Why high-quality financial reporting matters

erim_logoRoll back to February 2003: Ahold shares lose 60% of their value in a single day as investors react to news of major accounting irregularities at the company’s overseas subsidiaries. Other high-profile financial scandals such as Enron and Worldcom, Parmalat in Italy or Satyam in India have reverberated around the globe. And in some cases, corporate managers have profited hugely at the expense of their shareholders, who were not privy to what was really going on within the company.

Such events have refocused attention on the importance of the quality of financial reporting. Far tighter systems of disclosure were brought into force in the US post-Enron, with the 2002 Sarbanes-Oxley legislation. Elsewhere regulatory systems have also been strengthened. So are they actually working? And if financial reporting requirements are now stricter, does this translate into more equal information for shareholders?

These are questions that intrigue Dr David Veenman of the Erasmus School of Economics. With colleagues Professor Hollis Skaife of the University of Wisconsin-Madison and Dr Daniel Wangerin of Michigan State University, he has been looking for evidence of the benefits to outside investors of higher quality information. The team has been exploring the relationship between the strength of a company’s internal controls and the level of profit that senior managers can extract for themselves through insider trading, at the expense of shareholders.

Whether or not insider trading takes place, says Veenman, there is an inherent information asymmetry: those inside companies clearly know far more than those outside. This gives them an information advantage when making investment decisions, and the incentives for senior executives may be such that some will exploit their privileged knowledge for personal gain – selling or buying shares at points that are most advantageous.

High-quality financial reporting helps to redress this, he argues: “It gives outside investors better information with which to judge a company’s quality and value, and it also offers a means by which they can monitor and measure the performance of its senior managers.”

The stringent regime in the United States, where there is public disclosure of auditor judgements, meant that data on US companies provided an ideal test-bed for their research, says Veenman:

“Since 2004, US companies have had to include in their annual report a statement that the policies and procedures that lead to the financial figures are adequate. The external auditors then give their opinion on whether they believe the management’s evaluation to be correct, and whether there are any ‘material weaknesses’. The management are meant to give a truthful account, but it is the auditor who has the final say.”

Using a large set of US companies, the researchers examined the auditor statements on the effectiveness of the companies’ internal financial control systems. Their goal was to test whether there are greater information imbalances in financial markets when the quality of financial reporting is deemed to be low, as indicated when an auditor flags instances of “material weakness”.

Where these weaknesses in internal control are identified, there is a greater likelihood that material misstatements in financial reports will arise. Previous research had shown that firms with ineffective internal controls over financial reporting gave out less reliable financial information.

Effective internal controls, by contrast, should restrict the management’s ability to change or manipulate the numbers reported in financial statements – ensuring that there are adequate checks to pick up on accidental errors and leaving little room for deliberate attempts to ‘cook the books’.

Measuring “quality” of reporting is notoriously difficult, says Veenman. “The benefit of using these statements is that the internal control statements give a relatively strong and direct signal of whether the quality of the company’s financial reporting is likely to be high or low.”

What they found was that managers accrue significantly more from insider trading when the quality of financial reporting is low, as indicated by auditor verdicts of material weaknesses in internal control.

“On average, managers in companies with weak internal control gain personal benefits of just under $300,000 in a year, compared with around $50,000 in firms with no internal control problems,” Veenman explains.

“When we tested this longitudinally, we found this effect to be present in the years before any statement of “weak internal control” emerged, but to disappear the year after. This suggests that revealing and subsequently resolving the issue reduces the information problems.”

The situation was shown to be worse, with greater adverse effects for shareholders, when the internal control problems are identified by external auditors as driven by poor “tone at the top”. “On average, in these companies the annual personal benefits to managers increase to about $1,000,000,” says Veenman.

Tone at the top is used to denote the attitude of a firm’s senior managers towards maintaining effective systems of control and more generally towards high-quality financial reporting.

With weak tone at the top, senior managers are far more likely to engage in behaviours that involve manipulating the figures. With fewer restrictions placed on what they can do, managers have more discretion as to which accounting measures and estimates they use. As earlier research suggests, the information disseminated in such cases is less reliable. This gives the advantage to company insiders, who are more likely to profit when trading their shares.

“This research gives a clear message that high-quality financial reporting is indeed important for the proper functioning of financial markets,” says Veenman. “Our findings should be of direct benefit for regulators who design accounting rules, disclosure requirements and other mechanisms to facilitate a proper information flow from companies to markets.

“Revealing and then addressing the internal control issues clearly helps to reduce information problems in financial markets. It is therefore important that companies should be required to disclose auditor statements on the adequacy of internal control systems as this should then enhance the quality and value of financial reports – giving investors vital evidence with which to make more informed decisions.”

Dr David Veenman is an Associate Professor in the Department of Business Economics, Erasmus School of Economics. ‘Internal control over financial reporting and managerial rent extraction: evidence from the profitability of insider trading’ by Hollis A Skaife, David Veenman and Daniel Wangerin was published in the Journal of Accounting and Economics in February 2013.

