Corporate Governance Mechanism and Quality of Financial Reports in the UK

Introduction

Hamilton and Micklethwait (2016) stated that the quality of financial reporting has received criticisms because of wave of accounting scandals such as Parmalat, Enron and WorldCom. The poor quality of financial reporting has weakened the confidence of investors in financial reports and management team. The failure of financial disclosures has prompt the need to improve the quality financial as well as strength the management control through good corporate governance.

Cao, Myers and Omer (2012) discussed that financial report is an important source of information for investors to make investment decisions in capital markets. The financial report of a company enables the firm stakeholder’s to analyse past performance, monitor actions of managers and predict future performance of firm. The linkage between financial information and corporate includes governance mechanism, director shareholding, board independence and auditor reputation.

The goal of this report is to analyse how corporate governance mechanism can improve the quality of financial reporting in the UK context. The focus is how corporate governance mechanism improves and influences the quality of financial reports.

Corporate governance mechanism

McCahery, Sautner and Starks (2016) indicated that corporate governance is defined as the way through which organisations are directed and controlled. It enclosed the system of rules, processes and practices to balance the interest of company stakeholders such as customers, management, shareholders and suppliers. The figure 1 below enclosed the concept of corporate governance and how it affects the quality of financial reporting. The bounded rationality of principle (shareholders) provides opportunistic tendencies for the agent (shareholders). This represents the gap between the level of confidence and information need of shareholders.

According to agency theory the availability of good quality information enable the principle to access the performance and activities of agent and thus principal intended to act in best interest of principal (Bushee, Carter and Gerakos, 2013).

The figure 1 enclosed interrelationship between various actors of corporate governance mechanism. The interaction includes relationship between external auditor and audit committee, internal auditors, the board and management to achieve high quality of financial reporting (Singh and Davidson, 2013).

corporate governance and financial reporting quality

Corporate governance mechanism in the UK context

In 2015, FTSE 350 figures highlighted that company compliance with UK governance code has dropped from 93.5% to 90% and overall compliance rate decreased from 61% to 57%. In the UK, company compliance with ‘UK corporate governance code published by the financial reporting council (FRC). The main section of the code is leadership, accountability, effectiveness, remuneration and relationship with shareholders. Corporate governance is principle based approach and it is based on ‘Combined Code (2003)’ (Nordberg and McNulty, 2013).

The combined code elaborate boards structure, role and responsibilities of director, financial reporting, audit and auditor role and communication with shareholders. Corporate governance code helps the companies to manage risk, prevent abuse of power and reduce mismanagement. Corporate governance is important to identify strength and function of organisation and ensure quality of financial reporting process (Tihanyi, Graffin and George, 2014).

Quality financial reporting

Dehaan, Hodge and Shevlin (2013) analysed that financial reporting is a practice which discloses financial status of company to external stakeholders. Financial reporting includes an external financial statement such as income statement, balance and cash flow statement. The primary objective of financial reports is to provide stakeholders with high-quality financial and non-financial information to highlight the performance or organisation. The quality of financial reporting involves factors such as financial statements, earning management and fraud and thus, management of these factors is important for high-quality financial reporting process.

Shi, Connelly and Hoskisson (2016) added that the value of high-quality financial reporting has the positive influence on stakeholders and capital providers. The resource efficiency highlights the past performance and future potential profitability to enhance market efficiency. Therefore, it important financial reports are prepared with integrity to improve trust and confidence of stakeholders. The financial reporting has affected the quality and reliability of information based on corporate governance of the organisation. The key players involve the board of directors, internal and external auditors and audit committee (Hamilton and Micklethwait, 2016).

Relationship between quality financial reporting and corporate governance

Wang and Hussainey (2013) evaluated that the financial reporting plays an important role to connect people involved in the corporate governance mechanism. This includes shareholders, board of directors, analyst, auditors and information distributors. It bridges the gap between the stakeholders through communication and measure the performance of company. The financial information is important and first source of true and independent information and manager use it to communicate performance of company. The financial reporting integrity depends upon conduct of people involved in financial reporting and these are management, auditors and directors.

Cohen et al (2013) added that financial reporting is important communication channel for financial information. Integrity of financial reporting is contingent upon the corporate governance. The board of directors are responsible for financial reporting progress and produce financial statement which company is profitable and going concern. Moreover, financial report assures the wide range of stakeholders on future performance of company. Moreover, auditor reviews the corporate reporting and gives opinion on integrity of the financial by giving true and fair view on the reported information (Bushee, Carter and Gerakos, 2013).

