Disclosures in Financial Statements for better Governance

When there is a contentious issue that requires disclosure, most people throw out the excuse that shareholders rarely read this information or they won’t understand the issue and therefore should not confuse them! In practice this may be true, for small investors. However, companies are obliged to make disclosures to provide information that would not otherwise be obtainable and on which informed decisions can be made. When management understands that they will have to publish something which was not appropriate they would be very careful. Thus disclosure requirements will guide the decisions of management if they know in advance that they will have to reveal the information later.

The need for better disclosures is important to deter management and directors unilaterally misusing or mismanaging companies. Disclosures other than in financial statements like for SEC or regulatory purposes also are very important.

For example, to prevent excessive remuneration being drawn by directors and executives, Switzerland opted for public disclosure of compensation. In addition to disclosure, Switzerland also mandated shareholder vote. Its the so-called “say on pay” mechanism of the ordinance in 2014. The logic is that companies will adjust their behavior to ensure the proposals are not rejected by the shareholders. Mostly, this has resulted in better governance of public companies.

Another way of deterring inappropriate conduct is when company insiders know in advance that a decision will be subject to shareholder approval, this changes the nature and content of the decision itself. For example, entry to a new market or entering into a major transaction, etc. Due to disclosure requirements, management would be forced to justify and evaluate pros and cons, under a conflict of interest situation.

Disclosures on related party transactions would highlight if some shareholders are taking more than their share as directors’ remuneration without declaring adequate dividends, as the basis of distributing profits.

Another area that highlights proper governance mechanism is the communication of judgments and estimates made in preparing the financial statements. The 2008 financial crisis brought to light the inadequate nature of disclosure of risks associated with the business and also the inadequacy of minimum disclosure regime encouraged by accountants and auditors. Needless to say, it’s not easy to provide investors with a complete understanding of the underlying economic effects of transactions and account balances through disclosures in financial statements. The Investor relations unit should handle information needs of institutional investors, in addition to the required disclosures.

Lack of transparency in financial reporting, affects investor trust, especially when it occurs in financial institutions. When this happens the overall stock market will decline and underperform . Consequences of inadequate disclosure therefore can affect the broader economy as investors will stay away from the capital market.

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About surenraj

“Views expressed are my own”
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