BAB 12 (PALEPU)

COMMUNICATION AND GOVERNANCE

Financial market meltdowns in Asia & USA in the early 2000s, the global
financial crisis that began in 2008 & European sovereign crisis in 2010-2011
proved the problems of accounting misstatements & lack of corporate
transparency, as well as governance problems & conflicts of interest among the
intermediaries charged with monitoring management and corporate disclosures.
It increased the challenge for managers in communicating credibly with
skeptical investors. While financial reports (the traditional communication
platform) has already viewed with skepticism following a number of widely
publicized audit failures.
The Sarbanes-Oxley Act
attempts to increase accountability & financial competence for audit
committees, external auditor, CEO, & CFO
The Dodd-Frank Act
attempts to protect investors by increasing the transparency &
accountability of credit rating agencies

Governance Overview
Conflict of Interest : Investor vs Management
Outside investors require access to reliable information on firm
performance, but manager tends to paint a rosy picture of the firms
performance in their disclosure.
There are 3 reasons why managers behave like this :
1. Most managers are genuinely positive about the firms prospects.
2. Firm disclosures play an important role in mitigating agency problems
between managers & investors.
3. Managers are also likely to make optimistic disclosures prior to issuing
new equity.
Entrepreneurs tend to take their firms public after disclosure of
strong reported, but frequently unsustainable, earnings
performance.
 Financial & information intermediaries help reduce agency & information
problems faced by outside investors.
The level & quality of information & residual information & agency problems
in capital markets are determined by the organizational design of these
intermediaries & regulatory institutions.

Management Communication with Investors

Some managers argue that communication problems are not worth
worrying about. They maintain that as long as managers make investment &
operating decisions that enhance shareholder value, investor will value their
performance & the firms stock accordingly.
Does it matter if a firm is over- or undervalued for a period?
Most managers would prefer to not have their stock undervalued or
lenders over-estimate their firms risk, since it makes it more costly to
raise new financing. Undervaluation also more likely increase the
chance of a takeover by a hostile acquirer, with an accompanying
reduction in their job security.
Managers of firms that are overvalued may also be concerned about
the markets assessment, since they are legally liable for failing to
disclose information relevant to investors.

It is natural that many managers believe that firms are undervalued by

the capital market because it is difficult for them to be objective about their
companys future performance & its part of their job to sell the company. In
addition, forecasting the firms future performance objectively requires them to
judge their own capabilities as managers.

Ex : Communication Issues for Jefferies Group, Inc.

In 2011, Jefferies Group, Inc. was a mid-sized global securities &
investment banking firm that had been in business for almost 50 years. They
managed to not only survive but also expand its global operations (esp in
Europe) in the 2008 crisis.
 In early October 2011, Jefferies stock price declined precipituously
concerned by the firms exposure to the growing European debt crisis. The firms
management issued a press release on October 31 explaining that it had only
minimal exposure but failed to stem the markets concerns. Then, the rating
agency downgraded their debt. Jefferies made a quick respond by issuing 2
increasingly detailed press releases on the same day disclosing its limited
exposure.
The declining stock price was continued in November & the market
expected that the company would generate a ROE lower than its cost of capital.
Jefferies management expressed surprise & frustation at the sharp drop in price
& argued that the market was unjustly punishing the firm for exposure that it
didnt have.

COMMUNICATION THROUGH FINANCIAL REPORTING

Accounting as a Means of Management Communication
Financial reports are an important medium for management communication
with external investors
Reports provide investors with an explanation of how their money has been
invested, a summary of the performance of those investment, and a discussion of
how current performance fits within the firms overall philosophy and strategy.
Accounting reports not only provide a record of past transaction but also reflect
management estimates and forecast of the future.
Factors That Increase The Credibility of Accounting Communication
1. Accounting Standards and Auditing
2. Monitoring by Financial Analysis and Rating Agencies
3. Management Reputation
Limitations of Financial Reporting for Investor Communication
1. Accounting Rule Limitations
2. Auditor, Analyst, and other Intermediary Limitations
3. Management Credibility Problem

ALTERNATE FORMS OF INVESTOR COMMUNICATION

 Given the limitations of accounting standards, auditing, and monitoring
by financial analysts, as well as the reporting credibility problems faced by
management, firms that wish to communicate effectively with external investors
are often forced to use alternative methods.