Corporate governance and quality financial reporting in the UK context

Board of director

According to Van den Berghe (2012), board of directors and audit committee influence the corporate governance mechanism. The board is responsible for sustainable financial performance and create long-term value for shareholders. Board is accountable to shareholders and review policies and financial performance of company. The board of company set standards and values along with obligation towards stakeholders.

The various factors of board and audit committee which affect the quality of reporting includes independence, composition, knowledge and expertise, roles and responsibilities, effectiveness and relationship between earning manipulation, fraud and board characteristic (Van den Berghe, 2012).

Independence and Composition of board

Knyazeva, Knyazeva and Masulis (2013) highlighted that the relationship between structure of board and quality of financial reporting is examined through the composition and size of board (Number of executive and nonexecutive directors), role and responsibilities (separation of CEO and Chairman) and independence of the board (number of independent director on board) is important to review financial reporting process. The composition of Board of director’s has significant effect on governance of organisation. The size of board influences the quality of financial reporting. The smaller board size increase degree of coordination as well as communication among director and with managers.

On the other hand, large board size reduces the information content as well as intensifies the earning management. The increase number of directors improves the value relevance of financial statements. In the UK, financial reports enclosed role of chairman along with number of executive and non-executive directors. The financial report enclosed composition of board, appointments, interdependence and outcome of board actions (McCahery, Sautner and Starks, 2016).

Shi, Connelly and Hoskisson (2016) elaborated that independent board mitigates the earning management as well as quality of information increases with outside directors. In the UK, board independence allows to disclose the good quality information of the firm. Corporate governance literature highlights the importance of separate position of CEO and chairman to ensure the independence of board and increase transparency of information content.

Tepalagul and Lin (2015) explained that the single CEO-Chairman increases the violation likelihood for accounting standards and reduces the quality of financial information. In the UK, separation of board of chairman and director is relevant to case of financial reporting through improved quality of information content. It is common practice in the UK to include separate statement from the CEO and chairman highlight the vision and performance of company. This assures the stakeholders the role and responsibilities of CEO and Chairman are separated (Krause, Semadeni and Cannella, 2014).

Knowledge and expertise

Wang, Xie and Zhu (2015) stated that it is important that board members have financial literacy and one member should be financial expert and it is important in context of audit committee. The activities for general reporting include internal control management, auditing, communication with external auditors. The strength of financial reports is enhanced through highlighting the strategic review conduct and area of board endorsement to improve financial reporting process. The financial report enclosed tenure of board and time spend on various activities.

For example, In the UK, financial reports enclosed detail section on directors’ experience and function which ensure the stakeholder about independent of directors. The degree of consensus and expertise in auditing enable to elaborate the disputes from auditor side and increase credibility of financial reporting process (Tricker, 2015).

Power and Effectiveness

Bain and Band (2016) highlighted that the dimension of power and effectiveness highlight the importance of three roles which are communication with external auditors, financial reporting and internal control. The knowledge power is important to effectively perform the function. Reporting integrity increased through highlighting the board work during the year and this allows the investors to understand present and future priorities of company. The importance of leadership attributes such as transformational leadership is important in order to evaluate the opportunities and risk associated with business (Bain and Band, 2016).

For example, Tullow plc financial report enclosed detail information on financial reporting process. The power of enable to undertake responsibilities based on timely communication of information and support from the organisation. For example, TESCO previous CEO Philip Clarke has enable the company to expand the business into Asian markets. Moreover, financial reporting context in the UK highlight division of responsibilities of directors to improve the quality of financial reporting (Wang and Hussainey, 2013).

Role and responsibilities

In the UK, financial reports enclosed profiles of directors along with role and responsibilities. The quality of information improved through including experience of team. The professional standards highlight that role and responsibilities of director to improve the quality of financial reporting falls into three categories which are internal controls, audit and communication with shareholder and external auditors. The ability to lead committees and ensuring the effectiveness of financial statements, reviewing internal and external auditors and management communication is important (Abbott et al., 2016).

For example, ARM holdings plc discloses experience of director team and increase communication and coordination and companies enclosed the number of meeting held between board and committee (Van den Berghe, 2012).

