Poor financial reporting by banks and other financial institutions can be seen as a core contributor to the financial crisis and the lack of trust in the financial sector that ensued. Despite the lessons of a decade ago, we are still hearing of accounting scandals today – Tesco, BT, Carillion to name but a few.
Financial reporting is critical to trust in business. Misleading accounts will undermine the confidence of investors and other stakeholders to the point where financial support can dry up and the franchise is lost.
Yet this is more than just a question of conforming to the rules laid down by standard setters. Most accounting involves judgment and all judgment contains an ethical dimension.
Fund managers should always remember that International Financial Reporting Standards (IFRS) are principles-based; therefore, financial statements which are prepared in accordance with IFRS reflect judgments and assumptions made by boards.
To analyse financial statements properly, fund managers need to be competent on matters of financial reporting. These judgements and assumptions are, by their very nature, subjective, have ethical dimensions and are prone to management bias. Professional investors should be particularly vigilant to ensure that the judgments and assumptions used are not unduly optimistic.
A half empty bottle should not be presented as a half full one. Rather accounts should reflect the neutrality supported by prudence, which is one of the essential hallmarks of responsible financial reporting.
The hallmarks of responsible financial reporting are not negotiable. They are: Truthfulness, integrity, fair presentation and freedom from bias, prudence, consistency, completeness and comprehensibility.
Bearing in mind that shareholders are the primary users of financial statements, they should provide feedback - both positive and critical - to boards of investee companies about the quality of their financial reporting, especially their consistency and comprehensibility.
Indeed, those who are signatories to the UK Stewardship Code have a responsibility to consider the quality of a company's reporting and they should not shirk from fulfilling this.
Their views should be seen as invaluable and should be listened to and evaluated carefully by independent non-executive directors.
My final point is one of training. To analyse financial statements properly, fund managers need to be competent on matters of financial reporting. Yet many seem unwilling or unable to engage on such matters with confidence and conviction.
Fund management houses must improve the competence of their fund managers by investing much more in their training and continuing professional development to ensure they not only have a solid grounding in analysing financial reports but also stay up to date with emerging issues.
Only by doing this can they effectively hold boards to account, consistent with the public interest, and thereby fulfil the substance of their stewardship responsibilities to their clients.
Guy Jubb is the author of a Board Briefing from the Institute of Business Ethics, called: Responsible Financial Reporting: doing the right thing.
