FA Study Text 2023-24 ISDC (1) PDF

The regulatory framework 1 Overview Introduction This chapter provides the underpinning knowledge to enable you to understand the regulatory framework, and its importance to financial reporting. The content of this chapter is an import...

The regulatory framework 1 Overview Introduction This chapter provides the underpinning knowledge to enable you to understand the regulatory framework, and its importance to financial reporting. The content of this chapter is an important foundation for your future ACCA studies, in particular for Financial Reporting and Strategic Business Reporting. 2 The regulatory framework Why a regulatory framework is necessary A regulatory framework for the preparation of financial statements is necessary for a number of reasons: to ensure that the needs of the users of financial statements are met with at least a basic minimum of information to ensure that all the information provided in the relevant economic arena is both comparable and consistent. Given the growth in multinational companies and global investment this arena is an increasingly international one to increase users’ confidence in the financial reporting process to regulate the behaviour of companies and directors towards their investors. Accounting standards on their own would not be sufficient to achieve these aims. In addition, there must be some legal and financial market-based regulation. 26 KAPLAN PUBLISHING  Chapter 2 National regulatory frameworks for financial reporting There are many elements to the regulatory environment of accounting. A typical regulatory structure includes: national financial reporting standards national law market regulations security exchange rules. For example the UK has the Financial Reporting Council that issues financial reporting standards in the UK. The main item of legislation affecting businesses in the UK is the Companies Act 2006. However, there are also many other pieces of UK, EU and even US legislation (the Sarbanes Oxley Act) that affect accountability in the UK. There are also industry-specific regulators that affect accounting in the UK, for example, the Financial Conduct Authority, who aims to ensure that financial markets work well for individuals, businesses and the economy as a whole. Finally, there are regulations published by the London Stock Exchange for companies whose shares are quoted on this market. 3 IFRS Standards Due to the increasingly global nature of investment and business operation there has been a move towards the 'internationalisation' of financial reporting. This 'harmonisation' was considered necessary to provide consistent and comparable information to an increasingly global audience. If companies use different methods of accounting, then before any decisions can be made about different entities the accounts would have to be rewritten, so that the accounting concepts and principles applied are the same. Only then could relevant comparisons be made. Harmonisation illustration To illustrate the importance of harmonisation, do some research on the internet for words that have totally different meanings in different countries. When you have done this, you will undoubtedly have a much better appreciation of the benefits of a harmonised approach to information that will be available in an international arena. Your research may also help you avoid some very embarrassing predicaments in the future! IFRS Standards are not enforceable in any country. As we will see shortly, they are developed by an international organisation that has no international authority. To become enforceable they must be adopted by a country's national financial reporting standard setter. KAPLAN PUBLISHING 27 The regulatory framework Within the European Union, IFRS Standards were adopted for all listed entities in 2005. Other countries to adopt IFRS Standards include: Argentina, Australia, Brazil, Canada, Russia, Mexico, Saudi Arabia and South Africa. The US, China and India are going through a process of 'convergence,' whereby they are updating their national standards over time to become consistent with IFRS Standards. 4 Structure of the international regulatory system IFRS Foundation (the Foundation) The Foundation is the supervisory body for the IASB® and is responsible for governance issues and ensuring that each member body is properly funded. It consists of a monitoring board which deals with public accountability and a board of trustees that has responsibility for governance, strategy and oversight of activities. The principal objectives of the Foundation are to: develop a set of high quality, understandable, enforceable and globally accepted financial reporting standards promote the use and rigorous application of those standards to take account of the financial reporting needs of emerging economies and small and medium sized entities bring about the convergence of national and international financial reporting standards. International Accounting Standards Board (the Board) The Board is the independent standard setting body of the Foundation. Its members are responsible for the development and publication of IFRS Standards and interpretations developed by the Interpretations Committee (IFRIC® Interpretations). Upon its creation the Board also adopted all existing International Accounting Standards (IAS® Standards). 28 KAPLAN PUBLISHING  Chapter 2 Many national standard setting bodies are represented on the Board and their views are taken into account so that a consensus can be reached. National standard setters can issue discussion papers and exposure drafts issued by the Board for comment in their own countries, so that the views of preparers and users of financial statements can be represented. A major national standard setter normally takes the ‘lead’ on international standard-setting projects. IFRS Interpretations Committee (IFRIC®) The IFRIC reviews widespread accounting issues (in the context of IFRS Standards) on a timely basis and provides authoritative guidance on these issues (IFRIC Interpretations®). Their meetings are open to the public and, similar to the Board they work closely with national standard setters. IFRS Advisory Council (The Council) The Council is the formal advisory body to the Board and the Foundation. It is comprised of a wide range of members who are affected by the Board's work. Their objectives include: advising the Board on agenda decisions and priorities in the their work, informing the Board of the views of the Council with regard to major standard-setting projects, and giving other advice to the Board or to the Trustees. Development of an IFRS Standard The procedure for the development of an IFRS Standard is as follows: The Board identifies a subject and appoints an advisory committee to advise on the issues. The Board publishes an exposure draft for public comment, being a draft version of the intended standard. Following the consideration of comments received on the draft, the Board publishes the final text of the standard. At any stage the Board may issue a discussion paper to encourage comment. The publication of an IFRS Standard, exposure draft or IFRIC interpretation requires the votes of at least eight of the 15 Board members. KAPLAN PUBLISHING 29 The regulatory framework International Sustainability Standards Board (ISSB) The ISSB was formed in 2021 with the objective of delivering a comprehensive global baseline of sustainability-related disclosure standards. This should provide relevant information to investors and other interested parties to help them make informed decisions concerning sustainability-related risks and opportunities relevant to individual companies. 