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Since investors would require a higher expected return when providing capital to a company where the perceived risk of misrepresented financial statements is high, companies are better off in the long-term when they maintain high financial reporting quality. Additional safeguards include market regulation, auditors, and private contracts.
Securities regulators set and enforce standards to safeguard the interests of investors. Most regulators are members of IOSCO, which is the global standard-setter in securities regulation. ESME is the European member of the IOSCO. Other members include SEC, FSA (Japan), etc. Typical requirements of a regulatory regime which reinforce financial reporting quality include:
Regulators require public companies to get their financial statements audited. Private companies may also obtain an audit opinion because it may be required by any outside party, such as banks, etc.
In addition to an opinion on whether the financial statements are true and fair, regulatory authorities typically require auditors to attest to other matters too, such as the effectiveness of internal control, etc. Audit reports also highlight key audit matters in their reports.
However, because an audit is based on a review of information prepared by management, and that too on a sample basis, and it is not designed to detect fraud, it does not provide any guarantee that no wrongdoing has occurred. Further, there might be a conflict of interest element because auditors are paid by the company and they might be providing additional services.
Private contracts, such as investment contracts or loan agreements contain covenants which the investor/borrower must adhere to. These can act to discipline a company’s financial reporting quality because the private parties must be vigilant to not let a company misrepresent its compliance with covenants.
by Obaidullah Jan, ACA, CFA on Sat Apr 25 2020
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