Ethics in Corporate Financial Reporting

1, INTRODUCTION

Ethics assume importance in a society of interdependence. Ethical behaviour is one that conforms to moral 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 the society 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 stakeholder theory of corporate governance has wider acceptance. However, in spite of cultural differences among societies, 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 those concepts 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 or organisation, 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 seriously considered as ethics, will have to define right behaviour as the behaviour, which optimizes each party's benefits and thus make the relationships harmonious, constructive, and mutually beneficial.
(Source: - "The changing world of the Executive Truman Talley Books, Times Books, New York, 1982.)

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

2. FUNDAM ENTAL RELATIONSHIPS

Fundamental relationships in a company structure of business are well defined. The Companies Act stipulates 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 of directors 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. The executive management is accountable to the board of directors for the use of authorities delegated to it and for the proper execution of tasks assigned to it. The fiduciary relationship between the board of directors and shareholders brings ethical dimension in the board's behaviour. In the Gower's Principle of Modern Company Law, sixth Edition, 1997, it is stated: "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 of the company; (2) that they must exercise the powers conferred upon them for purposes different from 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 place themselves 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 ethics together 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 which they 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 overall productivity of resources. It also endeavours to enhance the value of the company through "financial engineering9 . 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 impleme ntation enhances the value of the company. 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 on information available to it. It revises the same with every new information that flows to it.

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 required to 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 most potent tool for managing capital market expectation is 'earnings management'. Thus, the behaviour of 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 its residual 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 is verifiable only if different experts arrive at estimates, which differ in a na rrow range. Thus, errors in an 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 of the company. Let us take few examples: (a) Avoidance of 'discretionary costs', such as advertisement expenses, training expenses, expenses on 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 term performance. It is not in the best interest of the company, but it helps to maintain the profit at the current level.

(c) Structuring an acquisition deal in a manner that 'pooling of interest method of accounting can be used 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 other countries 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 social pressure 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 is in the i nterest 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 annual accounts. Similarly, in order to avoid disclosure of information on discontinuing operation, the board of 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 adversely affects those shareholders. It may also affect the ability of the company to approach the capital market for 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-term interest in the company. Therefore, the board of directors generally believes that the 'smoothing of profits 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, without significant adverse impact in the valuation of the company. The variation in the perception of the corporate management and standard-setters create ethical dilemma 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 the correct accounting estimate. In other words, law does not permit earnings management. Therefore, the board of directors f aces the dilemma in those situations, when it believes that earnings management will 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, rather earnings 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 all enterprises irrespective of their strategies. They seldom provide flexibility in the selection of

accounting principles and methods. For example, a company, in its initial years, may decide to spend heavily 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 loss account for the period in which they are incurred. This accounting principle provides enough disincentives 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 the company. The strategy requires amortisation of the expenditure over number of reporting periods, which are expected to benefit from the same. Capital market reacts sharply if, a company reports poor performance, 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 to build competitive advantage a company should spend on training, restructuring, etc., particularly when the going is bad. However, when the company passes through a bad phase, the stipulated accounting principles, accentuates the temptation to avoid such activities. It is not always a bad idea to allow enterprises a choice in selecting accounting principles. For example, 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 borrowing costs. If, in a subsequent revision it withdraws the alternative accounting treatment, no enterprise will be 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 put the 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 a difficult 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 to choose 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 difficult issues, 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 .

'Controls take a strong grip when accountability is not otherwise enforceable. Therefore, in order to avoid 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 corporate reporting, until corporate management demonstrates their respect for corporate ethics. Accounting Standards preclude 'smoothing of profit on the premise that investors understand the business of the company in which they invest. Therefore, they can appreciate the fluctuations in the performance 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 for shareholders. Both those premises require a reality check. A strong argument against allowing different enterprise to use different accounting methods for the accounting 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 unwittingly boosted 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 the strategy of the enterprise. This is not to suggest that comparability is not important or that we should come 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 the accounting policy adopted by the company and by disclosing facts, which will facilitate adjustments for analysing the accounting numbers. The dilemma in corporate financia l reporting has the potential to create conflict in the corporate boardrooms, 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. With powerful audit committee, compliance of Accounting Standards will improve, but that may not always benefit investors.