It is difficult to separate corporate financial reporting from corporate governance. There are two reasons for this. First, shareholders have the right to receive information timely on the economic consequences of transactions entered into by the company and other events on the financial position and performance of the company.
Therefore, timely presentation of financial information, which reflects the economic consequences of transactions and events, is a part of good corporate governance. Second, high quality financial information helps the market to value the shares and other securities appropriately and thus strengthens the passive monitoring of the executive management by those who do not have control rights (e.g. analysts and credit rating agencies).
As a result, high quality financial reporting improves corporate governance. Therefore, it is not surprising that with increased focus on corporate governance, the focus on corporate financial reporting has also increased. Almost every country has initiated action to improve the quality of financial reporting in order to enhance the value relevance of the financial information provided in financial statements.
Prudence, reliability and relevance are the cornerstones of financial reporting. Application of the principles of prudence requires a company to recognise a loss or a liability immediately it is identified, while it prohibits a company to recognise an income unless it is earned and its collectability is reasonably certain.
Thus, the principle of prudence is a check against the opportunistic behaviour of the management that has the incentive to defer recognition of a loss or liability and to advance the recognition of income. It ensures timelier recognition of liabilities and losses. Although accounting is moving away from the historical cost basis of accounting, standard setters have not yet given up this concept of prudence.
Accountants and standard-setters often face a trade-off between the relevance of financial information to target users on the one hand and reliability of estimates in measuring the appropriate attribute on the other. For a very long time, the balance was tilted towards reliability, but recently there has been a greater emphasis towards relevance. One reflection of this is the attempt to bridge the gap between the economic and the accounting measures of income. This has required giving a greater scope to judgement and discretion in estimating values of assets and liabilities.
As an example, we may examine one of the principles of the new rules for the accounting for lease that has been recently approved jointly by IASB and FASB. With some changes, the principles and methods stipulated in the Exposure Draft (ED) issued in 2010 are retained. It is expected that the new ED will be released in the third quarter of 2012. Estimation of the lease term is critical in measuring the value of the leased asset and the corresponding liability.
The ED defines the lease term as the longest possible term that is more likely than not to occur. It stipulates that a lessee shall determine the lease term by estimating the probability of occurrence for each possible term, taking into account the effect of any options to extend or terminate the lease. It should take into consideration contractual factors, non-contractual factors, business factors and other lease related factors in estimating the lease term. According to these rules estimation of the lease term requires identification of possible terms based on perception about the future and assigning (subjective) probability to each term. It implies that the lease term cannot be obtained directly from any document. In a way, the ‘lease term’ is a perception, of course based on internal and external evidence.
There will be situations where the management’s estimate and the auditor’s estimate will differ significantly. In some of those situations, the company will accept the auditor’s estimate because no company wants a qualified audit report. If the auditor is a medium or small audit firm, it is likely that it will accept the management’s estimate. Neither of these are desirable outcomes because while the management is expected to have a better understanding of the external and internal factors, its estimate might be influenced by its reporting incentive.
Therefore, the audit committee will have to play a very important role in ensuring that the estimates are reasonable. Usually, the audit committee depends on the opinion of the internal auditor and the statutory auditor. It limits its role in protecting the audit independence to enable auditors to form independent judgement without any management pressure.
This model might have worked well over the years. But it might prove inadequate in the coming years. The audit committee will be required to get deep into the underlying assumptions and analyses of estimates, which are based on judgement and perception.
The author is the chairperson of Riverside Management Academy Email: asish.bhattacharyya@gmail.com, www.riversidemanagement.in
