Essay: Regulatory Frameworks for Financial Reporting (2007)
Compare and contrast the Regulatory Frameworks for Financial Reporting in the UK and the USA
1: Introduction: The reason for regulatory requirements
In the United Kingdom there has been a shift towards international standards. However, British regulatory requirements remain. “Mandatory requirements take the form of Statements of Standard Accounting Practice (SSAPs) and Financial Reporting standards (FRSs) issued by the Accounting Standards Board” (Elliot and Elliot 2006). Mandatory standards are needed because companies might want to make the accounts appear unrealistically favourable. If this were to happen then shareholders would not be obtaining an accurate view of the business. For example, if discretionary expenditure were deferred, such as spending on research and training, then earnings would be artificially improved.
There is a need to make it more difficult to manipulate accounts such as by deferring expenditure.
2: The background in the United Kingdom
In the 1960’s confidence was lost in accounting procedures. Shareholders were unaware of hidden problems which were only exposed after takeovers or when companies went into administration (Elliot and Elliot 2006)
The GEC takeover of AEI in 1967 exposed inconsistencies in accounting procedures. “The pre-takeover accounts prepared by the old AEI directors, differed materially from the post takeover accounts prepared by the new AEI directors” (Elliot and Elliot 2006). AEI produced a £10m profit forecast in 1967, which had the backing of the auditors. However, when GEC took over AEI it forecast a loss of £4.5 million. This was partly due to inconsistencies such as different views over the value of stock. Mandatory standards were needed to resolve this inconsistency and to make the accounts ‘objective’. That is, the profit should be the same regardless of who was preparing them. A similar problem occurred with Pergamon Press in 1968. Profits were overstated on the basis of an independent investigation, which highlighted a failure to reduce the valuation of stock to the lower of cost and net realisable value.
The problem, shown in these two cases, was that there was too much scope for companies to produce different “results based on the same transactions” (Elliot and Elliot 2006). The investing public cannot be sure of the profits because they depended upon who was responsible for their preparation and audit. Therefore, there was a need for common standards and ‘statements of standard accounting practice’. After the late 1960’s there was an Accounting Standards Steering Committee (in 1970), which aimed to reduce areas of difference in accounting practice and develop consensus. Also disclosure of accounting standards was encouraged so that the investing public were aware of policies such as those relating to depreciation. To further improve accountability (by 1982) the terms of reference of the Accounting Standards Committee was widened to include consultation with representatives from industry and government.
The purpose of these Committees was to ensure consistent standards between companies so that comparisons of performance could be made. This was to encourage credibility with investors, as profits ought to be the same regardless of who prepared the accounts. In terms of the later developments, “the operating and financial review statement was issued by the ASB in 1993 to encourage the development of best practice”. This was intended to have a persuasive rather than a mandatory force (Elliot and Elliot 2006). The report was not prescriptive; it was there to provide an overview of the business. “The emphasis (of the OFR) was on providing a readily understood discussion that dealt with both good and bad aspects of the business; that commented on trends, factors and uncertainties that had affected or would affect the results”(Elliot and Elliot 2006).
“Although the reporting of risks attaching to financial instruments is being addressed, the reporting of business risks and how management is dealing with them has been lacking” (Elliot and Elliot 2006). The directors have been left to consider how they want to analyse their business. Investors still need to investigate the accounts for themselves, as the review does not emphasise weaknesses in the business.
The Financial Reporting Review Panel is independent of the Accounting Standards Board. It prefers to deal with defects by agreement implying that it has been working more on a voluntary rather than a mandatory basis. However, it challenged Trafalgar House in 1991 when it reclassified current assets to fixed assets; thus avoiding a loss to the profit and loss account. The FRRP has, since 1988, been criticised for being a reactive body responding to issues appearing in individual sets of accounts. “This led to the criticism that the FRRP was not addressing significant financial reporting issues and was dealing with disclosure matters that had readily been detected” (Elliot and Elliot 2006).
