In majority of cases, the report starts saying ‘directors are pleased to present accounts,’ reproduces operating results that mention dividend amount, if declared, informs that ‘spring is around the corner’ and finally acknowledges the efforts of staff and thanks them.
It is of no value to users; it is there only because the law mandates it. If it were excluded, it would not affect users in any way whatever. The situation should have raised serious concerns but half a century has not been enough time to attract attention. There may be many reasons for this situation to continue unhindered and unhampered. For example, one of the reasons might be that the stock exchanges are virtually led by self-serving brokers who would not or cannot see beyond their personal gains. Another reason might be that the companies are, by and large, controlled and managed by owner-directors who run them like ‘corner shops’. The minority shareholders are an anonymous class and are not to be worried about.
The minority shareholders the world over are at great disadvantage but various associations and forums help them. Wishing here to be so may be likened to asking for moon. Unfortunately, institutional investors, e.g., the ICP or the NIT, whose nominees sit on boards of various companies have not played a desirable role. Yet another reason might be that Section 236 of the Companies Ordinance, 1984 that requires directors to publish their report along with a balance sheet does not prescribe any details that the report must contain. Given the corporate culture, this position is exploited by majority of the companies to its fullest measure.
The purpose of financial statements is to facilitate wide-range of users in making economic decisions. (Paragraph 12, Framework, International Accounting Standards). Another objective of financial statements is to show the results of the stewardship of management, or the accountability of management for the resources entrusted to it to enable users to make decisions; for example, whether to hold or sell their investment in the enterprise or whether to reappoint or replace the management, (Paragraph 14, Framework, IAS).
The financial statements however suffer from ‘terminal illness’, which is in its genes as identified by no other than the IASC. Paragraph 13 of the Preface to IASs cautions that: Paragraph 13—” financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effect of past events and do not necessarily provide non-financial information.”
The traditional accounting therefore suffers genetically. As pointed out by Syed Masoud All Naqvi, traditional accounting provides a historical look at financial data that is a “fuzzy approximation of a distant past”. (“Accountants’ Role in Revival of the Economy”, The Pakistan Accountant, May-June 2001, pages 33-41). The authors of the book ‘Strategy-focused Organization’ have called profit as a ‘lag-indicator’. That is, profit is a measurement after the fact; by the time we get information, it is already too late’.
Being a weakness of genes, no matter even if the infrastructure of disclosures were over-loaded, the balance sheet would still structurally not portray anything other than the financial effects of past events.
Rational decisions, for exmple ,whether to hold or sell investments or whether to change or not to change the management or evaluation of financial position or performance, etc, cannot be made on the basis of information relating to past only. Bill Hess, President and CEO of the Canadian Venture Exchange, has said: “People who invest in a company want to have a sense of assurance about how it’s managed... Investors want to ... (have) an eye on the company’ s direction.” (Simon Hally, “From boys club to culture club”, CA magazine, August 2001, pp 14-20, Canadian Institute of Chartered Accountants). “The people who read financial statements are interested in the future.
Bankers and suppliers want to know if obligations will be met. Investors want to know if their expectations will be met, adds Naqvi. (“Accountants’ Role in Revival of the Economy”, The Pakistan Accountant, May-June 2001, pages 33-41).
The core purpose of directors’ report is or should be to compensate financial statements’ weakness of genes. The directors in their report must provide information that deals with corporate dynamics and enables the user to know the ‘company direction, to understand the main influences on the overall results and how they interrelate and to become aware of the factors that either have varied in the past or are expected to change in the future.
A number of jurisdictions have already taken steps to make the directors’ report of real value for users. For instance, the Hong Kong Society of Accountants has prescribed comprehensive Operating Review Report under which directors’ of quoted companies are required to report on a total of about 100 different aspects concerning 13 aspects relating to business dynamics that virtually ‘push into the open’ almost ‘every nook and corner’ of company’s business dynamics profile. The company law must respond to reality on ground.
This differs from country to country. Hence, different countries have significantly different provisions. (See link 1 below). Our Companies Act 1987 is based largely on UK’s Companies Act. While our Act, barring few minor amendments, is still in its original shape for the last 20 long years, substantial and very significant changes have been made more than once in the UK Act.
The UK’s Act is again presently under total overhaul under the project aptly titled “Modern Company Law for a Competitive Economy”. It is time for the Security Exchange Commission to subject the extant Companies Ordinance, 1984, to full scale review and make it responsive to reality that exists on the ground here; meanwhile, format of the directors’ report should be provided in the Act on priority basis. (See link 2 below).
Furthermore, directors’ report is not a part of financial statements and is therefore outside the scope of statutory audit. It is suggested that it should be made a part of the financial statements and auditors should be obliged to report on it when on the basis of financial statements in their opinion the information given by directors in their report doesn’t represent a true and fair picture of the state of affairs. (See link 3 below).
