1. 1 Corporate Financial Reporting I Lecture 1 Development of Financial Reporting

2. 2 Aims and Outcomes Aims: Aims: This lecture aims to introduce students to the corporate governance framework of UK financial reporting and the historical context of current financial reporting requirements. This lecture aims to introduce students to the corporate governance framework of UK financial reporting and the historical context of current financial reporting requirements. Learning outcomes: Learning outcomes: After the lecture and recommended reading students should be able to: After the lecture and recommended reading students should be able to: Describe the UK system of corporate governance and the discuss the role of financial reporting therein Describe the UK system of corporate governance and the discuss the role of financial reporting therein State and discuss various arguments in favour and against the regulation of this system and of financial reporting State and discuss various arguments in favour and against the regulation of this system and of financial reporting Outline problems that the UK system of corporate governance has faced Outline problems that the UK system of corporate governance has faced Discuss generally the development of financial reporting from 1844 to the 1990s Discuss generally the development of financial reporting from 1844 to the 1990s

3. 3 The Art of Practical Accounting Accounting or Financial Reporting is a practical discipline Accounting or Financial Reporting is a practical discipline It has developed in response to practical problems It has developed in response to practical problems Napier – History of Financial Reporting in the United Kingdom Napier – History of Financial Reporting in the United Kingdom Development of commerce Development of commerce Need to attract investment Need to attract investment Pre-requisites: Pre-requisites: Security of investment Security of investment Income stream from investment Income stream from investment

4. 4 Stimulus and Response Prior to 1844 formation of companies via Royal Charter or Act of Parliament Prior to 1844 formation of companies via Royal Charter or Act of Parliament Growth of huge infrastructure projects of 1700s and 1800s Growth of huge infrastructure projects of 1700s and 1800s Growth of Deed of settlement companies Growth of Deed of settlement companies Unregulated until 1844 Joint Stock Companies Act Unregulated until 1844 Joint Stock Companies Act Companies required to register with Registrar of Companies Companies required to register with Registrar of Companies New companies could be incorporated by registration New companies could be incorporated by registration Legal requirements to: Legal requirements to: Keep proper books of account Keep proper books of account Balance them periodically Balance them periodically Present balance sheet to shareholders at each meeting Present balance sheet to shareholders at each meeting Auditors appointed by shareholders to report on balance sheet Auditors appointed by shareholders to report on balance sheet Accounts filed with Registrar Accounts filed with Registrar

5. 5 Making it up No limited liability: shareholders = creditors No limited liability: shareholders = creditors Purpose: Purpose: To assess solvency To assess solvency Maintain capital Maintain capital Drawback: Drawback: No proper accounting policies No proper accounting policies Very flexible approach to drafting balance sheets Very flexible approach to drafting balance sheets

6. 6 The modern corporation Limited liability Act 1855 Limited liability Act 1855 Companies could incorporate with limited liability Companies could incorporate with limited liability Needed to make public the fact by Limited Needed to make public the fact by Limited Further legal moves Further legal moves 1856 Joint Stock Companies Act 1856 Joint Stock Companies Act Repealed accounting requirements of 1844 Act Repealed accounting requirements of 1844 Act But introduced: But introduced: Articles of association Articles of association Requirements of internal accounting records Requirements of internal accounting records Format for balance sheet Format for balance sheet Audit requirements – true & fair view Audit requirements – true & fair view Consolidated into first Companies Act 1862. Consolidated into first Companies Act 1862.

7. 7 Outcomes These Acts established a particular system of corporate governance in the UK. These Acts established a particular system of corporate governance in the UK. Agency theory can be adopted to explain the development of this system. Agency theory can be adopted to explain the development of this system.

8. 8 Definition Agency problems arise whenever a division of labour results in one party (the principal) delegating decision-making authority or control over resources to another (the agent). Agency problems arise whenever a division of labour results in one party (the principal) delegating decision-making authority or control over resources to another (the agent). The agency problem occurs whenever The agency problem occurs whenever (a) it is difficult or expensive for one party to evaluate the performance of the other, and (a) it is difficult or expensive for one party to evaluate the performance of the other, and (b) the motives of the parties to an exchange may be different, such that each has an incentive to act in a different or incompatible way. (b) the motives of the parties to an exchange may be different, such that each has an incentive to act in a different or incompatible way. The factors that make it difficult or expensive to evaluate the performance of the other party are due to the existence of uncertainty in environmental, organizational, or task conditions. The factors that make it difficult or expensive to evaluate the performance of the other party are due to the existence of uncertainty in environmental, organizational, or task conditions. The parties have incentives to act differently because they have different risk preferences, or because they may have different propensities to act opportunistically The parties have incentives to act differently because they have different risk preferences, or because they may have different propensities to act opportunistically Managing internal corporate entrepreneurship: an agency theory perspective Managing internal corporate entrepreneurship: an agency theory perspective Jones & Butler, Journal of Management Dec. 1992 Jones & Butler, Journal of Management Dec. 1992

