Financial Reporting and the Need for Trust

Question: The importance of financial statements to any person who is analyzing a business or other organization appears rather obvious. The wide range of information provides a portrait of the reporting entity that reflects both its financial health and potential for future success. However, a degree of skepticism seems only natural when studying such statements because they are prepared by the company’s own management, hardly an impartial group.

Decision makers are not naïve. They must harbor some concern about the validity of figures and other data that are self-reported. Company officials operate under pressure to present positive financial results consistently, period after period. What prevents less scrupulous members of management from producing fictitious numbers just to appear especially profitable and financially strong? Why should any investor or creditor be willing to risk money based on financial statements that the reporting organization itself has prepared?

Answer: The possible presence of material misstatements (created either accidentally or on purpose) is a fundamental concern that should occur to every individual who studies a set of financial statements. Throughout history, too many instances have arisen where information prepared by management ultimately proved to be fraudulent causing decision makers to lose fortunes. In fact, the colorful term “cooking the books” reflects the very real possibility of that practice. Enron, WorldCom, and Madoff Investment Securities are just a few examples of such scandals.

The potential for creating misleading financial statements that eventually cause damage to both investors and creditors is not limited to a particular time or place. Greed and human weakness have always rendered the likelihood of a perfect reporting environment virtually impossible. In addition, fraud is never the only cause for concern. Often a company’s management is simply overly (or occasionally irrationally) optimistic about future possibilities. That is human nature. Therefore, financial information should never be accepted blindly, especially if monetary risk is involved.

Over the decades, numerous laws have been passed in hopes of creating a system to ensure that all distributed financial statements fairly present the underlying organization they profess to report. Because of the need for economic stability, this is an objective that governments take seriously. Under capitalism, the financial health of the entire economy depends on the ability of worthy businesses to gain external financing for both operations and expansion. Without trust in the reporting process, people simply will not invest so that the raising of large monetary amounts becomes difficult, if not impossible. As has been seen in recent times, hesitancy on the part of investors and creditors restricts the growth of businesses and undermines the strength of the entire economy.

In the United States, ultimate responsibility for the availability of complete and reliable information about every organization that issues publicly traded securitiesFor this introductory textbook, a security will include ownership shares of a company as well as debt instruments such as bonds that can be sold from one party to another. A debt instrument is a promise to pay a stated amount plus a specified rate of interest at a particular point in time. lies with the Securities and Exchange Commission (SEC)Federal government agency holding legal responsibility over the reporting made by companies that issue publicly traded securities in the United States; works to ensure that this entire reporting process functions as intended by the government; has opted to leave development of authoritative accounting principles to FASB, although a change to IFRS produced by the IASB may be required in the future.. The SEC is an independent agency within the federal government established by the Securities Exchange Act of 1934. Its mission, as stated at its Web site (http://www.sec.gov), “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Virtually all U.S. companies of any significant size—as well as many foreign companies—fall under the jurisdiction of the SEC because their securities (either ownership shares or debt instruments such as bonds) are traded publicly within the United States. Financial statements and numerous other formal filings have to be submitted regularly to the SEC by these companies. A Form 10-K, which includes financial statements as well as a substantial amount of additional data, must be submitted each year. A Form 10-Q serves the same purpose each quarter. This information is then made available to the public through a system known as EDGAR (Electronic Data Gathering and Retrieval)SEC reporting system requiring companies to file their financial statements and other information electronically to allow current and potential investors access quickly and easily over the Internet..Considerable information on accessing the financial data filed with the SEC can be found at http://www.sec.gov/edgar.shtml. Any student considering a career in financial analysis or the like should visit this site to become familiar with its contents, especially the tutorial, so that the EDGAR system can be used to gain information provided by publicly traded companies. All such statements and other released data must conform precisely to the extensive rules and regulations of the SEC.

Companies that do not issue even a minimum amount of securities to the public normally are required to comply with state laws rather than with the SEC and federal laws. Financial statements for such companies, although not as likely to be public information, are often required by financial institutions and other interested parties. For example, a bank might insist that a local convenience store include financial statements as part of a loan application. The form and distribution of that financial information must conform to state laws (often referred to as “blue sky laws”).

