Hong Kong should regulate towards more transparency?

Presentators:Mable Tang 50192529Mandy Cheng 50126041Fion Lau 50194105

Agenda

• Part I: Introduction • Part II: Market Wide Problems• Part III: Specific Problems in Annual Repor

t• Part IV: Recommendations

Part I: Introduction

Introduction

• Who demand for regulating towards more transparency?– Primary user: shareholders;– Other users: employees, creditors

• Why they demand that? Information asymmetry

Introduction

– AICPA, 1994 report, Improving Business Reporting: A Customer Focus suggested that,

effective information sharing effective functioning of capital

markets

management credibility analysts’ understanding of the firm investors’ patience and confidence share value (Eccles and Mavrinac, 1995)

Leading to

Increasing

– In Hong Kong, after financial crisis of 1997, unexpected company failures and financial scandals,

negative publicity about excessive directors benefits, investor confidence many investors and auditors have called for improving company disclosure

practices (A Study of Corporate Disclosure Practice and Effectiveness in

Hong Kong, Simon S.M. Ho and Kar Shun Wong)

Introduction

Decreasing

Leading to

– Re-develop the confidence of financial users after collapse of Enron is a must

Part II: Market Wide Problems

•Information Asymmetry •Lack of Credibility •Lack of Comparability•Dynamic of Environment•Globalization (International Trade)

1.Information Asymmetry

• Whether there is market failure for disclosure?• Window dressing is the main problem• Management level know more information

than investors, tends to hide bad news and show good position of company

• Some information not available to investors• If no full and true information provided,

investors will be misled

Benefits towards more disclosure

• More qualified and quantified information will be released, users can make better investment decisions

• More disclosure make investor more confident and enhance share value-also greatly related to survival and maximizing share value of a company

2.Lack of Credibility

• Less transparency, creditors not know whether the company is worth lending money or not

• Refer to “Enron Case”• Problem: no standardized rule for

recognition of earnings for energy

resource industry

• Energy trading earnings based on mark-

to- market accounting

• Companies can inflate profits by using unrealistic price forecast

• However, Enron smoothed earnings rather than inflate them- gave appearance that Enron’s earnings stream highly reliable, to pump up stock price

- creditors wrongly believed Enron has the ability to repay the debts and finally suffered great losses in the bankruptcy of Enron

3.Lack of Comparability

• Annual report is presented for general purpose to the public

• It does not fulfil the needs of any specific users

• E.g., a investor may need more detailed information on a company’s profit generating ability but not any general figures

• Although in the same industry, different companies may use different accounting policies and practices in preparing annual reports

• Thus, difficult for users (not professionals) to compare the information between different companies

4. Dynamic of Environment

• Arising of more complicated Business mode (New Economy)- e.g. E-commerce: no regulation, mostly depends on self-monitoring

• Rapid technological innovation

• E.g. use of information system (EDP department, internet)

• Chang (1998) and Lev Zarowin (1999) find the decline in value relevance of financial statement items is partially explained by an increase in technological innovation

Globalization (International trade)

• Nowadays, institutional investors, corporations and internet-based

trading invest around the globe• Globalization of capital markets has

been accompanied by calls for globalization of financial reporting

• Some problems arise:- Is it possible to have a global accounting standard?- Which convergence of financial reporting institutions will take place?- What are political and economic consequences?

• Traditional financial reporting model fails to capture economic implications of changes in a timely way

Part III: Specific problems in Annual Report

• Non-inclusive Management Report• Involuntary Disclosure • Misuse of Graphical Representation• Incapable for Disclosure of Complex Structure

1.Non-inclusive Management Report

• It includes….. - Management Discussion and Analysis

-Comment from management on operation and future development - Directors’ Report

-Guidance on the annual report - Five-Year Summary

-Tubular analysis on past five years’operation

What’s the Problem?• Merely “promise” by using exaggerated

wordings - no guideline on how should they evaluate

the company• ALL about future is Optimistic! - hinder bad news, pessimistic viewpoint• Un-audited - even audited, it that credible?• Gradual improvement in profit figure - reliable? Even under current economic

situation? - certain degree of manipulation!

2. Involuntary Disclosure

• Do you know the unique features of Hong Kong Business structure ?

• Professor Tsui, “the major weakness of such companies was a lack of accountability in terms of disclosure and the quality of disclosure” (SCMP, 10/2/02)

Studies in Hong Kong

• Of Heng Seng 100 companies - about 39% have more than 2 family members on BOD - about 38% have a chief executive being the chairman as well (15% coming from the same family)

Lower level of voluntary disclosure!!