9. 9 Development of the System Members/Independent Members/Independent ShareholdersAuditors ShareholdersAuditors appoint report Board of Directors report delegate monitor

10. 10 The rôle of Financial Reporting Financial Reporting is an important element of this system, being a key part of the process by which Directors meet its accountability requirements. Financial Reporting is an important element of this system, being a key part of the process by which Directors meet its accountability requirements. Financial reporting is the means by which the board of directors reports to the owners, with independent auditing monitoring on the truth and fairness of those reports. Financial reporting is the means by which the board of directors reports to the owners, with independent auditing monitoring on the truth and fairness of those reports.

11. 11 Traditional mindset Traditionally (pre-1970s) this model of corporate governance supported a particular stewardship emphasis in financial reporting: Traditionally (pre-1970s) this model of corporate governance supported a particular stewardship emphasis in financial reporting: the primary purpose of annual accounts of a business is to present information to the proprietors showing how their funds have been utilised, and the profits derived from such use (ICAEW, 1952). the primary purpose of annual accounts of a business is to present information to the proprietors showing how their funds have been utilised, and the profits derived from such use (ICAEW, 1952). This supported a traditional financial accounting framework, which included: This supported a traditional financial accounting framework, which included: An early emphasis on the balance sheet An early emphasis on the balance sheet Asset measurement at historical cost Asset measurement at historical cost Prudence in the reporting of income and expenses Prudence in the reporting of income and expenses Realisation with respect to the recognition of income Realisation with respect to the recognition of income The calculation of profit (for capital maintenance purposes) via the matching of income and expenses The calculation of profit (for capital maintenance purposes) via the matching of income and expenses Traditionally, also this system has been either lightly or self- regulated. Traditionally, also this system has been either lightly or self- regulated.

12. 12 Not quite what it says on the tin There may, however, be some problems with a stewardship emphasis to accounting: There may, however, be some problems with a stewardship emphasis to accounting: It does not help in assessing whether business activities were appropriate (i.e. commercially justifiable) It does not help in assessing whether business activities were appropriate (i.e. commercially justifiable) It will not necessarily help in predicting the future, and It will not necessarily help in predicting the future, and It provides no information with respect to the valuation of assets and the business It provides no information with respect to the valuation of assets and the business

13. 13 Stimulus & Response (again) These conflicts of interest are not a recent occurrence These conflicts of interest are not a recent occurrence Two major classes of event shift the emphasis of the role of financial reporting as an intermediary Two major classes of event shift the emphasis of the role of financial reporting as an intermediary Accounting Scandal/Failure Accounting Scandal/Failure Increasing shareholder bases Increasing shareholder bases

14. 14 Newton –v- Birmingham Small Arms Co (1906) At extraordinary meetings of the BSA shareholders in early 1906, the directors had passed a special resolution to allow them to create an "internal reserve fund" out of profits, which they could use for any purpose they thought fit. At extraordinary meetings of the BSA shareholders in early 1906, the directors had passed a special resolution to allow them to create an "internal reserve fund" out of profits, which they could use for any purpose they thought fit. Transfers into the fund might be made in any year in which the company had paid a dividend of at least 10% on the ordinary shares and had paid all preference dividends. Transfers into the fund might be made in any year in which the company had paid a dividend of at least 10% on the ordinary shares and had paid all preference dividends. The auditors were to be informed of this fund and any transfers to or from it, but they were not to be permitted to disclose information about it to the shareholders, and it was not to be disclosed separately in the balance sheet. The auditors were to be informed of this fund and any transfers to or from it, but they were not to be permitted to disclose information about it to the shareholders, and it was not to be disclosed separately in the balance sheet. The result would be the creation of a fund about which the shareholders were not entitled to be informed. The result would be the creation of a fund about which the shareholders were not entitled to be informed.

15. 15 A shot across the directors bows Challenged by Sir Arthur Newton (a shareholder) Challenged by Sir Arthur Newton (a shareholder) Upheld but on grounds that the directors might not prevent the auditors from making disclosures to shareholders Upheld but on grounds that the directors might not prevent the auditors from making disclosures to shareholders LJ Buckley argued the permissibility of inner reserves on grounds of prudence LJ Buckley argued the permissibility of inner reserves on grounds of prudence Further impetus (examples) Further impetus (examples) 1925 Company Law Amendment Committee 1925 Company Law Amendment Committee 1931 Royal Mail Case (Rex v Kylsant) 1931 Royal Mail Case (Rex v Kylsant) 1967 GEC/AEI takeover 1967 GEC/AEI takeover Common denominator is lack of control of directors activities Common denominator is lack of control of directors activities Flaw in accounting regulation? Flaw in accounting regulation? Flaw in control mechanisms/accountability of directors? Flaw in control mechanisms/accountability of directors?

