Costs and benefits of financial reporting enforcement

Often, the attention of the media turns to accounting scandals in companies that seemed to be above suspicion. And when this happens, there are calls for a more effective regulatory and enforcement system. Many insist that to protect investors, and stakeholders in general, the regulatory framework and oversight mechanisms must be revised. But are such measures actually effective?

At an institutional level, a key element is the system of enforcement regarding financial statements and financial reporting by listed firms. An effective system functions in different directions. Above all, it can contribute to protecting investors, which in turn shores up confidence in the markets. Clearly regulatory bodies are better positioned with respect to investors to identify possible errors, accounting distortions and information gaps. Yet for company shareholders, more rigorous enforcement can also lead to a net loss in value. At a company level instead, intense enforcement can have two additional repercussions: increasing compliance costs due to higher audit fees, while simultaneously generating higher quality financial reporting. This specifically refers to diminishing discretionary accruals, that is, entries on the balance sheets that do not correspond to actual monetary transactions. There are numerous discretional accruals choices included in corporate financial statements, many of which can lend themselves to misleading earnings management practices when adequate enforcement by regulatory bodies is lacking. More intense enforcement can improve the quality and transparency of the information provided to the market.

In the UK, the body responsible for enforcing the implementation of accounting standards is the Financial Reporting Review Panel (FRRP), a subsidiary of the Financial Reporting Council. Beyond its ordinary activity, from 2004 to 2011 the FRRP adopted a proactive approach to enforcement. Each year the panel selected the financial statements of companies in certain industrial sectors, which were deemed priority. The sectors that would be subject to proactive review were announced at the end of the previous year. This gave the impacted companies time to prepare for the enhanced enforcement. The announcement ex-ante and the selection of the priority sectors makes the enforcement activity of the FRRP a unique experience, one that is particularly well-suited to revealing the concrete consequences of more intensive enforcement. In fact, we can pinpoint the costs and benefits in any given year by analyzing the sectors chosen for review and comparing them to the ones that were not.

Based on this premise, we conducted a a study on the costs of compliance and the quality of financial reporting of 2.709 non-financial companies listed on the Main and the Alternative Investment Market (AIM) segments of the London Stock Exchange from 2000 to 2011. As regards the costs of compliance, the companies in sectors under review saw an average increase of 6.8% in audit fees in the year in question. However, this rise is particularly significant for companies listed on AIM (the less-regulated segment, consisting of younger companies that are more financially constrained with respect to the Main segment). In addition, higher audit fees proved to be a transitory effect which dissipated when the sector was no longer under review. The transitory nature of these costs indicates that more intense enforcement did not represent an opportunity for auditing companies to mark up the pricing on their services permanently; instead higher pricing reflects higher demand by companies for an accurate and exhaustive audit.

As for the benefits, our study reveals that more scrupulous enforcement is associated with better-quality financial reporting, with a sizeable reduction in accruals. However, this improvement is limited to companies on the Main segment, and to the more discretional components of accruals, that is, operating accruals (-2.1% in review years), in particular the sub-components of non-current operating accruals (-1.6%) relative to long-term operating activities. This indicates that in the years of proactive enforcement, listed firms manifest a more prudent and conservative approach to accruals.

Proactive enforcement involves regulatory bodies alerting the companies that may be subject to financial reporting review,a measure which could generate costs and benefits. On one hand, proactive intervention by regulators is associated with an increase in audit fees. Specifically, the higher a company’s risk level and the weaker its internal governance mechanisms, the larger this increase will be. On the other hand, our findings show that enforcement leads to more conservative management of discretionary accruals. Among the companies in our study, those which were more financially sound and had a more independent audit committee seemed to exercise greater caution in this regard. In fact, these are the very organizations which have a bigger incentive to provide better quality financial reporting.

Broadly speaking, regulators must be aware that more intense enforcement action augments both costs and benefits, but not always for the same companies. Instead more intense enforcement action is most advantageous to organizations that are more sound and better structured. What remains to be verified is whether this cost/benefit trade-off is reflected in the market valuations of the companies in question.