VOLUNTARY DISCLOSURE
Another way for managers to improve the credibility of their financial
reporting is through voluntary disclosure. Voluntary disclosures can be reported
in the firm's annual report, in brochures created to describe the firm to
investors, in management meetings with analysts, or in investor relations'
responses to information requests.
Managers then face a trade-off between providing information that is
useful to investors in assessing the firm's economic performance and
withholding information to maximize the firm's product market advantage.
A second constraint in providing voluntary disclosure is management's
legal liability Consequently many corporate legal departments recommend
against management providing much voluntary disclosure. One aspect of
voluntal), disclosure, earnings guidance, has been particularly controversial.

THE ROLE OF THE AUDITOR

In the United States the auditor is responsible for providing investors
with assurance that the financial statements are prepared in accordance with
U.S. Generally Accepted Accounting Principles, or U.S. GAAP, and that the
company maintains effective internal control over its financial reporting.
This requires the auditor to evaluate whether transactions are recorded
in a way that is consistent with the rules produced by regulators (including the
FASB, PCAOB, and SEC), whether management estimates reflected in the
financial statements are reasonable, and whether the company maintained
effective internal financial control systems.
The results of the audit are disclosed in the audit report, which is part of
the financial statements.

THE AUDITOR ISSUES AN UNQUALIFIED REPORT IF :

a) The firm's financial statements conform to U.S. GAAP,
b) The accounting methods are applied consistently throughout the prior three
years,
c) The internal financial reporting controls are adequate as of the end of the
audit period, and
d) There is no substantial doubt about the firm's ability to survive.
If the financials do not conform to U.S. GAAP, the auditor is required to
issue a qualified or an adverse report that provides information to investors on
the discrepancies. If the auditor is uncertain about whether the firm can survive
during the coming year, a going concern report that discusses the firm's survival
risks is issued.
If the auditor is uncertain about whether the firm can survive during the
coming year, a going concern report that discusses the firm's survival risks is
issued.
In contrast, in the United Kingdom and countries that have adopted the
U.K. system, such as Australia, New Zealand, Singapore, Hong Kong, and India,
auditors undertake a broader review than their U.S. counterparts. Their audits
are required to not only assess whether the financial statements are prepared in
accordance with accounting standards, but also to judge whether they present a
"true and fair view" of the client's underlying economic performance. This
additional assurance requires more judgment on the part of the auditor and
increases the value of the audit to outside investors.

THE ESSENTIAL PROCEDURES INVOLVED IN A TYPICAL AUDIT INCLUDE

1. understanding the client's business and industry to identify key risks for the
audit,
2. evaluating the firms internal control system to assess whether it is likely to
produce reliable information,
3. performing preliminary analytic procedures to identify unusual events and
possible errors, and
4. collecting specific evidence on controls, transactions, and account balance
details to form the basis for the auditor's opinion
 In most cases client management is willing to respond to issues raised by
the audit to ensure that the company receives an unqualified audit opinion. Once
the audit is completed, the auditor presents a summary of audit scope and
findings to the Audit Committee of the firm's board of directors.
It is worth noting that in both the U.S. and U.K. systems (and for that matter
elsewhere), the audit is not intended to detect fraud. Of course in some cases it
may do so, but that is not its purpose. The detection of fraud is the domain of the
internal .audit department of the firm itself.

ROLE OF FINANCIAL ANALYSIS TOOLS IN AUDITING

1. Strategy Analysis
2. Accounting Analysis
3. Financial Analysis
4. Prospective Analysis

THE ROLE OF THE AUDIT COMMITTEE IN THE UNITED STATES

Audit committees are responsible for overseeing the work of the auditor,
for ensuring that the financial statements are properly prepared, and for
reviewing the internal controls at the company. Audit committees, which are
mandated by many stock exchanges and by the SEC, typically comprise three to
four outside directors who meet regularly before or after the full board meetings.
The audit committee is expected to be independent of management and to
take an active role in reviewing the propriety of the firm's financial statements.
Committee members are expected to question management and the auditors
about the quality of the firm's financial reporting, the scope and findings of the
external audit, and the quality of internal controls.
In reality, however, the audit committee has to rely extensively-on
information from management as well as internal and external auditors. Given
the ground that it has to cover, its limited available time, and the technical nature
of accounting standards, audit committees are not in a position to catch
management fraud or auditors' failures a timely basis.
The audit committee also receives regular reviews of company
performance from management as part of their board duties. Committee
members should be especially proactive in requesting information that helps
them evaluate how the firm is managing its key risks, since this information can
also help them judge the quality of the financial statements.