Earning manipulation and fraud

The board characteristic and ownership structure affect corporate financial performance in terms of fraud. The board characteristic such as proportion of outside director, tenure of chairman and number of board meeting are associated with fraud incidence. The ownership structure of firm has positive affect on the financial reporting quality. For example, Ahmed et al (2006) studied that in Enron audit committee associated with correction of earning, lower incidence of litigation fraud and auditor turnover action because reporting dispute with management (Noor et al., 2015).

In addition, the presence of block holder is useful to control the discretionary behaviour of managers through selecting profitable strategies and reliable information. For example, TESCO enclosed in-depth review on governance structure, member of board and management control to assure external stakeholders about the financial reporting process and quality of information content. The likelihood of fraud decrease with increase in number of outside directors and in context of UK governance, the UK companies has three non-executive directors on the boards to review financial reporting progress (Cao, Myers and Omer, 2012).

Audit function and Quality of financial reports

Tepalagul and Lin (2015) elaborated that audit is useful to increase reliability and quality of financial report because it examines financial statement and reporting process. The role and function of external auditor is important aspect of corporate governance in order to ensure quality of financial result and thus increase value of information content. The audit committee reduce financial reporting problem incidence. The external audit is important way to monitor the actions of manager and well as improve the integrity of financial reports. The good quality of internal audit is useful to increase reliability of financial reporting because it discourages earning manipulation (Pizzini, Lin and Ziegenfuss, 2014).

Internal Audit and Audit committee

Abbott et al (2016) analysed that the audit committee and internal auditor have close relationship in term of improving financial reporting of company. The meeting between internal auditor and audit committee has positive influence on the integrity of financial reporting process. The strength of internal is depending upon the ability to access to the information within the company.

Audit committee ensures that financial reporting standards are followed and liaison to strength the internal control. The number of meeting held by audit committee has direct influence on value of information through better financial knowledge and independence. In the UK, audit committee act independently to review the effectiveness of process and financial reporting process (Wang, Xie and Zhu, 2015).

Ege (2014) added that Audit committee review the work performed by the internal audit and ensures it acts as independent function and implies financial standards. Internal audit monitor the activities of organisation and help the management to improve performance through financial and non-financial performance measures evaluation. Internal audit function of company processes detail and in-depth knowledge of company processes and ensure the integrity of financial process. In the UK, company disclose information on internal controls as well as section, independence of auditor and appointment of auditors to improve quality of information (Wang and Hussainey, 2013).

External audit

Cohen et al (2013) stated that the role of external auditor is important to increase the quality of financial reporting and auditor must coordinate with audit committee for integrity of financial reports. The three important stages include auditor selection, audit quality and audit opinion. The auditor selection is important to increase investor confidence in financial reporting. The independent external auditor appointment reduces the earning manipulation probability through lessening the managerial opportunisms.

Ege (2014) stated that in the UK, companies communicate the appointment and selection of external auditor with shareholders. The quality of audit is important and influences the financial reporting process. Moreover, reputation of auditor has positive affect on the quality of financial reporting. Audit firm BIG 4 (KPMG, PricewaterhouseCoopers, Deloitte and Ernst and young) increase the reliability of financial information when compare with other companies (Krause, Semadeni and Cannella, 2014).

In the UK, FTSE listing companies have big 4 as their auditor to review the integrity of financial statements. The auditor assessment of risk (substantive testing) enhances the value of information and reporting process. The use of external auditor increases reliability of information content among stakeholders based on true and fair view statement for financial statement. For example, in the UK, The financial statement discloses copy of true and fair statement issued by the auditor to improve confidence and trust of stakeholders in financial reporting (Tepalagul and Lin, 2015).

Conclusion

Corporate governance is important to enacted rules and regulation because of large corporate scandals. In the UK, corporate governance issues are managed through the application of UK corporate governance code. The adherence to corporate governance is high in the UK and companies following rules set in the code. The relationship between corporate governance and quality of financial reporting is evident for the quality of financial reporting.

Board of directors is cornerstone of financial reporting quality through overseeing the reporting process and manage a strategic aspect of the business to ensure the integrity of process and value of information content. Internal audit monitors the activities of the organisation and helps the management to improve performance through financial and non-financial performance measures evaluation.

The audit committee reviews the work performed by the internal audit and ensures it acts as independent function and implies financial standards. The independent external auditor appointment reduces the earning manipulation probability through lessening the managerial opportunisms and improves the quality of financial reports.

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