasks assigned to it.

The fiduciary relationship between the board of directors and shareholders brings ethical dimension inthe board's behaviour. In the Gower's Principle of Modern Company Law, sixth Edition, 1997, it isstated:

"In applying the general equitable principle to company directors four separate

rules emerged. These are:

(1) that directors must act in good faith in what they believe to be the best interests ofthe company;

(2) that they must exercise the powers conferred upon them for purposes differentfrom those for which they were conferred;

(3) that they must not fetter their discretion as to how they shall act; and

(4) that without the informed consent of the company, they must not placethemselves in a position in which their personal interests or duties to other

persons are liable to conflict with their duties to the company."

The corporate financial report is the report of the board of directors to the shareholders. It is

interesting to examine whether the principles laid down in Gower's Principle and concepts of ethicstogether allow the board of directors to manage earnings.

3. FOCUS ON SHAREHOLDER VALUE

It is now well established that in a market economy, the focus of corporate governance should be on

'shareholder value. Companies aim at creating shareholder value within the legal framework in whichthey operate. Management (board of directors) formulates business and financial strategies that

continuously enhance the value of the company. It searches for new investment opportunities,

abandons value destroying activities, and finds out methods and techniques to improve the overallproductivity of resources. It also endeavours to enhance the value of the company through "financialengineering9.

For publicly traded companies, the capital market determines the value of the company. In the long

run, the choice of right strategies and their effective implementation enhances the value of thecompany. However, 'short-termism' being the rule rather than an exception in the capital market, in the

short term, the value of a company depends on its performance relative to the market expectation.Share price goes up only if the performance of the company exceeds market expectation. Share price

comes down if the company fails to meet the market expectation. Market builds expectation based oninformation available to it. It revises the same with every new information that flows to it.


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Management cannot ignore the short-term performance of the company in the capital market. In order

to enhance the value of the company, the board of directors of a publicly traded company is requiredto manage the expectations of the capital market. In the short-term, effective management of capital

market expectation along with improved performance enhances the value of the company. The mostpotent tool for managing capital market expectation is 'earnings management'. Thus, the behaviourof the capital market, in particular those of analysts and investors, provide enough motivation for

earnings management.

4. ACCOUNTING STANDARDS

Potential for earnings management is inherent in the accrual system of accounting. Estimation is at the

centre of accounting principles and methods for valuation of assets and liabilities. In many situations,management's judgement or perception about a situation is an important input in estimating the cost or

value of a particular asset or liability. Let us take few examples:

(a) Depreciation depends on the management's estimate of useful life of the asset and itsresidual value.

(b) ' Management's perception about 'realisability' is the key to revenue recognition.(c) Recognition of 'development expenditure as an asset depends largely on management's

judgement about the company's ability and intention to use the new product or process.(d) Recognition of impairment loss depends on management's estimate about the cash

flow that the asset will generate in future.

There are many such examples;

Accounting principles stipulate that an estimate is reliable if, it is free from material error or bias.However, there is no technique to detect the presence of an error or bias in the estimate directly. The

only way to ensure that the estimate is free form error or bias is to test its 'verifiability'. An estimate isverifiable only if different experts arrive at estimates, which differ in a narrow range. Thus, errors inan estimate is acceptable, provided it is within the tolerance limit. In USA, an error of around 5 per

cent is acceptable. It is difficult to establish whether the error is deliberate or unintended, because'straight-jacket' rules cannot be laid down for arriving at accounting estimates. Therefore, management

can easily manage earnings, without attracting any criticism.

Earnings management is also possible by taking some decisions that may not be in the best interest ofthe company. Let us take few examples:

(a) Avoidance of 'discretionary costs', such as advertisement expenses, training expenses, expenseson preventive maintenance, and research expenses improves current profit, though it might

adversely affect the long term performance of the company.

(b) Avoidance of 'restructuring expenses', when restructuring is likely to improve long termperformance. It is not in the best interest of the company, but it helps to maintain the profit at

the current level.


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(c) Structuring an acquisition deal in a manner that 'pooling of interest method of accounting can beused for accounting the acquisition. It may not serve the best interest of the company, but it

shows better performance in subsequent years. Standard setters in USA, and in many othercountries have withdrawn the pooling of interest method of accounting for its misuse.

There are situations where deferment of decisions at the board-level avoids provisioning for'constructive obligations' or disclosure of certain information. Let us take an example. There is socialpressure on a company to pay compensation to 'casual workers, who lost employment due to a

decision of the board of directors. There is no legal obligation. The board of directors believes that it isin the interest of the company to pay the compensation. The board, in order to avoid immediate

recognition of the constructive liability, may defer the decision until the approval of the annualaccounts. Similarly, in order to avoid disclosure of information on discontinuing operation, the boardof directors may delay the formal decision to discontinue an operation.

Thus, accounting principles and methods stipulated in Accounting Standards provide enough

opportunities for 'earnings management , without inviting adverse comments.

5. THE ETHICAL DILEMMA

Usually, most shareholders, particularly small investors and institutional investors, do not have long

term commitment to the company. Therefore, even short-term volatility in share prices adverselyaffects those shareholders. It may also affect the ability of the company to approach the capital marketfor resource mobilisation. The board of directors is in fiduciary relationship not only with thos'e

shareholders who take long-term interest in the company, but also with investors who take short-terminterest in the company. Therefore, the board of directors generally believes that the 'smoothing ofprofits is beneficial for shareholders, and that to report a better performance than what capital market

expects, is not beneficial to shareholders. Reporting of better performance creates higher expectations,which the company may not achieve in future. Therefore, earnings management benefits shareholders.

Standard-setters do not share this perception.