5 Company ownership and control A company is a corporate body that has registered in accordance with the requirements of relevant national company law (e.g. the Companies Act 2006 in the UK), thus becoming a legal entity. Ownership of the company is evidenced by the issuing of shares to the owners (i.e. the shareholders). For some smaller and medium-sized companies the owners may also be the directors/managers of that company. It is also possible for directors of large, publicly-listed companies to own shares in the companies they work for. However, of the largest 100 UK companies, directors typically own less than 1% of the shares of the company they work for. Typically large, listed companies are owned by a wide range of individuals and organisations, such as pension funds, trusts and investment banks. These individuals and entities will not have any involvement in the day-to- day running of the business. Imagine if you had to organise a meeting of all shareholders every time the business needed to make a decision such as the hiring of a new member of staff or which leasing company to rent cars from. It would take far too long to make these decisions and consensus amongst such a large group might be difficult to achieve. 30 KAPLAN PUBLISHING  Chapter 2 Instead, directors are appointed to manage the business on behalf of the owners. This leads to the separation of ownership and control within the company. Unfortunately the objectives of owners and directors often conflict. Whilst they might both have the objective of increasing their own personal wealth, if the directors increase their own salaries and bonuses this reduces the profit available to the shareholders. Also, the directors will be rewarded for the financial success of the business, which leads towards a risk that bias may be introduced in the preparation of the financial statements. This could ultimately result in a reduction in reliability/credibility of the financial statements. The current financial reporting environment Recent history has been dogged with examples of unreliable, and often fraudulent, financial reporting, where directors or senior managers have put their own personal interests above those of the shareholders. Enron, Lehman Brothers, WorldCom, Parmalat and Wells Fargo are high profile examples where accounting misstatements (deliberate or otherwise) have resulted in the publication of unreliable financial statements which has misled shareholders, often with very significant personal gain to the perpetrators.. These cases only serve to exacerbate the problem of shareholder confidence, creating a culture of mistrust of directors (and auditors) of large companies. This has sadly led to a loss of credibility in published financial reports. Whilst the various regulators around the world have responded, not least with the move to harmonise both financial reporting and auditing, there is still a long way to go in the fight to restore credibility to financial statements. 6 What is ‘corporate governance’? The Cadbury Report 1992 provides a useful definition: 'the system by which companies are directed and controlled'. An appropriate expansion to this definition might include: 'in the interests of shareholders and in relation to those stakeholders beyond the company boundaries'. The use of the term stakeholders suggests that companies (and therefore their management team) have a much broader responsibility to the economy and society at large. This includes concepts such as public duty and corporate social responsibility. If directors of a company have a responsibility to these groups then they must also be held accountable to them. KAPLAN PUBLISHING 31 The regulatory framework 7 Purpose and objectives of corporate governance The basic purpose of corporate governance is to monitor those parties within a company who control the resources and assets of the owners. The primary objective of sound corporate governance is to contribute to improved corporate performance and accountability in creating long-term shareholder value. The need for corporate governance Simply put, if the stock market mechanism is to succeed then there needs to be a system that ensures publicly-owned companies are run in the interests of the shareholders and that provides adequate accountability of the people managing those companies. Note that there is an ongoing requirement to review and update corporate governance guidance to ensure that it remains relevant to current business and commercial practices. 32 KAPLAN PUBLISHING  Chapter 2 The basic elements of sound corporate governance include: effective management effective systems of internal control oversight of management by non-executive directors fair appraisal of director performance fair remuneration of directors fair financial reporting, and constructive relationships with shareholders. In order to be accountable to the stakeholders of the business the directors of a company have a range of duties such as: a general duty of care to act in good faith for the benefit of the company and its shareholders a duty of care to avoid a conflict of interest between personal interests and those of the company and its stakeholders, and to make disclosure if such a conflict arises. Directors’ responsibilities that are more specific are normally imposed by law or regulation in many countries and typically include the following responsibilities: establishing and maintaining an adequate system of internal controls which prevents and detects fraud and error maintaining adequate accounting records that provide a basis for the preparation of the annual financial statements preparing annual financial statements that show a ‘true and fair’ view of the financial position and performance of the company, including compliance with relevant laws, regulations and IFRS Standards responsibility to approve the annual financial statements prior to their publication, and to distribute or file the annual financial statements in accordance with local law and regulations. Note that, in many countries, directors may incur civil and/or criminal sanctions if they fail to discharge their duties and responsibilities. KAPLAN PUBLISHING 33 The regulatory framework Example of corporate governance - I The UK Corporate Governance Code (2018) The UK adopts what is commonly referred to as a 'comply or explain' approach to corporate governance. All listed companies in the UK have to submit a report stating how they have complied with the provisions of the code and a statement of compliance with the code. If they have not been compliant they have to explain why they have not complied and what alternative action they have taken. The code provides guidance on five areas of governance: (i) board leadership and company purpose (ii) division of responsibilities of the board of directors (iii) composition, succession and evaluation of the board of directors (iv) audit, risk and internal control (v) remuneration of the board of directors. Example of corporate governance - II The US Sarbanes Oxley Act In the US corporate governance is enshrined in law, meaning compliance is compulsory and failure to comply could lead to criminal conviction. The Act enforces: sound systems of internal control clear documentation of financial processes, risks and controls evidence that management have evaluated the adequacy and design of systems and controls evidence that the auditor has evaluated the adequacy and design of systems and controls. The fundamental aim of the Act is 'to provide the company, its management, its board and audit committee, and its owners and other stakeholders with a reasonable basis to rely on the company's financial statements.’ Test your understanding 1 Briefly describe the role of corporate governance. 34 KAPLAN PUBLISHING