16. 16 Shareholder changes Type of shareholder Type of shareholder Change in the dominant types of shareholder Change in the dominant types of shareholder leading to a significant divorce of ownership and control for certain entities and leading to a significant divorce of ownership and control for certain entities and change in the assumed information needs of these users towards a decision-useful perspective change in the assumed information needs of these users towards a decision-useful perspective

17. 17 Corporate Governance as Control Mechanism Cadbury Report 1992 Cadbury Report 1992 The majority of non-executive directors should be independent of management and free from any business or other relationship The majority of non-executive directors should be independent of management and free from any business or other relationship Non-executive directors should be appointed for specified terms Non-executive directors should be appointed for specified terms Service contracts should not exceed three years Service contracts should not exceed three years Executive remuneration should be subject to the recommendations of a Remuneration Committee made up entirely or mainly of non-executive directors Executive remuneration should be subject to the recommendations of a Remuneration Committee made up entirely or mainly of non-executive directors An Audit Committee, comprising of at least three non- executives, should be established An Audit Committee, comprising of at least three non- executives, should be established

18. 18 Further Developments Greenbury Report 1995 Greenbury Report 1995 Outlined: Outlined: The role of a Remuneration Committee in setting the remuneration packages for the CEO and other directors The role of a Remuneration Committee in setting the remuneration packages for the CEO and other directors The required level of disclosure needed by shareholders regarding details of directors remuneration and whether there is the need to obtain shareholder approval The required level of disclosure needed by shareholders regarding details of directors remuneration and whether there is the need to obtain shareholder approval Specific guidelines for determining a remuneration policy for directors Specific guidelines for determining a remuneration policy for directors Service contracts and provisions binding the Company to pay compensation to a director, particularly in the event of dismissal for unsatisfactory performance Service contracts and provisions binding the Company to pay compensation to a director, particularly in the event of dismissal for unsatisfactory performance

19. 19 And more… Hampel Report 1998 Hampel Report 1998 Viewed governance from a strict principal/agent perspective regarding corporate governance as an opportunity to enhance long term shareholder value Viewed governance from a strict principal/agent perspective regarding corporate governance as an opportunity to enhance long term shareholder value Asserted as the primary objective of the company Asserted as the primary objective of the company Previous codes focused on preventing the abuse of the discretionary authority entrusted to management Previous codes focused on preventing the abuse of the discretionary authority entrusted to management Report favoured greater shareholder involvement in company affairs Report favoured greater shareholder involvement in company affairs The Board was identified as having responsibility to maintain a sound system of internal control, thereby safeguarding shareholders The Board was identified as having responsibility to maintain a sound system of internal control, thereby safeguarding shareholders The Board was to be held accountable for all aspects of risk management, as opposed to just the financial controls as recommended by Cadbury. The Board was to be held accountable for all aspects of risk management, as opposed to just the financial controls as recommended by Cadbury.

20. 20 And more… Combined Code 1998 Combined Code 1998 Consolidation of Cadbury, Greenbury & Hampel Reports Consolidation of Cadbury, Greenbury & Hampel Reports Higgs Report 2003 Higgs Report 2003 Examined the role, independence and recruitment of non-executive directors. Examined the role, independence and recruitment of non-executive directors. Viewed the non-executive directors role as: Viewed the non-executive directors role as: making contributions to corporate strategy making contributions to corporate strategy monitoring the performance of executive management monitoring the performance of executive management satisfying themselves regarding the effectiveness of internal control satisfying themselves regarding the effectiveness of internal control setting the remuneration of executive directors setting the remuneration of executive directors being involved in the nomination, removal and succession planning of senior management being involved in the nomination, removal and succession planning of senior management Revised Combined Code 2003 Revised Combined Code 2003 Incorporates Higgs. Incorporates Higgs.

21. 21 Back to Financial Reporting Particular issues relating to financial reporting were: Particular issues relating to financial reporting were: Content issues relating to creative accounting (the exercise of choice in accounting to improve the performance and position of the business – EPS and gearing ratio in particular), which appeared not to be effectively addressed by the auditing function or the efficiency (ability to see through) of the stock market. Content issues relating to creative accounting (the exercise of choice in accounting to improve the performance and position of the business – EPS and gearing ratio in particular), which appeared not to be effectively addressed by the auditing function or the efficiency (ability to see through) of the stock market. Context issues relating to the nature and effectiveness of the regulation of financial reporting in curtailing creative accounting Context issues relating to the nature and effectiveness of the regulation of financial reporting in curtailing creative accounting