The Relationship of the SEC to Official Accounting Standards

Question: Companies such as General Electric or Starbucks that issue securities to the public are required to satisfy all applicable federal laws and regulations. The SEC has authority over the amount and nature of the information that must be provided and the actions that can be taken by both the buyer and the seller of the securities. Does the SEC develop the specific accounting principles to be followed in the production of financial statements that are issued by public companies?

Answer: Legally, the SEC has the ability to establish accounting rules for all companies under its jurisdiction simply by specifying that certain information must be presented in a particular manner in the public filings that it requires. However, for decades the SEC has opted to leave the development of authoritative accounting principles to the Financial Accounting Standards Board (FASB). As discussed in an earlier chapter, for nearly 40 years FASB has had the primary authority for producing U.S. GAAP. Because FASB is a private (rather than government) organization, this decision has, at times, been controversial. Some view it as an abdication of an important responsibility by the federal government so that the public is at risk. The assumption by the SEC is that the members of FASB can be trusted to study each reporting issue meticulously before arriving at a reasoned resolution.

The SEC does allow certain companies to follow International Financial Reporting Standards (IFRS) so that, in those cases, the same reliance is being placed on the work of the International Accounting Standards Board (IASB) in London. As indicated previously, movement to a single set of global standards over the next few years is constantly under debate. One of the arguments about the possible move by the SEC from U.S. GAAP to IFRS is whether the IASB as it is currently structured can be trusted as much in the future as FASB has been in the past.

At present, FASB produces accounting rules to be applied by all for-profit and not-for-profit organizations in the United States, while state and local governments follow accounting standards produced by a sister organization, the Governmental Accounting Standards Board (GASB)Nonprofit organization that holds the authority for establishing accounting standards for state and local government units in the United States; sister organization to FASB.. In July, 2009, FASB Accounting Standards Codification was released to serve as the single source of authoritative nongovernmental U.S. GAAP. As a result, all the previous individual rules that had been created over several decades were reclassified into a logical framework. According to a FASB news release, “The Codification reorganizes the thousands of U.S. GAAP pronouncements into roughly 90 accounting topics and displays all topics using a consistent structure. It also includes relevant Securities and Exchange Commission (SEC) guidance that follows the same topical structure in separate sections in the Codification.”News release by FASB, July 1, 2009.

Groups other than FASB also contribute to accounting standards but in a much less significant fashion. The most important of these is the Emerging Issues Task Force (EITF)A group formed to assist FASB by examining new accounting issues as they arise in hopes of arriving at quick agreement as to the appropriate method of reporting based on existing U.S. GAAP., which was created in 1984 to assist FASB.In Chapter 2 "What Should Decision Makers Know in Order to Make Good Decisions about an Organization?", http://www.fasb.org was mentioned as an excellent source of information about FASB. One of the tabs available at this Web site discusses the role of the EITF. The EITF examines new problems when they initially arise in hopes of coming to quick agreement as to an appropriate method of reporting based on existing U.S. GAAP. Thus, the EITF is not forming U.S. GAAP as much as helping to apply it to newly emerging situations. If consensus is achieved (that is, no more than three members object), the conclusions rendered by the EITF are considered to be authoritative until such time—if ever—as FASB provides its own formal guidance. In this way, FASB does not have to issue hasty pronouncements to resolve every unique reporting concern when it first appears.

The SEC itself is not totally absent from the formation of U.S. GAAP. It occasionally issues guidelines to ensure that adequate information is being disclosed to the public through its own rules and interpretive releases. That is especially true in situations where reporting concerns have emerged and adequate official guidance does not exist. The SEC tends to restrict its own power over financial reporting to those areas where U.S. GAAP—for whatever reason—has not yet been well constructed. Assume, for example, that a new type of transaction arises and the EITF is unable to arrive at a consensus resolution. The SEC might specify relevant data to be included in the notes to financial statements to better describe these events or could prohibit certain methods of reporting until FASB has the opportunity to provide a studied ruling.