THE SORRY STATE OF DISCLOSURE PRACTICES IN PAKISTAN
Financial disclosure has always been a very sensitive issue in Pakistan but now as Pakistan opens up its economy to international business practices this is an area where we have to do a face-lift
By Khurram Baig
Oct 13 - 19, 1997
Today's business community in Pakistan is now exposed to a whole new set of boundaries and if it is to keep pace with international requirements and in the process become an integral part of the global business village it will need a revamped financial reporting system that provides truly comparable financial statements and greater disclosure of risks and uncertainties.
This new system if ever legislated and more importantly, implemented would better protect investors and managers alike from the kind of unpleasant surprises associated with unforeseen business failures and financial setbacks.
It is a fact that the advent of more intense foreign competition plus today's more rapid pace of technology and more volatile economic and political conditions all have added new complexities to the judgments managements must make.
Perhaps it is time that Pakistan also adopted an internationally comparable process of preparing and presenting financial statements that incorporate greater disclosure of risks and uncertainties. These statements would better protect investors and also help companies in such activities as conducting corporate surveillance, extending credit to customers , evaluating alternative suppliers and potential partners for international alliance and joint ventures, raising capital abroad and investing in foreign securities. It goes without saying that the demand for disclosure will become stronger and stronger but before any steps can be taken to move in this direction we need to look at the state of disclosure practices in Pakistan, the disadvantages of the current practices, how to go about in improving those practices and then at the potential advantages of having a more efficient and transparent system of financial reporting.
The growing need for disclosure
Disclosure is a part of an evolutionary process. In a democratic setup, the demand for disclosure automatically increases. This is because all of the people directly or indirectly involved with the company in question will want to be able to quantify their risk. The right to information will slowly envelope all folds of activity and hence people will exercise that right on an increasingly frequent basis. These include first of all the shareholders followed by the customers, the regulatory authorities, the employees, the lenders and also social pressure groups, although not necessarily in that order. Shareholders will want to know if their capital is safe and whether the investment that they have made is viable or not. To be able to assess this they need to know as much about the company as possible. The customers need to know about the quality of the product they are buying, they need to know about the manufacturing process to see if there is any risk to their health involved. For example a diabetic will want to know if he can use the product or not and so will people with allergies. Social pressure groups include those covering the environment, child labour, working conditions, wage scales and other factors that have social implications. They will also demand access to such information which until recently has been and to a great extent still is classified information. Similarly all the parties that have financial and business dealings with a particular company will want to know the viability and financial strength of the company.
Among some of the standards that are followed internationally, the most prominent are the GAAP. These are generally accepted accounting principles and their primary principle is to help accountants provide relevant and comparable information. In other words, financial accounting practices should be produce information that is of relevance to the decisions made by financial statement users. The information should also allow them to compare companies. These comparisons are more likely to be useful if all companies use the same practices. GAAP identify uniform practices that make financial statements more understandable and useful.
GAAP were basically developed through common usage. A practice was only considered good if it was acceptable to most accountants. This history is still reflected in the term "generally accepted". GAAP consist of both broad and specific accounting principles. Broad principles are rooted in long-used practices. More specific principles usually result from the work of authoritative bodies and are described in the official pronouncements published by these bodies. One has to understand that accounting principles are not natural laws like the laws of physics or other sciences but are identified in response to the needs of the users and others affected by changes in accounting. And the primary source for GAAP is the Financial Accounting Standards Bureau.
The reason we mentioned the GAAP here is because among other things, the need for GAAP arose to facilitate the users of financial reports and so it led to not just better reporting but fuller and more complete reporting.
However as the accounting profession grew, the need for more specific rules and regulation were needed and the International Accounting Standards Committee (IASC) was formed by a group of the leading countries of the world and since its formation in 1973 the IASC has issued 26 new accounting standards
Similarly the Securities and Exchange Commission in the United States has among other things, taken upon itself to ensure that companies make prompt and proper disclosure and also ensure that disclosure is made in such a way that it is easily understood by all those that use it.
Mandatory or voluntary
Do the reporting and disclosure practices of the listed companies provide the required information? The inadequacies are on the companies' reluctance to spell out their objectives, account for poor performance or offer detailed data about operating performance. So apart from the obvious need for disclosure one question is whether the required information should be provided voluntarily or whether it should be mandatory.