Why’s that?

• Control over company policy inevitably involve biased by majority interest (Big Family)

• “what should be included” Vs “what is requested” by SSAP - e.g. Connected party transactions• Disclose it in superficial way ?

3.Misuse of Graphical Representation

• Techniques for misleading: - missing baseline - over-extended & multiple scales - optical illusions - omission or obtrusive

gridlines…..etc….• Is that a need to regulate ?

Example: VTech Holding Limited

• Electronic Sector….• According to the research by Dr. Courtis, Electronic & Component Industry had around 33% graphical

misrepresentation for turnover in 1994-95• Annual Report used: 2000/01

Comments:

1/ Not clear Zero-baseline

10.212.5 12.5

7.8

-11.7

7.49.4 9.1

4.4

-15

-20

-15

-10

-5

0

5

10

15

1997 1998 1999 2000 2001

%

EBITDA/SalesEBIT/Sal e s

Comment:1/ No zero baseline2/ Scale - misleading?

731842

9611046

1335

0

200

400

600

800

1000

1200

1400US$'M

1997 1998 1999 2000 2001

Turnover

So, up till now…

• Again, Do you think it is a need to have

more regulations on transparency?

4. Incapable for showing Complex Structure

• Growth of Multinational Business Entity• Rise of E-commerce “Business Entity” - Without Physical office or even selling

pure services (online movie)• Active Merger and Acquisition activities - SSAP not have the best measure for

this• Is traditional accounting adequate?

Part IV: Recommendations

Recommendations

• Enable the management level and outsider receive the same level of information as to avoid information asymmetry

• Standardized rule for recognition of earnings as to ensure borrowing credibility

Recommendations

• Specific reports should be generated for specific users in future financial statement

(Accounting Theory, Ahmed Riahi Belkaoui)

– Public reporting of corporate financial forecasts• Provide information useful for the

predictive process when it will enhance the reliability of users’ prediction

(Trueblood report)

• Rules should be generated to identify and measure earnings in e-commerce transactions

• Calling for regulations on globalization of financial reporting

• Credibility of management disclosures should be enhanced by regulators, standard setters, auditors and other capital market intermediaries

(A review of the empirical disclosure literature, Paul M. Healy and Krishna G. Palepu)

Recommendations

Recommendations

• Concern on providing “Quality ” information rather than just “Quantity”. FASB says, it should be– Relevant– Timely– Understandable– Reliable– Neutral– Representationally faithful (Accounting Theory, Eldon S. Hendriksen and

Michael F.van Breda)

Incentives for Regulating towards More Transparency

Leading toLevel of Disclosure

StockLiquidity

Proved by Healy et al. (1999a)

Incentives for Regulating towards More Transparency

Leading toLevel of Disclosure

Cost of Capital

Proved by Botosan (1997)

Incentives for Regulating towards More Transparency

Leading toLevel of Disclosure

Information Intermediation

Proved by Lang and Lundholm (1993)

Conclusion

• Regulating towards more transparency enables to disclose all relevant and material information to the user. Credibility of the financial report will then be increased. So, the users to have more confident on relying the financial report in making informed decision.

Reference List• Annette Chiu, Attitudes must change before clear corporate picture seen

South China Morning Post; Hong Kong; Feb 10, 2002.• Ben Kwok, Governance makes gains

South China Morning Post; Hong Kong; May 31, 2000. • Hendriksen, Eldon S. Accounting theory 5th ed. Homewood, Ill. : Irwin, c1992.• John E. Core, A review of the empirical disclosure literature: Discussion, Journal of Accounting and Economics, Volume 31, Issues 1-3, pp441-456, September 2001. • Paul M. Healy & Krishna G. Palepu, Information asymmetry, Corporate disclosure, and the capital markets: A review of the empirical disclosure literature, Journal of Accounting and Economics, Volume 31, Issue 1-3, pp.405-440, September 2001.• Riahi-Belkaoui, Ahmed, Accounting theory . 3rd ed. Fort Worth : Dryden Press : Harcourt Brace Jovanovich, c1993.• Simon S.M. Ho & K.S. Wong, A Study of Corporate Disclosure Practice and Effectiveness in Hong Kong, Journal of International Financial Management and Accounting, 2001.