It is quite common that companies write off substantial amount in a period in which the performance

of the company is below expectation. This helps the company to start with a clean slate, withoutsignificant adverse impact in the valuation of the company.

The variation in the perception of the corporate management and standard-setters create ethicaldilemma for the board of directors. Ethics require the board of directors to act in the good faith in what

it believes to be in the best interest of the company. The law requires the board of directors to comply

with Accounting Standards, and carry assets and liabilities at cost or value that it believes to be thecorrect accounting estimate. In other words, law does not permit earnings management. Therefore, theboard of directors faces the dilemma in those situations, when it believes that earnings managementwill benefit shareholders. It may be argued that one should respect the law of the land and should

comply with its requirements. Therefore, the question of ethical dilemma does not arise, ratherearnings management itself is unethical. However, it may be mentioned mat on many occasions on is

difficult to distinguish between earnings management and judicious business decisions.

Strict compliance of the law (Accounting Standards) often leads to bad business decisions, which are

not in the best interests of shareholders. Accounting Standards are uniformly applicable to allenterprises irrespective of their strategies. They seldom provide flexibility in the selection of


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accounting principles and methods. For example, a company, in its initial years, may decide to spendheavily on advertisement and marketing. The company expects that through such a brand building

exercise the company will benefit immensely in-future periods.

The "asset-liability measurement approach, an approach that finds favour with most standard-setters

in the world, including India, requires the company to charge those expenses to the profit and lossaccount for the period in which they are incurred. This accounting principle provides enoughdisincentives to adopt the strategy, which the board of directors believes to be the best strategy.

Recognition of the expenditure as an expense for the period does not reflect the strategy of thecompany.

The strategy requires amortisation of the expenditure over number of reporting periods, which areexpected to benefit from the same. Capital market reacts sharply if, a company reports poorperformance, any amount of explanation does not change the situation, and therefore, board of

directors is always wary to take decisions that will result in reporting lower profit. Discretionary costs

usually benefit future years, and therefore, there is always a temptation to avoid those costs. In order tobuild competitive advantage a company should spend on training, restructuring, etc., particularly whenthe going is bad. However, when the company passes through a bad phase, the stipulated accountingprinciples, accentuates the temptation to avoid such activities.

It is not always a bad idea to allow enterprises a choice in selecting accounting principles. Forexample, IAS 23, Borrowing Costs, stipulates, as the benchmark treatment, expensing of all borrowing

costs. However, as an alternative accounting treatment, it allows capitalisation of certain borrowingcosts. If, in a subsequent revision it withdraws the alternative accounting treatment, no enterprise willbe allowed to capitalise any portion of the borrowing costs, though the rationale for capitalisation will

continue 'to hold good for certain enterprises. Therefore, withdrawal of the alternative treatment might

theoretically improve the Accounting Standard, but it will lose in terms of practically and would putthe board of directors of certain companies in a difficult situation.

The board of directors has the fiduciary relationship with its shareholders and therefore, it should

adopt a strategy that it believes to be in the best interest of the company. This puts the board in adifficult situation. It has to make a choice between reporting higher profit and selection of the strategy

that it believes to be right. The board of directors faces a similar difficult situation, when is has tochoose between taking decisions at the right time and strict compliance with Accounting Standards.Resolution of ethical issues may not be easy.

Regulators, academia, and analysts criticise companies for their game of earnings management,

without appreciating their predicament. The board of directors will have to resolve many difficultissues, when the Accounting Standard on 'Interim Financial Reporting will be in place.

6. CONCLUSION

Accounting Standards have brought regulatory regime in corporate financial reporting. Regulations are

improving the efficiency of the market mechanism. However, a regulation is effective only if it

provides appropriate flexibility in decision making. A regulation that lacks flexibility results in

'control', which stifles the enterprise and results in sub-optimal utilisation of resources. Perhaps,

Accounting Standards are moving from 'regulations' to 'controls.


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'Controls take a strong grip when accountability is not otherwise enforceable. Therefore, in order toavoid undesirable 'controls the board of directors should build confidence among investors by

improving corporate governance. None will accept the idea of allowing greater flexibility in corporatereporting, until corporate management demonstrates their respect for corporate ethics.

Accounting Standards preclude 'smoothing of profit on the premise that investors understand thebusiness of the company in which they invest. Therefore, they can appreciate the fluctuations in theperformance of the company, which is inherent in the nature of the business. Another premise, on

which standard-setters formulate Accounting Standards, is that 'conservatism is always good forshareholders. Both those premises require a reality check.

A strong argument against allowing different enterprise to use different accounting methods for theaccounting for similar transactions is that it will impair comparability. This argument cannot be set

aside easily. However, there is a need to examine whether the standard-setters have unwittinglyboosted the advantages of uniformity in accounting practices. It is important to evaluate correctly the

benefits of providing adequate choice for selecting the appropriate accounting methods that reflect thestrategy of the enterprise. This is not to suggest that comparability is not important or that we shouldcome out of the Accounting Standards regime. The suggestion is to examine if, the recent trend of

reducing the number of acceptable alternative accounting methods really benefits investors. Further,analysts do not work with raw data. They always make certain adjustments to make the analysis

meaningful. Therefore, comparability can be achieved with enhanced transparency about theaccounting policy adopted by the company and by disclosing facts, which will facilitate adjustmentsfor analysing the accounting numbers.

The dilemma in corporate financial reporting has the potential to create conflict in the corporateboardrooms, particularly with the new structure of the board of directors. In all likelihood, independent

directors will not favour earnings management and will not allow bad business decisions. Withpowerful audit committee, compliance of Accounting Standards will improve, but that may not always

benefit investors.

ethics in corporate financial reporting

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