1. MISLEADING FINANCIAL STATEMENTS AND REPORTING
1.1. If financial statements are produced to deliberately mislead, this is a crime BOOM
1.1.1. Although fraudulent financial reporting is a crime, aggressive accounting policies may be permissible within the accountancy regulations and standards and accepted by external auditors.
1.1.2. Significantly, the collapse (or near collapse) of many companies have involved fraudulent or aggressive accounting policies
1.1.3. EXAMPLE: ENRON is a great example of major issues with financial reporting and auditing features.
1.2. What are some of the ways financial statements can be misleading?
1.2.1. There could be a fraudulent misrepresentation of the affairs of the company, where the company's management deliberately presents a false picture of the financial position and performance.
1.2.2. The company might use accounting policies whereby it presents its reported position and profits more favourably than would be the case if more conservative accounting policies were used.
1.2.3. The financial statements could be complex and difficult for investors to understand.
1.3. What are some of window dressing financial reports?
1.3.1. A company may claim to earn revenue and profits earlier than it probably should. E.g. a company claiming all the revenue in the first year for a three year contract instead of spreading it out over three years.
1.3.2. A company may try to take debts off its balance sheet. This can be achieved by setting up separate companies (SPVs)
1.3.3. A company may over value assets that it owns, either to increase its reported balance sheet reserves or avoid writing off a fall in value as a loss in its income statement.
2. GOING CONCERN STATEMENT
2.1. This is the view that the company will continue to trade for the foreseeable future (at least the next 12 months). The financial statements are therefore prepared on this basis, and assets are valued differently from what their value might be on a break up basis (e.g. in a fire sale if the company went into liquidation).
2.2. The going concern statement is a statement in the annual report by directors that the company is a going concern and will continue to be so for at least the next year
2.3. The UK Listing Rules require the directors of listed companies to make a statement in the report and accounts that the company is a going concern, together with supporting assumptions and qualifications.
2.3.1. The Code contains similar provisions (see C.1.3. AND C.2.2)
3. RESPONSIBILITY FOR DETECTING ERRORS AND FRAUD
3.1. Fraud is intentional, error is unintentional: Both lead to incorrect figures if they are not detected.
3.2. The board is responsible for preventing and detecting fraud/errors.
3.3. It is not the primary responsibility of external auditors to detect fraud. The auditors will assess the risk or possibility that fraud/error might have caused the financial statements to be materially misleading. The external audit may act as a deterrent to fraud as the auditors will carry out checks of control procedures, documents and transactions in the course of their work. They may discover fraud in which case it would be their responsibility to report it to directors.
3.4. Accounting systems and internal control procedures are also vulnerable to fraud and error. E.g. criminal collusion between employees and decisions by management to override systems of controls.
3.5. It can be argued that a failure by the auditors to discover a major fraud or material error might be the result of professional negligence. CA2006 provides some protection for auditors against liability for negligence or breach of duty but also introduces two new criminal offences for auditors in connection with the auditor report:
3.5.1. It is a criminal offence to a) knowingly or recklessly cause an audit report to include any matter that is misleading, false or deceptive in any material particular; or
3.5.2. b) knowingly or recklessly cause an audit report to omit a statement that is required by certain specified sections of the act.
4. TRANSPARENCY
4.1. The FRC Report 'Effective Company Stewardship: Enhancing Corporate Reporting and Audit (2011) recommends:
4.1.1. There should be higher quality narrative reporting
4.1.2. The annual report should communicate high quality and relevant information
4.1.3. Directors should take full responsibility for ensuring that an annual report provides a fair and balanced report on their stewardship of the business
4.1.4. Directors should describe in more detail the steps that they take to ensure the reliability of information on which the management of a company is based and transparency about activities of business and associated risks.
5. THE CODE (FINANCIAL AND BUSINESS REPORTING - C.1)
5.1. MAIN PRINCIPLE: The board should present a fair, balanced and understandable assessment of the company's position and prospects.
5.2. SUPPORTING PRINCIPLE: The board's responsibility to present a fair, balanced and understandable assessment extends to interim and other price-sensitive public reports and reports to regulators as well as to information required to be presented by statutory requirements.
5.3. SUPPORTING PRINCIPLE: The board should establish arrangements that will enable it to ensure that the information presented is fair, balanced and understandable.
5.4. CODE PROVISION C.1.1. The directors should explain in the annual report their responsibility for preparing the annual report and accounts, and state that they consider the annual report and accounts, taken as a whole is fair, balanced and understand and provides the information necessary for shareholders to assess the company's position and performance, business model and strategy. There should be a statement by the auditor about their reporting responsibilities.
5.5. CODE PROVISION C.1.2. The directors should include in the annual report an explanation of the basis on which the company generates or preserves value over the longer term (the business model) and the strategy for delivering the objectives of the company.
5.5.1. Section 414C CA2006 requires a description of a company's business model and strategy as part of the Strategic Report.
5.6. CODE PROVISION C.1.3. In annual and half yearly financial statement,s the directors should state whether they considered it appropriate to adopt the going concern basis of accounting in preparing them, and identify any material uncertainties to the company's ability to continue to do so over a period of at least 12 months from the date of approval of the financial statements.
5.6.1. This provision overlaps with Listing Rules.
6. ACCOUNTABILITY
6.1. The annual report and accounts of a company are the principal way in which the directors make themselves accountable to shareholders. It is therefore essential that the report should be transparent.
6.2. The shareholders use the information in the annual report and accounts to assess the stewardship of directors and the financial health of the company. It should therefore be clear and understandable, reliable and believable.
6.3. If investors have doubts about the honesty or transparency of financial reporting, they will hold back from investing and share value will suffer.
7. RELIABILITY
7.1. The reliability of the annual report and accounts will depend on: 1. The honesty of the company in preparing them (companies may indulge in window dressing through the use of accounting policies) 2. The care used by directors to satisfy themselves that the financial statements do give a 'true and fair view' and that everything of relevance has been properly reported. 3. The opinion of the external auditors, which the shareholders should be able to rely on as objective.
8. LEGAL DUTIES OF DIRECTORS FOR FINANCIAL REPORTING
8.1. Responsible for the preparation and content of the financial statements. They are responsible for the reliability of information they provide
8.2. Companies must prepare an annual report and accounts (CA2006). The accounts must be approved by the board and signed on behalf of the directors
8.3. Directors have a duty to prepare a directors' report, which must also be approved and signed off by the board. Unless the company is subject to the small companies' regime, the directors report must also contain a strategic report.
8.4. Directors of quoted company must prepare a director's remuneration report, which must be approved and signed off by the board.
8.5. The accounts and reports of a public company must be laid before the shareholders in a general meeting and the shareholders must be invited to approve the company's remuneration policy (binding) every three years, and approve the implementation report annually (advisory).
8.6. The accounts must be filed with CH together with the directors' report, the auditor's report and for quoted companies the remuneration report.
8.7. Management and directors are responsible for identify and correcting any error or misrepresentations in the financial statements. In UK law, the directors are potentially liable for any errors or misleading info. Any person suffering a loss as a consequence of error or misstatement may sue the company, and the company may take legal action against the directors.
9. COMPONENTS OF REPORT
9.1. The financial report presents a report on the financial performance of the company over the previous financial year and the financial position of the company as at the end of the year.
9.2. The director's report, the strategic report and other statements provide supporting info, much of it narrative rather than numerical.
9.2.1. The director's report contains the strategic report.
9.2.2. Directors of quoted companies must also produce the remuneration report.
9.3. For larger companies, the annual financial statements and elements of the annual report are audited by a firm of independent external auditors.
9.3.1. Auditor's report.