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:
- Registration requirements: Companies are required to provide information including recent financial statements and register their securities before issuance.
- Disclosure requirements: Regulators often require public companies to present financial statements and other reports to disclose information useful for investors.
- Auditing requirements: Regulators require companies’ financial statements to be accompanied by an audit opinion stating that the financial statements provide a true and fair view as per the applicable accounting standards and/or that the controls are effective.
- Management commentaries: Regulators require publicly traded companies to provide a fair review of the company’s business by management plus disclosure of significant risks, etc.
- Responsibility statements: Regulators often require acknowledgments and/or attestations from individuals responsible for preparing financial statements as to their correctness.
- Regulatory review of filings: Regulators typically review all initial registration documents and a sample of subsequent filings.
- Enforcement mechanisms: Regulators are often assigned powers to assess fines, suspending or banning market participants or initiating criminal proceedings.
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.
Limitations of audit
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.