Lack of reliable data exacerbates the quality of the information that lacks in many respects. What should then be the detail and level of information? Is a recipe available for corporate disclosure? The quality of data serves as an influencing factor in investors' decision making. Investors not only want companies' objectives to be clearly stated, they also want to know "whether or not companies have met those objectives, and if not, why notand what the companies plan to do about it."
The information revolution has raised the expectation level of the reader and as such his appetite for information has grown. While disclosure requirement may be mandatory, it is generally observed that one which comes voluntarily has more weight. In a recent study it has been found that in the matter of corporate disclosure Swedish, Canadian and French companies offer the most information in the text portion of their annual reports with the US tied with Britain for fourth place.
US statutory disclosure requirements are the best in the world. But in terms of voluntary disclosure, US companies lag behind UK and France. The study discloses,the distinction between voluntary and mandatory disclosure is critical because in case of mandatory requirement everyone has access to the same information. The only way a company can give added value in its reporting is through voluntary reporting.
Besides, if for example in a country like Pakistan we were to make full disclosure akin to the 10K and 10Q reports in the United States, mandatory, rather than improving the situation all we would achieve would be an increase in the size of the black economy and also in the process cause the closure of many businesses as financiers back out once the actual condition of such companies is revealed. This is because, disclosure in Pakistan is as alien a concept as paying taxes honestly, perhaps even more so. In fact the two have a lot in common and increased disclosure among other things would automatically reduce chances for tax evasion.
Pakistan has never been a democratic society until recently and therefore the government as well as the bureaucrats have been totally immune from any kind of political accountability. It was a more or less self serving setup that we have had here for the most part of our independence and this attitude has permeated all levels of society. The government never presented itself as accountable or ever believed in sharing everything with the people of the country and in the same way, companies have also been following similar practices. One of the biggest deterrents to the establishment of better disclosure practices was and still is the absence of an independent and credible legal system capable of enforcing regulations.
Besides it was not in the interest of governments to encourage disclosure. For example if we look at banking laws before the recent reforms, banks were forbidden by law to disclose loan loss provisions. This figures because it is now becoming apparent that the bulk of the bad loans were politically directed. besides a lack of disclosure helped the government to cover black holes in advances' portfolios. As we move towards a free market economy, the demand for disclosure will increase and while a lot has been done, at least in banking, a lot still needs to be done. Disclosure practices in the textile sector to name just one are terrible but there are problems all across the spectrum. In Pakistan it is not so much because of the lack of laws but more because of the lack of implementation and because of a lack of business ethics. Even if the existing laws were fully implemented or followed, the situation would be a million times better than it is right now.
The lack of disclosure on the part of corporates in Pakistan has a lot of disadvantages for all those involved. Be it the management, the suppliers, the lenders, the customers or the investors, all are at a disadvantage because of the lack of sufficient disclosure.
For example, unless the investor or share holder who has capital stuck in the company knows whether the company is in a position to give him an adequate return would most probably be comfortable investing elsewhere. A supplier or lender with no information about the credit-worthiness of a client because of faulty disclosure will probably take his business to other well known corporate entities. In short, lack of disclosure means the lack of any information about the future potential of a company and this can result in a backing off of investors both local and foreign.
The lack of disclosure entices managers to indulge in unacceptable practices; inter-company transactions lose credibility and share holders suffer. It is the lack of proper disclosure laws that have caused mishaps like the Mohib case, the loss of millions of rupees to share holders in the companies of the Tawakkal Group and other similar instances where company numbers were doctored to depict a false impression of prosperity. The case where funds were misused by the management of Paramount Spinning could also have been avoided or at least predicted by the share holders had the management accorded them full disclosure of the company's financial position.
Who is involved
The question here is about financial reporting and whether it is adequate or not. To be able to answer that question we need to look at the parties involved in the preparation of such a report and where the fault lies. The process of communicating financial information not only requires a clear statement of objectives but also demands that the participants in the process be identified because each has a significant responsibility and concerns attached to his role.
We believe that the three main participants in the preparation of a financial statement and ensuring its validity are the management, the auditors and the regulators or the government.
Most observers of the financial reporting process would agree that the management has a primary responsibility to keep investors and creditors informed of the financial condition and result of operations of the corporation and at the same time seek to maximize the wealth of stockholders. Unfortunately however, fulfilling both these responsibilities suggests a conflict of interest.