After the Enrol scandal (discussed later) regulators could not react to events. The Financial Reporting Review Panel (FRRP) has responded in a more proactive manner recently such as checking interim accounts. “The FRRP has raised concerns that stakeholders might have a false expectation that the panel is providing a guarantee that financial statements are true and fair, stressing that no system of enforcement can or should guarantee the integrity of a financial reporting regime” (Elliot and Elliot 2006). It is admitting that it cannot enforce standards fully. This implies that little more can be done. A voluntary approach still appears to be the method in the United Kingdom.
An important recent development is that the Accounting Standards Board has recommended that a summarised cash flow statement to reconcile operating profit with operating cash flow. The argument is that financial reporting and auditing systems should provide full disclosure at an appropriate time to affect decisions.
3: The Cadbury Committee
The Cadbury Committee Report produced a voluntary code of best practice for how boards of directors should operate. It was suggested that the board should retain control over important decisions such as major capital expenditure and bank borrowings.
Non-executive directors should be able to exert significant influence because of the number of non-executives and their experience. However, it is unclear whether non-executive directors really can play a significant role in corporate governance. Also, the position of chairman should be separate from that of chief executive.
4: The current situation and recent scandals: Enron and Ahold
The issue of a regulatory framework is relevant given the Enron case. The company was formed in the mid 1980’s and became by the end of the 1990’s the seventh largest company in revenue terms in the United States. It concealed off balance sheet debts and it had overstated its profits by half a billion dollars ($500,000,000) (Elliot and Elliot 2006). Enron had not been disclosing its debts as they had been in the accounts of other companies. These other firms were established by Enron but the accounts were kept separate; that is they were kept off the main balance sheet. The auditors, Andersen, had failed to disclose Enron’s real financial position. Between 1996 and 2000 sales revenues grew by more than 600%. Dubious accounting had covered up its rapid growth. Cash flow could not be reconciled with the firm’s debts (Macousie et. al. 2003)
In 2003, “Ahold, the world’s third largest grocer reported that its earnings for the past two years were overstated by more than $500 million as a result of local managers recording promotional allowances provided by suppliers to promote their goods at a figure greater than their cash received (Elliot and Elliot 2006). These two examples show that management should not have complete control over the way accounts are presented. “Rules are needed to ensure uniformity in the reporting of (similar) commercial transactions (Elliot and Elliot 2006).
In the United Kingdom the standard setting bodies have considered accounting rules as being about general principles. A culture of voluntary compliance still exists in the United Kingdom. However, there is a proposal to make the (operating and financial review (OFR) mandatory. Also European directives seem to be moving, domestic accounting standards, towards mandatory accounting procedures. However, the directives only provide a framework for financial reporting.
5: A comparison between the United Kingdom and the United States
The United Kingdom and the United States use equity markets (rather than loan finance) to raise capital to a greater extent than France and Germany. “A system of financial reporting has evolved (in the U.K. and the U.S. to satisfy a stewardship need where prudence and conservatism predominate and to meet the capital market need for fair information” (Elliot and Elliot 2006).
In contrast, the banks are both the main lenders and shareholders in Germany. As principal lenders they receive internal information such as cash flow forecasts, which is therefore also available to them in their role as shareholders. German banks have the power to obtain all of the information they require without reliance on the annual accounts (Elliot and Elliot 2006). Published disclosures are less relevant in Germany than in the U.K, and presumably the United States, where individual or small shareholders will need disclosures.
6. Contrasts between the United Kingdom and the United States
The collapse of Enron emphasised a number of deficiencies in financial reporting. “The application of U.S. GAAP had led to a lack of transparency, regarding revenue recognition (profits), valuation of intangible assets, special purpose entities, and off balance sheet finance. The United States’ detailed regulations has had its faults and the broader regulations based on principles as applied by the United Kingdom standards board may be a better way forward (Elliot and Elliot 2006).