Linkages:1A. To give random examples, UK’s proposed Companies Act shall, inter-alia, include provision for a statutory statement of directors’ duties to encourage responsible and informed decision-making. The statement will give clear guidance to directors on what is expected of them, and will bring over 250 years of court decisions into line with modem business practice.
Directors will continue to be accountable to their shareholders and will also need to take due account of wider interests such as relations with employees, suppliers and customers. The impact of actions on the community and the environment will also move up the agenda. 1B. In Germany, if there is a loss of 50per cent of the share capital the managing director must notify shareholders. Liquidation should also be considered. The managing director is exposed to personal liability if corrective action is not taken and the company then fails. 1C. In Japan and Greece, holders of 10per cent and 5per cent shareholding respectively can force the EGM, require information from directors or seek an investigation.
2. Peter C Dey, former chairman of the committee on corporate governance established by the Toronto Stock Exchange is of the view that corporate governance does not lend itself to regulations from public sector. “Regulations for corporate governance should come from the market, and not imposed by the public sector, he observes. In view of the situation obtaining in the stock exchanges and the state of corporate culture, regulations in Pakistan have per se to be imposed by public sector.
The McKinsey & Co, Consultants’ survey of attendees of IFC’s Global Private Equity Conference held on 9-11 May 2001 has shown 55 per cent of the respondents to be of the view that reform of institutional context__ reform driven by governments, local stock exchanges, and regulatory bodies__ was at least as important as reforms of companies__ 46 of these respondents manage assets of about $5 billion, 90 per cent of which is in emerging market. Financial transparency was said to be the most important need. The adoption of internationally recognised legal standards and enhanced shareholder rights were respectively the second and third most immediate pressing needs. Boards’ reform, as an immediate pressing need, came only fourth.
The Security Exchange Commission of Pakistan (SECP) is appointing the chief executive officers of the stock exchanges for last 3-4 years. This is sufficient time for the CEOs to have studied why local stock exchanges lack in dynamism and aren’t proactive as elsewhere, e.g. the initiatives for corporate governance elsewhere have come invariably from the stock exchanges. The Commission in this regard may like to study the interim report of the joint committee established by the Toronto Stock Exchange and the Canadian Institute of Chartered Accountants.
The most pertinent aspect of this report is that, as clarified in the report, unlike other reports on governance, it deals with the situation where majority of the companies are either foreign held subsidiaries or are closely held companies. This situation is more close to the local corporate scenario than the scenario catered to by other reports.
In its aptly titled report “Beyond Compliance: Building a Corporate Culture released in March 2001, the ‘Committee’ has observed, “disclosures are increasingly concerned with structure, as opposed to behaviour.” The ‘Committee’ is of the view that “governance efforts need to refocus and concentrate more on behaviour and less on structure.” The “Committee’ says, “We believe that what boards do and how they do it is more important than their structure.” “It is important to explore how the capacity of the boards to govern well can be increased through such means as the selection, training and assessment of directors”, it adds. In other words, the ‘Committee’ is concerned with issue like the minimum orientation and competency requirement for a director? The ‘Committee’ has approvingly quoted conclusion from an article “The Active Board’ of Directors and Performance of the Large Publicly Held Corporation” by Ira Mill Stein “ published in Columbia Law Review, (Vol. 98, pp. 1283-1322). Being highly relevant it is reproduced below:
“To me it is intuitively correct that to maximise the corporation wealth-producing capacity we must ensure that the accountability mechanism provided in the legal structure of the governance system works... Think about it: No one questions that the CEO’s performance matters a great deal to corporate performance. And the board is charged with hirer., the best CEO it can find, helping the CEO set goals and priorities for the long-term viability of the corporation, monitoring his or her accomplishments against those goals and, if necessary, replacing him or her in a timely manner. How can board performance not matter to corporate governance?”
2A Hopefully, the SECP and the CEOs of the stock exchanges may be about ready to put in place major strategic policy initiatives to uplift the working of the stock exchanges to international standards.
3A. In the UK, besides other requirements, directors are required to disclose how the board discharges its responsibility for internal control (including risk management) by summarizing the process it has applied in reviewing the effectiveness of the system of internal control. In addition, the external auditors are required to review the directors’ statement of compliance with regard to this process. 3B. In the USA, auditors are required also to discuss with the audit committee information related to judgments about the quality, not just the applicability, of a company’s accounting principles. 3C. Again in the US, the SECP has established a Financial Fraud Task Force to focus exclusively on financial reporting and accounting investigations in response to what it saw alarming increase in financial reporting irregularities. Over 360 companies, including several large multinationals restated earnings in year 2000 and in just nine of these cases, investors lost $41 billion in market value within a week.
The writer is working as Technical Manager in the Institute of Chartered Accountants of Pakistan. The views are not shared by the Institute.