On the one hand the management will wish to disclose enough information to investors and creditors to maintain their confidence and to cultivate new sources of capital. For a company in an unstable or unusual financial condition, disclosure of too much information could result in precisely the opposite: withdrawal of investor support and closing off of capital sources. So it has to be a balance between the two, of course there can be no compromise on the honesty of the disclosure, no matter what the risk to the company.
The second very important role is the one played by the auditors. The usefulness of financial information is dependent as much on faith with which users accept the information as on the information itself. The user of a financial report must be satisfied that the auditor has understood and evaluated the information in the statements and that his testimony is a fair one. Therefore the auditor has an initial responsibility to bring to his task a comprehensive knowledge of the accounting model, a familiarity with the complexities of information systems, and an understanding of the economic substance of the transactions of the enterprise. The auditor has another responsibility, often overlooked that not only must his performance and commitment be entirely professional, it must also appear so to the users of the information. Regardless of the degree of expertise and integrity he brings to his work, unless he can convince outsiders of the reliability of his work, it remains valueless to them.
Unfortunately, the auditor cannot simply perform his particular task and present it to the users. He must instead assume the initiative of educating the users about the nature and function of an audit, and demand that the profession continually reaffirm, publicly and privately, its allegiance to the highest standards of accounting measurement and financial reporting.
The third most important role is that of the government as the regulatory authority, which in our case is the State Bank of Pakistan for banking institutions and the Corporate Law Authority (CLA) for listed companies be they financial companies or not. These regulatory authorities need to make sure that laws are formulated that adequately cover the disclosure requirements of the users. Then they have to make sure that the laws are implemented in letter and spirit and that companies do not get away by fulfilling just the bare minimum that the law requires. As a rule disclosure requirements are usually enforced by regulatory bodies because they represent a check on the behaviour of managers.
Now for the report to be accurate, easy to understand and for it to be in compliance not just with existing laws but also with general business ethics, the onus is on the accountants, the auditors and the regulators. Of course it is imperative that they should know of the GAAP and other such loose or specific regulations but more importantly, they need to be honest. There is the generally accepting auditing standards or the GAAS which are the rules adopted by the accounting profession as guides in conducting audits of financial statements and it tells auditors what they must do in their audits. Even if disclosure laws are followed, unless accountants and auditors fulfil their obligations completely, financial reports can be both misleading as well as cryptic.
Objectives and advantages
The readers are more interested in the objectives the company has achieved and also why did it otherwise fail to achieve the same. And as a sequel actions the company formulates to take care of eroded performance. This is the result of the increasing opportunities of investments and the investors need to make a fair assessment. Result oriented and information based companies are likely to brace the confidence of the investors.
Information which is provided to the readers is either mandatory or one that is provided under a strategic plan whereby the company voluntarily provides information to the clients and investors. In case of Pakistan there is now a growing awareness that information that is better presented and better understood improves the image of the company and carries a long-term impact. While the regulatory authorities have provided guidelines for disclosure requirements of listed companies, nevertheless, administration over such requirements is feeble.
Investors from outside then need to have information of the type and level that they are used to in their global dealings. As such mandatory or by default the seekers of foreign investment need to comply with such requirements. A lot of improvement is discernible in the information that is now been provided by local companies. The narrative as well as quantitative information provided by listed companies has considerably improved. Although majority of listed companies are still lagging behind nevertheless general awareness to provide improved information augurs well for those who are inclined towards that thinking.
As source of data, the institutional investors prefer annual, quarterly and interim results. The quality of information and its disclosure also speaks of how the company wants to be in contact with the outside world. The quality of the information and its sensitivity vis a vis the core operations of the company is more relevant than the quantity.
The more the company keeps the clients, customers and investors aware of its activities and objectives the more it is likely to gain the confidence of such groups. To attract foreign investment in Pakistan, the corporate sector must open itself to scrutiny by overseas investors and hence should improve on disclosure and reporting practices.
Chairman of the SEC, Arthur Levitt issued a challenge to all SEC employees to find the worst piece of "gobbledygook" and transform it into plain English. The "before" language can originate either from within the SEC or from a document submitted to the Commission by the public. A $250 U.S. Savings Bond was offered as an award for the best entry.
Chairman Arthur Levitt said, "What is the point of disclosure if the people who need it most don't understand it? This contest will heighten the awareness of everyone at the SEC that communicating in plain English is the best way to serve investors. Gobbledygook must go!"