Unethical practices in financial statement analysis

The financial sector plays a vital role in fostering economic growth, providing funding for businesses, and facilitating trade and investment in Bangladesh, like many other countries. However, the sector has increasingly become stained by unethical and immoral activities, particularly concerning the integrity of financial statements. Financial statements, which serve as the cornerstone for decision-making by investors, creditors, and regulators, are often manipulated to present a misleading picture of an organisation’s financial health. The impact of such practices on stakeholders and the necessary reforms to restore transparency and trust in the country’s financial system need careful analysis.

The Role of Financial Statements in Economic Stability: Financial statements—including the balance sheet, income statement, cash flow statement, and statement of changes in equity—are essential for gauging a company’s financial performance and position. Investors rely on these reports to assess the profitability and risk associated with a business, while regulators use them to ensure companies comply with financial standards and laws. In Bangladesh, the Institute of Chartered Accountants of Bangladesh (ICAB) is tasked with setting financial reporting standards, primarily guided by the Bangladesh Financial Reporting Councils (BFRC).

Commonness of Unethical Practices in Financial Reporting: Fabrication and manipulation of financial data. Many companies in Bangladesh are involved in fabricating financial data to mislead investors, regulators, and the public. Many firms inflate revenue figures to present a facade of profitability and growth, aiming to attract investors and inflate stock prices. Companies often conceal liabilities or report them at lower values to create the illusion of financial stability. Hiding operational losses or shifting them into future periods, commonly known as “smoothing” earnings, is a strategy many organisations use to avoid reporting negative results. This fabrication of data not only undermines the decision-making process and raises questions about the ethical standards followed by corporate management and auditors.

Creative accounting practices. Creative accounting refers to manipulating accounting policies within the legal framework but in ways that deceive stakeholders. In Bangladesh, creative accounting practices often include: (i) Inflating asset values, such as real estate or inventory, to improve the appearance of the balance sheet. (ii) Changing depreciation methods or adjusting the useful life of assets to reduce expenses and increase profitability in the short term. (iii) Some companies recognise revenue before the actual sale or delivery of goods or services, violating the revenue recognition principle.

While these practices may technically comply with accounting standards, they undermine the accuracy of financial reporting and erode stakeholder confidence.

Agreement between management and auditors. In Bangladesh, agreement between corporate management and external auditors is another prevalent issue. Some auditors, often due to financial incentives or pressure, overlook discrepancies or fail to highlight questionable accounting practices in their audit reports. This lack of independence in auditing has led to a culture of impunity where companies believe they can manipulate their financial statements without facing consequences.

Effect of Unethical Practices on the Financial Sector: Erosion of investor confidence including foreign investors. Investors rely heavily on financial statements to make informed decisions. When these reports are found to be inaccurate or manipulated, they erode investor confidence, leading to reduced investment in the market. This not only affects individual companies but can also have far-reaching implications on the stock exchanges, such as the Dhaka Stock Exchange (DSE) and Chattogram Stock Exchange (CSE), potentially destabilising the entire financial system.

Regulatory oversight and disappointments. Despite the presence of regulatory bodies like the Bangladesh Securities and Exchange Commission (BSEC), instances of fraudulent financial reporting continue to rise. Regulatory oversight is often weak due to a lack of enforcement, insufficient resources, and, in some cases, political influence and bureaucratic complexity that hamper the imposition of penalties on large or influential corporations. The failure to hold companies accountable for unethical financial reporting has created a climate of complacency, further perpetuating the problem.

Economic significances. The manipulation of financial statements can have a severe negative impact on the economy as a whole. Companies that inflate their performance are often awarded large loans from financial institutions, creating a systemic risk in the banking sector. When these companies fail to generate the profits reflected in their falsified statements, they default on their loans, leading to a surge in non-performing loans (NPLs), which remains a significant issue in Bangladesh’s banking industry.

Origin causes of unethical financial reporting. Several underlying factors contribute to the prevalence of unethical practices in financial statement reporting in Bangladesh. Many companies lack strong corporate governance structures, enabling management to manipulate financial data without checks and balances. Auditors often face pressure from management or are financially dependent on the companies they audit, leading to biased audit reports. Despite the presence of laws and regulations, enforcement is often inconsistent or ineffective, allowing unethical practices to go unpunished. A culture of non-compliance and impunity, where unethical behaviour is tolerated or encouraged, exacerbates the problem of financial manipulation.

Suggestions for Improving Financial Reporting Standards: Strong Corporate Governance. Improved corporate governance practices, such as independent oversight from boards and audit committees, can help ensure that management adheres to ethical standards in financial reporting. Accountability must be enforced at every management level to foster a culture of transparency.

Ensuring auditor independence and improvement. Audit firms in Bangladesh play a critical role in ensuring transparency, accuracy, and compliance in financial reporting. Their key responsibilities include (i) Financial Statement Audits, (ii) Compliance Assurance, (iii) Fraud Detection and Prevention, and (iv) Investor Confidence.
Ensuring auditors’ independence is crucial to maintaining the integrity of financial reporting. To avoid conflicts of interest, audit firms should rotate more frequently, and auditors should not be allowed to provide non-audit services to the same clients.

Healthy regulatory framework: All Regulators must take a more proactive stance in monitoring financial reporting. Enhanced surveillance, stricter penalties for non-compliance, and consistent enforcement of financial reporting standards are necessary to curb unethical practices.
Thus, the pervasiveness of unethical practices in financial statement reporting in Bangladesh poses a significant threat to the credibility of the financial sector. Fabricated financial statements mislead investors and regulators and create systemic risks that can weaken the economy.

The author is an experienced CEO of Investment Bank and AMC.
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