Republished with permission of the Erasmus Research Institute of Management, ERIM

Roll back to February 2003: Ahold shares lose 60% of their value in a single day as investors react to news of major accounting irregularities at the company’s overseas subsidiaries. Other high-profile financial scandals such as Enron and Worldcom, Parmalat in Italy or Satyam in India have reverberated around the globe. And in some cases, corporate managers have profited hugely at the expense of their shareholders, who were not privy to what was really going on within the company.

Such events have refocused attention on the importance of the quality of financial reporting. Far tighter systems of disclosure were brought into force in the US post-Enron, with the 2002 Sarbanes-Oxley legislation. Elsewhere regulatory systems have also been strengthened. So are they actually working? And if financial reporting requirements are now stricter, does this translate into more equal information for shareholders?

These are questions that intrigue Dr David Veenman of the Erasmus School of Economics. With colleagues Professor Hollis Skaife of the University of Wisconsin-Madison and Dr Daniel Wangerin of Michigan State University, he has been looking for evidence of the benefits to outside investors of higher quality information. The team has been exploring the relationship between the strength of a company’s internal controls and the level of profit that senior managers can extract for themselves through insider trading, at the expense of shareholders.

Whether or not insider trading takes place, says Veenman, there is an inherent information asymmetry: those inside companies clearly know far more than those outside. This gives them an information advantage when making investment decisions, and the incentives for senior executives may be such that some will exploit their privileged knowledge for personal gain – selling or buying shares at points that are most advantageous.

High-quality financial reporting helps to redress this, he argues: “It gives outside investors better information with which to judge a company’s quality and value, and it also offers a means by which they can monitor and measure the performance of its senior managers.”

The stringent regime in the United States, where there is public disclosure of auditor judgements, meant that data on US companies provided an ideal test-bed for their research, says Veenman:

“Since 2004, US companies have had to include in their annual report a statement that the policies and procedures that lead to the financial figures are adequate. The external auditors then give their opinion on whether they believe the management’s evaluation to be correct, and whether there are any ‘material weaknesses’. The management are meant to give a truthful account, but it is the auditor who has the final say.”

Using a large set of US companies, the researchers examined the auditor statements on the effectiveness of the companies’ internal financial control systems. Their goal was to test whether there are greater information imbalances in financial markets when the quality of financial reporting is deemed to be low, as indicated when an auditor flags instances of “material weakness”.

Where these weaknesses in internal control are identified, there is a greater likelihood that material misstatements in financial reports will arise. Previous research had shown that firms with ineffective internal controls over financial reporting gave out less reliable financial information.

Effective internal controls, by contrast, should restrict the management’s ability to change or manipulate the numbers reported in financial statements – ensuring that there are adequate checks to pick up on accidental errors and leaving little room for deliberate attempts to ‘cook the books’.

Measuring “quality” of reporting is notoriously difficult, says Veenman. “The benefit of using these statements is that the internal control statements give a relatively strong and direct signal of whether the quality of the company’s financial reporting is likely to be high or low.”

What they found was that managers accrue significantly more from insider trading when the quality of financial reporting is low, as indicated by auditor verdicts of material weaknesses in internal control.

“On average, managers in companies with weak internal control gain personal benefits of just under $300,000 in a year, compared with around $50,000 in firms with no internal control problems,” Veenman explains.

“When we tested this longitudinally, we found this effect to be present in the years before any statement of “weak internal control” emerged, but to disappear the year after. This suggests that revealing and subsequently resolving the issue reduces the information problems.”

The situation was shown to be worse, with greater adverse effects for shareholders, when the internal control problems are identified by external auditors as driven by poor “tone at the top”. “On average, in these companies the annual personal benefits to managers increase to about $1,000,000,” says Veenman.

Tone at the top is used to denote the attitude of a firm’s senior managers towards maintaining effective systems of control and more generally towards high-quality financial reporting.

With weak tone at the top, senior managers are far more likely to engage in behaviours that involve manipulating the figures. With fewer restrictions placed on what they can do, managers have more discretion as to which accounting measures and estimates they use. As earlier research suggests, the information disseminated in such cases is less reliable. This gives the advantage to company insiders, who are more likely to profit when trading their shares.

“This research gives a clear message that high-quality financial reporting is indeed important for the proper functioning of financial markets,” says Veenman. “Our findings should be of direct benefit for regulators who design accounting rules, disclosure requirements and other mechanisms to facilitate a proper information flow from companies to markets.

“Revealing and then addressing the internal control issues clearly helps to reduce information problems in financial markets. It is therefore important that companies should be required to disclose auditor statements on the adequacy of internal control systems as this should then enhance the quality and value of financial reports – giving investors vital evidence with which to make more informed decisions.” 

© Hollandse Hoogte/Corbis Images

Dr David Veenman is an Associate Professor in the Department of Business Economics, Erasmus School of Economics. 

‘Internal control over financial reporting and managerial rent extraction: evidence from the profitability of insider trading’ by Hollis A Skaife, David Veenman and Daniel Wangerin was published in the Journal of Accounting and Economics in February 2013.

– See more at: http://www.erim.eur.nl/news/detail/3193-why-high-quality-financial-reporting-matters/#sthash.tnuJlwt5.dpuf

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