There are more rules in the United States than in the United Kingdom. The Securities and Exchange Commission was born out of complex legislation. This body is responsible for requiring the publication of financial information for the benefit of shareholders. There are still problems though with United States financial accounts. The reconciliation between net income reported under IAS (international accountancy standard) and the U.S. GAAP (generally accepted accountancy principles) for Nokia demonstrates that in spite of the convergence project there remain differences United States GAAP and International Accounting Standards. In the United States, with a widespread ownership of companies by shareholders; they often who do not have access to internal information so there will be pressure for disclosure, audit and ‘fair’ information (Parker and Nobles 1995).
The major feature of U.S. inventory valuation is that many companies use the last in first out method of determining the cost of inventory. LIFO is not acceptable for tax purposes in the United Kingdom. The use of LIFO means that the most recently used inventory is deemed to be the earliest to be used up in production or sales.
Also, if there is an acquisition and there is negative goodwill then in the U.K. then this is added to the reserves. In America, the acquired assets are written down so that negative goodwill does not arise. For positive goodwill the U.S. practice is to treat goodwill as an asset and to amortise it over its economic life. In the U.K. goodwill is deducted from group reserves. United States group assets look larger than United Kingdom practice would suggest.
The British preference for writing off goodwill directly to reserves has meant that companies engaging in the acquisition of other companies whose main resources are intangible rather than tangible have found their assets and reserves shrinking. (Parker and Nobles 1995).
7: Further discussion on the United Kingdom and the United States
“The securities (shares) markets are the dominant influence on accounting regulation in the United States. Investor protection is regulated and enforced at the federal government level under the Securities Act of 1933 and the Securities Exchange Act of 1934, which were passed in response to the stock market crash of 1929 and subsequent financial crises” (Radebaugh and Gray 2002).
“Corporations are required to follow FASB (Financial Accounting Standards Board) standards otherwise the SEC (Securities and Exchange Commission) will refuse registration and hence trading in their securities”. “The FASB standards are quite detailed and voluminous compared to UK standards. The United States is similar in many ways to the United Kingdom it is unique in having the most comprehensive system of accounting regulations in the world; particularly as far as the share markets are concerned” (Radebaugh and Gray 2002).
In the United Kingdom, the informational needs of investors are prioritised too. However, company law in the United Kingdom has a much wider remit than the United States securities laws. The United Kingdom Companies Act of 1985 includes accounting information for all limited liability companies not just large companies (as in America). Also the accountancy profession and the stock exchange appear to be more involved in the accountancy process, whereas it is the federal government, which is setting the agenda in America. “In 1970 to stave off government interventions and the creation of a United States style SEC, the United Kingdom profession set up its own self regulatory organisation, the Accounting Standards (steering) Committee”.
“Anglo American accounting tends to be relatively less conservative and more transparent than that of the Germanic countries and Japan” (Radebaugh and Gray 2002). Accounting in the United States is similar to the United Kingdom given the historical and investment connections between the two countries. The United States has adapted rather than adopted the United Kingdom’s accounting tradition (Radebaugh and Gray 2002). The United Kingdom takes a stakeholder approach whereas United States accounting appears to be focused on large corporations, although the needs of creditors and other users are recognised.
The United States has many accounting regulations, which typically contain detailed provisions. By contrast, the United Kingdom has fewer regulations and its regulations are more general in nature. British accountants have become involved in regulation more recently than America, and the volume of regulation in Britain may be approaching that of America
Elliot B. and Elliot J. (2006), Financial Accounting and Reporting, tenth edition, Prentice Hall
Marcousie I. editor (2003), Business Studies, Second edition, Hodder Arnold
Parker, R. and Nobles C. eds. (1995), Comparative International Accounting, Prentice Hall
Radebaugh L. and Gray S. (2002), International Accounting and Multinational Enterprises, Fifth Edition, John Wiley